About the Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.

Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio. Josh joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity research associate, he returned to Morningstar in 2004 to develop DividendInvestor.

Peters holds a BA in economics and history from the University of Minnesota Duluth and is a CFA charterholder. He is also the author of a book, The Ultimate Dividend Playbook, which was released by John Wiley & Sons in January 2008.

 
Investment Strategy

Dividends are for everyone regardless of age. The outcome of owning dividend-yielding stocks is the key variable-higher-yielding stocks with safe payouts being less risky while affording investors who don't need current income the ability to reinvest/reallocate the capital.

The goal of the Dividend Select Portfolio is to earn annual returns of 9% - 11% over any three-to-five year rolling time horizon. We further seek to minimize risk, as defined by the probability of a permanent loss of capital. For our portfolio as a whole, this goal is composed of:

3% - 5% current yield
5% - 7% annual income growth

 
 
Mar 02, 2015
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Josh Peters, CFA
Equities Strategist and Editor
Equities strategist Josh Peters is the editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks.Josh manages DividendInvestor's model dividend portfolio, the Dividend Select Portfolio.
Featured Posts
Updates to Discount Rates -- The Week in Dividends, 2015-02-27

It was a quiet week on Wall Street, which has a refreshing quality following the earnings season that preceded it. Long-suffering McDonald's MCD registered our biggest gain for reasons that weren't immediately obvious; it seems a meeting between some investors and incoming CEO Steve Easterbrook kicked the market's rumor mill into action. But this isn't the kind of "news" that I regard as having any substance, and I wouldn't bet on a sudden turnabout from McDonald's recent trends. It was only by coincidence that McDonald's was one of four DividendInvestor portfolio holdings to receive an increase to its fair value estimate this week--and all four shared a common reason.

Our fair value estimates have two basic elements: (1) a forecast of expected cash flows and (2) a discount rate that blends the cost of debt and equity capital in order to value those future cash flows in present-day dollars. In the past few weeks we've launched an updated approach for estimating capital costs, and the cost of equity--the average annual total return we believe shareholders will require from the business over the long term--has come down, primarily because inflation has come down relative to the average of the last 50 years. For a business with average cyclical risks, we now use a 9% cost of equity rather than 10%; those with below-average risks use 7.5% instead of 8%.

All else being equal, a lower cost of equity assumption will lead to a higher fair value estimate. Of course, in practice, our analysts consider all of the latest information about a particular business when updating our valuations, so the correlation won't be one to one. Our fair value estimate for American Electric Power AEP rose $5 to $59 a share with its new cost of capital assumptions; Southern Company's SO rose only $1 to $47. The other two changes this week were the aforementioned McDonald's (up $3 to $98) and Philip Morris PM (up $2 to $92). More fair value estimate changes along these lines are coming over the next month or so.

A lower cost of equity doesn't change the cash flows we're forecasting or that portion of cash flow we expect to be paid out as dividends. We haven't suddenly become more optimistic about the market as a whole. Instead, our new assumptions are meant to reflect how nominal returns should behave in an environment of lower inflation. However, with fair value estimates more likely to rise than fall within our new cost of equity framework, a few more of our holdings may shift into buy territory. American Electric Power is one name that, thanks to this week's update, looks like a possible destination for new money.

Best regards,

Josh Peters, CFA
Director of Equity-Income Strategy
Editor, Morningstar DividendInvestor

Disclosure: I own the following stocks in my personal portfolio: AEP, APU, CLX, CVX, EMR, GE, GIS, GSK, HCN, JNJ, KO, KRFT, MCD, MMP, NGG, O, PAYX, PEG, PG, PM, RCI, RDS.B, SE, SEP, SO, UL, UPS, WFC.


News and Research for Builder and Harvest Portfolio Holdings

FCC Approves Proposed Open Internet Policy; Carriers Already Looking for a Fight
Industry Note 02/26/2015 | Michael Hodel, CFA

As expected, the U.S. Federal Communications Commission voted 3-2 along party lines to approve the open Internet (or "net neutrality") plan Chairman Tom Wheeler proposed earlier this month. The complete 300-page order has yet to be released to the public, but the provided summary of the rules is nearly identical to the initial proposal. The primary tenet of the order is the reclassification of broadband Internet access and the interconnection between carriers and content providers as telecommunications services subject to utilitylike regulations (under Title II of the 1934 Telecommunications Act).  


