Southern Company

Moat: 3/5

Understandability: 1/5

Balance Sheet Health: 2/5

Southern Company is a large, vertically integrated utility that generates, distributes and sells electricity, along with natural gas, in the Southeastern United States. It is involved in traditional electric generation, as well as renewable energy projects and the distribution of natural gas.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Southern Company (SO) is a holding company comprised of multiple subsidiaries, operating primarily in the regulated utility sector. These subsidiaries provide essential services, making the company resilient but also vulnerable to regulatory changes.

Business Overview

Southern Company operates as a vertically integrated utility holding company, with its main subsidiaries being electric operating companies, a wholesale energy service business, a retail natural gas distributor and other businesses. The regulated nature of its core operations provides a degree of stability, but this comes at the cost of being subject to regulatory oversight and rate-of-return limitations.

  • Electric Utilities: The company’s electric subsidiaries are the main sources of revenue. They generate, transmit, distribute and sell electricity across several states in the Southeastern U.S.
  • Natural Gas Distribution: The retail natural gas business includes pipeline assets, distribution operations, and gas marketing services.
  • Wholesale Energy: The company’s wholesale business provides energy services to municipal, cooperative, and investor-owned utilities, as well as retail companies and industrial energy users.

The utility industry is experiencing significant changes, driven by increasing adoption of renewable energy, evolving regulations, and increasing concerns for environmental protection. As energy prices fluctuate, new sources of energy are being explored, which requires capital investments into unproven technologies.

In a transition to renewable energy and away from fossil fuels, large-scale changes in an economy could cause companies to fall behind the transition, or face high debt loads trying to change fast enough, thereby, also making such businesses risky.

  • Increasing Focus on Renewables: Renewable energy technologies are getting cheaper and more reliable, making them an attractive alternative to traditional fossil fuel production. The shift towards clean energy is prompting companies to expand their investments in renewables and energy storage projects.
  • Regulations: Regulations aimed at lowering carbon emissions are becoming more stringent, which may benefit companies with large investment in renewables, or companies that can get their carbon capture technology approved, but may cause troubles for companies that are heavily dependent on fossil fuels.
  • Competition: While regulated markets provide a degree of protection against price competition, increased focus on price in some retail sectors has led to increased pricing pressure, especially for traditional energy sources and increasing pressure to switch to renewables in order to retain customers.
  • Economic cycles: Industrial demand for electricity and natural gas is directly correlated to the economic state of the region, causing volatility during depressions and recessions.

Financial Analysis

Based on their latest filings, the company has a debt to equity ratio of around 2.3x, and a liability to asset ratio of about 0.7x. These indicate that they are highly leveraged and the liabilities are also a substantial proportion of their assets.

Southern Company’s financials reflect the characteristics of a large, capital-intensive utility company. They are predictable and have stable revenue streams, but they are also heavily reliant on debt financing due to their capital-intensive nature. In order to offset the debt, Southern company is required to maintain sufficient cash flow and earnings in order to get funding, and continue existing as a business. Below is an analysis of different parts of the business.

  • Revenue: The company’s revenue comes from its subsidiaries, with significant retail electricity revenue, and a growing component of renewables and other clean energy sources, along with natural gas sales, all of which are regulated by appropriate authorities in the areas they conduct business.

  • Operating Margins: Southern Company reports consolidated operating margins around 24% in 2023, and operating profits increased to 11% from previous year in 2022, but is still less than the company was achieving 2019.
    • Net margins for Southern Company were close to 12% in 2023 and 11% in 2022, and has seen its debt burden climb since 2022.

  • Capital Expenditures: Given the large infrastructure requirements and need for large power projects (such as Nuclear, natural gas, and renewables), the company has consistently invested in new power generation assets to meet current demand and future growth, and this also includes maintenance of current infrastructure. Capital expenditures have recently exceeded 5 billion USD annually in the past 2 years.

  • Cash Flow: Southern Company’s free cash flow is negative since 2022 and has only generated a positive cash flow in one of the past four years. Because utilities have less risk than other sectors, their reliance on debt is higher, but requires a constant cash flow, in order to service the debt, and also expand the business in the long term.

The fact that Southern company has had negative free cash flow in recent years highlights the risks associated with the company.

  • Dividend: Southern Company is also known for its reliable and consistent dividend payouts, and it has been paying out a relatively stable dividend (around 4% yield) for a number of years, which may provide an income stream for conservative investors, but this is directly tied to their business outlook, and future stability is not guaranteed. They will be forced to cut dividends if the company struggles with performance.

Moat Analysis

Southern Company’s moat stems from several factors. But it’s more of a “narrow” moat and a wide-moat is harder for the company to achieve for several factors listed below.

  • Regulated Monopoly: Due to the fact that they operate in regulated markets, SO faces less competition, since only one utility company is responsible for a given geographic area. They are essentially a “mini monopoly” for the areas that they operate in. But they have to operate under strict regulatory guidelines with restrictions on their rate of returns, thus capping upside potential, despite lack of competition, making moat narrow rather than wide.
  • Distribution Network: The company has a large distribution network, which are difficult and costly to replicate, thus providing a cost advantage over potential competition, but they are not unique in that most large utilities have similar distribution networks, making it just a source of economic moat, rather than a differentiator or competitive advantage.
  • Intangible assets: The company also benefits from strong brand recognition and reputation, along with relationships with the local communities it operates, as a reliable provider of electricity and natural gas, adding to their reputation of dependable essential services, that are also difficult for other companies to copy, but may diminish over time, as the company invests into unproven technologies.

