Infrastructure

Still Big Upside Potential for Southern Co. After AGL Acquisition News

The deal is not expected to close until the second half of 2016, and Argus noted that Southern will have to raise debt and equity to pay for the deal. Argus did address at least one more concern here. The firm said:

On the negative side, the company is building a new coal-gasification plant and two new units at its Vogtle nuclear plant, and both projects have been hampered by delays and high construction costs. Income-oriented investors may like the dividend yield of about 5.1%, above the utility industry average of 3.8%. … Excluding the impact of the recently announced AGL merger, we expect the company to provide consistent and stable earnings growth…

Argus has a 2015 EPS estimate on a stand-alone basis of $2.85, which is above the midpoint of management’s guidance range. It has also maintained its 2016 estimate of $2.95 per share. With projected capex of $6.8 billion in 2015, capex should be about $16.6 billion spread over the next three years.

On the dividend strength, Argus said:

Our financial strength rating for Southern is Medium-High, the second highest point on our five-point scale. Both S&P and Moody’s give the company investment-grade credit ratings. However, Moody’s lowered its outlook to negative from stable on news of the AGL Resources transaction. On August 17, S&P also lowered its ratings on the parent company and its subsidiaries, citing a deteriorated regulatory environment in Mississippi and uncertainty about future rate increases in the state; its outlook remains stable.

At the end of 2Q15, Southern’s total debt/capital ratio was 56.4%, up from 54.9% at the end of 2Q14. EBITDA covered interest expense by a factor of 7.4 in the 12 months ended June 30, 2015, down slightly from 7.6 in the prior-year period. Operating cash flow for the trailing 12-month period ending June 30 was $5.9 billion, down from $6.2 billion a year earlier. Cash flow covered 99% of capital expenditures in the period, compared to a coverage factor of 110% in the 12 months ended June 30, 2014. In the second quarter of 2015, Southern raised its quarterly cash dividend to $0.5425 from $0.525 per share, or $2.17 annually. This represents a seven cent, or 3.3%, increase in the annualized rate. … The current yield is about 5.1%.

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Another issue that should stand out here is that this Buy rating is at a time when Argus has an Underweight rating for the utilities sector as a whole. The sector has underperformed the S&P 500 so far in 2015, with a loss of 2.6%, and with the sector having a 2.9% weight in the S&P 500.

Argus noted that Southern trades at 14.4 times its 2016 EPS estimate, below the midpoint of the five-year forward price-to-earnings (P/E) range of 13.0 to 17.8 and the peer average of 15.3. Argus believes that Southern deserves to trade at a premium given its growing dividend, significant capital investments, and the potential for economic growth in its service territories.

Southern shares were at $42.45 on Wednesday afternoon, with a consensus price target of $45.64 and a 52-week trading range of $41.40 to $53.16. If Argus is correct, then Southern has raw price appreciation upside of 18%. Then there is the 5.1% yield to consider, for a total return possibility of about 23%. That is higher upside than most investors expect from the utility sector.