In the late 1990s, Southern Company’s (NYSE: SO) executives were fond of saying, “that if Thomas Edison were to walk into the utility’s lobby and look around, he’d remark that nothing had changed.”

This statement has often been emblematic of the firm’s early resistance to electric deregulation, emission regulation, new renewable technologies, and various other changes that have occurred in the industry over the last few decades. But this has not necessarily been a negative. Southern Company’s fidelity to the status quo has often preserved value, in contrast to other firms that rushed into new, untested business initiatives that proved unwise and caused significant value destruction.

In fact, Southern Company has been a stellar income investment for generations, which makes its recent financial troubles all the more disturbing.

Southern Company’s total return is down 6.4 percent over the last year versus the S&P 500’s gain of 17.7 percent. But even against its sector peers, the utility has been a laggard: Over that same period, Duke Energy Corp (NYSE: DUK) is up 5.8 percent, and American Electric Power Co (NYSE: AEP) has returned 2.1 percent.

The action in Southern Company’s stock has mirrored the performance at the underlying company. Income from continuing operations has fallen 21.4 percent over the last year, with earnings declines on flat power demand at various utility subsidiaries, as well as cost overruns at its nuclear and clean-coal build-out. Revenues are slightly up, by 2.2 percent, while net income has declined 13.2 percent, and operating margin has compressed 18.8 percent. Beyond that, debt levels have increased 8.7 percent in the last year.

Chart A: Southern Company’s Earnings Hurt by Flat Electricity Demand

Created with YCharts

In its most recent quarterly earnings report in late July, the utility took a $278 million after-tax charge on cost overruns at subsidiary Mississippi Power’s clean-coal project and abandoned its attempt to increase its budget for a nuclear plant in Georgia. The former helped cause Southern Company’s second-quarter earnings to slump by 52 percent to $297 million, or 34 cents per share, down from $623 million, or 71 cents per share, a year ago. Absent these one-time items, earnings would have risen to 66 cents per share.

The project to build Plant Ratcliffe, a coal-gasification plant in Mississippi, has cost Southern Company $611 million in after-tax charges so far this year, and there could be more write-offs in future quarters. During the company’s earnings call, CEO Thomas Fanning said the latest charges represent the company’s best estimate, and he couldn’t guarantee there won’t be further losses in the future.

As noted earlier, the firm has also increased its debt to dangerously high levels that haven’t been seen since the early 2000s–a 130.9 percent debt-to-equity level. And the aforementioned cost overruns caused Moody’s Investors Service to downgrade its rating on preferred stock issued by one of the firm’s subsidiaries to Baa3, just one notch above junk status.

This transpired even as Southern Company announced the need for additional debt and equity issuances over the next two years to pay for its new power infrastructure. That’s a potentially problematic move given the prospect of a rising interest rate environment, and the company’s higher cost of capital as a result of its subsidiary’s downgrade. These are all negative indicators that we’ll address in more detail below.

Fortunately, Southern Company clearly sees the risks inherent in maintaining the status quo. The utility seems to be quickly changing its business model to survive, planning natural gas plants to replace its coal plants (a seemingly tacit acknowledgement of the inevitability of carbon regulation and change in natural gas market fundamentals), while also increasing its involvement in renewable energy and energy efficiency (another tacit acknowledgement of this technology’s disruptive potential).

Further, its move to build an integrated-gasification plant with carbon-capture technology in Mississippi, and new nuclear plants at its Vogtle nuclear facility in Georgia, are also clear signals the firm is focusing on the challenges at hand and trying to change with the times. Other Southern project highlights include the nation’s largest biomass generation plant in Texas, a massive wind-data study to determine the feasibility of wind farms across Alabama and Georgia, and a leading fleet of hydroelectric power generation.

But is this all too little too late? Perhaps due to no fault of its own, the firm undertook a massive build-out, which necessitated gargantuan amounts of debt just as its earnings stream went negative on declining power demand as a result of the downturn in the economy (and cost overruns), new competing technologies, and cheaper natural gas.

