Summary
- Against the backdrop of sharply rising input costs, The Southern Company reported solid earnings on Feb. 16, 2023.
- Investors have become accustomed to earnings adjustments due to cost overruns at Vogtle Units 3 and 4, which are scheduled to come online in May/June and early next year, respectively.
- In this update, I share my assessment of Southern Company's 2022 results, focusing on customer growth, energy sales growth and margins.
- I will also discuss the company's debt levels in light of rising interest rates.
- In closing, I'll outline why I'm not adding to my The Southern Company position, even though SO stock is 20% off its 52-week high and offers a forward yield of 4.25%.
Introduction
The Southern Company (SO), the regulated utility that operates primarily in Georgia and Alabama, reported its fourth quarter and full year 2022 results on February 16, 2023. It's been some time since I last looked at the company - 15 months to be exact - when I compared Southern Company to Duke Energy (DUK) and WEC Energy Group (WEC).
In this brief update, I'll share my opinion on Southern's performance in 2022 and update my investment thesis - after all, the landscape has changed significantly. The world, at least according to leading experts, is on the verge of a recession, inflation is higher than it has been in decades, and the Federal Reserve has been raising interest rates at an unprecedented pace.
Southern Company 2022 Earnings Recap
For 2022, The Southern Company reported adjusted earnings of $3.9 billion on a corporate basis, up 7.1% from the prior year. On a reported basis, Southern earned $3.5 billion in 2022. Once again, the company posted an estimated loss on plants under construction (namely Vogtle Units 3 and 4), albeit a much smaller one than in 2021 - $199 million versus $1.7 billion.
Finally, it appears that the two new units in Georgia are nearing completion, and management expects Vogtle Unit 3 to be in service in May or June 2023 , with Unit 4 likely to follow in the first quarter of 2024. Other significant adjustments included a $119 million impairment of goodwill (PowerSecure Inc. write-down due to deteriorating macroeconomic conditions) and charges of in total $131 million (pre-tax) attributable to the sale of Southern Company Gas' natural gas storage assets. On an adjusted basis, Southern reported earnings per share of $3.60 compared to $3.41 in the prior year, an increase of 5.6% year-over-year (YoY), pointing to modest dilution (see below). For 2023, Southern expects earnings to be about flat on an adjusted per share basis ($3.55 to $3.65).
Earnings growth of 7% is pretty strong for a regulated utility (excluding the infamous Vogtle cost adjustments), but of course somewhat muted when compared to operating revenue growth of 26.7% YoY. Southern is feeling the impact of significantly higher input costs and, as a result, experienced a gross margin contraction by nearly 1,200 basis points (Figure 1), resulting in gross profit growth of 5.7% YoY. Adjusted EBITDA margin and adjusted operating margin were 33.5% and 19.6%, respectively, down 620 and 290 basis points YoY, but still an acceptable level given the higher input costs and compared to long-term profitability (2017-2022 averages of 39.2% and 23.2%, respectively).
Figure 1: Southern Company's [SO] gross margin, calculated by taking into account fuel costs, purchased power, cost of natural gas, and cost of other sales (own work, based on the company's 2017 to 2022 10-Ks)
Adjusted return on equity ((ROE)) was very robust at 11.2% and in line with the long-term average. The solid ROE is due in part to the positive regulatory climate in the states where Southern operates. While the report is somewhat dated, it nevertheless shows that Georgia and Alabama are among the most favorable jurisdictions from a regulatory perspective, which puts Southern in a good position with respect to upcoming rate negotiations. In fact, Alabama is the only jurisdiction rated "Above Average/1" by Regulatory Research Associates (the best rating).
While it's easy to see the glass half empty in times of high inflation and customers who don't want to put up with rate increases, I think it's important to understand that regulators - especially in favorable jurisdictions - are constantly trying to find a compromise between the interests of shareholders (reasonable ROE) and customers (tolerable price increases).
