The Southern Company (SO) is a utility company that generates and distributes energy. During uncertain times, many investors may view the utilities sector as a safe option for parking their money.
However, we are not big fans of The Southern Company for many reasons, and we believe there are better defensive stocks out there. As a result, we are neutral on the stock.
Large Investments, Little Growth
To begin with, the industry itself is a high CapEx industry, as building infrastructure to generate electricity is not a cheap endeavor. The Southern Company has seen negative free cash flows since 2016, as it has been investing heavily in properties, plants, and equipment (CapEx).
If we use depreciation & amortization as a proxy for maintenance CapEx, we can see that a large chunk of the overall CapEx spending went towards growth initiatives.
However, revenue has grown at a compound annual growth rate of only 2.5% over the same time period. This mediocre performance doesn’t justify the heavy investments made towards growth initiatives, especially if it results in negative free cash flow.
High Debt Load
Since The Southern Company has been investing more cash than it generates, it has had to take on more debt. As a matter of fact, total debt has almost doubled since 2015, reaching over $54 billion in its last quarter. This puts the leverage ratio at 6x total debt/EBITDA.
Although it is common for companies in the industry to have a lot of debt, it still increases the risks associated with the company. The main issue we have with the borrowing is that interest rates have been climbing quickly as a result of inflation.
However, when looking at the company’s long-term debt maturity schedule, there’s over $5 billion in debt maturing from 2022 to 2023. SO is not planning to pay down the debt and instead will roll it over with $8 billion in new debt within the same time period.
With such a high debt load, the company will likely continue to roll over a large portion of its debt even after it decides to pay it down. In a rising interest rate environment, this is not exactly what an investor should want to see, especially if inflation becomes worse than expected.
Although we don’t believe investors should worry about bankruptcy, a high debt load in such a situation could definitely impact the company’s dividend growth.
Valuation
To value The Southern Company, we will use a dividend discount model since that is the main reason why investors park their money in utility stocks.
Since the company grows in the low single digits, we will use a single-stage growth model. For the perpetual growth rate, we will use the 30-year U.S. Treasury yield as a proxy for expected long-term growth.
The calculation is as follows:
Fair Value = Dividend per share / (discount rate – growth)
$71.35 = 2.64 / (0.06 – 0.023)
As a result, we estimate that The Southern Company is worth $71.35 per share under current market conditions.
Wall Street’s Take
Turning to Wall Street, The Southern Company has a Hold consensus rating, based on four Buys, six Holds, and two Sells assigned in the past three months. The average Southern Company price target of $70.36 implies 6.9% upside potential.
Final Thoughts
Although SO’s stock may be less volatile than that of the overall market, it’s still not immune to drawdowns when the market falls, and is slow to recover when the market picks back up.
In addition, the amount of money spent on growth initiatives does not justify the actual results the company has seen in its underlying business.
Because of this, along with a low margin of safety in the valuation, we remain neutral on the stock.
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