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Southern Company – Rising Infrastructure Assets But Look Out For Some Challenging Quarters

Summary Southern Company is one of the largest utilities in America. Will grow to #2 spot by customer count after the AGL Resources purchase. Southern announced its plan to acquire AGL Resources for $8B cash – fueled by debt and equity issuance. The company is a dividend contender having raised dividends for 15 consecutive years; 5-yr dividend CAGR is 3.7% and Chowder Rule is 8.56. The Southern Company (NYSE: SO ) is one of the largest utilities company in America. The company serves more than 4.4 million customers and has approximately 46,000 megawatts of generating capacity serving the Southeast through its subsidiaries. Subsidiaries include electric utilities in four states – Alabama Power, Georgia Power, Gulf Power, and Mississippi Power; a growing, competitive generation company – Southern Power; a licensed operator of three nuclear generating plants – Southern Nuclear; and fiber optics and wireless communications – Southern Telecom and SouthernLINC Wireless, respectively. (Source: September 2015 Southern Company Overview Presentation ) In August 2015, Southern Company announced that it will be acquiring AGL Resources Inc. (NYSE: GAS ) in an $8B cash deal. This combined company will shift Southern from being an electric-only utility company to an electric-and-gas utility company. The customer base is expected to double with this move and pushes Southern to become the second largest utility company in America (by customer count), if the deal is approved. Corporate Profile (from Yahoo Finance) The Southern Company, together with its subsidiaries, operates as a public electric utility company. It is involved in the generation, transmission, and distribution of electricity through coal, nuclear, oil and gas, and hydro resources in the states of Alabama, Georgia, Florida, and Mississippi. The company also constructs, acquires, owns, and manages generation assets, including renewable energy projects. As of December 31, 2014, it operated 33 hydroelectric generating stations, 33 fossil fuel generating stations, 3 nuclear generating stations, 13 combined cycle/cogeneration stations, 9 solar facilities, 1 biomass facility, and 1 landfill gas facility. The company also provides digital wireless communications services with various communication options, including push to talk, cellular service, text messaging, wireless Internet access, and wireless data; and wholesale fiber optic solutions to telecommunication providers in the Southeast. The Southern Company was founded in 1945 and is headquartered in Atlanta, Georgia. A Closer Look The Southern Company has remained focused as an electric utility company through the years. The company has remained a heavy user of dirty fuels such as coal (accounts up to 42%) for its power generation over the years, but has started transitioning to cleaner resources including natural gas, solar and wind. This move will also be welcomed as the company aligns itself with the US government mandate targeting power plants to cut carbon emissions by 32% (by 2030) on the 2005 levels. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) Acquisition of AGL Resources Inc. In August 2015, Southern Company announced a plan to acquire AGL Resources Inc. for about $8B in cash, fortifying SO’s assets with the natural gas infrastructure. AGL Resources distributes gas in Georgia, Illinois, Virginia, New Jersey, Florida, Tennessee and Maryland. Southern Co. owns utilities in Georgia, Alabama, Florida and Mississippi. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) This move lowers SO’s dependence on power generation and pushes SO to the #2 spot in the utility sector by customer count after Exelon Corp. (NYSE: EXC ). The combined company will operate 200,000 miles of electric lines and 80,000 miles of gas pipelines. The deal is expected to close in the second half of 2016. Southern Company will be issuing $3B in new stock and also tapping into the debt markets to finance the merger. (click to enlarge) (Source: September 2015 Southern Company Overview Presentation) The deal is expected to raise the long-term EPS growth rates by 4-5%. In addition, the dividend growth is expected to rise faster than current rates. Dividend Stock Analysis Financials Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations. (click to enlarge) (Source: Created by author. Data from