Will Southern's Dividends Keep Heading North?

 Southern Company (SO) was the worst performer of its 30 largest U.S. regulated utilities peers in 2013 as investors feared cost overruns at its Kemper power plant project would hurt regulatory relationships and a still-weak economy weighed on short- and medium-term growth. However, we think investors should consider the long-term view for this dividend stalwart. Southern now trades at a discount to fair value, a dynamic we've seen only twice since early 2010, while many of its peers trade at or above our fair value estimates. Southern's strong narrow Morningstar Economic Moat Rating, above-average 5% yield, and 15 price/earnings ratio suggest investors will enjoy solid total returns even if rising interest rates pressure dividend-paying stocks. We believe Southern's impressive regulatory relationships and financial footing will support earnings and dividend growth for many years.

Regulatory Environment Remains at Top of Class
Southern's regulated utilities operate under exclusive rights to charge rates that allow a "fair" return on and of the capital they invest to build, operate, and maintain their systems. In exchange, regulators set returns at levels that aim to minimize customer costs while offering sufficiently attractive returns to encourage debt and equity investment. This implicit contract has allowed Southern to earn its cost of capital--and, on average, well above its cost of capital--although returns fluctuate year to year based on electricity demand, investment cycles, operating costs, and financing costs.

Southern's narrow moat is based on the efficient-scale advantage generated by its four-state network of electrical wires, equipment, and power plants that allow it to generate and distribute power to millions of customers. Regulatory oversight precludes Southern and all regulated utilities from establishing wide moats; however, we think sustainability of returns, not their nominal size, is the most critical factor supporting an economic moat. We expect Southern's returns on invested capital will average 7.7% for 2014-17, well above our assumed 5.7% weighted average cost of capital.

Southern long has realized earned returns on equity and invested capital above peer averages, and we forecast that will continue. Outperformance is driven by Southern's premium allowed ROEs in its largest jurisdictions and excellent cost-recovery mechanisms. Between 2008 and 2012, Alabama Power and Georgia Power on average earned ROEs of 13.1% and 11.7%, respectively, despite falling power demand in a weak economy.

Regulatory outcomes from 2013--an unusually busy regulatory year for Southern's utilities--reaffirm our belief that the regulatory environments supporting the company's narrow economic moat remain strong and among the most constructive of any regulated utility.

Alabama. During 2013, Alabama Power had a full review of its streamlined regulatory process, which led to only superficial changes in the utility's ratemaking structure. In contrast, other utilities suffered allowed ROE cuts because of low interest rates and political pressure to lower rates in a slowly recovering economy. Intervenors in the Alabama Power case proposed an allowed ROE as low as 9%, but Alabama regulators determined the company's earned returns were reasonable and effectively left them untouched. The regulators specifically rejected the connection between current capital market conditions and a fair return to Alabama Power investors. This is remarkable, given that regulators in most other jurisdictions have used low interest rates and lower computed equity risk premiums to justify substantial ROE cuts.

Regulators also reaffirmed Alabama Power's best-in-class cash recovery mechanisms that help ensure it earns its allowed returns. Its ratemaking formula allows the utility to recover a return on and of investment on a forward-looking basis, eliminating the typical regulatory lag between cash investment and cash recovery. A similar mechanism exists for Southern's environmental projects. Regulatory lag is the primary reason utilities underearn their allowed returns. Eliminating this lag enhances cash flow and supports a more sustainable, growing dividend.

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Georgia. Unlike Alabama, Georgia Power must file ad hoc requests with regulators to raise customers' base rates. However, the utility has negotiated three-year rate agreements in recent years, resulting in more transparent returns as well as flexibility to deal with changes in the operating environment that might otherwise negatively affect the utility's finances. Georgia Power settled a full rate case in 2013 that resulted in another three-year plan. The plan included precertification of capital costs, a move that removes some of the regulatory risk involved in large, multiyear capital investments.

The size of the rate increase was 20% below our projections and below Georgia Power's original request, but the company's top-tier allowed ROE was dinged by a mere 50 basis points and remains well above average at 11% (within an allowed range of 10%-12%). In a period of generally negative rate case outcomes, Georgia Power's settlement is relatively positive. The settlement--like the previous one--includes a "safety valve" called the ICR tariff. If Southern's earned returns look likely to slip below 10%, regulators and the company have an option to negotiate further rate changes to address any shortfall. This isn't as good as Alabama Power's annual formulaic true-ups, but it is a financial out that is the envy of most utility peers, who must eat the negative financial impact of a mismatch between projected and realized costs.

