Global Research

29 July 2016

 

Southern Company

Setting the Stage for Halloween Update

What to expect at the Analyst Day? Maintaining the 4-5% EPS growth rate

In the absence of any material new developments, we expect Southern Company to reaffirm its 4-5% EPS growth rate target at its October Analyst Day rather than discuss any increase in the guidance range. Management hinted on the 2Q16 call that it could increase this range but given the potentially delayed rate relief for Kemper and 2016E tracking towards the high-end of the range, we anticipate SO extending the runway on the range rather than lifting it. Since management increased the guidance range to 4-5% with the AGL transaction, the company’s latest acquisitions have minimal near-term EPS accretion including PowerSecure, the Kinder Morgan SONAT transaction, and further renewables (high IRR but low ROE). Concerns about weaker sales growth will also be an incremental negative. Net-net, expectations for the upcoming Analyst Day should remain modest, particularly given the regulatory/construction uncertainty.

Crunch time for Kemper: how long will it take to sustain performance?

SO maintained its September 30th target for Kemper in-service but hedged its language by highlighting likely “challenges” in the upcoming weeks. The near-term debate relates to in-service qualifications with management targeting a 60-70% capacity factor, potentially a high bar to achieve. Separately at Vogtle, we believe the prudency process could be challenging with the independent monitor saying that SO has not supported the schedule; an update is expected in mid-October. Rather than focusing on the EPS growth range, we believe a positive update at the Analyst Day would involve a favorable update on Vogtle prudency and a firm timeline for a Kemper rate recovery.

Southern Power pivoting to wind should reduce concerns of ITC ‘cliff’

The shift to wind from solar investment could provide more visibility into growth with management recording ~$0.18 of one-time solar ITC earnings in 2016 (6% of 2016E).

Valuation: Maintain $51 Price Target; entering the critical execution period

Valuation is based on a sum-of-the-parts analysis. Sentiment has been improving but we continue to see an unfavorable risk/reward skew as we enter the critical portion of the Kemper timeline and with management expecting to issue significant equity ($2Bn less potentially ~$500Mn from internal equity plans) in the upcoming months.

Equities

Americas

Electric Utilities

12-month ratingSell

12m price targetUS$51.00

PriceUS$53.26

RIC:  SO.N BBG:  SO US

Trading data and key metrics

52-wk rangeUS$54.54-41.98

Market cap.US$49.7bn

Shares o/s934m (COM)

Free float99%

Avg. daily volume ('000)1,783

Avg. daily value (m)US$91.6

Common s/h equity (12/16E)US$22.6bn

P/BV (12/16E)2.2x

Net debt / EBITDA (12/16E)4.3x

EPS (UBS, diluted) (US$)

12/16E

From

To

% ch

Cons.

Q1

0.58

0.58

0

0.58

Q2

0.72

0.77

7

0.74

Q3E

1.13

1.18

5

1.11

Q4E

0.41

0.32

-21

0.47

12/16E

2.83

2.88

2

2.84

12/17E

2.85

2.90

2

2.98

12/18E

2.97

3.02

2

3.10

Julien Dumoulin-Smith

Analyst

julien.dumoulin-smith@ubs.com

+1-212-713 9848

Paul Zimbardo

Associate Analyst

paul.zimbardo@ubs.com

+1-212-713 1033

Jerimiah Booream, CFA

Associate Analyst

jerimiah.booream@ubs.com

+1-212-713 4105

Highlights (US$m)

12/13

12/14

12/15

12/16E

12/17E

12/18E

12/19E

12/20E

Revenues

17,087

18,499

17,527

18,203

18,708

19,248

19,801

20,451

EBIT (UBS)

4,552

4,743

4,834

5,202

5,418

5,660

5,926

6,104

Net earnings (UBS)

2,377

2,516

2,628

2,666

2,723

2,832

2,925

2,998

EPS (UBS, diluted) (US$)

2.71

2.80

2.89

2.88

2.90

3.02

3.12

3.20

DPS (US$)

2.01

2.08

2.15

2.22

2.29

2.36

2.43

2.50

Net (debt) / cash

(22,636)

(25,558)

(27,377)

(32,253)

(33,101)

(33,983)

(34,221)

(34,292)

Profitability/valuation

12/13

12/14

12/15

12/16E

12/17E

12/18E

12/19E

12/20E

EBIT margin %

26.6

25.6

27.6

28.6

29.0

29.4

29.9

29.8

ROIC (EBIT) %

12.7

12.6

12.1

11.8

11.4

11.5

11.8

12.0

EV/EBITDA (core) x

9.7

9.9

10.2

9.5

9.4

9.0

8.6

8.3

P/E (UBS, diluted) x

16.1

15.8

15.6

18.5

18.3

17.6

17.1

16.7

Equity FCF (UBS) yield %

0.6

(0.6)

(3.3)

(6.0)

2.2

2.3

3.7

4.2

Net dividend yield %

4.6

4.7

4.8

4.2

4.3

4.4

4.6

4.7

Source: Company accounts, Thomson Reuters, UBS estimates. UBS adjusted EPS is stated before goodwill-related charges and other adjustments for abnormal and economic items at the analysts' judgement. Valuations: based on an average share price that year, (E): based on a share price of US$53.26 on 28 Jul 2016 18:43 EDT

 

Kemper & Vogtle timelines in focus

SO disclosed further delays to Kemper with multiple timelines for Train B and another $38Mn charge ($23Mn after-tax) and management has stated that the first two weeks of August will be ‘critical’ to the plant. At Vogtle, management has made progress but we remain cautious given the negative commentary from the Georgia PSC Staff Independent Construction Monitor who stated there was a high probability of further delays (details in our preview - Page 76).

