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Southern Company: A Stock For Income Investors

SO has been undertaking correct strategic initiatives by incurring capital spending to develop and strengthen power generation fleet. Company can opt to accelerate its capital spending targeted at renewable power sources. Southern expects to grow its long-term earnings in a range of 3%-4%. Dividend offered by SO stays secure, and the stock is a good investment prospect for income-hunting investors. Utility companies have remained a popular investment choice for income-seeking investors, as utilities offer attractive and solid dividends. In recent times, utility companies have accelerated their capital spending to expand and strengthen regulated operations. Also, utility companies have been scaling down unregulated operations, which will provide stability to their revenue and earnings. Southern Company (NYSE: SO ), which has a solid regulated asset base, stays an impressive investment prospect for long-term income investors, as it offers a solid yield of 5.1% . The company has been undertaking various construction projects and incurring capital investment to strengthen its regulated asset base, which will fuel its rate base and earnings growth in future. However, delays and cost overruns associated with the ongoing construction projects have inflated the company’s risk profile and will limit the upside to the stock price in the near term. The stock is trading at a slight discount to its peers on the basis of forward P/E, which I think is justified given risk delays and cost overruns. Financial Highlights and Stock Price Catalysts The company’s financial performance is backed by its regulated assets base; the company generates more than 90% of its earnings from regulated operations. Southern Company posted a strong performance for 2Q2015; EPS for the quarter came out to be $0.71 , ahead of consensus of $0.69 and the 2Q2014 EPS of $0.68. The performance for the second quarter was supported by rate increases, the strong performance of its subsidiary Southern Power and favorable weather conditions; total weather normalized sales increased by 1%. Also, the company enjoyed weather normalized growth for the second consecutive quarter in all of its three customer segments, including commercial, residential and industrial segments. The company maintained its 2015 EPS guidance range of $2.76-$2.88; however, I think given its strong first half performance, Southern will increase its EPS guidance range for 2015 in October during the 3Q2015 earnings call. The company has been making capital investments to strengthen its power generating fleet; the company plans to make capital spending of more than $16 billion from 2015 through 2017, which will allow its long-term earnings to grow in a range of 3%-4% . In addition, the company has been aggressively working to grow its renewable generation portfolio, and plans to have a renewable generation capacity of almost 3,200MW, including solar, wind and biomass. The company will continue to direct capital spending toward the expanding renewable energy portfolio to take advantage of the 30% solar investment tax credit before the end of 2016. Moreover, given the attractive regulatory environment for renewable capital spending, the company can opt to increase its capital spending for future years, which will positively affect its future earnings growth and the stock price. The following graph reflects the current and planned renewable resources for Southern. Source: Investors Presentation Despite the company’s strong regulated asset base, the ongoing construction of nuclear and coal gasification (IGCC) projects stay a concern for investors. The company’s nuclear project ‘Vogtle’ is on track, and unit 3 and unit 4 are expected to be in operation in 2Q2019 and 2Q2020, respectively; however, substantial construction work remains, and cost overruns and delays will weigh on the stock price. On the other side, the company registered another charge of $14 million for the Kemper project; the project is expected to be completed by 1Q2016. However, delays beyond 1Q2016 are expected to increase the project cost by $20-$30 million every month. Cost overruns and construction delays associated with the ongoing two construction projects have inflated Southern’s risk profile and will limit stock price appreciation in the near term, and the stock return will be dividend driven. The stock trades at a slight discount to peers, which I think is justified given the construction risk attached to the company; Southern is trading at a forward P/E of 15.20x , versus the utility sector’s forward P/E of 16.5x . In my opinion, the stock valuation will not expand and the stock will not trade in-line with its industry P/E multiple until the company’s construction project-related risk decrease or/and its EPS growth accelerates. Separately, the company’s management does not have any plans to issue equity until 2017 to finance its planned capital investments; however, if the company experiences delays and increases in construction costs, the management might revisit their financing assumptions and could consider to issue equity, which will adversely affect its EPS. Summation Southern Company has been undertaking the correct strategic initiatives by incurring capital spending to develop and strengthen its power generation fleet. Going forward, the company can opt to accelerate its capital spending targeted at renewable power sources, which will augur well for its long-term earnings growth; currently, Southern expects to grow its long-term earnings in a range of 3%-4%. Also, dividend offered by the company stays secure, and the stock is a good investment prospect for income-hunting investors, as it offers a yield of 5.1%. However, the construction risk will limit a stock price increase in the near term. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Concentration Consternation

