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Thursday, May 16, 2013

The Safety Net: The South(ern) Will Rise Again

English: AH3 free flow diving helmet front view
English: AH3 free flow diving helmet front view (Photo credit: Wikipedia)
By Wealthy Retirement

Boston, May.16, online stock trading .- One of the keys to my 10-11-12 income strategy is to invest in companies that raise their dividend every year.

That's because an increased dividend tells the market that management is confident the company's cash flow will be sufficient to pay a higher dividend over the years.

Additionally, when a company has a long history of annual dividend raises, management knows that shareholders have grown to expect a dividend hike. If the company doesn't raise the dividend, investors will know trouble is brewing and will sell their shares by the boatload.

So the 12-year history of annual dividend hikes is an important part of my dividend safety analysis of electric utility Southern Company (NYSE: SO).

In 2012, Southern Company earned $2.4 billion, but generated $4.9 billion in cash flow from operations. If you're new to The Safety Net, you should know that when analyzing the safety of a dividend, I always look at cash flow from operations and free cash flow rather than earnings.

Cash flow is a more accurate representation of a company's ability to pay the dividend. Earnings include all kinds of non-cash items like depreciation and amortization.

Think of it this way - you own a business that brought in $100,000 in profits. But two years ago, you paid $50,000 for a piece of equipment that depreciates at $10,000 per year. So you get to deduct $10,000 worth of expenses, which brings your profit down to $90,000.

Plus, another $10,000 in receivables from last year was paid this year, adding $10,000 to what you actually brought in.

So, you report to the government $90,000 in taxable income ($100,000 profit - $10,000 in depreciation), but your cash flow was actually $110,000 ($100,000 + $10,000 change in receivables).

If you were considering paying a dividend on your business, it would be more accurate to look at the $110,000 figure rather than the $90,000 to figure out how much you would pay to your partners or shareholders.

A Better System

In 2012, Southern Company paid $1.7 billion in dividends. The payout ratio (the percentage of earnings or cash flow that is paid out in dividends) based on earnings is 71%. However, I mentioned that I use cash flow as it's a more accurate representation of a company's ability to continue to pay (or raise) the dividend.

On a cash flow from operations basis, the payout ratio is just 49%. Far below my 75% threshold. When the figure is above 75%, I get concerned that a bad year or two could result in a dividend cut or the dividend not being raised.

If we look at free cash flow, which is cash flow from operations minus capital expenditures (capex), the story is different. Utilities tend to spend a lot of money on capex, often using debt to fund those investments.

Last year, Southern spent $4.8 billion in capex - nearly all of its cash flow from operations.

So based on free cash flow, the payout ratio far exceeds 100%. That has been the case with Southern Company for years. And in fact, when you look at other utilities like PPL Corp. (NYSE: PPL), Northeast Utilities (NYSE: NU) and Consolidated Edison (NYSE: ED), they also tend to pay out over 100% of free cash flow, yet have raised their dividends for 12, 15 and 39 consecutive years, respectively.

So in the case of electric utilities, free cash flow is not the best way to analyze the dividend safety. You have to look at a stock based on its industry.

For example, if a consumer stock had a payout ratio of over 100% when its competitors did not, I'd be nervous. But since utilities raise debt to fund capex, I'm not especially worried, particularly in this low interest rate environment.

Using the 49% payout ratio based on cash flow from operations, there is plenty of room for Southern to boost the dividend again next year (it just raised the dividend this month by 3.5%). And with earnings expected to grow in the mid-single-digits annually over the next five years, the bottom line growth will generate more cash flow to put toward a higher dividend.

My only concern is that if interest rates jump higher, it will cost more to fund capex and the company may have to sacrifice a dividend raise as a result. It's not a big concern at this point, but one that I'll keep in the back of my mind.

As a result, I can't give Southern Company a perfect score, but it's pretty darn close.

Dividend Safety Rating: B

If you'd like me to take a look at the dividend safety of one of your stocks, please leave the ticker symbol in the comments section below.

Grade Guide
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