The rise in bond rates has resulted in a substantial recent pullback in utilities stocks. A lot of this move has been warranted, because these stocks were selling at the higher end of their historic valuation trading bands. But in the wake of this pullback, a few select opportunities in the utilities space are now appealing.
One is Southern (SO). The company has underperformed its peers over the past year because of what should be one-time operating hiccups. First, Southern is experiencing construction cost overruns at generating plant expansions in Mississippi and Georgia. These setbacks should be resolved in 2014. Second, rate increases at regulated power subsidiaries in Florida, Georgia and Alabama look like they will be shy of expectations. Fortunately, overall power rates and allowed returns are still very healthy.
As a result of these operating shortfalls, analysts reduced their 2013 EPS estimates for Southern by $0.10 to $0.15. Earnings for 2013 are expected to be $2.66, flat with 2012's results. The company will also have to issue an additional $1 billion in equity, and that has added to the downward pressure on the shares.
Because of these factors, Southern's stock price has underperformed the utility group in 2013. The shares are down about 5% year to date, compared with low-to-mid-single-digit gains for most of the sector. Southern now trades in line with peer earnings multiples, at 15.3x 2013's EPS estimate of $2.66 and 14.6x 2014's EPS estimate of $2.80.
This depressed level of valuation is a surprise to many long-term utility investors, since Southern has historically traded at a 15% premium to the group, thanks to its first-rate management team, higher growth rates and superior margin levels. The company's operating footprint is in the higher population growth states of Florida, Georgia, Alabama and Mississippi. Furthermore, these states have typically granted utility operators more steady and favorable rates of return over time.
While we don't believe Southern will be a home run, we do look for modest appreciation over time. The utility has the opportunity to be upwardly revalued by 15%, returning to its longer-term valuation premium. Earnings should increase better than the industry average over time because of Southern's superior operating environment, higher population growth and better regulatory regimes. On the other hand, if the utilities group pulls back an additional 5% or 10%, Southern can stay flat or modestly increase, as we expect it to return to a premium to the group.
In the meantime, investors will receive a very attractive 4.96% dividend. The dividend is safe and should grow 3% to 4% annually over time. We also believe that the weak stock performance this year and a more reasonable valuation should enable the stock to provide better downside protection than most interest-rate-sensitive stocks, assuming bond rates continue to rise in the coming year.
Accordingly, we believe Southern should be an attractive core holding for conservative dividend investors seeking a healthy current yield, with below market volatility over the next year or two.