Dividend Safety Analysis: Southern Company (SO)

This week, I will be taking a look at the dividend safety of Southern Company (SO). If there are other companies you would like me to analyze for dividend safety, please leave a comment at the bottom of this article.

 

My full thesis on Southern can be seen here, but I will be focusing on the company’s Dividend Safety Score in this article.

 

Before analyzing Southern’s dividend, let’s review how the company makes money. After all, the most effective investors understand that one of the best pieces of investing advice is to only invest in simple, easy-to-understand businesses.

 

Southern Company has been in business for more than a century and is a major producer of electricity in the United States.

 

The company’s four regulated utilities service roughly 4.5 million customers residing in Georgia, Alabama, Florida, and Mississippi.

 

In addition to its regulated utility operations, which generate approximately 90% of earnings, the company also has a small wholesale energy company.

 

By power source, coal generated 33% of Southern Company’s total megawatt hours in 2015, gas accounted for 47%, nuclear was 16%, and hydro power was 3%.

 

Investors should note that Southern Company’s business mix materially changed in July 2016 as a result of its $8 billion acquisition of AGL Resources.

 

AGL Resources is a natural gas utility. As a result of the merger, Southern is now the second-largest utility company in the U.S. in terms of customer base.

 

The combined company has 11 regulated electric and natural gas distribution companies providing service to 9 million customers.

 

Its energy mix has shifted from 100% electric to a 50/50 mix of electric and natural gas.

 

Southern Company’s Dividend Safety

I created a Dividend Safety Score metric to help conservative investors find the safest sources of dividend income for their portfolios.

 

Dividend Safety Scores analyze a company’s key fundamental metrics and answer the question, “Is the current dividend payment safe?”

 

Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak.

 

Dividend Safety Scores have flagged a number of major companies as high risk stocks before they cut their dividends.

 

Kinder Morgan, BHP Billiton, Potash, and ConocoPhillips are some of the companies that scored in the bottom 10-20% for Dividend Safety before announcing their dividend cuts.

 

Since we started tracking dividend cut announcements for all companies, businesses that cut their dividends by at least 50% has an average Dividend Safety Score of 6.

 

Investors can learn more about how our Dividend Safety Scores are calculated and review their track record here.

 

The utility sector is one of the safest areas for dividend income. However, that doesn’t mean all utilities are solid income plays.

 

Fortunately, Southern pays one of the most reliable dividends in the market as indicated by its Dividend Safety Score of 89.

 

Southern Company has paid uninterrupted dividends every quarter since 1948 and increased its dividend by 2.9% per year over the last 20 calendar years.

 

 

Investors have enjoyed higher dividends from Southern for 15 consecutive years, and it wouldn’t surprise me if the company ultimately joined the dividend aristocrats list in 2026.

 

Simply put, Southern Company has been one of the most predictable and dependable dividend stocks in the market for more than six decades.

 

Some investors are surprised by the company’s dividend reliability when they see its relatively high payout ratio, which sits above 80%.

 

The payout ratio measures how much of a company’s earnings are paid out as a dividend. High payout ratios can be riskier because there is less wiggle room to continue paying dividends if earnings unexpectedly decline.

 

Southern’s elevated payout ratio doesn’t concern me because it generates extremely steady earnings. Many utility companies can maintain relatively high payout ratios compared to most businesses because their financial results are so stable.

 

While two of the company’s major capital projects have experienced delays and cost overruns (read my thesis for more information), I do not believe they impair Southern’s long-term earnings power.

 

As seen below, the company has recorded stable profits for more than a decade. Earnings fell by less than 10% during the financial crisis as well because people continued to need electricity to power their homes.

 

 

Earnings stability has resulted in a consistent payout ratio. The following chart shows that Southern’s payout ratio has generally remained between 70% and 80% for the last decade.

 

 

Looking ahead, the company’s projected payout ratio based on analysts’ earnings estimates and SO’s current dividend per share is 79%, 75%, and 72% in 2016, 2017, and 2018, respectively.

 

In other words, more of the same is expected from the company over the next few years. Since the business is recession-resistant, income investors don’t need to worry much about Southern’s elevated payout ratio.

 

Return on invested capital (ROIC) is another important metric to analyze when it comes to evaluating dividend safety. ROIC measures how efficiently a company utilizes its assets.

 

Companies with higher returns can compound their earnings faster and often have competitive advantages. I like to invest in businesses with high and steady returns.

 

Regulated utilities act like monopolies in their service areas, but their rates are regulated, capping profitability.

 

As seen below, Southern generates a moderate but predictable mid-single digit return on invested capital. The dip in fiscal year 2013 (FY13) was due to write-offs on its capital projects, but the favorable regulatory environment in its key states has helped it earn somewhat higher returns than many other utility companies.

 

As Southern’s large projects go live over the next five years, ROIC should edge higher and cash flow generation will improve.

 

 

Beyond payout ratios, business stability, and asset efficiency, a company’s balance sheet makes a major impact on dividend safety.

 

Utilities are capital-intensive businesses and require a lot of debt to build and maintain their costly infrastructure.

 

Companies will always make their debt and interest payments before declaring dividends.

 

Businesses with high debt levels can be at greater risk of cutting their dividend if they unexpectedly fall on hard times. During such periods, earnings can be significantly reduced and existing cash must be preserved.

 

Southern’s balance sheet took on an additional $8 billion in debt to finance the company’s acquisition of AGL Resources.

 

Once the company reports results next quarter, its cash balance will fall by around $8 billion, leaving the business with under $2 billion in its bank account compared to roughly $38 billion in total debt.

 

Several credit agencies downgraded Southern’s debt ratings and outlook because of the company’s higher financial leverage resulting from its acquisition of AGL.

 

Moody’s slightly downgraded the company’s credit rating to Baa2, which indicates “average creditworthiness relative to other domestic issuers.” S&P also lowered its outlook on the company but continues to assign it an investment grade rating.

 

While Southern will need to improve its leverage ratios over the coming years, it’s important to recognize the benefits AGL Resources brings.

 

Gas distribution is a fairly low-risk business, and AGL operates in environments mostly characterized by supportive regulations. Southern’s increased scale and revenue diversity also lower risk.

 

I expect Southern’s debt ratios to improve over the next few years as management integrates AGL and works on completing several major construction projects.

 

Until then, the company’s consistent earnings should more than support its ongoing cash needs.

 

 

Finally, it’s always worth reviewing a company’s recent sales and earnings trends to make sure no surprises are brewing.

 

Southern Company reported earnings on July 27. Sales grew 2.7% compared to the prior-year quarter, and adjusted earnings per share increased by roughly 4%.

 

The company’s acquisition of AGL Resources closed on July 1, so all attention will turn to integrating the business and positioning it for growth.

 

All things considered, Southern’s dividend payment is very secure. The company’s scale, recession-resistant services, favorable regulatory environments, improved diversification (AGL acquisition), and proven commitment to continue paying and growing its dividend more than offset any worries about its elevated payout ratio and balance sheet.

 

Closing Thoughts on Southern’s Dividend

Southern Company is one of the most reliable dividend-paying stocks in the market. The company’s acquisition of AGL Resources stretches the balance sheet but provides healthy diversification by customer type, geography, and regulatory body.

 

As long as the company’s major capital projects don’t experience any more negative developments and merger integration work remains on track, Southern should continue to provide stability for years to come.

 

With a healthy dividend yield of 4.4% and the potential for 3-5% annual dividend growth going forward, Southern Company is a favorite investment for retired income investors.

 

The stock doesn’t look particularly cheap with a forward P/E ratio of 18.0, but the dividend should remain solid.