Overall, the company has limited pricing power, due to the fact that it is a regulated utility, and hence cannot control the rates that it can charge. Thus, making this a limited economic moat.

Moat Rating: 3/5

Risks to the Moat and Business Resilience

While Southern Company appears to benefit from a number of economic moats, it is not without risks. Below is a list of issues which could harm their moats:

  • Regulatory Risks: Given they are a regulated business, changes in regulations could change the company’s profitability, and may force to cut dividends if it can no longer maintain profitability within these changes.
  • Technological Disruption: The move towards renewables and distributed energy sources is a risk, if the company is unable to adapt fast enough. The risk of being overtaken by upstart new technology firms is also a real one, or if their long-term investments in large projects, such as nuclear power, fail to produce the intended returns or fail all together.
  • High Debt Levels: The company operates with high debt levels, and these can create risk in case there is an economic downtown, or if the returns on some of the projects turn out to be lower than expected, especially in this high interest rate environment.
  • Commodity Price Volatility: The prices of natural gas and other fuel inputs are not predictable, and an increase in those input prices could cut into the company’s profitability unless they can be passed onto consumers, which is not guaranteed by regulators.
  • Climate Change: Climate change could lead to unexpected damages and other weather-related incidents and could cause disruptions of power production, or delivery, and also require additional investments to make the infrastructure resilient to extreme weather conditions.

Even with these risks, Southern Company does have several factors that allow it to be fairly resilient in times of crises, and to mitigate potential risks.

  • Essential Services: They provide indispensable services that are needed by consumers, and are not easily substitutable. This makes their services resilient to economic downturns and changes in preferences of customers.
  • Long-Term Contracts: A lot of their services are provided through long-term contracts, providing good revenue visibility.
  • Diverse Business Segments: Though primarily a utility, the company has diversified their operations into related areas such as energy trading, and infrastructure construction.
  • Regulated Market: Having regulated operations also offers a certain degree of stability, with limited downside, as they are always guaranteed to return on capital by regulatory authorities, and therefore prevents massive fluctuations of the business.

Business Resilience: 3/5

Understandability

While their general business model is straightforward -generating and distributing power- a utility company has many moving parts and intricacies. Below are some reasons for why this makes the company complicated to understand:

  • Complex Financial Statements: Utility companies have complicated financial statements, including non-standard accounting methods, unique types of assets, as well as unique liabilities.
  • Regulatory Oversight: The business model is highly regulated, and it is very difficult to understand the legal and political aspects. Understanding the effects of different regulations is needed for proper investment analysis, but can be difficult even for seasoned investors.
  • Technical Aspects: It is a very capital-intensive business, which means a significant portion of their revenue goes to upkeep, maintenance, and building new plants and infrastructure, and understanding these technical aspects requires knowledge of power generation technologies, their pros and cons, as well as their costs.
  • Integration and Subsidiaries: The company has a vast number of subsidiaries and operations, which creates an opaque financial reporting structure, making it difficult to discern information about individual business units.

Understandability: 1/5

Balance Sheet Health

Given the highly leveraged balance sheet of Southern Company, there are major concerns about its financial health. A credit rating of BBB+ still allows it to access debt markets, but this might be hampered during major credit crunches. This low credit rating shows that the company is at a higher risk of not being able to pay its debts.

Southern Company has large amounts of debt on its balance sheet, which means a higher amount of financial risk. However, they do have large amounts of property, plant, and equipment, which provides significant assets to offset these liabilities. Below are some points on their balance sheet health:

  • High Debt: The company has a significant amount of debt on its balance sheet, which creates a higher reliance on debt financing and makes the company very sensitive to changes in interest rates.
    • Total Debt: $73.6 billion
    • Total Equity: $32.1 billion
  • Good Credit Rating: A BBB+ S&P rating still allows the company access to credit markets, which means lenders feel fairly confident that the business would not falter.
  • Large Asset Base: It operates a physical business, with a lot of infrastructure, generating its own power and owning distribution channels. This large asset base makes the company fairly resilient and able to weather economic downturns.
  • Deferred Tax Liabilities: Has significant amounts of deferred tax liabilities, which makes the financials somewhat complicated to understand. A change in regulation could cause a significant one-time expense that may have a big impact on their future earnings.

Balance Sheet Health: 2/5

Recent Concerns

  • Georgia Power rate hike: In January 2023, Georgia Power announced its request to increase its rates by more than $2 billion a year. This has brought public pressure against the company due to the amount that consumers would have to pay, and regulatory authorities are yet to decide on final rate increases. This also makes the outlook for the future and any positive outlook from the management uncertain.
  • Plant Vogtle Nuclear Project: The project has faced several cost overruns and delays over the past few years, and is still not online fully, which has cost the company additional expenses, and the company has also stated that cost estimates for the project may be higher than expected, further increasing financial risks for them.
    • In their latest quarterly report, management has expressed confidence in the ability of completing the project, but has also noted that some cost savings may not be realized as they expect, thus implying future returns might be less than planned.
  • Market outlook: The company has underperformed the broader stock market over the past 5 years, and the earnings per share for the first 3 months in 2023 have fallen to $0.79, from $1.09 in the first three months of 2022, which are major concerns for long-term profitability of the company.
    • The management stated that the drop was mainly due to a drop in revenue from retail customers, a reduction in tax benefits due to lower income, and continued negative impact of new nuclear units.

In conclusion, Southern Company is a complicated, highly leveraged, but relatively essential and predictable business. Its economic moat is only narrow, given high competition and their business model and limited ability to grow margins. It is also facing several headwinds in regards to cost increases and public backlash regarding their rates hikes. For that reason, Southern Company has a poor long-term outlook.