While we may have more to say after the full order is released, we still don't believe this order will meaningfully alter the competitive landscape in the industry. If the order becomes the law of the land, we expect the outcome would amount to a lost opportunity for carriers rather than a radical change to current business practices. That is, we doubt that a dramatic slide into heavy-handed regulation is likely in the near term. We would note, however, that shifting regulation is always a long-term risk in this industry, given the public and political nature of Internet access service.

Several Internet access providers have already denounced the FCC's action, including Verizon, which released a statement datelined 1934 and written in Morse code. We expect one or more carriers will sue to block implementation of the new regulations shortly, leading to a long legal battle. In addition, we wouldn't be surprised to see action out of Congress with respect to rewriting telecom law.

Based on the summary provided, the order sticks to Wheeler's proposal, calling for somewhat stronger prohibition than the rules proposed in 2010 and struck down in the courts last year. Carriers, both fixed-line and wireless, will not be allowed to block or throttle any legal content, applications, services, or devices or accept payment to prioritize traffic and the FCC will have the option to intervene in disputes between carriers and content or application providers, like Netflix. In addition, the proposal calls for the FCC to refrain from enforcing several elements of Title II, including rate regulation, wholesale unbundling, and universal service contributions.

American Electric Power AEP
Analyst Note 02/25/2015 | Andrew Bischof, CFA

We are reaffirming our $59 per share fair value estimate, narrow economic moat, and stable moat trend ratings for American Electric Power after the Public Utilities Commission of Ohio ruled against the company's requested PPA as part of its Electricity Security Plan filing. The company had requested additional consideration for its interest in Ohio Valley Electric Corporation, or OVEC.

The commission's decision sends a mixed signal. The commission's ruling supported the legality of a regulated utility establishing a PPA, however, it noted that the PPA did not benefit ratepayers, and delayed its final decision. We think the commission's PPA decision will make it difficult for the approval of the company's much larger purchase power agreement filing for 2,671 MW of Ohio generation later this year. Given previous commentary by management, the partial ruling against the OVEC PPA will make it difficult to attain the rate-regulated type returns that management has sought from the business.  We expect management to pursue a sale of the companies 7.9 GW merchant generation unit.

While our forecast sale of the predominantly coal-fired fleet (67%) will be occurring during a depressed environment for coal generation, recent transactions indicate we might have reached the market trough. Duke Energy's recent sale of its unregulated Ohio assets to Dynegy for $2.8 billion was significantly higher than our estimated $2.0 billion-$2.5 billion range, which was based on recent market transactions.

We believe AEP's controlled fleet should be attractive to private equity and independent power producers looking to bet on a rebound in power prices. We estimate a deal could fetch up to $2.5 billion. A sale would allow management to focus on the company's attractive growth plan, which will support 7.5% regulated rate base growth, a 4%-6% earnings forecast, and above-average dividend growth.

American Electric Power: Investment Thesis 02/24/2015
American Electric Power, long the stalwart regulated utility providing consistent earnings growth and dividend payments, faces a business transformation that could change its earnings and dividend growth profile. AEP generates 95% of its earnings from its regulated operations now. However, as Ohio makes the transition toward deregulation, that share of regulated earnings will fall, exposing AEP to volatile power, coal, and natural gas commodity markets.

AEP is currently undergoing a strategic review of the business, and we suspect management will divest the unit similarly to recent industry merchant divestitures. In our view, an upcoming decision from Ohio regulators related to a purchase power agreement for approximately 2,700 megawatts of unregulated generation is likely to determine whether AEP retains or divests the unit.

We see regulated earnings growth for AEP from increased earned returns, environmental investments, and transmission construction. The company has underearned its allowed returns recently, but recent rate increases in Indiana, Michigan, Ohio, and Virginia should help align earned and allowed returns.

Transmission investment is AEP's most attractive long-term growth opportunity, given federal government incentives to improve the efficiency of the U.S. power grid. AEP has several multibillion-dollar projects in the works for the next five to 10 years, with plans to spend $4.8 billion in 2015-17. Its system size and grid operating experience give the company the resources and know-how to participate in just about any transmission project in the United States. AEP already has stakes in some of the largest, most advanced transmission projects in the United States and probably will have more opportunities like these in the future.

Environmental investments also provide another growth area for AEP. Nearly 60% of AEP's power plant fleet burns coal, making it one of the largest coal-fired fleets in the United States. Government emissions regulations could require AEP to spend $4 billion-$5 billion through 2020 to retrofit its plants. The company should be able raise customer rates to recover most of this investment and a return on capital.