Figure 1: Kemper IGCC Monthly Status Reports

Picture 3

Source: Company Filings

Below we present our takeaways from our recent state regulator meetings:

Mississippi

Defining a period of sustain operations

Duke’s IGCC plant historical capacity factors:
2013: 19%

2014: 39%

2015: 56%

In evaluating the project performance, a key emerging question is precisely just how long Kemper will need to be in operation in order to be adequately deemed as such for rate recovery. While the plant is nominally targeted for in-service by September 30th, management does not anticipate filing until year-end at the earliest. From our conversations with stakeholders, we understand Kemper will need to run consistently for approximately six-weeks in order to fulfil this requirement. As mentioned above, on the 2Q16 earnings call SO indicated it was targeting 60-70% capacity factors. Using Duke’s Edwardsport IGCC as an example, it took approximately one-year to achieve a capacity factor over 60% with notable operational challenges occurring during the winter period.

Figure 2: Edwardsport IGCC Capacity Factor (%)

Picture 8

Source: SNL Energy

What do we think of shares?

Halloween will really be 'trick or treat' as SO enters critical 3Q execution on Vogtle/Kemper

While Street sentiment has clearly shifted more constructively of late, we remain cautious considering the execution risks in the near-term around Vogtle as well as Kemper. We see the company as poised to enter a critical period of execution as Kemper in-service ramps up as well as prudency efforts around Vogtle. With $2 Bn in equity lingering as an overhang, we believe this will only further keep investors on the sideline. Rather, the outcome of these two projects show provide a critical juncture into 2017. Management decided to host an Analyst Day on October 31st to layout this future. While we remain skeptical of meaningful execution hurdles and recent public statements from regulators, mgmt remains more confident than in prior periods over its ability to address ongoing challenges.

Georgia

Will SO pursue yet another nuclear plant?

The Georgia PSC voted 4-1 on July 28th to approve Georgia Power’s Integrated Resource Plan (IRP) which includes $175Mn of rate recovery for the potential greenfield new nuclear plant in Western Georgia (along the Alabama border) to be known as Stuart 1&2. Southern will have until the 2019 IRP filing to assess the viability of a new nuclear plant With existing pipeline capacity already running through the site it would appear SO is prepared to expand via gas if needed; despite the preparatory work, we ultimately doubt the project will move forward as nuclear plant given latest cost trends relative to cheaper gas and renewable alternatives (albeit this decision is quite some distance off). Bottom line, the approval of spending to support new nuclear is a positive datapoint for regulatory treatment of Vogtle. Docket # 40161

Procurement: Looking at up to 1.6GWs of Solar?

Big solar push continues

The PSC also approved by a 4-1 vote 1.2GW of additional renewables in Georgia by 2021 which was stipulated in a settlement with the Staff earlier this summer. In comparison, the first proposal requested 525MW and a proposal to add 1.7GW was voted down 3-2. We emphasize the continued reinvestment in solar provides an opportunity if SO so chooses to continue to invest in solar (and garner ITCs). We see this solar effort as principally driven by the GA PSC rather than necessarily driven by the commission itself.

Bringing wind to the Southeast?

Effort to scale wind could drive push for long-distance transmission. We could yet see SO's latest push into wind result in regional wind resources imported into the Southeast region via long-distance HVDC lines. While this had previously appeared impractical due to permitting and costly, we think the latest pushes by Clean Line and Pattern Energy could prove competitive vs. regional solar and have a differentiated dispatch profile. Bottom line, we could see SO not only owning the contracted wind back to the Southeast but also the transmission line itself.

GA Power: layoffs to support 3-year rate stayout plan under AGL deal

Mgmt confident it can earn its ROE at GA Power through 3-years period

Georgia Power committed to a three year rate stayout as part of the deal to acquire the AGL system, with the latest round of layoffs in recent weeks aimed to support this end of maintaining its ROE through the period. We emphasize keeping GA Power out of a case for a three-period was part of the deal with GA regulators in approving the AGL deal; given the spend anticipated at AGL, mgmt is keen to subsequently file for rate recovery.

Ongoing negotiations in prudency proceeding with Staff

We remain concerned over ongoing efforts to get expedited prudency on the project; if successful, this would de-risk the story in ~4Q

SO mgmt anticipates providing an update on its ongoing negotiations with Staff in the ~October timeframe on progress for a prudency decision on both historical costs as well as prospective costs involved in the project. We note the decision to pursue this approach has proven controversial among some parties. The emphasis in the ongoing proceedings remains for SO to avoid deeming any spend imprudent thus far – and focused instead seemingly on costs incurred by Georgia Power vs. recovered. That said, assuming SO is successful, we believe this could appear to meaningfully reduce subsequent risk on the project.

