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Bull of the Day: Southern Company (SO)

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2018 hasn’t been a great year for energy and utility stocks. The threat of rising interest rates has made the yield on these historically high-dividend companies look relatively less attractive and the energy sector as a whole is down 10% on the year and the third worst performer in the S&P 500, behind only materials and financials.

In some cases, high levels of debt as a result of expensive acquisitions and capital intensive projects threaten the future of dividend payouts. The combination of ballooning construction costs and regulatory control over the rates charged for energy have put the squeeze on energy companies who find themselves overextended.

The sheer size of a project to build new power generation facilities and the associated transmission infrastructure - along with a limited ability to raise end-user prices at will - leaves these companies with little margin for error when undertaking new investments.

Certain energy companies still pay attractive dividends however, and Atlanta-based Southern Company (SO - Free Report) is one of them, yielding better than 5% annually and management is making a concerted effort to shore up the balance sheet and continue returning cash flow to investors.

Bucking the Industry Trend Toward Acquisitions

Unlike several of its competitors, Southern Company has been actively divesting some of its ancillary interests to raise cash and reduce debt. Having been involved in some expensive and troubled projects in the recent past, Southern recently sold its interest in Florida’s Gulf Power to NextEra Energy (NEE - Free Report) for $5.1B in cash and the assumption of $1.4B in debt.

Southern Company shares have also been depressed lately over concerns about the fate of the Vogtle Nuclear plant, a project in which the company owns 46%. The costs of the project have gone from an initial estimate of $14.5B in 2008 to over $27B – and the plant had been intended to be completed by 2016 but is currently only about halfway done.

The cost overruns and delays triggered covenants in the agreement that will allow the other partners in the Vogtle project to vote to discontinue construction. Initially, it seemed that Southern Company might be on the hook for a significant portion of what’s been spent already - and also cleanup costs - of $4B or more and the markets soured on SO shares as the situation played out.

Now however, it seems as though the absolute worst case scenario is that even if the whole project is scuttled, Southern will have less than $2B of exposure and there’s a good chance that the project will continue to completion.

Because of the discipline Southern has been exhibiting, it is an excellent candidate to avoid most of the debt problems that are afflicting other energy companies. By focusing on its core strengths, Southern has seen forward earnings estimates revised upward of late. It is currently a Zacks Rank #1 (Strong Buy).

In examining the results of a utility company, other metrics are more important than simple net earnings. Southern handily beats the industry in return on equity (13.1% vs 7.1%), return on assets (3.0% vs. 2.1%) and return on capital (4.8% vs. 3.4%). Though its debt load remains higher than industry averages, management is clearly working hard to reduce it without jeopardizing the dividend.

Though companies that pay out 87% of cash flows as a dividend have a lower chance for significant capital appreciation – and thus look relatively boring during raging bull markets – that income certainly starts looking a whole lot more interesting when the broad markets get choppy.

Dividends are an often overlooked component of total return in a balanced portfolio and can help dull the pain sometimes experienced in growth stocks. The management at Southern Company definitely seems to understand this concept and is taking aggressive measures to ensure it.

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