American Electric Power: Economic Moat 02/24/2015
Service territory monopolies and efficient-scale advantages are the primary sources of economic moat for regulated utilities such as AEP. State and federal regulators typically grant regulated utilities exclusive rights to charge customers rates that allow the utilities to earn a fair return on and return of the capital they invest to build, operate, and maintain their distribution networks. In exchange for regulated utilities’ service territory monopolies, state and federal regulators set returns at levels that aim to minimize customer costs while offering fair returns for capital providers.

This implicit contract between regulators and capital providers should, on balance, allow regulated utilities to achieve at least their costs of capital, though observable returns might vary in the short run based on demand trends, investment cycles, operating costs, and access to financing. Intuitively, utilities should have an economic moat based on efficient scale, but in some cases regulation offsets this advantage, preventing excess returns on capital. The risk of adverse regulatory decisions precludes regulated utilities from earning wide economic moat ratings. However, the threat of material value destruction is low, and normalized returns exceed costs of capital in most cases, leaving us comfortable assigning narrow moats to many regulated utilities.

We believe the merchant generation business is a no-moat business. Few of its plants maintain an entrenched low-cost position in their markets, subjecting returns on capital to the whims of commodity markets. In Ohio, deregulated markets subject its fleet to customer switching margin loss and market power, coal, and natural gas prices. Although AEP's retail business has been able to retain the some of the retail customers in its service territory, these customers typically come with lower margins and face virtually no switching costs.

American Electric Power: Valuation 02/24/2015
We are maintaining our $59 per share fair value estimate after incorporating year-end 2014 results that were in line with our expectations. At the regulated utilities, we forecast $17.6 billion of planned infrastructure investments in 2014-18 and consistent regulatory treatment leading to 9% regulated earnings growth. But power plant closures and customer switching weigh on unregulated earnings, resulting in 5% consolidated annual earnings growth through 2018. Primary growth investments at the regulated utilities include environmental controls on AEP's power plants and large interstate transmission projects. Higher average returns on its capital investments should help earnings as transmission projects become a larger share of its regulated asset mix. We assume a normalized energy demand growth rate of 1%. We project regulated earnings will account for approximately 95% of consolidated earnings in 2013-14 but then decrease to roughly 85% beginning in 2015, as we assume Ohio Power fully deregulates and we account for forecast plant closures. We incorporate the revised capacity pricing system approved by Ohio commissioners in 2012. This settlement provides for $188.88/MW-day capacity payments through May 31. Incorporating management's guidance, we assume Ohio Power divests 8.9 gigawatts of competitive generation, adjusting for the 2.4 GW transfer to the Kentucky and Appalachian utilities and 3.1 GW of planned plant closures. In 2016, we assume the generation unit earns $500 million of EBITDA, based on our midcycle prices for natural gas ($5.40 per thousand cubic feet), Powder River Basin coal ($28 per ton delivered), and power (average 8.0 market heat rate). We do not incorporate any additional market incentives, such as the pending PPA request, in our fair value estimate. We use a 6.0% weighted average cost of capital and 7.5% cost of equity in our discounted cash flow valuation.

American Electric Power: Risk 02/24/2015
The primary uncertainty surrounding our fair value estimate is AEP's ability to achieve timely, constructive regulatory rate adjustments. This involves negotiations with multiple utility boards and the FERC. That said, AEP's regulatory exposure is diversified due to operations in 11 state jurisdictions and its federal-regulated transmission projects.

Another potential risk for AEP shareholders is the decline in power prices due to decreasing electricity demand or falling natural gas prices. Declining power prices have reduced the attractiveness of the company's merchant Ohio assets. In addition, the company has a significant ongoing development program that is subject to potential cost overruns and political and regulatory risk. Tightening environmental compliance regulations could require significant capital investment or added operating costs that may have uncertain cost recovery in unregulated power markets or traditional regulated rates. This is a risk facing all power plants but especially coal-fired ones and roughly 60% of AEP's generation capacity in operation is coal-fired.

