Thesis For Growth
To be perfectly blunt, there really isn’t much of a growth thesis for The Southern Company (NYSE:SO). Founded in 1945, Southern Company is an electric utility company that serves over 4.4 million customers in Alabama, Georgia, Florida and Mississippi. As a regulated utility, the company is better known for its high payout ratio rather than exceptional growth.
Earlier this month, value investor Mohnish Pabrai took part in a Q&A session with William & Mary College students. Q3 2021 hedge fund letters, conferences and more Throughout the discussion, the hedge fund manager covered a range of topics, talking about his thoughts on valuation models, the key lessons every investor should know, and how Read More
Yet that doesn’t mean an investment in this slow-grower can’t still be worthwhile. For one thing – like most utilities – The Southern Company (NYSE:SO) is effectively a monopoly that is allowed to give its shareholders “reasonable” returns. So immediately an investor is less worried about whether or not the company will remain in business – after-all, you can’t just shut off the lights for millions of people overnight. Instead, an investor is probably more concerned with whether or not the current market price allows for a reasonable chance at tracking the company’s business results.
In our view, considering today’s low interest-rate environment, we believe that it would be prudent to consider Southern Company as a bond alternative rather than an equity replacement. In this way, the prospective risks and opportunities of the company are important, but they are likely to be less extreme than their equity counterpart as well.
Aside from the monopoly-like benefits of the business, The Southern Company (NYSE:SO) has also received awards such as being named the “No. 1 Electric Utility in North America”, the “2012 Energy Company of the Year” and was recently named as one of the “World’s Most Admired Electric and Gas Utilities.” As we will see in the return results below, the company has been nothing if not consistent.
Moving to the risk side of the table, Southern Company faces anything from regulation and ligation concerns to economic risks and unexpected construction delays. In turn, many of these factors – much like any other company – are out of management’s hands. For example, Morningstar analyst Mark Barnett lists nuclear cost overruns and emissions legislation as two uncertain cost areas; while further indicating that the deterioration of Southern Company’s positive regulatory relationships would be the most devastating risk factor. However, it should again be noted that while these risks exist, they are likely to be “watered down” in a regulated and essential utility business.
Finally, while we have thus far been describing Southern Company as a slow but steady monopoly, the company also likes to tout the fact that shareholders received greater total returns than the S&P 500 index for the last 5, 10 and 30 years. F.A.S.T. Graphs™ wrote about Southern Company a little over a year ago, indicating that it was “A Solid Dividend Choice Worth Waiting For.” At the time, Southern Company had a P/E ratio around 17.6 and a current dividend yield of 4.3%. Today, the P/E is closer to 15 and the current yield is just shy of 5%; in other words, we believe the wait might be over.
15 Years of Results
The Southern Company has grown earnings (orange line) at a compound rate of 3.2% since 1999, resulting in a $35+ billion dollar market cap. In addition, the Southern Company’s earnings have risen from $1.90 per share in 1999, to today’s forecasted earnings per share of approximately $2.74 for 2013. Further, Southern Company has paid a dividend for 263 consecutive quarters and has been able to increase this payout for the last 12 years. For a look at how the market has historically valued Southern, see the relationship between the price (black line) and earnings of the company as depicted on the Earnings and Price Correlated F.A.S.T. Graph below.
Here we see that the Southern Company’s market price has mostly paralleled its justified earnings growth; with the exception of starting to become undervalued during the most recent recession and being slightly overvalued in the last year or two. Today, Southern Company appears fairly valued in relation to both its historical earnings and relative valuation.
In tandem with the consistent earnings growth, Southern Company’s shareholders have enjoyed a compound annual return of 5.5% which correlates closely with the 3.2% growth rate in earnings per share. A hypothetical $10,000 investment in Southern on 12/31/1998 would have grown to a total value of $21,866.87, without reinvesting dividends. Said differently, Southern Company’s shareholders have enjoyed total returns that were roughly 1.5 times the value that would have been achieved by investing in the S&P 500 over the same time period. It’s also interesting to note that an investor would have received about 3.5 times the amount of dividend income compared to the index as well.
Looking to the Future
But of course – as the saying goes – past performance does not guarantee future results. Thus while a strong operating history provides a fundamental platform for evaluating a company, it does not by itself indicate a buy or sell decision. Instead an investor must have an understanding of the past while simultaneously thinking the investment through to its logical, if not understated, conclusion.
In the opening paragraphs a variety of potential risks were described. It follows that the probabilities of these outcomes should be the guide for one’s investment focus. Yet it is still useful to determine whether or not your predictions seem reasonable.
Twenty-two leading analysts reporting to Standard & Poor’s Capital IQ come to a consensus 5-year annual estimated return growth rate for Southern Company of 4.7%. In addition, Southern is currently trading at a P/E of 15, which is inside the “value corridor” (defined by the orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Southern’s valuation would be $51.37 at the end of 2018, which would be a 9.2% annualized rate of return including dividends. A graphical representation of this calculation can be seen in the Estimated Earnings and Return Calculator below.
Now, it’s paramount to remember that this is simply a calculator. Specifically, the estimated total return is a default based on the consensus of the analysts following the stock. The consensus includes the long-term growth rate along with specific earnings estimates for the two upcoming years. Further, the dividend payout ratio is presumed to stay the same and grow with earnings. Taken collectively, this graph provides a very strong baseline for how analysts are presently viewing this company. However, a F.A.S.T. Graphs’ subscriber is also able to change these estimates to fit their own thesis or scenario analysis.
Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk Treasury bonds. Comparing an investment in the Southern Company to an equal investment in a 10-year Treasury bond, illustrates that Southern Company’s expected earnings would be 2.8 times that of the 10-year T-Bond Interest. This comparison can be seen in the 10-year Earnings Yield Estimate table below.
Finally, it’s important to underscore the idea that all companies derive their underlying value from the cash flows (earnings) that they are capable of generating for their owners. Therefore, it should be the expectation of a prudent investor that – in the long-run – the likely future earnings of a company justify the price you pay. Fundamentally, this means appropriately addressing these two questions: “in what should I invest?” and “at what time?” In viewing the past history and future prospects of Southern Company we have learned that Southern Company appears to be a consistent company with reasonable upcoming opportunities. However, as always, we recommend that the reader conduct his or her own thorough due diligence.
Disclosure: No position at the time of writing.