Southern continues to recover Vogtle nuclear project costs through an annually negotiated tariff independent of retail base rates that reflects forward-looking projections. In 2013, Southern extended the project's finish date to 2017-18 and raised the estimated total project cost to $6.8 billion. Previously, the utility had semiannual cost reviews during which regulators had to certify plant costs. But the utility and regulators agreed to delay a vote to approve recovery of any costs beyond the already certified total project costs until the first new unit is finished in 2017. This was a favorable outcome for Southern. Without this agreement, the utility would be asking in the present for future rate hikes in a sluggish economic environment. Still, we think investors should consider the potential for larger increases in the project's estimated cost. We think the chance of a material unrecoverable cost overrun is small and the market seems to be assigning too high a probability to that worst-case scenario. Our fair value estimate already incorporates an estimated $725 million of unrecoverable charges, including the amount subject to a commercial dispute with contractor Chicago Bridge & Iron.

Mississippi. Mississippi Power's new coal integrated gasification combined cycle facility in Kemper County dominated headlines in 2013, as major cost overruns and schedule revisions on the project led Southern to a mea culpa; the utility proposed a cap on certain capital costs that led to pretax financial charges of nearly $1.2 billion for unrecoverable future costs and, in our view, fueled the beating that Southern's shares took during the year. The overruns stem primarily from locking in fixed-price contracts for work on a largely first-of-its-kind facility (designed to capture carbon dioxide, aka "clean coal") when only 10% of the engineering was done, a mistake that cost the utility's CEO his job. It was a rare construction misstep for a company that has demonstrated excellent project management with huge annual construction budgets in the past, and the market's reaction was punishing.

The cost overruns are certainly a weight on shareholder returns, but we think fears that the project has harmed regulatory relations in Mississippi are misguided, and concerns that the course of events is applicable to Southern's Vogtle nuclear project in Georgia are unfounded. Mississippi Power achieved a series of rate outcomes in 2013 that show the regulatory process is far from broken, in our opinion. Regulators improved a 1.9% increase in traditional base rates, a 15% increase in 2013 rates, and a 3% increase in 2014 rates pertaining to ongoing Kemper costs, paving the way for a seven-year rate agreement that will allow a fixed rate of cash recovery while amortizing a regulatory liability on the balance sheet. A key step remains in mid-2014, when regulators will conduct a prudency review of incurred capital costs that will either confirm the utility's own estimates of future financial losses unrecoverable from shareholders or increase that burden.

The situation in Mississippi was a case of utility error, and the project is enormous relative to the size of the utility's customer base. In Georgia, cost escalation so far is driven by contractor mistakes (and there's a chance a lawsuit or settlement out of court will dismiss a good portion of Georgia Power's financial responsibility to bear them) and related schedule revisions. Further, Georgia Power is a much larger utility and the impact on rates of Vogtle costs is much smaller relative to the customer's total bill. It's also important to recognize how constructive Southern's regulatory history has been in Georgia --qualitative factors (read: political clout, public perception, electoral cycles, and so on) can have very meaningful quantitative impacts on regulated utilities.

Florida. Southern's Florida utility, Gulf Power, reached a settlement agreement for new rates at the end of 2013 that boosts margin by $35 million in 2014 and a further $20 million in 2015. Unlike Alabama and Georgia, Gulf's allowed ROE is near the peer average at 10.25%. Gulf had requested an increase to 11.5%, generating a requested rate increase of $91 million, but Florida's regulators maintained existing returns.

Gulf Power remains a very small piece of the Southern pie, although attractive demographics and favorable rate mechanisms--including a formulaic environmental capital expenditure recovery clause, minor generation performance incentives, and formulaic forward-looking recovery of other costs--have helped the utility overearn its allowed ROE.

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Projected Dividend Growth In Line With Peers, but Premium Yield Offers Better Total Return
Southern's large capital expenditure program will preclude any aggressive dividend hikes. Its 75% forward payout ratio is already toward the high end of its peer group. However, we think management can continue and increase its clockworklike annual dividend increases through at least 2017, representing 4% annual growth.