By Chris Bennett “There are 3 kinds of lies: lies, damned lies, and statistics.”- Mark Twain Earlier this week, The Wall Street Journal pointed out that a mere six stocks (Amazon (AMNZ), Google (NASDAQ: GOOG ), Apple (NASDAQ: AAPL ), Facebook (NASDAQ: FB ), Gilead, and Disney) had accounted for more than 100% of the S&P 500’s year-to-date gains. This degree of concentration (reminding some of the peak of the 1990s’ technology bubble) is said to raise “concerns about the health of the market’s advance.” While the article’s arithmetic was correct, its concerns may be misplaced . We don’t have to look back to the tech bubble to see a similar concentration of index returns: During 2011, 4 stocks (Exxon, Apple, IBM, and Pfizer) accounted for more than 100% of the total return of the S&P 500. This did not “presage a pullback,” however, as the S&P 500 followed with 3 straight years of double-digit gains . What was similar about 2011 and 2015 through July 27 (the date of the Journal ‘s analysis)? Aggregate returns were de minimis . In 2011, the S&P 500 gained 2% on a total return basis (and was flat on a price return basis). The total return of the S&P 500 in 2015 was less than 2% through July 27. In both periods, the return of the index was relatively low, making it easy for a small group of strong stocks to account for more than 100% of total performance. Following a few positive trading days, incidentally, “The Only Six Stocks That Matter” now account for only half of the S&P 500’s year to date total return. As of July 29, it would take 22 stocks to account for 100% of the market’s return. Just as the concentration of performance doesn’t lead to reliable conclusions about the market’s future absolute return, it also tells us little about the relative performance of active managers vs. their passive benchmarks. Active managers tend to underperform both when index returns are heavily concentrated among a few stocks and when returns are more widely distributed. In 2011, when four stocks accounted for 100% of the market’s return, 81% of large cap U.S. funds lagged the S&P 500 . 2014 was quite a different year in terms of returns and individual stock contributions to index returns: the S&P 500 ended the year up 14% and it required 176 stocks to account for the market’s total return. Yet active managers did not prosper in these conditions either, as 86% of large cap funds failed to outperform the S&P 500. While it makes for an exciting headline, concentration is no cause for consternation . Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .

VNQ And The Interest Rate Panic

Summary The biggest drawback of VNQ compared to some other equity REIT investments is its lower yield. One common argument I hear is that investors should wait for higher yields on the bond market to push share prices down. I don’t see small changes in interest rates hurting the fundamental operations of equity REITs. When rates on MBS go up, it makes houses less affordable. For tenants, that means renting for a longer period. Materially higher rates could have a small direct negative impact on equity REITs that are rolling into new debt financing for their properties. When I talk to people about REIT ETFs, the most common thing I hear is: “I’m planning to buy some shares; I’m just waiting until interest rates go up so I can get a better deal”. The good news about that response is that it shows investors are being prudent about their risk and expected return. When investors become irrational and assume the market will only go up, I become concerned that euphoria has taken hold and that there will be too many purchases without enough reasoning. One of my favorite REIT investments is the Vanguard REIT Index ETF (NYSEARCA: VNQ ). I believe VNQ or a very similar fund should be a core part of an investor’s retirement portfolio. Specifically, I like REIT ETFs as an investment tool for tax-advantaged accounts or for investors in very low income tax brackets. Due to the extensive diversification provided by VNQ, I believe it offers better risk-adjusted returns than individual equity REITs. I back this theory up with my own money, and hold a material portion of my retirement accounts in VNQ. The best argument against VNQ There is one major argument against VNQ, and it deserves recognition. The yield on the ETF is “only” 3.87%. Many REIT investors are investing in REITs primarily for income, not for growth, and the level of dividend yield is a very important consideration. While I do advocate using total return as the primary measure of performance, I like to see investors considering yields on equity investments as another important measure. I want them to look at yields, because it reminds them that when prices go down, the investment becomes more attractive. When the prices are soaring, the investment is less attractive. In many