Undervalued Dividend Growth Stock of the Week: Southern Co. (SO)

There’s an old tongue-in-cheek saying in politics: vote early and vote often.

While it’s certainly amusing when thinking about the voting process, it’s a saying that one should readily adapt when it comes to investing.

Invest early and invest often. 

If there’s just one thing I could tell the 15-year-old version of myself, it’d be that.

Compounding is an amazing thing.

It’s a superpower as far as your money is concerned.

It allows money to make more money.

But it requires a healthy dose of time in order to truly see its magnificence unleashed.

And that’s why you should invest as much as possible, as often as possible, as soon as possible. 

That’s what today’s article is all about, folks.

I’m going to, below, highlight a high-quality dividend growth stock that appears to be a compelling long-term investment right now.

It appears compelling because, first of all, it’s a great business.

As you might expect, any company that’s able to pay its shareholders increasing dividends for years on end has to do a lot of things right.

It’s nigh impossible for a terrible company to send out ever-larger checks to its shareholders. You practically cannot run a poor business and simultaneously send out increasing dividends for years or decades on end.

Investing in high-quality dividend growth stocks has literally changed my life, allowing me financial independence in my early 30s via the five-figure and growing passive dividend income my real-life and real-money FIRE Fund generates on my behalf.

Jason Fieber's Dividend Growth PortfolioThat portfolio was built by simply living below my means and investing in world-class businesses that routinely increase their dividends to shareholders.

This is why David Fish’s Dividend Champions, Contenders, and Challengers list is such a treasure trove for dividend growth investors: it contains information on more than 800 US-listed stocks that have all raised dividends each year for at least the last five consecutive years.

While I’m not stating that every stock on Mr. Fish’s list is an investment candidate for every investor at every time, there are some viable long-term ideas on the list due to the very nature of what a dividend growth stock is and implies.

However, one needs to narrow down their choices into the truly exceptional businesses that are within one’s circle of competence. That’s done through due diligence and analysis.

And even once an investor has a great long-term investment idea that makes sense, the investor also needs to make sure the valuation at the time of stock purchase is as appealing as possible.

An appealing valuation is, of course, one that represents a price well below estimated intrinsic value.

Said another way, one should aim to buy a high-quality dividend growth stock when it’s undervalued. 

That’s due to the number of benefits that undervaluation confers to the long-term investor.

These benefits are significant.

An undervalued dividend growth stock should present an investor a higher yield, greater long-term total return potential, and reduced risk. 

It’s easy to see how this plays out.

The higher yield comes about due to the way price and yield are inversely correlated; all else equal, a lower price results in a higher yield.

This higher yield should not only positively impact current and ongoing investment incom

e, but it should also positively impact total return.

That’s because total return is comprised of investment income (via dividends or distributions) and capital gain – the former is boosted via that higher yield, meaning long-term total return potential is greater.

But it gets better, because long-term total return potential is given another boost via the “upside” that exists between a lower price and higher intrinsic value.

When an investor pays much less than a stock is intrinsically worth, there’s a lot of possible capital gain that could and should come about if/when a stock is more appropriately priced by the market.

While the stock market isn’t necessarily all that good at accurately pricing stocks (pricing them in line with their intrinsic value) over the short term, price and value tend to more closely correlate over the long run.

Getting in when there’s a favorable disconnect between price and value means more possible capital gain.

And that’s on top of whatever capital gain is possible as a business naturally becomes worth more as it sells more products and/or services, increasing its profit (and thus value) in the process.

Of course, all of this serves to reduce risk.

It’s fairly straightforward to understand that it’s less risky paying less than paying more for the same, exact thing.

Undervaluation should also offer a margin of safety to the long-term investor, whereby they protect themselves against a downward revision in intrinsic value in case a business does something wrong, or in case a business doesn’t perform as expected.

While it’s easy to see how undervaluation is far more preferable to overvaluation or a fair valuation, the good news is that it’s not a particularly difficult thing to assess or take advantage of.

Thanks to fellow contributor Dave Van Knapp’s dividend growth investing “lesson” on valuation, any dividend growth investor should be able to estimate the fair value of just about any dividend growth stock out there, which allows an investor to more or less pick out the best stocks at the best values.

A high-quality dividend growth stock that’s undervalued can be a fantastic long-term investment.

