XLU - About 1999 - Why American Electric Power's 4.2% Yield Is Attractive

2023-09-12 16:02:02 ET

Summary

• Utility stocks have underperformed the broader market in 2023, marking their worst performance since the dot-com bubble.
• American Electric Power is a top-tier utility stock with consistent earnings and dividend growth.
• AEP offers a current yield of 4.3% and has a solid approach to balancing dividends, strengthening its balance sheet, and achieving net-zero emissions by 2045.

Introduction

It's time to talk about 1999.

In 1999, a few notable things happened:

• Euro Introduced : On January 1, 1999, the euro was introduced as an electronic currency for banking and financial transactions in 11 European Union countries.
• The Matrix Released : The science fiction film The Matrix , directed by the Wachowskis and starring Keanu Reeves, Laurence Fishburne, and Carrie-Anne Moss, was released in March 1999.
• Hubble Space Telescope Servicing Mission : In December 1999, the Space Shuttle Discovery carried out the third servicing mission to the Hubble Space Telescope.

It was also the last time the underperformance of utility stocks was as bad as it is now.

According to the Wall Street Journal on September 5, utility stocks have significantly underperformed the broader market in 2023, with a 13% slump, marking their worst performance since the dot-com bubble.

This decline contrasts their usual stability and high dividends in uncertainties.

Essentially, we're dealing with a number of headwinds.

While I disagree with the Wall Street Journal that an improving economic outlook favors non-defensive stocks (we're seeing slower growth), I agree with its assessment of more competition for income-generating stocks from high-yielding government bonds.

Bond proxies like utility stocks are losing their appeal, making investors reevaluate their investment choices. Additionally, the sector faces local-level risks, such as extreme weather events, which can impact utilities' operations and profitability.

It also does not help that sticky inflation is pressuring companies with low margins and causing the Fed to stick to elevated rates. That's unfavorable for companies with high debt loads. Utilities are among the companies with the most debt, as their anti-cyclical businesses can carry a lot of debt.

Also, they need it to expand their operations and become carbon-neutral over the next few decades.

The good news is that this comes with long-term opportunities, as even the best utilities are selling off. One of them is American Electric Power ( AEP ) .

This Ohio-based giant is now yielding 4.2%. Its management is sticking to its favorable long-term growth outlook and effectively dealing with ongoing issues.

I believe that AEP will remain a long-term outperformer in its sector and a great income tool for dividend investors.

So, let's dive into the details!

American Electric Power Is Among The Best

I have occasionally owned AEP shares in the past ten years. The only reason I do not own AEP anymore is my focus on dividend growth over income. If I were focused on income, I would likely buy AEP again.

Headquartered in Columbus, Ohio, American Electric Power services 5.6 million customers in 11 states. Its distribution network of 225 thousand miles is one of the biggest in the United States.

The company has a terrific track record of reporting higher-than-expected earnings. Just once since 2010 has the company reported EPS below the midpoint of its guidance range.

The company also has very consistent dividend growth.

Essentially, the company believes it is a 9% to 10% annual return opportunity, consisting of consistent EPS growth and an elevated dividend yield.

Since 2016, the company has accelerated its dividend growth. The compounding average growth rate of its dividend since then has been slightly above 6%.

The current yield is 4.3%, backed by a 66% payout ratio. The company targets a 60% to 70% payout ratio, which means consistent EPS growth should translate to consistent hikes.

Furthermore, AEP has paid a dividend for 112 consecutive quarters. It has 13 consecutive annual dividend hikes.

In general, the company has a number of objectives, including dividend growth, strengthening the balance sheet, managing the portfolio, and reaching net-zero emissions by 2045 while keeping customer rates affordable.

Between 2023 and 2027, the company is forecasting to spend roughly $40 billion. 65% of this will be allocated to wires. Roughly a fifth will be allocated to renewables.

Between 2013 and 2017, the company spent $20 billion, which shows the ballooning capital requirements of this industry. While AEP isn't risking its balance sheet, it makes sense that the market somewhat avoids an industry that relies on accelerated debt to achieve its financial and environmental targets.

With that in mind, the company believes it can maintain a compounding 7.5% rate base growth between 2021 and 2027.

This is expected to pave the way for 6% to 7% annual EPS growth.

