Fair Valuation Important When Investing in Utility Stocks
Utility stocks are generally low-growth high-yield investments.
As I will soon illustrate, both Southern Company (SO) and AGL Resources Inc (GAS) neatly fall into that category. These low-growth and above- average dividend yield characteristics have led me to only invest in utility (NYSEARCA:XLU) stocks when two important conditions are met.
First and foremost, when considering utility stocks I am even more of a stickler for fair valuation. My logic is simple; since long-term historic and future prospects for growth are low, I consider it imperative to only invest when utility stocks can be bought at fair value or below. There is typically not enough growth available to produce an attractive enough total return if you overpay even slightly. With most utilities, the dividends are consistent, but also grow at low rates in conjunction with the utility’s earnings growth.
Second, I like to utilize utility stocks when current and dependable income is my primary investment objective. Although many utility stocks can be classified as dividend growth stocks, I tend to like them more for current income than total return. However, when purchased at or below sound valuation, investments in utility stocks can produce acceptable levels of long-term total return. On the other hand, when investing at sound valuations, utility stocks do tend to produce significantly more cumulative dividend income than the average company.
As the following two announcements and reports indicate, Southern Company will become the second-largest utility company in the U.S. by customer base after buying AGL Resources. Importantly, Southern Company’s management expects the transaction to accelerate earnings growth in the first full year from its traditional 2% to 3% rate to a higher but still moderate 4% to 5% earnings growth rate.
“Southern Co. to buy AGL Resources in $12B deal
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Aug 24 2015, 07:49 ET | By: Carl Surran, SA News Editor
- Southern Company (NYSE:SO) agrees to acquire AGL Resources (NYSE:GAS) for $66/share in cash, a 38% premium over Friday’s closing price, in a deal with an enterprise value of ~$12B including debt.
- SO says the deal will create the second-largest utility company in the U.S. by customer base, with 11 regulated electric and natural gas distribution companies providing service to ~9M customers with a projected regulated rate base of ~$50B.
- SO expects the deal to increase EPS in the first full year after the close and drive long-term EPS growth to 4%-5%”
Southern Co. agrees to buy AGL Resources in $12 billion deal
Published: Aug 24, 2015 7:41 a.m. ET
By Ciara Linnane
CORPORATE NEWS EDITOR
Shares of AGL Resources Inc. GAS, +28.52% surged almost 9% in premarket trade Monday, after Southern Co. SO, -3.14% said it has agreed to buy AGL in a deal with an enterprise value of about $12 billion. Southern Co. said it expects the deal to boost earnings per share in the first full year after the close, and to drive long-term EPS growth to 4% to 5%. AGL will become a wholly owned unit of Southern Co., creating the second-biggest utility in the U.S. by customer base. AGL shareholders will receive $66 in cash for each share, a premium of 36.3% over the volume-weighted average stock price over the last 20 trading days through Aug. 21.
We believe the addition of AGL Resources to our business will better position Southern Company to play offense in supporting America’s energy future through additional natural gas infrastructure,” Chief Executive Thomas Fanning said in a statement. The deal is expected to close in the second half of 2016. Southern Co. shares were up slightly in premarket trade, but are down 6.7% in the year so far, while the S&P 500 has lost 4.3%.”
Here is a link to a report on Reuters that outlines the deal:
The Southern Company Purchase of AGL Resources by the Numbers
As a shareholder of both Southern Company and AGL Resources I immediately wanted to know what I might expect from this transaction. In other words, does the deal make economic sense and will it benefit shareholders over the long run? Therefore, I looked at the deal through the lens of the F.A.S.T. Graphs™ fundamentals analyzer software tool and the FUN Graphs (fundamental underlying numbers) in order to evaluate the value to me as a Southern Company and AGL Resources shareholder.
From The Perspective of an AGL Shareholder
I was quite content with my position in AGL Resources as I considered the company fairly valued with a blended P/E ratio of 14.3 and I appreciated the 4.3% dividend yield. Additionally, since my cost basis was approximately 39, I was enjoying a reasonable level of capital appreciation coupled with its current above-average yield that had been growing at about 2½% to 3% per annum. The following earnings and price correlated graph illustrates my contentment.
Of course the approximate 30% premium over fair value significantly improves the total return I will receive when the transaction is complete. Therefore, from the perspective of an AGL Resources’ shareholder, I am quite pleased with the windfall. The following forecasting calculator on the day of the announcement and based on AGL Resources’ expected midterm future earnings growth illustrates the premium that Southern Company is paying.
This is what the same graph looks like as of 8/24/2015, which shows the premium price that Southern Company is paying for AGL Resources. This would indicate that technically speaking AGL Resources has become overvalued as a result of the premium paid by Southern Company.