Gas marketshare? Focus on control in Georgia

Among other nascent issues we perceive is the total market share controlled by SO in the state of Georgia, including both AGL as well as its 50% SONAT stake. We emphasize this has garnered some attention from independent retail gas marketers in the state of late.

But while delay risks for Vogtle linger, PTC extension possibilities exist

While management downplayed the need for such an eventuality, we note efforts in DC appear clearly underway for a potential extension of the nuclear Production Tax Credits (PTCs) eligibility beyond the firm 12/31/2020 deadline for reaching in-service. We suspect the outright removal or substantial extension is quite likely following similar actions for wind earlier this year from IRS.

Mississippi

Focused on MS PSC itself – budget issues limit staff

We further note that Commission has suffered multiple budget cuts, following a decision to fund the PSC through the general legislative budget and not directly through utility payments. The Commission currently does not anticipate emergency rate relief for Kemper or directly passing along Kemper’s cost overruns to rate payers.

Laying out the Estimates – the Moving Pieces

We include below our latest EPS estimates, which continue to exclude AGL as well as the SONAT acquisition. We emphasize the total accretion with both deals include adding ~$0.08 to the period forecast cumulatively or ~0.8% total to the growth rate off 2016 base. We emphasize the key offsets could well include Kemper earnings on the project, GA rate case (this would be timing related on the ROE), and lower normalized sales growth prospects (following a reduction in 2016 expectations to below 0.5%, towards 0.3% on the back meaningfully lower industrial sales, admittedly the lowest margin sales).

Assuming a 'couple EBITDA turn improvement' in deal economics for SONAT per the deal call at the time, we see this as potentially adding a further ~$0.02 in EPS.

Figure 3: Southern Company EPS Estimates

Picture 9

Source: Company Filings, FactSet, and UBS Estimates

Valuation: Maintain $51 Price Target

Valuation is based on a sum-of-the-parts analysis.

Figure 4: Southern Company Sum-of-the-Parts Analysis

Picture 10

Source: Company Filings, FactSet, and UBS Estimates

Forecast returns

Forecast price appreciation-4.2%

Forecast dividend yield4.3%

Forecast stock return+0.1%

Market return assumption5.7%

Forecast excess return-5.6%

Valuation Method and Risk Statement

Factors that could prevent Southern from achieving our earnings, cash flow, and price target objectives include: adverse weather conditions; changes in the regional power regulatory environment; adverse regulatory decisions in its various states jurisdictions (primarily GA, AL, MS, FL) as well as from the federal regulator, FERC; interest rate & capital market risks; slowdown in regional economy; risks associated with operating nuclear units; more stringent environment regulation; and the impact that changes in commodity prices could have on the unhedged portion of its competitive generation operations, Southern Power. An added risk is the corresponding construction and financial risk associated with its proposed new nuclear unit at Vogtle. Valuation is based on a sum-of-the-parts analysis.

Required Disclosures

This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.

For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission. UBS acts or may act as principal in the debt securities (or in related derivatives) that may be the subject of this report. This recommendation was finalized on: 29 July 2016 02:59 AM GMT.

Analyst Certification: Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.

UBS Investment Research: Global Equity Rating Definitions

12-Month Rating

Definition

Coverage1

IB Services2

Buy

FSR is > 6% above the MRA.

47%

32%

Neutral

FSR is between -6% and 6% of the MRA.

38%

25%

Sell

FSR is > 6% below the MRA.

15%

21%

Short-Term Rating

Definition

Coverage3

IB Services4

Buy

Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.

<1%

<1%

Sell

Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.

<1%

<1%

Source: UBS. Rating allocations are as of 30 June 2016.
1:Percentage of companies under coverage globally within the 12-month rating category.

2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months.

3:Percentage of companies under coverage globally within the Short-Term rating category.

4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months.

KEY DEFINITIONS: Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months.

EXCEPTIONS AND SPECIAL CASES: UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece.

Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with FINRA. Such analysts may not be associated persons of UBS Securities LLC and therefore are not subject to the FINRA restrictions on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows.

UBS Securities LLC: Julien Dumoulin-Smith; Paul Zimbardo; Jerimiah Booream, CFA.

Company Disclosures

Company Name

Reuters

12-month rating

Short-term rating

Price

Price date

Southern Company2, 4, 5, 6a, 6b, 7, 16

SO.N

Sell

N/A

US$53.26

28 Jul 2016

Source: UBS. All prices as of local market close.
Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date

2.UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months.

4.Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity or one of its affiliates.

5.UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months.

6a.This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided.

6b.This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided.

7.Within the past 12 months, UBS Securities LLC and/or its affiliates have received compensation for products and services other than investment banking services from this company/entity.

16.UBS Securities LLC makes a market in the securities and/or ADRs of this company.

Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Investment Research.

Southern Company (US$)

Source: UBS; as of 28 Jul 2016

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