Southern Company (SO 2.24%) reported a 20% year-over-year drop in first-quarter 2019 adjusted earnings. That's pretty awful, but not nearly as bad as it looks when you dig into the details a little bit. Here's why Southern's earnings drop was more good than bad.
What the heck happened?
Utilities are supposed to be slow and steady businesses with fairly consistent earnings. That's the expected trade-off based on the government-regulated-monopoly model that accounts for the vast majority of Southern's business. When the company reported first-quarter adjusted earnings, however, the $0.70 per share it had earned was well below the $0.88 from the same period of 2018.
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There were some puts and takes that largely balanced out in the quarter to have no impact. Which left just two big negatives. First up was weather, which no one can control or predict. And weather can have a material impact on electricity and natural gas demand. That single factor was a roughly $0.07-per-share headwind. But that accounted for only about a third of the difference between the two quarters.
The rest of the decline in adjusted earnings, or $0.11 per share, was related to the sale of assets. Essentially, Southern's business was smaller in the first quarter of 2019 than in the same stanza of 2018. That, in turn, led to lower earnings. So the year-over-year earnings decline isn't as bad as it looks, but you still need to know why Southern would make the decision to shrink its business.
It's mostly about Vogtle
If you follow Southern Company, the name Vogtle is likely to cause a visceral reaction. This is the name of the nuclear power project that the utility has been working on, which has faced material delays and cost overruns. With completion dates for the two nuclear reactors Southern is building at the Vogtle site landing in 2021 and 2022, the company is nearing the home stretch. But it hasn't been easy, with Southern forced to take over management of the project following the bankruptcy of former contractor Westinghouse. At this point, however, it looks like Southern has gotten the project back on track.
But Southern isn't done yet, so it still needs to pay for the rest of the Vogtle project. To put it simply, building nuclear power plants is expensive. There are only a few options available for coming up with this cash. Southern could sell debt. However, with leverage at the high end of the utility peer group, that's not a great option. To be fair, its debt-to-equity ratio has improved drastically over the past year (helped along by the asset sales). But that doesn't change the fact that leverage remains elevated.
Southern's Leverage Is Falling, but Still High
SO Debt to Equity Ratio (Quarterly) data by YCharts
The next option is to sell stock. That's not a bad choice -- Southern stock is up roughly 20% so far in 2019. But a comparison to today's price isn't fair, since the decision to sell assets, most notably Gulf Power in Florida, was made in May of 2018 -- before the 2019 rally. Selling stock last year was a much less compelling option. In fact, the stock price today is nearly 25% higher than it was when the sell decision was made. The Guld Power deal, for reference, was basically completed by the end of 2018.
Which helps explain why Southern chose to sell Gulf Power to giant Florida utility NextEra Energy. And while the impact of the sale was an $0.11-per-share decline in earnings, you need to think through the decision a little more before passing judgment. CFO Andrew Evans explained during Southern's first-quarter 2019 conference call: "In aggregate, our 2018 and 2019 divestitures have proven to be an efficient source of equity with a substantially lower cost of capital than issuing new common shares. These transactions have also enabled us to significantly strengthen Southern Company's balance sheet, as evidenced by the $4 billion, or over 25%, reduction in holding company debt year-over-year."
Further, Evans noted that despite the immediate impact of the divestitures on earnings, Southern expects the transactions to add to earnings per share over the course of the full year. That's due in part to the fact that Southern won't have to sell shares at less-than-compelling prices as it looked to shore up its finances so it could continue to spend what it needed on the Vogtle project. Keep in mind that sales of additional stock would have reduced earnings, too, since earnings would have been spread over a larger number of shares (also known as dilution). All in all, the asset sales are a win for Southern and its shareholders even if they led to a sizable drop in year-over-year earnings in the first quarter.
Still working through it
Southern is muddling through a difficult period right now, highlighted by a very large and troubled construction project. It hasn't been particularly pretty, and the utility has had to make hard decisions. The asset sales are a big piece of the puzzle and clearly had a notable negative impact on first-quarter results. But when you step back, keeping in mind that the Vogtle outlook is starting to brighten, Southern appears to be making the right choices for the business and its shareholders.
On that last front, it's worth noting that the utility upped its dividend again in the first quarter despite the year-over-year earnings decline. That makes 2019 the 18th consecutive year with an annual increase -- and the 71st year with an equal or greater dividend. That's a track record that speaks volumes about Southern's shareholder-friendly focus. The headline number in the first quarter was rough, but Southern hasn't taken its eye off what is important over the long term.
