AEP - A Path To Over 11% Annual Returns - Why 4.5%-Yielding American Electric Power Is Attractive

2023-11-27 15:21:22 ET

Summary

• American Electric Power is a high-quality company with safety, growth, and outperformance potential.
• The utility sector is showing signs of potential growth and attractive valuations.
• AEP has solid earnings growth, financial stability, and a commitment to shareholder returns, making it an appealing investment option.

Introduction

As most of my readers know, I'm increasingly emphasizing safety when it comes to long-term investments. I'm mildly nervous about elevated risks related to a wave of debt maturities in the next two years, increasing delinquency rates in key areas like commercial real estate debt, and the general direction of the economy.

Nonetheless, I'm not a seller. On the contrary, I buy high-quality companies at great prices.

In this case, I look for companies that come with safety, growth, and a high likelihood of outperformance.

One of these companies is American Electric Power ( AEP ) , a company I have owned in my dividend growth portfolio in the past. The only reason why I do not own it now is my switch to higher-yielding Duke Energy ( DUK ) when I restricted my portfolio in 2020.

Because of tax reasons, I wanted higher-yielding utilities.

I never added AEP again as I didn't feel like owning more than one utility company in my dividend growth portfolio.

That was no mistake, as DUK has outperformed AEP over the past three years, mainly because dividends were a bigger part of the total return.

Nonetheless, over the past ten years, AEP has outperformed its peers. It even outperformed the S&P 500 rather consistently until inflation started to accelerate last year, pressuring the returns of utility companies.

On September 12, I wrote an article titled About 1999 - Why American Electric Power's 4.2% Yield is Attractive , highlighting the relative attractiveness of utilities.

In this article, I'll also start by doing that and make the case for an investment in AEP, which has a fantastic mix of safety, income, and total return potential.

So, let's get to it!

Are Utilities Back?

Two months ago, Moody's raised the sector outlook for utilities.

Moody's highlighted a decrease in inflation rates compared to 2022 highs, offering relief to household budgets. This reduction also contributes to moderating utility maintenance and construction costs.

It also emphasized that the overall U.S. regulatory environment for utilities remains supportive. Rate case outcomes have been more positive than anticipated, considering challenges such as high fuel charges and costs from extreme weather events.

Barron's had similar findings when it wrote that " utility stocks won't be this cheap for long ."

The relative strength of defensive stocks hit a 23-year low in September, according to Barron's, using Bespoke Investment Group data.

Despite the struggles, there's a potential silver lining for utility stocks. The sector's relative valuation compared to the S&P 500 is at historic lows, presenting an opportunity for income-seeking investors looking for stable dividends.

According to Barron's:

• Bobby Edemeka, portfolio manager of the PGIM Jennison Utility fund, anticipates annual dividend growth for electric utilities around 5%, aligning with earnings growth.
• Teresa Ho Kim from J.P. Morgan Asset Management notes that utilities offer attractive valuations.
• Stephanie Link of Hightower Advisors suggests opportunities to acquire major utilities at relatively low multiples.

This brings me to American Electric Power.

Solid Earnings Growth & Financial Stability

Incorporated in 1906 in New York, AEP is one of America's largest regulated utility companies, with a market cap of more than $40 billion.

The company has roughly 5.6 million customers in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia, and West Virginia and an asset base of almost $100 billion.

Despite inflationary headwinds, American Electric Power is doing well.

In its most recent quarter, the company reported growth in GAAP earnings, with $1.83 per share, up from $1.33 in 2022.

Year-to-date GAAP earnings were $3.62 per share, impacted by nonoperating costs.

As we can see below, growth was attributed to favorable rate changes, transmission project execution, increased retail load, and positive O&M.

Furthermore, normalized retail load grew 2.1% in Q3. Residential load increased, and commercial load was impressive, up 7.5%, driven by data center additions.

Speaking of data centers, AEP benefits from more than just secular growth caused by much higher electricity needs from data centers.

Its customers are strategically located to benefit from the ongoing economic re-shoring trends, where companies accelerate investments in the U.S.

The map below shows major economic development projects, including data centers, industrial real estate, food production, and so much more.

