Investors typically view utility stocks as dependable, slow and steady investments. Utilities are highly recession-resistant, as people need electricity no matter the prevailing economic climate. This allows utility companies to generate consistent profits and pass along the bulk of their earnings through to investors in the form of rock-solid dividends.
But it's important to remember that all stocks carry risk. There's no such thing as a risk-less stock, and this includes utilities. Southern Co (NYSE:SO) enjoys a high reputation, and its merits as a dividend stock are well-deserved. Southern has paid consecutive quarterly dividends for more than 65 years, and last year, it raised its dividend for the 13th year in a row.
However, Southern is facing some significant headwinds investors should consider. First, the company is having major complications at its massive Kemper project, including significant cost overruns. This has negatively affected Southern's profits, and it could continue to suppress its growth going forward. Second, the stock valuation is high, especially considering the company's current challenges.
Because of this, investors may want to wait for a better price before buying Southern Company.
Continued problems at the Kemper plant
One of the biggest things Southern investors should be concerned with right now is the state of the company's Kemper County plant.
The Kemper project holds the potential to revolutionize the way coal is burned in the United States. This would be a huge development, since coal is under intense scrutiny in the United States, yet still represents a major form of domestic electricity generation.
The Kemper facility is a 582-megawatt electric power plant that features a high-efficiency technology capable of utilizing lignite, which accounts for more than half of the world's coal reserves. The technology is called Transport Integrated Gasification, or TRIG, and it was developed by Southern Company along with KBR.
This technology converts lignite to gas at a much lower temperature than traditional coal conversion, resulting in significantly lower costs than what's possible with existing gasification techniques. The Kemper facility will employ two KBR TRIG gasifiers to produce clean coal energy. Southern hopes the project will ultimately result in cleaner power, at a lower cost of generation. In addition, the facility is more environmentally friendly than existing coal-burning technologies since it involves fewer emissions of sulfur dioxide and carbon dioxide.
Cost overruns an ongoing headache
Southern has encountered a number of problems at the Kemper plant that threaten to drag down the company's profits. Over the past year, Southern's Mississippi Power has had several cost overruns. Most recently, it identified $177 million in cost increases, including $152 million in additional construction costs. This is a recurring problem for Southern. Last year, the company booked $536 million in after-tax charges related to the increased cost estimates at Kemper. In 2013, Southern was hit with $729 million in additional costs for the project.
In all, the added costs take the total price tag for the Kemper project to more than $5.2 billion, which is significantly higher than the $2 billion initially anticipated. This Southern-specific issue is not being encountered by most of its utility peers, most of whom have more effective cost controls in place. As a result, Southern may carry a unique risk profile that investors should consider.
Not enough margin of safety
Southern's profits are being weighed down by its bloated costs, but the reaction from investors so far has been a collective shoulder-shrug. Shares of Southern are flat over the past year. This has resulted in a valuation that does not leave much wiggle room. The stock currently trades for 20 times trailing earnings per share, is about the market multiple of the S&P 500. But as a utility, Southern should arguably trade at a discount to the broader market. Utilities typically trade for lower valuations than the S&P, since they generate lower earnings growth. For example, American Electric Power and Consolidated Edison both trade for 16 times EPS.
While Southern pays a solid 4.7% dividend, its dividend yield could go even higher if its stock price falls. Considering its relatively high valuation and the mounting costs at its massive Kemper project, this is a very real possibility. Because of this, it may be wise to wait on the sidelines for a better buying opportunity.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Southern Company. 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.
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