McDonald's MCD
Valuation 02/25/2015 | R.J. Hottovy, CFA

We are raising our fair value estimate to $98 per share from $95 as we recalibrate our cost of capital assumptions to better align with returns that equity investors are likely to demand over the long run. We now assume a 9% cost of equity, down from 10%, aligned with the 9% rate of return we expect investors to demand of a diversified equity portfolio and reflecting a lowered 2.25% long-term inflation outlook. Our updated fair value estimate implies 2016 price/earnings of 18 times, enterprise value/EBITDA of 11 times, and a free cash flow yield of 4%. McDonald's has reiterated its long-range growth objectives of 3%-5% annual sales growth, 6%-7% average annual operating income growth, and return on invested capital in the high teens, the low end of which is aligned with the later years of our explicit discounted cash flow forecast period. With persistent global macro headwinds, increased competitive pressures, and the food quality and safety concerns in Asia, we expect a mid-single-digit revenue decline during 2015, as contribution from 1,000 new restaurant openings worldwide will be offset by a low-single-digit decline in comparable sales (compared with a five-year historical trend of 3% growth) after factoring in aggressive industry promotional activity, menu changes, limited price increase opportunities, and foreign currency headwinds. Over a longer horizon, however, we anticipate low- to mid-single-digit consolidated revenue growth, driven largely by international unit openings and a return to comparable sales growth through new menu innovations, modernized customer experience, and inflationary price increases. While McDonald's will likely fall short of its 6%-7% operating income growth target in 2015, we believe it can return to margin expansion over a longer horizon because of its bargaining clout with suppliers and strong franchisee system. We expect that company-owned restaurant margins will contract almost 40 basis points this year (from 15.9% in 2014) amid elevated payroll costs and expense deleverage stemming from global sales softness, but gradually improve toward 18%-19% over our 10-year explicit forecast period. Over the next 10 years, our model assumes consolidated operating margins approach 33% (compared with expectations of 28.4% in 2015), driven by higher franchisee rent and royalties, increased emerging-market franchises (including China), and margin-friendly menu additions, but tempered by labor and occupancy cost inflation.

Philip Morris International PM
Investment Thesis 02/24/2015 | Philip Gorham, CFA, CRM

Philip Morris International is one of the strongest businesses in our consumer defensive coverage. The company generates industry-leading normalized operating margins in the low- to mid-40% range and boasts a wide economic moat with strong brand loyalty and cost advantages at its core. Nevertheless, we see room for execution improvement and we think margins could go even higher.

Philip Morris' profitability in emerging markets is a key differentiator against its competitors, and it has a strong presence in Asia. The advantage of selling in emerging markets is that volumes are in some cases, increasing. Indonesia (where Philip Morris has about a 31% share), Turkey (about 45%), and the Philippines (about 90%) are all growing in volume at a low- to mid-single-digit rate as a more lax regulatory environment in those regions has led to higher levels of smoking initiation. This should help to slow the firm's decline in volumes over the next decade. The disadvantage of emerging markets is that on the whole, they are less profitable than developed markets. This is less true for Philip Morris International than it is for its competitors. It generated a 2014 EBIT margin (excluding unfavorable foreign exchange movements) of 40% in Asia, in line with the group EBIT margin and above that of British American. The Asia segment margin is skewed by the firm's strong presence in the profitable Japanese market, but it also reflects Philip Morris' positioning in premium categories.

An opportunity for margin expansion lies in improving its operational efficiency, and we would like to see management focus on optimizing its manufacturing processes. Since its creation in 2008, the firm has consistently operated with less efficient asset turnover and cash conversion ratios than its competitors, despite its greater scale. We believe there is some fat to trim in the firm's cost structure, including consolidating manufacturing plants, which by bringing the firm's asset turnover ratios in line with competitors, we estimate could add a further $800 million or 200 basis points to the EBIT margin.

Philip Morris International: Economic Moat 02/24/2015
Powerful intangible assets are at the core of Philip Morris International's wide economic moat. In addition, the company's platform of total tobacco products and e-cigarettes gives it economies of scope and scale that make it difficult for new entrants to gain the critical mass of volume necessary to compete. Finally, the addictive nature of tobacco products makes demand fairly price inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.

Tobacco brands' intellectual property has created a loyalty among tobacco users toward the brands they enjoy. Philip Morris has an impressive brand portfolio that is quite evenly balanced across price points. In spite of the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. In fact, it is the bans on advertising that help to keep market shares stable and new entrants out. Philip Morris' leading brands include Parliament, Virginia Slims, and Chesterfield, and the firm also offers the only truly global and highest-volume brand, Marlboro. The company is the largest cigarette manufacturer outside of China and is the only one of the largest four players (excluding China National Tobacco) to increase its market share (by 30 basis points to 16%) since 2008.