Southern Company also faces significant future costs to swap out its overall fleet to cleaner power plants, with 15,648 megawatts of coal-based power plants set to retire in the next decade. While not all of these coal plant wills be replaced, in a recent statement, the firm said, “By 2020, we anticipate being able to generate approximately 35 percent to 55 percent of our electricity from natural gas and 25 percent to 45 percent from coal–enabling our company to minimize costs to customers by utilizing the lowest-cost fuel source.”

While some may regard this as future upside potential, the question is how can the utility accomplish this at current debt levels? The last time Southern Company had a similar debt burden was in the early 2000s, during the merchant-energy collapse and the general downturn that followed the bursting of the Internet bubble. Fortunately, the succeeding economic boom (2003 to 2008) helped the firm repair its balance sheet.

Today, Southern Company faces different obstacles:

1) The continuing recovery from the deepest financial and economic crisis since the Great Depression means US gross domestic product (GDP) and power-demand levels are unlikely to grow as quickly as in the early 2000s, which means Southern Company will get no mercy on paying its debt.

2) The Federal Reserve’s intent to curtail its extraordinary stimulus could mean higher rates are just around the corner. And rising GDP could entail inflation. While inflation will help Southern Company pay down debt, higher rates will make it that much more difficult for the firm to find financing to build the new power plants it needs. And given the regulated nature of the utility, it may encounter difficulty passing along higher commodity costs to customers during an inflationary period.

Additionally, as a rising-rate environment makes fixed-income securities more competitive with dividend stocks, retail investors could turn away from highly indebted companies such as Southern Company in favor of those that offer safer payouts. For instance, the firm’s trailing 12-month payout ratio now stands at 99 percent. That means Southern Company could lose some of its investor base at a time when it needs diverse sources of funding, such as secondary equity issuances. Over the last 12 months, in fact, diluted earnings per share (EPS) have been on the decline at various utilities, including Southern Company, whose diluted EPS has fallen by 22.1 percent.

Chart B: Southern Company’s Visible Slide in Earnings Per Share

Created with YCharts

To get a better sense of Southern Company’s growth prospects, Utility Forecaster developed a proprietary Discount Cash Flow Model to discern how those few Wall Street analysts with “buy” ratings were modeling the company. Most of the growth embedded in their models seems to rely on the utility’s past performance, as well as the management team’s optimistic guidance.

While it’s perfectly natural to extrapolate some elements of past performance to make forecasts about future growth, Wall Street analysts seem to have ignored the firm’s current earnings problems and future power plant development costs. Notwithstanding, the mix of analyst sentiment is essentially neutral, with three “buys,” 15 “holds,” and two “sells.”

High Debt Levels, Lower Income: A Threat to the Dividend

Southern Company has been paying a dividend since 1948, but today its 4.9 percent yield seems at risk. Given its 99 percent payout ratio, there is little room to increase the dividend. And certainly, if the firm incurs larger declines in its earnings, such as more write-downs due to cost overruns, the firm could eventually be forced to cut its dividend.

As many income investors know, the common payout ratio considers dividends as a percentage of net income. That metric usually works when evaluating healthy companies because they tend to use earnings to generate cash for dividend payments. But it can be a misleading ratio when some troubled companies borrow to finance their payout. And companies can’t indefinitely pay dividends that exceed free cash flow.

When firms are in the midst of transforming their business model, as Southern Company is presently doing, the cash dividend payout ratio offers a much more useful tool for evaluating the sustainability of the dividend. This alternative ratio shows the portion of cash flow, after capital expenditures and preferred dividends payments, that a company uses to make its common stock dividend payments. In this case, Southern Company actually has a negative cash dividend payout ratio.

