Southern Exposure

In October 1997, I bought my first shares of Southern Company (NYSE: SO) through the company’s direct stock purchase plan. Over the past 16 years, I’ve reinvested all my dividends for a total return of about 600 percent.

There have been ups and downs along the way. Southern Company’s aggressive foray into unregulated power generation and marketing ended with the bankruptcy of the former Mirant Corp, a division that the utility spun off in 2001. The stock also didn’t escape the carnage of 2008, with the share price sliding to a low of $26.48 on March 10, 2009, from a high of $40.00 on Sept. 17, 2008.

However, Southern Company has grown earnings steadily since 1997, benefiting from population growth in the Southeast communities it serves. Salutary relationships with state and local officials have ensured that rate increases have compensated the company for investments in system expansions and upgrades. Most of these rate hikes have been approved without major delays.

As is the case with all electric utilities, Southern Company’s earnings fluctuate seasonally. But the company has reliably grown its dividend at a quarterly rate of $0.0145 per share over the past four years.

Management’s current forecast calls for more of the same, with capital spending to reduce emissions from Southern Company’s power plants likely to drive growth.

Cutting into Carbon

On June 26, 2013, President Barack Obama issued a presidential memorandum directing power generators to reduce their emissions of carbon dioxide (CO2). As the owner of one of the nation’s largest fleets of coal-fired power plants, Southern Company ostensibly face a significant challenge.

But the utility is already well ahead of the game, having invested more than $5 billion to install equipment that reduces harmful emissions of mercury, sulfur dioxide and nitrogen oxides. The firm has also lowered its CO2 emissions by reducing coal to 35 percent of its generation mix from about 70 percent five years ago.

Southern Company’s long-term plan aims to give the utility the ability to switch between coal and natural gas at will to take advantage of potential arbitrage opportunities while meeting regulatory standards for CO2 emissions.

Renewable power also fits into Southern Company’s business plan. The company has targeted a tenfold increase to its investments in solar power and is eyeing opportunities to buy or build biomass-fueled power plants. Meanwhile, the utility is building a coal-gasification facility in Kemper County, Miss., that will dramatically reduce harmful emissions.

Finally, Southern Company is constructing two nuclear reactors at the existing Vogtle Electric Generating Plant, located in eastern Georgia. The modern design of these plants eliminates a host of safety concerns associated with previous generations of nuclear power plants. President Obama highlighted the Vogtle project in his June 25 remarks on climate change as signs of the nation’s progress in reducing CO2 emissions and securing energy independence.

Although Southern Company continues to negotiate terms of a federal loan guarantee to support the construction of these nuclear reactors, this backstop may not be necessary. Quasi-governmental entities collectively have a roughly 50 percent interest in the project, while the utility recovers building costs automatically via rate increases.

Over the past three years, Southern Company has spent approximately $13.4 billion on what management refers to as “property additions.” We expect the utility to maintain this pace of investment over the next three years, leaving ample room for earnings and dividend growth–assuming that regulators in its operating footprint remain supportive.

If relations with regulators deteriorate, Southern Company’s dividend growth will stall out as it did in 2001–the last time that the utility failed to raise its payout in a given year.

Regulatory Watch

In the 27 years that I’ve tracked the utility industry, I’ve found that regulatory disasters are akin to a slow train coming around a bend in the track. Accordingly, there’s usually plenty of time for investors to get off the tracks. That being said, it’s easy to put off a decision to sell, even when the locomotive is bearing down on you.

In the case of Southern Company, the slow train is still off in the distance and likely to switch tracks.

Although we expect the utility to benefit from a pick-up in industrial development in the Southeast, investors should keep their eyes on a few potential challenges.

Southern Company’s Georgia Power unit has filed for permission to increase rates by 6.1 percent to compensate the utility for investments in system upgrades. The Public Service Commission will hold hearings in the fourth quarter, with a final decision expected by Dec. 17, 2013.

The rate case coincides with a potentially much more important proceeding regarding Georgia Power’s long-term investment strategy, which includes closing or converting 15 coal-fired power plants (2,100 megawatts of capacity) to burn natural gas. The start-up of the two new nuclear reactors at the Vogtle power plant will offset these capacity losses.

At present, Georgia Power recovers the cost of constructing these reactors as they are incurred–a starkly different situation than when the company built the complex in the 1970s and got stuck with a huge write-off for its troubles.

Although regulatory support for the Vogtle expansion hasn’t wavered, major credit rating agencies have cut their outlooks for Southern Company and Georgia Power, as well as fellow stakeholders Oglethorpe Power Corp and Municipal Electric Authority of Georgia. The reason for the downgrade: Concerns about further cost overruns. This assessment, which is shared by the five Wall Street research analysts that have a Sell rating on Southern Company, reflects the travails of the last major building cycle in the 1970s and 1980s.

Even in the unlikely case that the Public Service Commission denies Georgia Power’s rate hike or delays cost recoveries on the Vogtle expansion, Southern Company won’t be derailed immediately. As the company has recovered costs as incurred thus far, only its return on future investment would be at risk.

The utility also faces challenges at its Kemper coal-gasification plant that’s under construction. Mississippi Power, a subsidiary of Southern Company, has agreed to absorb future cost overruns associated with the project and took a $540 million charge in April 2013 to account for the difference. In subsequent months, the company has identified another $160 million in extra expenses that could be incurred before the power plant comes online in 2014.

But it’s not all bad news in Mississippi: Regulators have already approved the return of $2.4 billion of the plants costs, signed off on the issue of $1 billion in bonds to support the project, and passed a 15 percent rate increase to help pay off the project. Coupled with the $540 million write-off in April, Southern Company is only on the hook for the remaining $160 million in overruns–a drop in the bucket for a company of its size.

At this stage, the only risks are that cost projections will continue to rise and regulators will remain unsympathetic.

Leaning Bullish

Shares of Southern Company hit an all-time high of $48.74 on April 22, 2013, and have pulled back to the low $40.00s in recent weeks. 

Source: Bloomberg

This correction reflects weakness in the Dow Jones Utilities Average, as opposed to stock-specific factors. Despite the unanimously negative outlook from credit rating agencies, Southern Company’s 30-year bonds still yield less than 4.5 percent to maturity–about one percentage point more than equivalent US Treasury bonds.

Like most utilities, Southern Company’s stock exhibits low volatility. The shares have an adjusted beta of only 0.51 relative to the S&P 500 and 0.333 relative to the 10-year Treasury note. This suggests that the ill-informed selloff in shares of Southern Company because of the stock’s sensitivity to interest rates could reverse.

The Verdict

Shares of Southern Company are a bargain after the recent correction. We will continue to monitor events surrounding the Kemper and Vogtle projects closely in Conrad’s Utility Investor.

Roger S. Conrad is founder and chief editor of Conrad’s Utility Investor, Capitalist Times and Energy & Income Advisor.