Historical returns on invested capital lend support to our wide moat rating. Philip Morris has generated returns on invested capital in excess of 30% since splitting from Altria in 2008, and ROIC has increased steadily over that time to around 45% in 2013. We forecast returns to remain at 45% over the next decade, comfortably ahead of our 9% estimate of the firm's weighted average cost of capital.

Philip Morris International: Valuation 02/24/2015
After a solid fourth quarter that was in line with our expectations, we are raising our fair value estimate for Philip Morris to $92 from $90, due to the impact of the time value of money, mitigated by further unfavorable foreign exchange movements. Our valuation implies a 2015 P/E multiple of 21.6 times and a 2015 EV/EBITDA multiple of 14.6 times. It also implies a 2015 dividend yield of 4.4%, which is around the middle of the pack for the international tobacco manufacturers. These multiples are higher than the historical average for tobacco companies, but when adjusting for the reduction in EPS of $0.80 next year caused by currency movements, the 2015 earnings multiple is 16 times. Our fair value estimate is based on three key valuation drivers: volume, pricing, and margins. We have lowered our 2015 estimates to account for the strengthening U.S. dollar, and now expect revenue to fall by 2.9% and operating income by 9.6% this year. Beyond 2016, we hold revenue growth in the mid-single digits for the remainder of our explicit forecast period. Our revenue assumptions are driven primarily by pricing, as global volumes continue to decline. We assume a long-term gross margin of 66%. Revenue growth is being driven by pricing, not volume, so the procurement advantage of growing scale is limited. In the absence of acquisitions, and given that raw tobacco prices are fairly stable, we see little opportunity for Philip Morris to expand its gross margin on a sustained basis. However, we do believe there is an opportunity at the operating margin for greater profitability. We forecast Philip Morris' operating margin to grow by 280 basis points over the 2014 margin of 41.5% (to 10 basis points belowits 2012 peak of 44.4%), mainly driven by cost leverage from pricing, but also because we believe there is some operational fat to trim. This is a key variable in our scenario analysis. Despite higher costs of borrowing in the later years in our forecast period, we model an average of 8.1% EPS growth (after a 16% drop this year on currency) driven by earnings growth with some support from share buybacks.

Philip Morris International: Risk 02/24/2015
Our uncertainty rating for Philip Morris International is low. Evidence from the recent economic volatility suggests that industry fundamentals--and, therefore, manufacturers' cash flows--remain stable. With pricing power intact, the greatest operational risks, in our view, are the risk of plain packaging measures in large markets and foreign exchange risk.

Any investor owning tobacco stocks should have the stomach for fat-tail risk. Although the businesses are stable, the threat of government intervention through large excise tax increases, for example, is omnipresent. Litigation risk is substantially lower for the European players as most countries do not have a class-action legal process. Nevertheless, we regard government and legal risks as low-probability events with high potential impacts that investors should be aware of.

In general, we believe government regulation does little to affect the economic moat or the cash flows of tobacco manufacturers, and in some cases, regulation actually limits competition, lowers cost, and strengthens pricing power. Plain packaging is different, though, because we believe that it could facilitate trading down, which would erode pricing power and be detrimental to moats in the industry. The most likely large market to follow Australia in introducing plain packaging is the U.K., where Philip Morris has only a small presence, but if plain packages are introduced in any other major EU market, this could be materially detrimental to the firm, given its positioning in premium categories.

Philip Morris' functional currency is the euro, but it reports in U.S. dollars. It also has exposure to currencies too small to hedge in large amounts on the open market. Although it has something of a natural hedge, with about 26% of its costs in euros almost offsetting the 32% of its revenue denominated in euros, strength in the U.S. dollar can have a significant and detrimental impact on Philip Morris' earnings.

Southern Company SO
Investment Thesis 02/23/2015 | Mark Barnett

Southern's total return proposition remains appealing for patient investors in a world of few decent income alternatives. This giant Southeast utility enjoys some of the best regulation in the United States and strong, consistent regulatory relationships in its key service territories of Alabama and Georgia. The company is in the middle of a huge investment program aimed at phasing out or retrofitting its massive coal fleet, building a low-carbon coal unit in Mississippi, and constructing the first new nuclear plant in the U.S. (in Georgia) after a more-than 30-year freeze.