Even in the midst of its heavy investment cycle, we think Southern's dividend growth will match peers'. Southern's relatively high cash flow transparency and financial backstop from its supportive regulatory environment make for a favorable comparison with peers that might offer modestly higher dividend growth under a more uncertain and less constructive regulatory framework. With similar dividend growth to peers, a best-in-class regulatory environment, and a 100-basis-point dividend yield premium, Southern offers an industry-leading total return package, in our view.

The key regulatory issues that remains an overhang is whether Southern will be able to achieve full recovery of the $6.8 billion Vogtle new nuclear project in Georgia, whether any further costs will have to be incurred at its now $5 billion Kemper coal plant in Mississippi, and whether prior costs could be disallowed by regulators during a prudence review in mid-2014.

On average, we forecast operating cash flow net of maintenance capex will cover the dividend more than 1.5 times on average through 2017. If Southern can't recover cost overruns related to Vogtle or faces long recovery lag, its cash dividend coverage still will remain at or above 1 times with negligible new equity issuance.

Our low- and high-cost-overrun scenarios wouldn't reflect the likely reality of a cost overrun scenario, since they each assume no ongoing recovery of extra costs. The process by which Georgia regulators determine cash collection in a given year includes forward test-year cost projections. Southern will probably know about changes of the magnitude we incorporate in our scenarios, and we expect it would work with regulators to resolve cost recoveries. Still, even if Vogtle incurs cost overruns that it is unable to recover from customers, Southern still exhibits robust dividend coverage except in the very worst-case scenario.

While We See Most Regulated Utilities as Overvalued, Southern Trades at a Discount
In 2013, Southern's total return was less than 1%, trailing its 30 largest regulated utilities peers, the Morningstar Utilities Index (14%), and the S&P 500 (32%). However, we think this offers investors an attractive opportunity to own one of the strongest dividend-paying companies at a discount to fair value. Southern's historical premium price/earnings to peers has eroded, and the shares now trade at a small discount to the peer group on 2014 earnings, though on a price/book value basis the shares continue to trade at a modest but diminished premium despite earned and allowed returns well above peer averages. While these relative metrics don't drive our bullishness on Southern's shares, they do highlight how investor perceptions shifted over the course of 2013.

We also think the threat Southern faces from rising interest rates is overblown. For investors who want stable total returns, we think high-quality dividend payers like Southern still offer attractive prospects based on where dividend yields stand relative to interest rates. During the past 20 years, utilities' dividend yields on average have traded in line with 10-year U.S. Treasury yields. With utilities' 4% average dividend yield--and Southern's 5% dividend yield--still well above the 2.7% 10-year U.S. Treasury yield, we think the market already is pricing utilities as if Treasury rates will hit 4%. This is in line with our long-term assumptions and suggests Southern and many of its utilities peers could produce total returns of at least 8% even if interest rates continue climbing.

Economic Recovery Offers Upside to Outlook
After updating our forecasts to include 2013 results, the Georgia rate case settlement, and management's capital expenditure guidance, we continue to expect 4% average annual earnings growth and 2% average annual EBI growth through 2017.

We've made a small cut in our electricity usage assumptions in the firm's service territories through 2015, but that didn't have a material impact on our long-term growth assumptions. We now assume 1.1% growth in total annual deliveries for 2012-17 in Southern's key Alabama and Georgia service territories. Like most of its peers with usage-exposed electric rates, Southern saw earnings and cash flows affected negatively by the reduced economic activity that followed the 2008 financial crisis. Before the crisis, per capita electric demand in Alabama and Georgia had grown nearly twice as fast as the U.S. average since 1990. However, over 2007-12, usage in both states fell more than the U.S. average.

Despite the difficulty comparing regional electricity usage, given weather changes and other regional variables--such as industrial bankruptcies, offshoring/onshoring of industrial capacity, state-level policy, and energy efficiency--electricity demand in Alabama and Georgia still was hit harder than most areas. However, if the national and regional economies continue to recover, demand growth could exceed the national average and support growth beyond our expectations. Each 50-basis-point annual increase in our Alabama Power and Georgia Power usage growth estimates in 2014-16 would boost our 2015 and 2016 earnings per share estimates by 3%-4% and add $1 per share to our fair value estimate.