Southern Company (SO -1.56%) is one of the largest regulated utilities in the United States. It is offering investors a dividend yield of roughly 4.2% today, which is notably higher than the roughly 3.7% for the average utility, using Vanguard Utilities Index ETF (VPU -1.14%) as a proxy. But the story gets even better when you look out to 2025.
A little (unfortunate) history at Southern
To understand why 2025 is so important, investors need to go back in time by a decade or so. That was when Southern was just getting ready to start building two new nuclear power plants, collectively known as the Vogtle project. Building a large-scale nuclear power plant is no easy task. They are complex, expensive, and time consuming to construct.
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And then there was the bankruptcy of Southern's contractor, Westinghouse. That forced Southern to take over the project's management. Shortly after this negative turn of events the global coronavirus pandemic broke out. That required workers to socially distance, reducing productivity, and resulted in sick days becoming a bigger headwind than normal. It shouldn't come as a surprise that the Vogtle project is over budget and late.
To be fair, that was the case before either of the above events. But the process has been surprisingly difficult for more reasons than just poor execution. Today, however, the utility has gotten one of the two nuclear power plants up and running and is on the verge of getting the second one up, too. This is great news for investors.
Risks are receding and opportunities are on the horizon
While Southern was building Vogtle, execution risk had Wall Street worried, and justifiably so given the project's track record. Once the second power plant is attached to the electric grid, however, this overhang will go away. The company is working on other projects, of course, but none are quite so large and complicated.
There's another important factor in this shift. Vogtle will go from a cash drain to a revenue source. In all, Southern estimates that cash flow from operations will increase by about $700 million. That's cash that can be used for other purposes, like capital investments, debt reduction, and dividends.
This is where the story gets interesting for income-oriented investors. Over the past decade, while construction was ongoing, Southern's annual dividend was increased by $0.07 to $0.08 per year. That amounts to a compound annual rate of roughly 3%, which is enough to keep up with the historical rate of inflation growth. That really represented a prudent balance of rewarding shareholders without overtaxing the company's finances. It also continued the company's streak of raising or maintaining the dividend each year, a record that now stands at an impressive 76 consecutive years.
The extra cash flow from Vogtle, however, will allow the utility to reduce its payout ratio to around 70%, or maybe a little lower (adjusting for the impact of unfavorable weather, the payout ratio was around 84% in the second quarter or 2023). That's a solid level for a large utility and will set the board of directors up to consider a dividend policy change. Basically, management is opening stating that it is likely to suggest that the dividend should start growing at the same rate as earnings by 2025. That should push the dividend growth rate into the mid-single digits, effectively growing the buying power of the dividend over time as opposed to just keeping it even with inflation.
Southern is worth a second look
If you have been avoiding Southern because of the risks related to the Vogtle project, it is time to take a second look. Management has not only worked to protect dividend investors through this difficult period, but it is now looking to reward those investors as the nuclear power plants start adding to cash flow. While Southern isn't likely to become a high-growth utility, it looks like it is on the verge of becoming an even more attractive slow and steady cornerstone investment for income investors. Even if you want to wait until the second nuclear plant is complete, now is the time to start researching the stock -- before the company changes its dividend policy for the better.