On the company's second-quarter earnings call, the company reported $1.13 in operating earnings per share, down from $1.20 in the prior-year quarter. This decline was due to less favorable weather and higher interest rates.

However, the company reaffirmed its 2023 full-year operating earnings guidance range of $5.19 to $5.39 per share and the aforementioned long-term earnings per share growth rate of 6% to 7% per year.

Again, note that this is per-share growth. This accounts for share dilution.

Furthermore, due to aggressive investments, the company's balance sheet health is deteriorating a bit.

In the second quarter, the FFO (funds from operations) to debt metric decreased to 11.1%, primarily due to an increase in debt issuance.

The debt-to-capital ratio increased to 64.6% on a GAAP basis.

Between 2023 and 2027, the company will need between $2.3 billion and $6.7 billion in annual capital, depending on longer-term maturities and investment requirements. It intends to achieve this without having to increase the debt-to-capitalization ratio.

In light of these requirements, the company is committed to reducing debt through announced sales and equity unit conversions, aiming to achieve a target FFO to debt range of 14% to 15% by early 2024.

On its second-quarter call, the company announced that the sale of its unregulated renewals portfolio achieved FERC approval and clearance from antitrust authorities.

The deal is expected to have been closed in August.

Other asset sales, such as the New Mexico Renewable Development Solar portfolio and retail and distributed resources businesses, were also mentioned during the call and are on schedule for closing.

AEP has also completed the strategic review of two non-core transmission joint ventures and intends to sell its interest in Prairie Wind Transmission and Pioneer Transmission.

Rating agencies are very upbeat about the company's plans to maintain a steady balance sheet despite higher capital requirements.

The company has investment-grade credit ratings from all major rating agencies- It has a BBB+ rating from S&P, which is one step below the A-range. Its outlook is stable.

When adding the mix of consistent EPS growth, a healthy balance sheet, and plans to balance future investments in renewables and its grid, the company is in a good spot to continue what it has done in the past: outperforming its peers.

Over the past ten years, AEP has returned 163%, beating the Utilities Select Sector SPDR ETF ( XLU ) by more than 20 points.

AEP has failed to outperform the S&P 500 during this period, which is mainly caused by underperformance starting in 2020.

Looking at the ratio between the AEP total return and the S&P 500 total return, we see that AEP has consistently outperformed the S&P 500 between the Great Financial Crisis and the pandemic. That's impressive, as the S&P 500 benefited from overweight tech exposure.

I do not expect AEP to outperform the market while inflation is elevated.

However, on a longer-term basis, AEP remains a top-tier pick, especially if we enter a lower-inflation and low-rate environment in the future. That will cause loads of capital to move back into the investments that did so well before inflation was an issue.

Valuation

Going back to the aforementioned Wall Street Journal article, it noted that utility stocks are trading at a price-to-earnings ratio of 15.9, below their 10-year average of 17.4.

Using my favorite indicator, EV/EBITDA, we see that AEP is trading at 11.1x NTM EBITDA. This would make it the cheapest valuation since 2018.

After dropping 18% year-to-date, AEP shares are now trading 21% below their consensus price target of $94.

I believe this price target is fair.

However, I do not believe that AEP will start a meaningful rally unless we see a consistent decline in inflation rates.

That may be annoying, but I believe that long-term investors benefit from the chance to add some great stocks on weakness. Despite my belief that inflation will remain sticky on a prolonged basis, I have been adding to the victims of this trend. This includes utilities, consumer staples, and real estate investment trusts.

I buy assets when they are cheap. On a prolonged basis, we'll reap the rewards.

Takeaway

AEP, headquartered in Columbus, Ohio, boasts an impressive history of consistent earnings and dividend growth. With a current yield of 4.3% and a payout ratio of 66%, it offers a compelling income opportunity.

The company's commitment to balancing dividends, strengthening its balance sheet, and achieving net-zero emissions by 2045 reflects a solid approach supported by credit agencies.

Over the past decade, AEP has outperformed its peers and remains a top-tier pick for long-term investors, particularly in a future lower-inflation and low-rate environment.

While the immediate future may be uncertain, AEP's valuation, trading below its longer-term average, presents an attractive entry point for long-term dividend growth investors.

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