This is why I’m going to now highlight a high-quality dividend growth stock that appears to be undervalued right now…

Southern Co. (SO)

Southern Co. (SO) is one of the largest utility holding companies in the United States, distributing electricity and natural gas to approximately 9 million customers across nine different states. It also has significant generating capacity that serves regulated utility customers across four different states.

Southern Co.’s energy mix (for 2016) is 47% natural gas, 31% coal, 15% nuclear, 5% renewables, and 2% hydro/other.

Southern Co. operates primarily through its regulated utility businesses, which is a fairly appealing business model due to the fact that power is necessary and ubiquitous in modern-day civilization.

A utility thus has a captive customer base – a consumer has almost always no choice but to buy this service.

It’s also a business model that’s monopolistic. There is usually just one utility choice in any one geographical area, limiting consumers’ choices as to who they buy power from.

That geographical monopolization is great from that perspective, but it also serves to geographically limit a utility company’s growth.

Because of these unique dynamics, the government heavily regulates utilities in the US.

Utility bills are often a relatively small percentage of most consumers’ monthly expenditures, which is great considering the necessity of the services and the power a utility company could wield if left unchecked.

While the regulation almost guarantees some level of profitability for a utility (based on a number of factors), making growth projects attractive on a case-by-case basis, there’s also a cap on that profitability.

As such, a utility company is typically a slow-growth investment.

But that slow growth is offset (sometimes more than offset) by the high yields most utility stocks offer.

Southern’s stock is a great example of this.

The stock right now offers a yield of 5.25%.

This yield is high in both relative and absolute terms.

First, it’s just a lot of income coming in.

It’s also more than twice the broader market’s yield.

Furthermore, it’s more than 60 basis points higher than the stock’s own five-year average yield.

But it’s not just that high yield investors are looking at; Southern has a fantastic track record for growing its dividend regularly and reliably.

The company has increased its dividend for 17 consecutive years.

And they have 68 consecutive years of dividends equal to or greater than the previous year.

That means you’re getting a big and reliable dividend that’s also growing.

Now, that dividend growth isn’t massive. This is a slow-growing utility we’re talking about.

However, the ten-year dividend growth rate is sitting at 3.7%, which is a bit higher than the low-single-digit inflation rate that’s been prevalent for years now (in the US).

So that high yield is at least keeping pace with country-wide inflation, if not beating it.

With a payout ratio of 76.8% (against TTM adjusted EPS), Southern should be able to continually modestly increasing its dividend annually for the foreseeable future. That payout ratio is in line for the industry and Southern’s own recent historical average.

But in order to build that future dividend growth expectation, which will help us determine what to expect and what the stock might be intrinsically worth, we need to first look at business growth – both in terms of the past and the future.

So we’ll first see what kind of top-line and bottom-line growth Southern has delivered over the last decade, which is a reasonable proxy for the long haul.

And we’ll then compare that to a professional forecast for near-term EPS growth looking forward.

Combining the known past and estimated future like this should give us a fairly good idea as to what kind of growth Southern is generating at the business level, which should more or less trickle down to dividend growth.

Southern has increased its revenue from $17.127 billion in fiscal year 2008 to $23.031 billion in fiscal year 2017. That’s a compound annual growth rate of 3.35%.

Fairly routine growth here for this business model, although Southern has also grown itself through acquisitions; the 2016 acquisition of AGL Resources for $7.9 billion is a notable recent example.

Due to the very nature of the business model, utility companies typically finance growth via a combination of debt and dilution.

This makes looking at bottom-line growth on a per-share basis, which is relative instead of absolute growth, important and more accurate for utility stocks.

Earnings per share advanced from $2.25 to $3.02 over this period, which is a CAGR of 3.32%.

Seeing that consistency, factoring in what’s actually fairly sizable dilution (the outstanding share count is up almost 25%), is great.

However, the FY 2017 EPS result I used is adjusted EPS due to the number of one-time charges the company took.

The Tax Cuts and Jobs Act of 2017 negatively affected Southern’s FY 2017 GAAP EPS.

But the larger issue with GAAP EPS for FY 2017 was the estimated loss Southern took on Kemper IGCC, which is a project that originally started as a first-of-its-kind power plant that was designed for gasification and carbon capture technologies using “clean coal”.

