Southern Company (NYSE: SO) is one of the most popular utility stocks for individual investors. The stock is a conservative investment that sports a solid 4.4% yield and has raised the dividend every year for 17 years.
So it might come as a surprise to find out that the dividend safety rating is not particularly high.
When it comes to dividend safety, an issue for utilities is that they don’t generate much free cash flow.
Operating cash flow, yes. Free cash flow, not so much.
Operating cash flow is how much cash the company generates from running its business. Free cash flow is operating cash flow minus the amount spent on capital expenditures (fixing, buying, and expanding facilities).
As you might imagine, utilities spend a lot of money on capital expenditures. So even though their businesses generate cash, once they spend the cash on their facilities, there is often nothing left.
SafetyNet Pro looks at free cash flow because it is the most conservative measure of how much cash comes in and out of the company, and it’s the most accurate metric to determine whether a company can afford its dividend.
And utilities just don’t generate much free cash flow…
In the entire utilities space, no company is rated an A by SafetyNet Pro. Only two, Alliant Energy Corp. (NYSE: LNT) and AES Corp. (NYSE: AES) have B ratings.
So let’s take a look at why Southern Company is not rated highly by SafetyNet Pro…
When we look at cash flow from operations, Southern Company has more than enough cash flow to pay the dividend.
In 2016, Southern’s cash flow from operations was $4.9 billion. It paid $2.1 billion in dividends. No problem, right?
But when you account for the more than $7 billion capital expenditures, free cash flow is negative $2.7 billion.
Free cash flow has been negative in five of the past six years.
It’s expected to be negative again in 2017 and 2018.
We considered adjusting the way SafetyNet Pro looks at utilities because so many of them have negative free cash flow. We were concerned that perhaps the ratings were too negative in the sector—especially considering that many of them, like Southern Company, have strong track records of paying and raising their dividends.
Utilities have a lot of debt, and when free cash flow is negative, debt is what is used to pay the dividend.
We found that utilities cut dividends most often when interest rates are high. So either the company’s debt level becomes crushing, or it is unwilling (or unable) to take on more debt at higher interest rates in order to sustain the dividend.
We decided to be more conservative and keep the ratings the way they are. I’d hate to have a stock rated safe, and then see interest rates spike, the dividend cut, and everyone wondering what happened.
Considering Southern’s 17-year track record of raising the dividend and today’s low interest rates, the dividend is likely not in immediate jeopardy.
But SafetyNet Pro is warning that the company’s dividend is not sustainable if the credit markets seize up or if rates go higher.
Dividend Safety Rating: D
If you have a stock whose dividend safety you’d like me to analyze, send me the ticker symbol by clicking on the green button below.
For Cashflow For Retirement