Southern Company's Customer Relationships
Southern Company operates in Georgia, Alabama and, to a lesser extent, Mississippi, serving approximately 9 million residential, commercial and industrial customers. The customer base is largely stable, with the exception of 2018 and 2019 (YoY declines of 3.6% and 4.4%, respectively, Figure 2). These are due to the sale of Elizabethtown Gas, Elkton Gas, and Florida City Gas in 2018 and the sale of Gulf Power Company in 2019. On a comparable basis, Southern would have added 77,000 and 73,000 customers in those years, respectively. Customer growth in 2022 was also acceptably strong at approximately 73,000 customers (+0.8% YoY). On a gross basis, Southern added 49,000 residential electric customers and 31,000 residential gas customers in 2022.
Figure 2: Southern Company's [SO] customer numbers (own work, based on the company's 2017 to 2022 full-year earnings releases and packages)
Southern Company's Energy Sales
Against the backdrop of higher energy prices in 2022, it is fair to say that Southern Company has delivered solid results - 5.6% growth in electricity consumption is no mean feat (Figure 3). Interestingly, residential sales grew the most (4.8% YoY), while commercial and industrial sales grew 3.5% and 1.5% YoY, respectively. This difference is largely due to warmer weather, but, of course, the ongoing recovery from the pandemic should also be taken into account. Going forward, consumption is likely to decline against the backdrop of a possible recession in 2023 or later. At the same time, a secular trend toward energy conservation among residential customers - and to a lesser extent among commercial and industrial customers - should be at least theorized, assuming energy price-related inflation remains high for the foreseeable future.
The Southern Company's energy mix did not change significantly from the previous year, with the share of natural gas in total consumption rising from 48% to 50%, while the share of coal and nuclear power each fell by 1% to 20% and 15%, respectively.
Figure 3: Southern Company's [SO] energy sales in billions of kilowatt-hours (kWh) (own work, based on the company's 2017 to 2022 full-year earnings releases and packages)
Development Of Debt, Shareholder Dilution, And Dividends At Southern Company
Regulated utilities are notoriously capital intensive. Not only do they require constant maintenance, but transition to fuels with more favorable environmental impact (e.g., from coal to gas and nuclear) or sustainable energy sources (e.g., wind, solar) comes at a high cost. Those who follow Southern have become more or less accustomed to cost overruns and delays due to operational challenges and setbacks at Vogtle Units 3 and 4. It is likely that the problems at Vogtle contributed to CEO Fanning's retirement in March 2023 - he will be replaced internally by Chris Womack .
Unsurprisingly, The Southern Company's net debt has also continued to rise in recent years, from $45.5 billion at the end of 2017 to $55.6 billion at the end of 2022, an increase of more than 22%. Shares outstanding increased slightly over the same period, from 1.01 billion to 1.08 billion, an increase of 7.2%. From a shareholder dilution perspective, there are definitely worse utilities. Still, Southern's leverage is worrisome given its substantial debt growth, only slightly outpaced by adjusted earnings growth, and especially given its stagnant operating cash flow. Figure 4 shows Southern's leverage in terms of adjusted EBITDA and operating cash flow. Readers accustomed to measuring leverage of utilities by the ratio of operating cash flow to net debt are unlikely to be thrilled either, given that the ratio declined from 14.1% in 2017 to 11.3% in 2022.
Of course, there are far worse utilities out there, and in fact I still consider Southern Company one of the best utilities, but the trend is discomforting - in part because capital expenditures will only continue to rise for the reasons mentioned above.
Moody's last reaffirmed Southern's long-term Baa2 rating (S&P equivalent of BBB) with a stable outlook in 2018, but is closely watching the latest construction and testing milestones as Vogtle Units 3 and 4 approach their in-service dates.
Figure 4: Southern Company's [SO] net debt to adjusted EBITDA and operating cash flow (own work, based on the company's 2017 to 2022 10-Ks)
Due in part to rising interest rates and the associated refinancing of maturing notes, interest expense increased from $1.84 billion in 2021 to $2.02 billion in 2022, resulting in a decrease in Southern's interest coverage ratio from 4.4 times to 4.1 times operating cash flow before interest. In 2017, the ratio was 4.8 times.
