Southern's Dividends May Not Last Forever

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, they also have the potential for capital appreciation. Simply put, dividend stocks can give your portfolio what almost no other investment can -- both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, stocks in the S&P 500 that don't pay dividends have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. That is an incredible difference -- one that you'd be crazy to not take advantage of!

But investing in dividends can be dangerous -- companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warnings signs that may alert you, and these red flags could be the crucial factor in determining whether a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out Southern Co. (NYSE: SO  ) .

What's on the surface?
Southern, which operates in the electric utilities industry, currently pays a dividend of 4.70%. That's certainly nothing to sneeze at, as the average dividend payer in the S&P 500, in 2009, sported a yield of 2%.

But what's more important than the dividend itself is Southern's ability to keep that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the past five years:

Source: Capital IQ, a division of Standard & Poor's


Source: Capital IQ, a division of Standard & Poor's

Clearly, there doesn't seem to be a problem here. Southern has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time.

The more secure, the better
One of the most common metrics that investors use to judge the safety of a dividend is the payout ratio. This number tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything above 50% is cause to look a bit further. According to the most recent data, Southern's payout ratio is 70.17%. Southern is obviously paying out a substantial portion of its net income in the form of a dividend. This isn't necessarily a bad thing -- companies can increase their payout ratios over time, possibly because they are becoming more mature, or possibly because that's the best way to increase shareholder value. What's important is if there's enough cash on hand to support that high payout ratio, so let's look at free cash flow.

Free cash flow -- all the cash left over after subtracting out capital expenditures -- is used by firms to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio, which is cash flow per share divided by dividends per share. Normally, anything above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Southern's coverage ratio is 0.24, which isn't enough to make me feel comfortable as an investor. There could be a number of reasons the number is so low -- maybe it's typical for the industry, maybe there's a significant amount of debt coming due, or maybe Southern is simply less than stellar at managing its assets.

Either way, it's always beneficial to compare an investment with its most immediate competitors, so in the chart below, I've included the above metrics with those of Southern's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Southern can illustrate that it's grown dividends over the past five years then there's a good chance that it will continue to put shareholders first in the future. Check out how Southern stacks up below:

Company

Dividend

Yield

Payout

Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Southern

4.70%

70.17%

(0.24)

4.11%

Exelon (NYSE: EXC  )

5.00%

53.02%

1.57

5.61%

Duke Energy (NYSE: DUK  )

5.50%

185.99%

(0.12)

(2.69%)

NextEra Energy (NYSE: NEE  )

3.60%

42.83%

(2.78)

6.95%

Source: Capital IQ, a division of Standard & Poor's.

The Foolish bottom line
Only you can decide what numbers you're comfortable with in the end; sometimes a higher yield and a higher reward mean additional risk. However, when we look at Southern's payout ratio compared to its peer average, we see that it is a lower percentage, which illustrates that its dividend is probably more sustainable. Out of this small bunch, Exelon certainly seems to emerge from the pact as having the most sustainable dividend. The bottom line, however, is to make sure that with anything -- whether it be a dividend, a share repurchase, or an ordinary earnings report -- you do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.

Jordan DiPietro owns shares of Exelon. Exelon is a Motley Fool Inside Value pick. Southern is a Motley Fool Income Investor pick. Duke Energy is a former Motley Fool Income Investor pick. The Fool owns shares of and has written covered calls on NextEra Energy. The Fool owns shares of Exelon. 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.


Read/Post Comments (6) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 26, 2010, at 5:05 PM, busterbuddy wrote:

    YOU know I believe you used to promote Enron as a great investment. And you like to talk about Utility companies dividends not lasting for ever. I guess if you live in California or the Northeast you might think that dividends from Utilities can be risk. But Dividends from the likes of Southern company are about as safe as those from the U,S or maybe safer.

    But do are your analysis you want, the smart money has always set Southern company as a fundamental investment. Do invest in Southern. More money for me.

  • Report this Comment On October 26, 2010, at 5:36 PM, rambocat22 wrote:

    Your article reads like a work of fiction. You can't find a more stable company than Southern Company to buy stock and receive a dividend of just less than 5 percent.

    You seem to contradict yourself too. Your headline warns that Southern Company's dividends may not last forever. But in your article who say "Clearly, there doesn't seem to be a problem here. Southern has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time."

  • Report this Comment On October 27, 2010, at 8:51 AM, ISF9 wrote:

    Whenever I read stupid articles like this I get upset by the lack of accurate information being posted. DUKE ENERGY DID NOT REDUCE THEIR DIVIDEND, THEY INCREASED IT!!!!! What they did was spin off

  • Report this Comment On October 27, 2010, at 8:53 AM, ISF9 wrote:

    Spun off Spectra Energy. They then adjusted the share price downward and the dividend to reflect the equity remaining. Then they increased the dividend. THIS WRITE IS BEING PAID TO PRODUCE GARBAGE LIKE THIS?????

  • Report this Comment On October 27, 2010, at 8:54 AM, anderson2510 wrote:

    Southern Company has a history of more than 62 years of paying quarterly dividends. I think that shows the strength of their business, management, and regulatory environment in which they operate.

    Perhaps you should examine where the free cash flow is going. They are spending on technology, infrastructure, and environmental controls. In other words, they are funding the business so that they can ensure another 62 years of paying dividends.

    Your readers deserve a better story, quite honestly.

  • Report this Comment On October 27, 2010, at 10:44 AM, SomeOldInvestor wrote:

    I agree with anderson2510. Southern's cash flow is being used to grow its future income stream. That's a good thing. You imply that it is not.

    Your comparison group is not the best. You should have noted that Southern is much safer than EXC and NEE and should therefore have a lower payout ratio etc. relative to SO. DUK is OK. A better group would have included ED and PGN.

    There are also a few analysts voicing concerns over EXC's future earnings ability. One calls the EXC dividend into question. Their comments on Southern's future are much more optimistic. You are at odds with many analysts in declaring that "Exelon certainly seems to emerge from the pact as having the most sustainable dividend".

    Would a better title be "Southern's Dividends Might Last Forever"?

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