SO - The Southern Company: Lower Inflation Is A Tailwind

2023-11-16 05:26:45 ET

Summary

• October CPI report showed weaker than expected inflation. As a result, many analysts expect the Federal Reserve to not raise interest rates any more. Some see cuts next year.
• With the beginning of the normalizing of interest rates, Southern Company's valuation could increase as its dividend could be more attractive.
• Southern Company continued to grow earnings for Q3 2023. For 2023, management expects adjusted EPS to be near the middle of its $3.55 to $3.65 guidance range.

The Southern Company ( SO ) is a leading energy provider that owns 7 electric and natural gas utilities , 43,000 MW of generating capacity, and serves 9 million customers. In 2022, the majority of Southern Company's revenues were from regulated utilities.

Given interest rates have increased, Southern Company stock hasn't done as well in the last year and half.

With the October CPI report and the company's third quarter earnings, however, there is reason to be optimistic on Southern Company's stock.

Inflation, Interest Rates, and Tailwind

Over the past two years, interest rates have risen because inflation has increased.

As a result of the interest rate increases and higher inflation expectations, U.S. Treasury yields have increased as well.

Higher U.S. Treasury yields have been a headwind for Southern Company as the company's dividend has been comparatively less attractive as a result of the higher U.S. Treasury yields. As a result, Southern Company's stock hasn't really increased much over the last two years.

In terms of its dividend, Southern Company has a forward annual dividend rate of $2.80 per share, which is a dividend yield of 4.11% as of November 14.

Recently, however, there has been pretty good news on the inflation front.

On November 14, inflation was lower than expected with the CPI rising 3.2% for October, versus estimates of a 3.3% rise. By contrast, the CPI rose 3.7% in September.

In terms of core inflation, which excludes volatile food and energy components, core CPI rose 4% year over year in October, the smallest increase since September of 2021.

Data also showed that job growth and wage growth was slowing in October.

This cooling of the economy leads some economists to think the Federal Reserve might have more flexibility in terms of not raising interest rates anymore. In fact, some think the Federal Reserve might even cut interest rates next year, with a cut potentially as soon as May depending on various economic data.

If interest rates begin to normalize, this could mean a better valuation for Southern Company. As of November 14, the 5 year U.S. Treasury bond fell 5.19% to 4.421% as a result of the news. Southern Company stock itself rose 2.78% on November 14, with a lot of it likely due to the inflation news.

More normalized interest rates could also help Southern Company's interest rate payments.

In terms of its balance sheet, Southern Company has projected long-term debt financing of $800 million to $1.1 billion for the remainder of 2023 as of November 2, 2023. The company also has a projected long-term debt financing of $3.4-$3.7 billion for 2024 and $4.275 billion for 2025.

With potentially lower interest rates and more normalized U.S. Treasury yields, there's potential for lower interest rates on Southern Company's debt it issues in 2024 and 2025.

Finally, there's another added benefit.

Less inflation expectations could mean more capital investment earlier.

With inflation weakening and U.S. Treasury yields decreasing, there could be less pressure on the U.S. government to spend less. With the decrease in U.S. Treasury yields, the U.S. government also won't have to spend as much on interest payments as it would have on the U.S. Treasury bonds it will issue in the next few years.

As a result, there could be more U.S. government spending, which could mean more investment to decrease carbon emissions given this summer having been the warmest summer on record.

If the high temperature trend continues, there could be more urgency to transition to green energy. With more renewable energy generation plugging into the grid, there's more opportunity for Southern Company to modernize its grid earlier.

Q3 2023 Earnings Results

For Q3 2023 , Southern Company continued to grow earnings as it had adjusted EPS of $1.42, up from $1.31 in Q3 2022, with warmer than normal weather being one reason for the increase.

For 2023, management sees adjusted EPS near the middle of its $3.55 to $3.65 guidance range.

Although the Vogtle two-unit nuclear reactor expansion project cost is now expected to be $10.75 billion , up from the previous $10.59 billion estimated in April, management continues to expect Vogtle 4 nuclear reactor to be in service on Q1 2024, which is what they previously guided.

The Vogtle two-unit nuclear reactor expansion project has been years behind schedule and billions of dollars over the original budget. Once it is complete, there is arguably less operational risk.

In terms of its estimated growth, management said during its Q4 2022 conference call that it has a five year capital plan of $43 billion with 97% at state regulated utilities. Management also sees long-term adjusted EPS growth rate of 5% to 7%.

Given electricity demand increases in a state like Georgia, however, there could be upside in terms of the capital plan, which could mean upside in terms of adjusted EPS in the long term.

Southern Company management said during the Q3 2023 conference call ,

With this 2023 IRP update, Georgia Power is proposing additional investments into Georgia's energy future to provide economical energy solutions that should benefit our customers and communities for generations to come...

But I think as we sit here today on the very front end of this IRP update process, we do see pretty substantial potential increases. And potentially, we're talking billions of dollars where our current five-year plan for capital is $43 billion. I think we easily see a plan that translates to something north of $45 billion, and it's really a question of how much higher than $45 billion once we get to February and kind of lay that out. And I say all that continuing to be conservative about including any owned renewables. We absolutely across all of our electric service territories expect to own renewables over the forecast horizon.

With that said, proposals are not the same as regulators approving increases. Nevertheless, there is opportunity for more investment in Southern Company's future.

Risks

Weather and extreme weather events such as wildfires could affect earnings.

A recession could be a near term headwind if it occurs.

Southern Company could have operational issues that decrease earnings.

Valuation

In terms of annual EPS estimates, analysts estimate Southern Company will earn $3.60 for 2023 and $4.03 for 2024. That gives Southern Company a forward PE ratio of 18.68x for 2023, and 16.73x for 2024 as of November 14.

In terms of its balance sheet, Fitch gives Southern Company a rating of ' BBB+ stable ' as of October 6, 2023 for its long-term issuer default rating, which is investment grade.

Since 2023 is almost over, I think the 2024 forward PE ratio of 16.73x is probably the most useful of the two.

In my view, 16.73x is pretty low for a quality utility like Southern Company which has legitimate long-term EPS growth potential. With potentially normalizing U.S. Treasury yields, I think the stock could trade for at least 18.5x 2024 estimated EPS, which would give it a price target of $74.56 per share. With an annual dividend of $2.80 per share, that gives a total return of 11.8% in around a year. If Treasury yields normalize further, I think Southern Company could achieve an even higher valuation than 18.5x, possibly 19x.

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