Is Southern Company a Buy?

The 46 gigawatts of power generation capacity, roughly 200,000 miles of electric transmission and distribution lines, and 9 million customers easily make Southern Company (SO +0.64%) one of the largest energy companies in the United States. While its historical focus has been on power generation and electricity distribution, the company's recent investments in natural gas are paying early dividends to shareholders. And given the growing importance of natural gas to Uncle Sam's energy security, the moves demonstrate that the company is thinking about the long-term picture. 

That should be encouraging to investors, as should the regulated electric utility business, which guarantees slow and steady growth over the long haul. However, a few riskier moves in a failed clean coal project and the ongoing construction of two expensive nuclear reactors don't exactly instill confidence. But given the 9% drop in stock price to open 2018 -- which pushed the dividend yield to 5.3% -- and relatively strong full-year 2017 earnings, is Southern Company a buy?

Image source: Getty Images.

By the numbers

Southern Company turned in a strong year of operations in 2017, although it took a $3.3 billion loss on the Kemper clean coal project in the second quarter. Going forward, the facility will simply continue generating electricity by burning natural gas, which was supposed to be a key part of the previously pursued clean coal project anyway. Ironic? Perhaps, but it's a sign of the times, especially when considering the growth of the company's natural gas utility business. 

Data source: SEC filing.

While year-over-year revenue growth of 137% in natural gas is impressive, the devil is in the details. The segment was created following the merger with AGL Resources in the summer of 2016 and contributed for exactly half of that year. Nonetheless, comparing natural gas revenue last year to the annualized total for 2016 still yields year-over-year growth of 19%.

Investors shouldn't expect a similar performance every year, but Southern Company plans to invest about $6 billion in its state-regulated gas portfolio between now and 2022. That bodes well for long-term growth (through rate increases over time) and reduced expenses (newly replaced pipelines will require less maintenance). 

Less impressive is a major decrease in operating income and EPS, although writing off the clean coal project cost shareholders $2.33 per share. Excluding unusual items Southern Company reported EPS of $3.02 in 2017, compared to $2.90 in the previous year. 

Meanwhile, management has guided for full-year 2018 EPS to fall within the range of $2.80 to $2.95, or about in line with performance in the last two years. How does that and other metrics compare to integrated energy peers?

Image source: Getty Images.

Comparison to peers

While Southern Company is the second-largest utility company in the U.S. based on its customer base of 9 million, Duke Energy (DUK +0.42%) and Dominion Energy (D +0.35%) are in the same league. Income investors drawn to the high yields of utility stocks may wonder if any one stock has a hands-down lead on its peers. Unfortunately, it's not so straightforward.   

Data source: Yahoo! Finance. EV = enterprise value. EBITDA = earnings before interest, taxes, depreciation, and amortization.

While Southern Company boasts the highest dividend yield and most attractive forward earnings ratio among the trio, that alone doesn't deliver a very convincing investment argument. Therefore, I think it's important for investors to consider the power generation mix of the integrated energy companies they invest in, especially with big changes expected at the national level in the coming decades. Here's an overview of the percent of power generated in each company's portfolio in 2017:   

Data sources: Southern Company, Duke Energy, and Dominion Energy.

On the one hand, having a balanced portfolio of generation assets helps to mitigate risks and provide reliable power. On the other hand, relying too heavily on coal and nuclear could represent a long-term risk for shareholders, especially if those power plants need to be closed and replaced. Southern Company is light-years ahead of Duke Energy and Dominion Energy when it comes to using natural gas and lessening its dependence on coal, although much of that has to do with its geographic position in the southeast U.S.

And although it has the lowest dependence on nuclear energy, that will change (and shift the generation mix of the entire portfolio) following the expected start-up of two new nuclear reactors in 2021 and 2022. Southern Company is going full steam ahead with construction following much-publicized cost overruns and delays, but recently reported that rates will be lower than expected. Nonetheless, it's worth wondering whether the massive investment in atomic energy will prove wise in 10 or 20 years' time.

Is Southern Company a buy?

Southern Company is a blue-chip utility stock that can provide investors with a steady stream of income, especially with its current 5.3% dividend yield. Despite a failed attempt to usher in the age of clean coal and controversial investment in new nuclear power, the overall business remains strong and bolstered by an expanding presence as a natural gas utility.

That said, investors may want to consider that shares of large utility companies -- namely Southern Company, Duke Energy, and Dominion Energy -- haven't come close to matching the total returns of the S&P 500 over longer periods of time. In the last five years, the index has returned 100% with dividends reinvested, compared to just 22%, 37%, and 57%, respectively, for the utility trio. The large and sudden drop in share price may create an opportunity for long-term investors, but risks presented by generation mix might suggest otherwise. That's why I'm not interested in adding any big utility stock to my portfolio.