Chart C: The Cash Dividend Payout Ratio

Created with YCharts

And the ratings agencies have been watching. In early August, Moody’s Investors Service downgraded subsidiary Mississippi Power Company’s senior unsecured rating to Baa1 from A3 and its preferred stock rating to Baa3 from Baa2. The rating outlook is stable. The credit rating agency did, however, affirm the parent company’s Baa1 senior unsecured rating, with a stable outlook.

“The downgrade of Mississippi Power’s ratings reflects the higher costs and ongoing difficulties being experienced by the company in completing the large and complex Kemper County integrated gasification combined cycle (IGCC) plant,” said Michael G. Haggarty, senior vice president.

“The utility has exhibited a considerable decline in financial metrics over the course of the construction period, which are unlikely to return to historical levels because of the planned issuance of approximately $700 million of securitized bonds after the plant becomes operational,” added Haggarty.

“The company’s cash flow pre-working capital to debt ratio has fallen from the 20 percent-plus range prior to the plant’s construction to 12.2 percent in 2011 and 13.5 percent in 2012. This compares to financial ratio guidelines of 13 percent to 22 percent for ‘Baa’-rated utilities outlined in Moody’s Regulated Electric and Gas ratings methodology. Although the most recent cost increases are being funded almost solely by equity issuances at the Southern parent company, the higher debt being incurred by Mississippi Power as a result of the plant will result in lower credit metrics going forward, including CFO pre-working capital to debt in the high teens, well below the parameters for a single ‘A’ rating.”

“We believe that issues associated with the plant may have also adversely affected the regulatory environment in which the company operates, with two of the three commissioners on the Mississippi Public Service Commission (MPSC) expressing serious concerns not only about the recent cost increases, but also the level of communication and transparency exhibited by the company during the construction process. Despite a $2.88 billion cap on project costs that largely insulates Mississippi ratepayers from additional cost increases, the historically credit supportive Mississippi regulatory environment has been strained by these developments and may not fully recover over the near term, especially if the plant continues to experience problems with the remaining construction, as well as the testing and start-up phase,” according to Moody’s.

Clearly, a downgrade alone would be an issue for concern. But even more concerning are the firm’s high debt levels and the fact that the regulatory environment (historically extremely supportive) is turning negative, not to mention the firm’s ability to carry out successful future power plant development in response to changing market fundamentals and emissions regulation.

On a Wing and a Prayer: Will the Regulator Gods Help Them?

Historically, Southern Company’s saving grace has been the fact that it operates in a very supportive regulatory environment. Certainly, that’s what investors have always counted on. But as per Moody’s report on the firm’s clean-coal plant in Mississippi, regulators are now taking issue with Southern Company’s handling of the project. And that’s putting into question how prudent the utility has been, a clear sign the winds have changed as to what support the firm can expect from regulators, at least in Mississippi.

In Georgia, the firm has experienced similar cost overruns at its nuclear power plant project. Under a proposed deal with regulators, Southern Company would withdraw its request to increase its budget to build two more nuclear reactors at Plant Vogtle. The company had previously asked to increase its budget by $737 million to $6.85 billion.

Instead, the discussion over whether to formally raise the construction budget would not happen until the first of the two reactors comes online, forecasted around January 2018 at the earliest, as per the latest timelines from a state monitor.

According to one press report, “The deal shifts financial risk onto Southern Company. If the utility exceeds its budget, then the burden would be on Georgia Power to persuade regulators that the excess spending should be passed along to its customers. But if the Public Service Commission votes to raise the project budget, then the law would assume Georgia Power was entitled to collect all of its budgeted costs from customers, so long as regulators couldn’t prove the spending was imprudent, reckless or somehow criminal.”

The preliminary agreement would also help the firm avoid a politically charged battle over project spending while it deals with a separate rate case in Georgia and the aforementioned over-budget coal gasification plant in Mississippi. Georgia regulators are set to vote on the deal Sept. 10.

But given the uncertainty surrounding future cost overruns combined with declining credit and earnings metrics, as well as what appears to be tepid support from regulators, Southern Company warrants additional scrutiny as a long-term investment.