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. 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