A Dividend That Could Head South

By Chad Henage - September 14, 2012 | Tickers: DUK, ETR, NEE, SO | 0 Comments

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I read a few articles by different authors suggesting that there could be a dividend bubble in this market. While on an overall basis I don't believe this is true, there are specific sectors that investors have bid up seemingly because of their yield. There might not be a better example of this bubble of fact than in the utility industry. One of the primary names that has been on a huge run is Southern Co. (NYSE: SO), which has risen from about $37 to nearly $46 in the last two years. I'm not suggesting that the big run-up in the shares is the reason to avoid them, because in a low interest rate environment it shouldn't be surprising that investors are chasing yield. However, when the underlying fundamentals of the business are deteriorating, while at the same time investors are chasing the stock, this can set up a dangerous combination. I've been keeping tabs on Southern Co. for a while in hopes that their financial situation would change. However, based on their recent earnings, the trend is clear and it seems this dividend could be in jeopardy.

Southern Co. is a well-respected utility that primarily operates in the southeastern United States. Some people would point to the higher growth rate at Southern Co. as a reason to favor this utility, but a slightly higher growth rate will not change the company's financial situation any time soon. Though analysts expect faster EPS growth than some of their competition, from Southern Co.'s earnings report this is not happening. The company operates in four major divisions and unfortunately for investors, all four divisions showed a decline in revenues. Overall revenues decreased 7.5%, which led to adjusted EPS decreasing 2.82%. Industrial and commercial sales represent just over 50% of total revenues and both were down just slightly. The other half of Southern's business, Residential and Wholesale sales were down 4.3% and 8.1% respectively. The company tried to put a positive spin on residential results by saying they added 20,000 new residential customers, which was more than they projected for the entire year. The main issue behind the sales decline was “near normal weather” versus an unusually warm second quarter last year. What should be an even greater concern, is the company's financial situation in regards to their dividend payment.

With a current yield of about 4.3%, Southern Co. is certainly attractive to income starved investors. With CDs and money market rates at near record lows, individuals and families looking to live off of their interest have likely shifted funds to utility stocks over the last year or so. This comes from the fact that utilities are seen as safe investments, and their stocks usually have low betas which leads to the illusion of less risk. However, the single greatest risk to any utility is the company's ability to maintain its dividend. Looking at Southern Co. versus several other competitors, I think you'll be able to spot the problem with their dividend.

You can see that if you dig into the cash flow numbers, each utility is very different. Novice investors might look at NextEra Energy's 3.56% yield and assume because the company's yield is the lowest, that their dividend should be well covered. However, as you can see, they were one of two companies that actually had a negative payout ratio over the last year. With negative payout ratios at both Duke and NextEra, technically these two dividends are in more danger than Southern Co. Of the four companies above, only Entergy can claim a reasonable payout ratio at just under 36%. Though the company is expected to grow more slowly than Southern Co., its yield of just under 5% is higher. Given the choice between a company with a roughly 5% yield and in theory a sustainable dividend, or a company with a questionable dividend, I'll take the stable dividend every time.

Southern Co. is paying out much more in dividends on average than the company generates in free cash flow. In fact, just to bring the payout ratio down to 100% of free cash flow, the company would need to cut about $200 million each quarter from their capital expenditures. Unfortunately for investors, these numbers are not an aberration, as over the last three years the company's payout ratio has been over 100% each year. In order to maintain and raise its dividend, Southern Co. has been doing what many utilities have done, and that is leverage up its balance sheet.

In the last several years Southern Co.'s balance sheet has deteriorated significantly.While on the surface the company's long-term debt doesn't appear to have changed much, the line item of deferred long-term liabilities may hide some issues. Southern Co. has seen an increase in its deferred long-term liabilities from $7.5 billion in 2009, to over $10 billion dollars by 2011. In the last four quarters, the company's cash flow issues are much more clear. Cash and investments have decreased by almost $700 million, long-term debt has increased over $700 million, and long-term liability charges have increased by almost $1 billion. With the stock selling at about 17 times forward earnings estimates, the shares look pricey as well.

The bottom line is, the numbers at Southern Co. paint a disturbing picture that lead me to believe this dividend could be headed south. A slow-growing enterprise, selling at over three times its growth rate, and the potential for a dividend cut are not a bet that I would make.

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