While regulatory risk is high--as evidenced by ongoing cost disputes in Mississippi and cost overruns at Vogtle's peer nuclear project in South Carolina--earnings and cash flow growth should improve as expenditures close to rates, driving 3.5% earnings and dividend growth through 2018. Although economic growth in the firm's four service territories might not remain above average, capital investment remains the primary engine of our growth forecast, and much of it closes to cash returns annually, keeping cash lag below many peers'.

Southern has more upside to economic improvement than most peers and has traditionally traded at a premium to the sector. While that premium has shrunk with uncertainty around Kemper and Vogtle, investors shouldn't underestimate Southern's constructive regulatory structure, despite above-average recovery risk during this investment cycle. Favorable and supportive regulation is a key driver behind the company's huge construction program and above-average returns.

Southern Company: Economic Moat 02/23/2015
We think Southern's narrow economic moat arises from the nature of the regulatory compact between its four utilities and state regulators. In return for its allowed monopoly in its service territory, regulators allow the utilities to recover their investments in the system with a reasonable return on and of their capital. The company's transmission and distribution assets would be extremely difficult and costly to replicate, which in the U.S. has traditionally served to justify its monopoly. These factors are balanced by the effective cap on returns provided by regulation.

Among its peers, Southern's regulatory environment stands out as the strongest and is supported by above-average economic fundamentals in its key regions as well. These factors contribute to the premium returns Southern has earned and have led to a constructive working relationship with regulators, the most critical component of a regulated utility's moat. We expect returns on invested capital to remain at a modest but consistent spread above Southern's cost of capital for the foreseeable future.

Southern Company: Valuation 02/23/2015
We are raising our fair value estimate to $47 per share from $46 after recalibrating our capital cost assumptions to better align with the returns equity and debt investors are likely to demand over the long run. We now assume a 7.5% cost of equity, down from 8%. This is lower than the 9% rate of return we expect investors will demand of a diversified equity portfolio, reflecting Southern’s lesser sensitivity to the economic cycle, and lower degree of operating leverage. Modestly offsetting this change is an increase in our long-term expected cost of debt financing to incorporate a more normalized rate environment, as well as small incremental charges at the Kemper IGCC. We continue to include a 75% chance that Southern settles with Chicago Bridge & Iron on the Vogtle cost dispute, assuming shareholders could bear roughly $300 million in a settlement. We also include an incremental $200 million in cost overruns at Kemper and $200 million in owners' costs at Vogtle. However, it's possible that Southern could pass any settlement costs to customers or win a fully litigated case in court, neutralizing the impact on investors. Our forecast for total capital investment from 2015 to 2018 is roughly $21 billion and incorporates expenditures to meet coal plant emission limits in the federal air toxics rule and revised costs for the Kemper plant and Vogtle project. We forecast this spending can deliver 4% average annual gross margin growth through 2018. We expect Southern's regulated utilities to continue earning near its industry-leading allowed returns, though we project modest declines in allowed returns on equity through the current rate cycle. We forecast 7.9% average ROIC during the next five years. We forecast average power demand growth of just below 1.5% for Southern's utilities from a strong 2014 through 2018. During the next five years, we assume consolidated operating margins average 26%. We anticipate Southern will increase its dividend 3.5% annually during the next few years, largely in line with management's projections. We use a 7.5% cost of equity and 5.7% weighted average cost of capital in our discounted cash flow valuation.

Southern Company: Risk 02/23/2015
Although we are bullish on this company's prospects overall, some uncertainties remain, including the impact of nuclear cost overruns, possible emissions legislation, and other fossil fuel regulations. However, compliance measures could prove to be less painful to shareholders than some might expect; regulators will allow Southern to pass most of the incremental costs on to customers, preserving the firm's long-term earnings power.

The biggest threat that Southern faces is a deterioration of its regulatory relationships in its four retail service territories. Much of the company's success hinges on the relationships it has built through years of low power prices and excellent customer service. While the Kemper facility has been a financial setback, we don't believe it has any long-term impact on Southern's regulatory relationships in Mississippi and certainly not elsewhere. The risk of declining customer usage has increased, although Southern's best-in-class regulation should help mitigate the effects.

Nuclear construction expenses are approved twice a year, but there is still a risk that additional expenses might not be recovered. Cost overruns could also lead to further stranded capital at the new coal gasification plant or at the new nuclear plants, though a revised process in Georgia eases the burden of approval for new costs. If tough federal environmental regulations further raise investment needs and costs for customers, regulators might be less willing to support above-average allowed returns on equity.


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