AEP - 4% Yield And Undervalued: Why American Electric Power Is A Utility Gem

2023-07-07 11:25:35 ET

Summary

• American Electric Power is a strong utility stock with a healthy balance sheet, consistent dividend growth, and a business model focused on future earnings growth through investments in renewables and decarbonization.
• AEP is expected to invest $40 billion in a mix of distribution and transmission assets and renewables between 2023 and 2027, with a goal to reduce Scope 1 emissions by 80% by 2030 and 95% by 2040.
• Thanks to a 10% drop in share price year-to-date, AEP is a compelling opportunity for long-term dividend investors.

Introduction

During the start of the pandemic, I was a shareholder in the American Electric Power Company ( AEP ) . Later that year, I restructured my portfolio. While I do not regret having bought any of the stocks I own, not keeping AEP was a mistake, as I believe it's one of the best utility stocks on the market.

The company has a healthy balance sheet, a decent yield of roughly 4%, consistent dividend growth, and a business model with strong and consistent future expected earnings growth.

Especially in light of the current stock price weakness, I believe that AEP offers opportunities for a wide range of investors.

So, let's dive into the details!

The Energy Transition

Buying utilities is boring. However, that's a good thing, as successful long-term investing doesn't need to be exciting. Silent compounders are often the best way to build wealth, as investors are less likely to invest based on emotions. I believe the risks of emotional investing are much bigger in other spaces like tech, consumer goods, and other sectors.

With a market cap of $44 billion, Columbus, Ohio-based AEP is one of America's largest utility companies. This regulated pure-play utility has 5.6 million customers in the South and the states surrounding Ohio.

Like all of its major peers, the company is investing in the future. Between 2023 and 2027, the utility giant is expected to invest $40 billion in a mix of distribution and transmission assets and renewables.

As one can imagine, utility companies, which are already highly capital-intensive, will have to invest billions to decarbonize their energy mix.

Hence, to put things into perspective, the company is almost doubling investments in wires and renewables from $22 billion between 2013 and 2017 to the aforementioned $40 billion between now and 2027.

The goal is to reduce Scope 1 emissions by 80% by 2030. By 2040, the company aims for a 95% emission reduction. These goals include a massive decline in coal. After retiring more than 10,000 MW of coal capacity between 2010 and 2022, the company aims to halve this number again by 2028.

Between 1999 and 2032, the company aims to reduce coal power by 47%. By 2032, less than 20% of total electricity will come from coal. In 2032, the biggest source of energy is expected to be renewables, with 54% exposure. Nuclear and natural gas are expected to be somewhat unchanged at 19% and 6%, respectively.

In the first quarter, the company announced that it was making significant progress in its transition to a clean energy economy through its $8.6 billion regulated renewables capital plan.

The company has already received approval or filed regulatory requests for investments totaling $6.7 billion. Various solar and wind projects are being pursued in different states, such as Indiana, Oklahoma, Arkansas, Texas, and Louisiana.

Furthermore, the company is focusing on core assets only as it entered into an agreement with IRG Acquisition Holdings for the sale of its 1,360-megawatt unregulated renewables portfolio.

So far, so good.

What matters to shareholders is how the company is handling an increasing need for capital and growing its earnings on a sustained basis.

Generating Shareholder Value With AEP

For starters, the company is using a very healthy balance sheet for its operations.

Starting with the bad news, in 1Q23, the FFO (funds from operations) to debt ratio was 11.4%, below the long-term target, primarily due to a $1.9 billion increase in balance sheet debt related to mark-to-market collateral positions.

However, the company expects this metric to improve by year-end as debt is reduced and funds from operations increase. AEP's liquidity position remained strong at $3.4 billion, supported by its credit facilities.

The debt-to-capital ratio increased to 64.1% on a GAAP basis, but the company aims to trend closer to 60% by the end of the year through the completion of announced transactions and equity units conversion. The funding status of the qualified pension decreased slightly to 101.3% due to falling interest rates.

Furthermore, while net debt is expected to rise from $25 billion in 2018 to $49 billion in 2025, the leverage ratio is expected to remain below 6x EBITDA. In 2025, that number is expected to be 5.6x. In 2022, it was 5.8x.

What this means is that higher debt is also generating value. Debt isn't wasted but spent on value-adding projects that support financial stability.

This also explains why the company has healthy balance sheet ratings of Baa2/BBB+/BBB.

Speaking of value-adding projects, the company's EPS track record is stellar. Looking at the chart below, we see that the company has consistently exceeded its guidance after 2013. Even prior to 2013, actual results would come in slightly above the guidance midpoint.

At this point, you're probably thinking that it is giving poor EPS guidance to easily beat its own targets. While this sometimes happens, it does not apply to AEP in my view. After all, it has very ambitious targets.

During the first-quarter earnings call , the company reaffirmed its full-year operating earnings guidance range of $5.19 to $5.39 per share and its long-term growth rate of 6% to 7%.

As the overview below shows, the company has boosted earnings growth over the past 13 years. Between 2010 and 2015, it grew earnings by 4% to 6%. That number has now gradually increased to the mid-6% range.

The overview below also shows that this has translated into accelerating dividend growth.

• AEP currently yields 3.9%. The Utilities Select Sector SPDR ETF ( XLU ) is yielding 3.2%.
• Over the past five years, the average annual dividend growth rate was 6.0%, which I expect to slightly increase toward 6.5%.
• The payout ratio is 65%, which is in line with the sector median.

As a result of decent and consistently rising income, the company has outperformed the XLU ETF on a consistent basis. Unfortunately, AEP and its peers failed to outperform the S&P 500 over the past ten years. This is due to the strong performance of tech stocks and the fact that the S&P 500 has so much tech in its top holdings.

So, what about the valuation?

Valuation

AEP shares are down 10% year-to-date. Shares are trading roughly 20% below their 52-week high.

This is the result of rising rates and expectations of a prolonged period of elevated risks. Given the capital intensity of the energy transition, that would be an EPS headwind.

However, for now, the company is managing these issues very efficiently and sticking to strong guidance.

AEP is currently trading at 11.5x NTM EBITDA, which I believe is a good deal.

The current consensus price target is $98, which is 15% above the current price.

I agree with that target.

While I do not expect AEP to suddenly start a strong and sustainable uptrend, I do believe that the $80 to $85 area offers buying opportunities for long-term dividend investors seeking conservative anti-cyclical utility exposure.

Takeaway

As an investor who regretfully sold my shares in American Electric Power during the pandemic, I recognize the company's potential as one of the best utility stocks in the market.

AEP boasts a robust balance sheet, consistent dividend growth, and a business model focused on future earnings growth through investments in renewables and decarbonization.

Thanks to the recent stock price decline, AEP presents a compelling opportunity for a wide range of investors.

While utility stocks may not be the most exciting investments, their stability and compounding growth make them an ideal choice for long-term wealth building.

With a reasonable valuation, a healthy dividend yield, and a solid track record, AEP offers a chance to generate shareholder value and benefit from the ongoing energy transition.

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