Morningstar) (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The utility industry is resilient and has seen a slow and steady rise over the years. Revenues and earnings are fairly constant with year-over-year growth ranging between -0.3% to +0.15%. The debt load is also stable and SO enjoys a ‘A-‘ credit rating from S&P. SO has a debt/equity of 1.36 and a current ratio of 0.80. Those numbers can be expected to change significantly over the course of next year or two as the AGL purchase moves closer to closing. Dividends and Payout Ratios Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: Utility companies are slow and steady growers and are perfectly suited for long-term dividend investors. Southern Company is a Dividend Contender having raised dividends consecutively for 15 years. The 1-, 3-, 5-, and 10-year dividend CAGRs are 3.5%, 3.6%, 3.7%, and 39% respectively. Coupled with a current dividend yield of 4.86%, SO has a Chowder Rule number of 8.56. The current payout ratio is 89%. Outstanding Shares Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The number of shares have risen steadily over the years and are expected to rise more as the company intends to issue $3B of new equity to finance the AGL deal – approx 66M new shares based on current price, an increase in the number of outstanding shares by ~7%. Book Value and Book Value Growth Expected: Growing book value per share. (click to enlarge) (Source: Created by author. Data from Morningstar) Actual: The book value is a bright spot in the company’s financials. The book value has steadily increased over the years maintaining a nice upward trajectory, although we can expect this to stumble when more debt and shares are issued in the coming years. Valuation To determine the valuation, I use the Graham Number, average price-to-earnings, average yield, average price-to-sales, and discounted cash flow. For details on the methodology, click here . The Graham Number for SO with a book value per share of $22.22 and TTM EPS of $2.35 is $34.28. Based on the last closing price, the stock is currently 30% overvalued. SO’s 5-year average P/E is 18.92, and the 10-year average P/E is 17.80. Based on the analyst earnings estimate of $2.94, we get a fair value of $55.62 (based on the 5-year average) and $52.33 (based on the 10-year average). SO’s average yield over the past five years was 4.60% and over the past 10 years was 4.61%. Based on the current annual payout of $2.17, that gives us a fair value of $47.17 and $47.07 over the 5- and 10-year periods, respectively. The average 5-year P/S is 2.16 and average 10-year P/S is 2.0. Revenue estimates for next year stand at $21.18 per share, giving a fair value of $45.74 and $42.35 based on 5- and 10-year averages, respectively. The consensus from analysts is that earnings will rise at 3.58% per year over the next five years. If we take a more conservative number at 3%, running the three-stage DCF analysis with an 8% discount rate (expected rate of return), we get a fair price of $36.73. The following charts from F.A.S.T. Graphs provide a perspective on the valuation of SO. (click to enlarge) (Source: F.A.S.T. Graphs ) The chart above shows that SO is slightly undervalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be 2.75%. (click to enlarge) (Source: F.A.S.T. Graphs ) Conclusion Electric utilities in general have seen slower sales industry-wide amid a combination of energy conservation, energy efficiency and shift towards independent power generation/natural gas usage. Coupled with the new regulations from the US government to reduce carbon emissions, electric utilities have started focusing a shift away from dirty fuels such as coal. Southern Company still relies heavily on coal, but has started focusing on cleaner energy alternatives to meet the target. In a move to diversify and fortify its assets, the company is moving to acquire AGL Resources Inc. in a deal financed by new share and debt issuance. While this is good for the overall company’s business, in the short term (over the course of next few quarters/years) some balance sheet damage can be expected as the company takes on more debt and investors see share dilution. An added risk for investors is the potential rise of interest rates by the US Fed. Bond substitutes such as utility stocks suffer the most in rising rate environments. Based on the metrics discussed above, if we give equal weight to all metrics, we get a fair value of $45.31. Full Disclosure: None. My full list of holdings is available here .