However, the project has been plagued with issues and cost overruns almost since the beginning. Southern has now abandoned the original plan, announcing that the plant will be supplied by natural gas instead.

The Kemper project exemplifies Southern’s recent opportunities and challenges.

The company’s sold electricity in 2000 was almost 80% generated via coal. That number is now sitting near 30%. And it’s expected to continuously drop moving forward as Southern moves toward natural gas, nuclear, and renewables.

However, this transformation has ended up taking longer and being more expensive than originally thought.

Another example is Southern’s Vogtle project, which is a nuclear plant that has faced numerous cost overruns and delays.

Still, Southern is positioning itself well for a future world where new energy solutions are necessary.

Moving forward, CFRA believes Southern will compound its EPS at a 2% annual rate over the next three years.

If this materializes, it would likely allow for like dividend growth over the same period, considering where the dividend and payout ratio are at right now.

Southern’s longer-term picture in terms of EPS growth and dividend growth is arguably much brighter once the company moves past recent challenges and capitalizes on its opportunities.

The company’s balance sheet is heavily leveraged, but it’s not completely unexpected or out of line for the business model and industry.

The long-term debt/equity ratio is 1.84, while the interest coverage ratio is negative right now due to the aforementioned issues with earnings for FY 2017.

Admittedly, the balance sheet has deteriorated in recent years due to the aforementioned issues and projects, which is something that Southern will have to rectify if their additional growth potential materializes.

Profitability is fairly robust for Southern.

Over the last five years, the company has averaged annual net margin of 9.95% and annual return on equity of 8.96%.

These numbers are heavily negatively affected by FY 2017; factoring that out brings these numbers up to strong averages.

Overall, there’s a lot to like about this stock, especially if an investor desires a high yield.

Southern’s dividend is one of the biggest in the industry. And it’s also one of the most reliable.

If you want a safe yield well north of 5% and inflation-beating growth, your choices are somewhat limited.

That said, Southern’s going through some growing pains right now. Shifting a massive utility like this isn’t easy or fast. And it’s been more difficult and slower than many had initially thought.

But challenges is what often brings a great stock down into an appealing valuation range.

One just has to consider if it’s cheap enough to warrant purchasing it based on the near-term challenges weighed against the long-term opportunities.

Well, these challenges seem to weigh on investors’ minds more than the opportunities, perhaps making this high-quality utility stock undervalued…

The stock is trading hands for a P/E ratio of 14.63 (using adjusted TTM EPS).

While not totally an apples-to-apples comparison, consider the five-year average P/E ratio for this stock is 25.2. And keep in mind the fact that the broader market’s P/E ratio is well over 20.

The utility’s cash flow is currently much cheaper than its three-year average.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock does look cheap. But how cheap might it be? 

To provide further clarity on this, reasonably estimating intrinsic value, I valued the stock using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 3.5%.

That DGR is roughly in line with the company’s own long-term track record regarding EPS and dividend growth.

A moderate payout ratio, long-term opportunities from growth projects, and the recent AGL acquisition all put Southern in a position to accelerate from what it’s already done over the last decade.

However, I’m also modeling in the near-term challenges; the forecast for EPS growth over the next three years could affect the long-term growth rate.

The DDM analysis gives me a fair value of $53.36.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So my analysis concludes the stock is undervalued here – and that’s assuming a long-term growth rate that doesn’t accelerate at all.

But I like to compare my valuation to what professional analysts have come up with, which adds perspective and depth.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates SO as a 4-star stock, with a fair value estimate of $51.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates SO as a 4-star “BUY”, with a fair value calculation of $39.01.

It’s interesting that the latter firm has a 12-month target price of $47.00, so I’m not sure of the disconnect. Nonetheless, averaging out the three numbers gives us a final valuation of $47.79, which would indicate the stock is 9% undervalued right now.

Bottom line: Southern Co. (SO) provides a service that’s both ubiquitous and necessary, wrapped up in a monopolistic business model. While the projects that are designed to position the company for the future have been thus far challenging, the company’s long-term opportunities are clearly present. Meanwhile, investors should be able to look forward to a reliable 5%+ yield, inflation-beating dividend growth, and the potential that shares are 9% undervalued.

— Jason Fieber

Note from DTA: How safe is SO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. 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. With this in mind, SO’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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