parts of the market, investors lose track of those fundamentals. In REIT investing, it is more common for investors to watch the yields. When investors choose not to buy into VNQ, one of the other top options is Realty Income Corporation (NYSE: O ). It offers a solid yield, currently over 4.7%, and a market cap over $10 billion, which is good for liquidity. If an investor wants to focus on yield and make a larger investment in Realty Income Corporation, I would encourage diversification – I can appreciate the emphasis on yields. The argument that I don’t trust Many investors are concerned that rising interest rates will mean poor performance across the equity REIT industry. I don’t think we should expect to see incredible returns, but I do expect a fairly solid performance. When interest rates go up, income investors will have more alternatives for investments that generate respectable levels of income. Since we are still dealing with supply and demand, a reduction in the demand for REITs should indicate that VNQ would either need higher dividends or a lower share price to encourage investment when investors are deciding between VNQ and bonds. The issue that investors are ignoring is that many equity REITs stand to profit from increasing interest rates. There is very little discussion about the economic impacts of the underlying businesses. People focus solely on the supply and demand for shares in the REITs, rather than how those businesses will perform. When short-term interest rates go up, long-term rates should also go up on MBS. I’m fairly confident about that – my primary area of focus as an analyst is the mREIT industry. I’ve been watching and analyzing the fluctuations across the yield curve over the last year. Higher short-term rates mean mREITs need to acquire higher yields on new securities to make up for paying higher rates on their repos (repurchase agreements). If the new MBS don’t offer higher yields, the mREIT has no good reason to purchase them (the MBS), because they would need to finance the purchase with repurchase agreements. When the interest rates on MBS increase, the cost of home ownership also increases. If the interest rate on mortgages increases, the same couple that could qualify for a loan before may be unable to qualify for the loan (assuming the same total loan value) after the interest rate increase. This is a factor that can keep more people renting apartments and drives up the performance of apartment REITs. Remember that it isn’t just share prices that are set by supply and demand; rent prices are set the same way. Increased competition from financially stable renters that are unable to get mortgages because of high interest rates would be a favorable development for the owners of the apartment building. Leverage It is true that many REITs using some debt financing; however, extensive leverage is rarely seen outside of the mREITs sector. The levels of leverage are frequently fairly low, and the length of the loans is fairly short. If interest rates become unattractive, many equity REITs will be able to exit the market for debt financing, or at least, reduce their use. I doubt we will see interest rates become that unattractive, but a reduction in the attractiveness of debt may also encourage a reduction in the development of new properties. If equity REITs spend less on developing properties, they will be reducing the future supply of apartment buildings. While REITs are required to make distributions based on their income, the level of “income” they report is often significantly different from their FFO (funds from operations). Many analysts view FFO as a better measure for estimating the amount of dividends that could be sustainably distributed. While FFO isn’t perfect, it does the job reasonably well. Income under FFO that is not income under GAAP can be reinvested in new properties. A reduction in the growth rate of properties would imply that REITs should be paying out more of their income and making less investment in future capacity. On the other hand, if they really find short-term debt financing unattractive, they can take the opportunity to pay down some debt, rather than raise dividends immediately. I don’t expect to see short-term yields become high enough to make using some debt financing unattractive for most equity REITs, but I have been watching MBS rates increase materially. Other Equity REITs Not all equity REITs are invested in apartments, and VNQ is offering a fairly diversified portfolio. However, the method of financing physical property remains a critical concern for customers of the equity REITs. Even stores that need a physical place to operate will be required to determine if they will buy or rent the property, and increases in MBS rates should create some similar problems for the corporate customer as it does for the couple renting and wishing to buy a home. Conclusion Since I’m considering total return, an increase in income offset by a decrease in growth is a wash. I simply see an attractive segment of the market that is somewhat out of favor because investors are waiting to see higher yields. I see a compelling long-term investment opportunity here, so I’ll keep investing and view temporary weakness in share prices as an opportunity to get more shares for the same amount of cash. Disclosure: I am/we are long VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.