Going forward, and assuming interest rates remain higher for a longer period of time, Southern Company's interest coverage ratio will continue to deteriorate. The company has upcoming maturities of $4.7 billion in 2023 and $11.4 billion by 2026, representing 7% and 21% of gross debt, respectively. However, while these numbers look somewhat concerning, I think the impact on Southern's debt service ability will remain manageable given its investment grade rating, favorable regulatory environment, and still very acceptable interest coverage ratio. Also somewhat reassuring is the fact that the current weighted average maturity of Southern's long-term debt is about 18 years.
Against this backdrop, the dividend seems safe to me, with a stable payout ratio of about 75% of adjusted earnings, or an average payout ratio of 40% based on operating cash flow. However, if rates stay higher for longer, I can imagine the usual $0.08 dividend increases being reduced. Still, I doubt Southern's management will signal a tightening of liquidity and cash flow anytime soon - let alone cut the dividend, with 21 years of uninterrupted growth - and I fully expect another $0.08 increase this April. Base on today's share price, this represents a forward yield of 4.25%, 40 basis points higher than the current yield on 30-year Treasuries
Concluding Remarks - Or Why I'm Not Buying SO Stock Despite Being 20% Off Its 52-Week High
Against the background of a currently rather difficult environment, The Southern Company has achieved solid results from a growth point of view, ignoring the well-known problems with the construction of Vogtle Units 3 and 4 and the resulting cost overruns. The decline in profit margins was significant, but is still manageable and should be considered temporary.
The elephant in the room, of course, is the massive capital spending and the associated increase in debt. While this is largely normal for utilities, and the two Vogtle units are likely to come online later this year and early next year, the continued significant investment in modern-era energy sources, as well as the costs associated with decommissioning coal plants and other older facilities, should not be ignored. Considering that the Federal Reserve has aggressively raised interest rates in 2022, the damage has already been done from a stock price perspective - Mr. Market has already factored in the radically changed environment, and Southern is currently trading 20% below its 52-week high. Interest expense will likely continue to rise as debt matures. Overall, investors should expect dividend growth to decline over the long term, but I am quite confident that Southern will continue to be able increase its dividend at its usual rate of $0.08 per share per year in the near term.
Although I don't like to call stocks a "bond substitute" - after all, stockholders have only a residual claim on a company's assets - I actually view my small investment in Southern Company as just that: it is a bond substitute with a yield currently 40 basis points higher than long-term Treasuries, the difference being that dividend growth preserves the dividend's purchasing power at least somewhat. Granted, Southern's 3.03% quarterly increase in 2022 (3.05% annualized) has not kept pace with inflation, and even if annual increases of $0.08 continue, Southern's dividend will decline in purchasing power. Personally, I expect inflation to come in waves, but believe the long-term average inflation rate will settle in the mid-single digits.
With this in mind, but also due to the still fairly noticeable overvaluation (Figure 5, Table 1), I am not interested in adding to my position at this time. The constant need for investment, growing debt, cost overruns at Vogtle, and perceived changes in the political landscape leave me rather uninspired as a utility investor. At the same time, I view quality utilities operating in a still favorable regulatory environment as acceptable defensive investments, so I am not thinking of selling my The Southern Company position at the current price either.
Figure 5: FAST Graphs chart of Southern Company stock [SO] (obtained with permission from www.fastgraphs.com) Table 1: Various valuation metrics for Southern Company stock [SO] (obtained with permission from seekingalpha.com/symbol/SO/valuation/metrics)
Thank you very much for taking the time to read my article. Do you agree or disagree with my conclusions? How did you like it, my style of presentation, the level of detail? Also, if there is anything you'd like me to improve or expand upon in future articles, do let me know in the comments section below.
For further details see:
Southern Company Q4 Earnings: The Damage Is Already Done