In order to satisfy future demand, maintain its existing asset base, and de-carbonize its assets, the company has a huge capital spending plan.

Through 2027, the company aims to invest $40 billion in its business.

• A fifth of its investment is spent on renewables. Since 1999, the company has rapidly reduced its dependence on coal, becoming one of America's largest renewable energy players.

• 65% of its capital is directed towards wires.
• The company expects 7.5% compounding annual base rate growth.

However, despite these massive investment requirements, the company is not expected to expose its investors to elevated financial risks.

During its third-quarter earnings call, financial health was addressed through the FFO to debt metric, which increased to 11.4%. This is below the targeted range of 14% to 15%. However, there was a positive trend with an increase of 30 basis points from the previous quarter.

This increase was primarily due to a $1.8 billion decrease in debt during the quarter, resulting from long and short-term debt retirements driven by proceeds received from the contracted renewable sale and the successful completion of planned equity units conversion.

The company also presented a detailed roadmap outlining how it plans to reach its targeted FFO to debt range.

Factors contributing to this improvement include a roll-off of approximately $600 million in cash collateral, deferred fuel, and other outflows from the fourth quarter of 2022.

Additionally, the continued cash recovery of deferred fuel balances in the fourth quarter of this year, totaling between $150 million and $200 million, was highlighted during the earnings call.

These measures are expected to result in an incremental 100 basis point improvement, putting the metric in the 13% to 14% range by year-end.

Furthermore, although net debt is expected to rise from $33 billion in 2020 to $49 billion in 2025, the net leverage ratio is expected to decline from 5.8x (EBITDA) to 5.6x, indicating prudent financial management and investments in value-added projects.

The company has an A- credit rating, one of the best ratings in its industry.

Shareholder Returns & Valuation

Another benefit of buying AEP is a well-covered dividend.

The stock currently yields 4.5%, which is backed by a 67% earnings payout ratio, using 2024 EPS expectations of $5.61.

Furthermore, the dividend has a five-year CAGR of 5.9%, which is very decent in its industry, and a dividend growth streak of 14 years.

AEP has a 60% to 70% payout range, which means dividends are expected to grow in line with earnings.

I already briefly highlighted it, but a big part of AEP's appeal is its total return. In other words, potential capital gains in addition to its dividend.

The total return consists of earnings growth, dividends, and valuation changes. If we exclude valuation changes, the company has a clear path to 10% to 11% annual total returns.

• AEP expects to maintain 6% to 7% annual operating earnings growth, supported by pricing and volume gains.

We also continue to be committed to our long-term growth rate of 6% to 7%. And as Julie mentioned earlier, our sales efforts to simplify and derisk the AEP portfolio remain on track. - AEP 3Q23 Earnings Call

When adding its +4% dividend yield, we get a path to over 10% annual returns.

• Between 1Q09 and 4Q23, AEP has returned 10.7% per year.

On top of that, I believe that AEP is undervalued, which could mean above-average total returns in the next few years.

Looking at the data in the chart below:

• AEP is expected to grow its earnings per share by 6% in the next few years, which is in line with company estimates.
• AEP currently trades at a blended P/E ratio of 14.9x.
• Going back two decades, the normalized valuation is 15.3x earnings.
• A return to 15.3x earnings, in addition to its expected EPS growth, could result in a CAGR of 12% through 2025. This is a theoretical performance, but it shows the attractiveness of AEP at these levels, even if elevated rates keep the valuation multiple from rising in the mid-term.

In other words, the bottom line is that while elevated rates could keep a lid on utility stocks in the next few quarters, the longer-term value of these stocks has become quite good.

Takeaway

In a landscape of economic uncertainty, American Electric Power stands out as a resilient investment.

A powerhouse in the utility sector, AEP boasts solid earnings growth, financial stability, and a strategic plan for the future.

With a substantial capital spending initiative focusing on renewables and a commitment to shareholder returns, AEP's 4.5% dividend yield, backed by a well-managed payout ratio, adds allure.

Despite short-term challenges, AEP's potential for 10-11% annual total returns, coupled with an attractive valuation, positions it as a compelling choice for investors seeking a blend of safety, income, and growth.

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