La Compagnie du Sud: high debt, low growth
The Southern Company (SO) is a utility company that generates and distributes energy. In times of uncertainty, many investors may see the utilities sector as a safe option to park their money.
However, we’re not big fans of The Southern Company for many reasons, and we think there are better defensive stocks out there. Accordingly, we are neutral on the stock.
Big investments, little growth
For starters, the industry itself is a high CapEx industry because building infrastructure to generate electricity is not a cheap business. The Southern Company has had negative free cash flow since 2016 as it invested heavily in property, plant and equipment (CapEx).
If we use depreciation and amortization as a proxy for maintenance CapEx, we can see that a large portion of overall CapEx spending went to growth initiatives.
However, revenue grew at a compound annual growth rate of just 2.5% over the same period. This mediocre performance does not justify the heavy investments made in growth initiatives, especially if it translates into negative free cash flow.
High debt load
Since The Southern Company has invested more cash than it generates, it has had to take on more debt. In fact, total debt has nearly doubled since 2015, reaching over $54 billion last quarter. This puts the leverage ratio at 6x total debt/EBITDA.
Although it is common for companies in the sector to have a lot of debt, it still increases the risks associated with the business. The main problem we have with borrowing is that interest rates have risen rapidly due to inflation.
However, when looking at the company’s long-term debt maturity schedule, there is over $5 billion in debt maturing from 2022 to 2023. SO has no plans to pay down debt and renew it with $8 billion in new debt within the same time period.
With such high indebtedness, the company will likely continue to refinance much of its debt even after deciding to pay it off. In a rising interest rate environment, that’s not exactly what an investor should want to see, especially if inflation gets worse than expected.
While we don’t believe investors should worry about bankruptcy, high leverage in such a situation could certainly impact the company’s dividend growth.
To value The Southern Company, we will use a dividend discount model since this is the primary reason investors put their money in utility stocks.
Since the growth of the business is less than 10 digits, we will use a one-step growth model. For the perpetuity growth rate, we will use the 30-year US Treasury yield as a proxy for expected long-term growth.
The calculation is as follows:
Fair value = Dividend per share / (discount rate – growth)
$71.35 = 2.64 / (0.06 – 0.023)
Accordingly, we estimate The Southern Company to be worth $71.35 per share under current market conditions.
The Taking of Wall Street
As for Wall Street, The Southern Company has a Consensus Hold rating, based on four buys, six holds, and two sells assigned over the past three months. The Southern company’s average price target of $70.36 implies an upside potential of 6.9%.
Although SO’s stock may be less volatile than that of the broader market, it is still not immune to declines when the market falls and is slow to recover when the market recovers.
Additionally, the amount of money spent on growth initiatives does not justify the actual results the company has seen in its underlying business.
Therefore, in addition to a low margin of safety in valuation, we remain neutral on the stock.
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