Atmos Energy – Great Company, But Overvalued

Summary Atmos Energy operates in highly favorable operating and regulatory environment. The company is a Dividend Aristocrat, having raised its dividend for over 31 years now. However, the company is overvalued. The yield is too low compared to historical averages and the company’s overspending of its cash is worrisome. Atmos Energy Corporation (NYSE: ATO ) operates primarily as a regulated natural gas distributor, in fact it is one of the largest pure play natural gas operations in the United States. Based out of Texas, he company has operations stretching across eight states serving over three million customers. Given its location, Atmos Energy has access to cheap natural gas sourced from the Val Verde and Barnett shale plays. Further bolstering the company is a favorable regulatory environment. Both Texas and neighboring Louisiana have company-friendly utility policies in the form of annual rate filing mechanisms. These allow Atmos Energy to put in requests to modify its rates on an annual basis without filing a formal rate request. What this means is that the company can recover a majority of capital expenditures and commodity prices from customers quickly. These two factors have created a prime situation for Atmos Energy’s utility operations. Overall, Atmos has been a consistently profitable business that has rewarded shareholders greatly over the years. The company is a member of the oft-observed Dividend Aristocrats index (companies with 25 or more years of consecutive dividend increases), which has led to Atmos Energy finding itself in many retail investor portfolios due to its strong yield and proven track record. But is the future for Atmos Energy as bright as the past? Company Track Record (click to enlarge) Total revenue has grown at a 3.74% pace since 2011. In reality, this understates growth as the company sold some of its natural gas distribution operations in four states as part of a streamlining initiative (Missouri, Illinois, Iowa, Georgia). Investors can see that this divestiture was wise as it likely contributed to improved operating margins from fiscal 2013 forward. Like I do with most utilities, I like to see how cash flow is used by the company. Dividend-paying companies have two main uses of cash outside of operational activities; capital expenditures and dividend payments. At worst, I like to see cash flow from operations = capital expenditures + dividend payments. As you can see, Atmos Energy has traditionally run a deficit on this metric. What this means is that the company has to raise cash to meet all of its obligations, either through debt or a dilutive stock offering. As should have been expected, Atmos Energy raised $386M net cash in 2014 from a stock issuance (9.2 million shares), the announcement of which sent shares plunging (shares have since recovered). Atlas has no plans to slow down capital expenditures, which the company has said is needed primarily to maintain pipeline integrity and general system improvements. In fact, capital expenditures may reach $1.1B annually by 2018 according to company estimates. I would expect Atmos to raise some funds in the debt markets in 2016 or 2017, possibly in the range of $500M, given its solid credit ratings. Application of the Dividend Discount Model As I highlighted in a prior article , the dividend discount model is a great way for conservatively valuing dividend companies, especially those with stable and proven track records. We can generate a valuation of Atmos Energy with the following assumptions: $1.65 expected dividend next year, an 8% discount rate, and 2.5% average annual dividend increases going forward (below the current three year average of 2.9% but below the ten year average of 2.0% increases). P = 1.65 / (.08 – .025) P = 1.65 / 0.055 P = $30/share This gives us a fair value of $30.00/share, indicating that shares might be overvalued based on the expected future cash flows to be generated from our investment. Further support of this relative overvaluation can be found in the five year dividend yield average for Atmos, which has historically averaged 3.80%, which would put fair value of shares at the $44-45/share range. Given the yield currently stands at 2.81%, I believe that shares may have appreciated in value too much compared to recent company earnings. Conclusion Atmos has a strong set of operations in a highly desirable area. Management history of rewarding shareholders is healthy. However, this status has made the company’s stock a bit crowded, especially given the risks related to the expected continued leveraging given the operational cash flow deficit. In my opinion, for investors that want safety, there are better picks in the utility or dividend aristocrat space that would present less material downside risk. At current prices, I simply could not become a shareholder.

Global Infrastructure Investments

By Todd Rosenbluth Once every four years, America’s civil engineers provide a comprehensive assessment of the nation’s major infrastructure categories. The latest report card has a poor cumulative GPA for infrastructure of D+, with rail and bridges each earning a C+. While Congress continues to debate whether, and how, to fund the projects to improve the quality of the nation’s backbone, there has been some encouraging news at the state level. Nearly one-third of U.S. states, including Georgia, Idaho and Iowa, are addressing infrastructure investment through gasoline tax increases to support improvement of local roads and bridges. Indeed, nearly two-thirds of the assets inside the S&P Global Infrastructure index are domiciled outside of the U.S., with China (5%), Japan (4%), Italy (8%), Spain (5%), and the United Kingdom (7%) among the ten largest countries. The S&P Global Infrastructure index seeks to provide broad-based exposure to infrastructure through energy, transportation, and utility companies in both developed and emerging markets. S&P Capital IQ Equity Analyst Jim Corridore thinks that companies that construct infrastructure are likely to see increased demand over the next several years due to the need for upgrade and expansion of infrastructure both within the U.S. and around the world. Within the U.S., aging and outdated roads, electric transmission grids, and energy transmission facilities are in dire need of repair and replacement, according to Corridore. Meanwhile pipelines, water treatment, and rail are seeing increased demand and need for expansion. From an industry perspective, transportation infrastructure (40% of assets) are well represented in the global infrastructure index, but this is partially offset by stakes in electric utilities (22%) and oil, gas & consumable fuels (20%) companies. Holdings include Kinder Morgan (NYSE: KMI ), National Grid (NYSE: NGG ) and Transurban Group ( OTCPK:TRAUF ). The S&P Global Infrastructure index generated a 9.6% annualized return in the three-year period ended July 2015. However, given the strength in the US dollar relative to most currencies in the last three years, many currency hedged international approaches have outperformed those that hold just the local shares. This is one of those examples, where the currency neutralized infrastructure index was even stronger with a 13.0% three-year return. On a calendar year basis, the hedged index outperformed in 2013 and 2014, after underperforming in 2012. Meanwhile, from a risk perspective the three-year standard deviation for the hedged S&P Global Infrastructure index was 20% lower. S&P Capital IQ thinks that global infrastructure needs has created some investment opportunities. However, we think investors need to be mindful of the impact currencies can play. There are four ETFs that offer global infrastructure exposure and 39 non-institutional mutual fund share classes. 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 .