On the other hand, when looked at from the perspective of expected future cash flows, the premium price that Southern Company is allegedly paying does not look so enticing. Cash flows are expected to increase significantly this fiscal year. Therefore, on the basis of price to cash flow, the apparent premium that Southern Company is paying based on earnings, looks like a bargain based on cash flows.
When reviewing the cash flow per quarter growth (cflq) that AGL Resources has generated thus far in fiscal 2015, those fiscal year 2015 cash flow projections appear to be on track. So now I am partially conflicted. I like the premium market valuation, but I’m not so sure that I’m truly receiving a premium price for my AGL shares based on potential cash flow growth. I have circled the last three quarters of cash flow highlighting the cash flow growth over the last three quarters.
Furthermore, when I evaluate AGL’s historical annual dividends paid per share (dvpps) coverage based on cash flows per share (cflps) I am confident that my dividend was secure. Of course, I am even more confident considering the recent quarterly cash flow growth presented above.
Furthermore, upon reviewing other valuation ratios, it appears that Southern Company instituted the transaction when AGL’s price to sales (ps) was at reasonable levels. However, the premium price they had to pay is common when a company is purchased outright.
Additionally, AGL’s price-to-book value (pb) at the time the transaction was initiated was within historical norms as well (the red line).
The bottom line is that as an AGL shareholder I have mixed views about the transaction. I like the premium market valuation, but I was also content to continue holding my AGL shares for the high-yield they were providing.
From The Perspective of a Southern Company Shareholder
The following long-term earnings and price correlated graph on Southern Company supports my contentment as a shareholder. Although my cost basis in Southern Company was approximately at the same level that the company was trading at prior to the announcement, I was quite happy with my 4.7% dividend yield and believed that the company was fairly valued. Consequently, I was committed to continuing to own this high-quality utility company for many years to come.
Moreover, even the approximate 5% price drop as a result of the transaction did not concern me very much because I felt the dividend was secure, above average, and had the potential for a modest amount of future growth. However, I was now faced with the issue of whether my Southern Company investment would continue to make sense after they purchased AGL.
At this point, I decided that I would give credit to management’s assertion that the transaction would in fact accelerate Southern Company’s future earnings, and therefore, along with it – future dividend growth. Therefore, I reviewed the Forecasting Calculator based on consensus estimates from S&P Capital IQ prior to the AGL transaction. Here I discovered that consensus expected Southern Company’s earnings to grow at a very modest rate of 2.7%.
Based on those consensus estimates and assuming that Southern Company would trade at a reasonable P/E ratio of 15 out to fiscal year-end 2018, I came up with a total annual rate of return expectation of 5.22%. Of course, that is nothing to write home about as it only represented capital appreciation of $.85. On the other hand, the $7.70 of projected dividend income was very attractive considering today’s low level of interest rates. Clearly, this is purely an income play and I had no delusions of anything different.
This is what the expected returns look like after Southern Company’s price drop as a result of the announcement. The announcement brought Southern Company’s stock price into better alignment with fair value.
For additional insight, I felt the forecasts prior to the transaction announcement were reasonably reliable considering the historical record of analysts forecasting Southern Company’s earnings. As the following analyst scorecard indicates, when making 1-year forward and 2-year forward estimates since calendar year 2000, the record of analysts following Southern Company has been consistently accurate at over 93%.
Then I ran a similar calculation using the custom Forecasting Calculator based on management’s expectation of earnings growth accelerating to between 4% and 5% as a result of the transaction. I split the difference and ran a calculation based on Southern Company’s 5% drop in price and a forecast 4.5% growth rate. Based on those calculations I was pleased that my Southern Company investment offered the potential for significantly more capital appreciation of approximately $11.11 versus the $.85 based on growth prior to the transaction.
However, I was even more pleased to discover that my dividend income of $13.19 would be close to double what I expected prior to the transaction. Note: all these calculations are made and based on purchasing one share of the stock.
The bottom line is that I have concluded that my Southern Company investment holds the potential to be much more attractive after the AGL transaction than it was prior to it.
As a bonus, I have prepared a free analyze-out-loud video on my website MisterValuation which provides a more in-depth and detailed look at Southern Company and AGL Resources’ transaction.
Summary and Conclusions
From the perspective of a Southern Company shareholder based solely on the numbers, I am enthusiastic and pleased with the AGL transaction. From the perspective of an AGL shareholder, I am disappointed that I will lose the company as a separate holding, but pleased that I will still benefit from its potential as a Southern Company shareholder. Of course, the premium over current market price is also a plus.
However, I am now also faced with the challenge of what I will do with the proceeds received from the AGL shares. At this point, I am not yet certain whether I would reinvest the proceeds into Southern Company, or look for another opportunity. However, I have time to assess the situation.
Disclosure: Long GAS,SO at the time of writing.