New Trade – $SO: Change Gonna Come At Last?

by Dan May 12, 2015 10:52 am • Commentary

Back in late December, with Utilities stocks at all time highs we expressed a dim view (New Trade – XLU: Utility Playa) of their future prospects:

The out-performance of the XLU, is surprising, even given the recent drop in oil, when you consider the too five holdings (DUK, NEE, D, SO & EXC which make up about 38% of the weight) have an average dividend yield of about 3.35%. Not a whole heck of a lot higher than the 2% expected for the S&P 500 in 2014.  What’s more, the components of the XLU are not exactly cheap, looking at the five largest holdings vs the S&P 500 trading at about 14.5x  2015 expected earnings growth of about 10%.  On average the five previously listed Uts are trading at about 18.5x expected earnings growth of about 5.5%.

So what are you getting for that added yield, expensive low growth stocks with investor sentiment very high.

Since late December the XLU is down almost 13% from those highs, making its components a good deal cheaper from a valuation standpoint (most below a market multiple), while the dividend yields look that much fatter.

A little while ago there was an opening buyer of short dated puts in The Southern Company (SO). When the stock was $43.32, a trader bought 15,000 June 43 puts for $1.05.  These puts break-even on the downside at $41.95, down about 3% in a little more than a month.

A quality technician would probably tell you that SO has a date with long term support between $40 and $42:

SO 4yr chart from Bloomberg
SO 4yr chart from Bloomberg

At those levels, SO’s current 5% dividend yield would be above 6%.  SO’s expected earnings growth in 2015 is only 1% with 3% expected sales growth, and frankly low single digits growth is probably as good as it is gonna get for a utility company from here till the end of time.  So the stock trading 15x expected earnings growth of 1% only makes sense for that fat dividend yield.  And after the stock’s decline, the yield at 2x that of the 10 yr Treasury may soon start to look a more attractive if the Fed is unable to raise rates anytime soon.

Is the stock approaching a level?? SO is down 19% from the 2015 highs, and only 3% from its 52 week lows made last summer:

SO 1yr chart from Bloomberg
SO 1yr chart from Bloomberg

For those who think the stock should find support back near $42, and think the bond move is getting a bit overdone, and rate sensitive stocks like SO could be near a period of stabilization, call sales are attractive against long stock as a yield enhancement.

For instance if you were to buy SO here at $43.45, and sell the August 45 call at 52 cents, you would create an additional 1.2% yield to the upside, with a call-away level of $45.52, up 4.8%, while creating a 1.2% buffer to the downside, in addition to the two 54 cent dividends to be paid, one in early June and one in early August creating a $1.08 buffer:

from Bloomberg
from Bloomberg
New Trade: Long 100 shares of SO at $43.45 and short 1 Aug 45 call at .52

Breakevens on Aug expiration: Gains and losses of the stock with losses buffered to the downside by .52 and added yield of .52 plus gains in the stock up to $45. Called away in the stock above $45 at an effective sale of $45.52.