Is Southern Company a Buy?

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Utility stocks are the very definition of slow-and-steady investing. Their businesses provide a product that is a necessity of human society and the companies in the industry operate in a highly regulated environment. For decades, investors have counted on the steady profits and reliable dividends paid by utilities, and for those reasons, utilities have been given the “widow-and-orphan stock” moniker.

In recent years, utility investors have been doubly rewarded in the form of big capital gains in addition to regular income. Stocks like Southern Company (NYSE: SO) have rallied considerably since early 2011. As a result, many utility stocks now trade for lofty valuations. Are valuation multiples beyond reason within the utility industry? Or are stocks such as Southern still worth buying?

Powering up your portfolio

Southern Company is up more than 33% since the beginning of 2011, and now trades for 19 times trailing earnings according to Yahoo Finance. Southern isn’t the only utility riding high. Industry peer American Electric Power (NYSE: AEP) has climbed 28% since the start of 2011, and now, like Southern, trades for 18 times trailing EPS.

Unfortunately, the rise in valuations of many utility stocks hasn’t been backed up by similar growth in underlying sales and profits.

Southern Company’s most recent full fiscal year saw diluted earnings per share rise only 4.7% along with a 6.3% decline in operating revenues.

American Electric Power, meanwhile, experienced a 1% drop in sales in 2012 in addition to a 4.5% drop in operating income during the year.

Ditto for Consolidated Edison (NYSE: ED), which trades for a trailing P/E of 16. Although a 16 P/E doesn’t sound expensive at first, it becomes much less attractive when you consider that the company expects little to no earnings per share growth this year.

Dividends aplenty

On the plus side, these utilities provide the dependable income that their investors take for granted. AEP recently raised its dividend 4%, and has a tremendous dividend track record. The company has paid a dividend to its stockholders every quarter since 1910.

Southern Company last raised its dividend in April, giving investors a 3.5% pay bump. This marked the 12th straight year of a dividend increase. Southern Company has a great dividend history of its own, having paid a dividend to its shareholders for 262 consecutive quarters.

In February, Consolidated Edison raised its dividend for the 39th consecutive year. However, it’s worth noting the dividend raise was just 1.7% from the company’s prior dividend.

Opportunity not year knocking

Utility stocks such as these have rallied considerably over the past couple years and now command valuations on par with the S&P 500 earnings multiple, despite little to no earnings growth.

Add in the likelihood that utility stocks may remain under near-term pressure as investors collectively fret the onset of higher interest rates, and I’d classify each of these stocks as holds.

Southern, AEP, and ConEd are highly profitable businesses that operate in an industry with a wide economic moat. Investors starved for income can rest assured that each of these stocks will continue to pay their hefty 4%-plus yields for years to come, a near certainty since electricity is a matter of national security.

That being said, utilities simply can’t offer significant enough revenue and earnings growth to justify paying 18 times trailing earnings. Small dividend increases over the past year is indicative of their extremely slow growth. While it’s true that utilities have come down somewhat in recent weeks, I’d still wait for dividend yields to get closer to 5% before jumping in. Investors would be wise to avoid buying utilities for now and wait for more attractive entry prices.

Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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