DTE - American Electric Power: A Very Reasonable Risk-Reward Trade

Summary

• American Electric Power Company, Inc. is one of the largest electric customers in the United States, serving 5.5 million customers in eleven states.
• The company is currently spending a great deal of money to expand and reducing its carbon footprint, providing investors with a 10% to 11% total return.
• The company is reasonably financed relative to its peers, reducing some risk with respect to its debt.
• The 3.76% dividend yield appears to be sustainable.
• American Electric Power Company, Inc. stock is quite reasonably valued relative to its peers.

American Electric Power Company, Inc. ( AEP ) is one of the largest regulated electric utilities in the United States, operating in eleven states in two different regions of the nation. One of the defining characteristics of electric utilities is stable cash flow regardless of overall conditions in the economy. This is one of the reasons why these companies have long been among the favorite investments of retirees and other conservative investors. They also tend to boast higher dividends than most other things in the market. American Electric Power is no exception to this, as the firm yields 3.76% at the current market price. The company also has a long history of increasing its dividend on an annual basis, which it is poised to continue going forward. When we combine this with a very attractive valuation, we certainly see a lot to like here.

About American Electric Power Company

As stated in the introduction, American Electric Power Company is one of the largest regulated electric utilities in the United States. The company boasts operations in eleven different states located in two separate regions of the United States:

This is something that is fairly rare among utilities, as most of them only serve one particular region, although operating in multiple states is not exactly unusual. As might be expected from a company serving such a large region, American Electric Power has a sizable customer base. The firm boasts approximately 5.5 million customers consisting of a combination of universities, residential customers, industrial customers, commercial customers, and others. This is something that is quite nice to see as many of these have somewhat different fundamentals. For example, universities and residences tend to be less susceptible to changes in the economy. For example, a residential customer is not particularly likely to change their electric consumption in either weak or strong economies (which also applies to universities).

As a result, the revenue and cash flow that American Electric Power will generate from these customers will likely be the same from quarter to quarter. After all, most people consider electricity to be a necessity, so they will normally prioritize paying their electric bill ahead of more discretionary expenses. In contrast, industrial or commercial customers may change their consumption considerably depending on changes in the business cycle, so they are less reliable customers. However, a business also typically consumes much more electricity than a residential one does. Unfortunately, American Electric Power does not specifically state what percentage of its revenue or earnings comes from each particular type of customer. However, as we can see here, the company’s revenues are typically very consistent from quarter to quarter:

This is something that is fairly nice to see since it is ultimately revenues that support a company’s ability to generate profits and earn an income. However, as investors, we are not satisfied solely with stability. We need to see growth and, fortunately, American Electric Power is well-positioned to provide growth going forward. The company is planning to do this by investing money into growing its rate base. The rate base is the total value of the company’s assets upon which regulators allow it to earn a specified rate of return. As this rate of return is a percentage, any increase in the size of the company’s rate base allows it to raise or otherwise adjust the price that it charges its customers in earn to earn that specified rate of return. The usual way that a company does this is by investing money into upgrading, modernizing, and possibly even expanding its infrastructure. American Electric Power is planning to do exactly this by investing approximately $39.3 billion over the 2023 to 2027 period in order to expand its infrastructure:

As we can see, the majority of this money is expected to be invested in the company’s transmission network. The transmission network is the network of power lines that transmits electricity over very large distances, such as to serve people that may live hundreds of miles away from the power plant. This is in stark contrast to a company’s distribution network, which transmits electricity over much shorter distances, such as the lines that run along the street to your home or business. This focus on transmission lines does make a great deal of sense for a company such as American Electric Power however given the enormous service area over which the company has to transmit power.

The curious thing is that the company’s proposed spending program is a considerable proportion of its current rate base. As of December 31, 2021, American Electric Power had a $50 billion rate base so the company is proposing to spend 78.9% of its rate base over the next five years. Unfortunately, this is unlikely to cause its rate base or income to actually grow to that degree. This is partly because of depreciation. In short, because of depreciation, any asset that the company purchases at the start of its investment program will be worth less at the program’s conclusion. In addition, some of the company’s spending is devoted to purchasing assets that will actually replace other assets that are being removed from operation. As such, these retired assets will no longer contribute to the company’s rate base. Indeed, the company has stated that its rate base should be growing at a 7.6% compound annual growth rate, resulting in average customer price increases of above 4%. The company is likely to add more customers during the projection period as well, resulting in a 6% to 7% earnings per share growth rate over the period. When we combine this with the company’s current 3.76% dividend yield, investors are likely to see a total return of 11% to 12% over the next five years. This is quite a respectable total return from a conservative utility company.

As we can see in the chart above, one of the areas in which American Electric Power is investing considerable amounts of money beyond its traditional transmission and distribution infrastructure is renewable energy. This is part of the company’s plan to achieve net-zero carbon emissions across its operations by 2045. This is admittedly not a particularly ambitious goal relative to many peers but there is a very good reason for this. This is partly due to the fact that the company still generates a considerable amount of electricity through the use of coal. In fact, currently, 41% of the company’s total generation comes from coal, which is much more than many other utilities. American Electric Power is planning to reduce this figure significantly over the coming years. However, it will still be generating 19% of its electric supply through the use of coal by 2030:

As is the case with many other utilities that still have a significant amount of coal generation capacity, American Electric Power is planning to achieve this reduction by retiring its coal power plants and replacing them with renewables. This is because coal generates more carbon emissions than any other form of electricity generation. This should give the company about 52% of its electric generation sourced from renewables by 2030, a significant increase from 23% today. This is one of the most significant reasons why the company’s rate base is growing much less than its planned spending would imply. After all, the retirement of this coal capacity will result in the company’s rate base declining as the plants no longer contribute their value to the firm’s rate base.

With that said, there may still be a potential upside here from an investment perspective, despite this high cost. This is mostly due to the significant amount of assets that are found in various environmental, social, and governance funds around the world. As of December 31, 2021, these funds had approximately $357 billion in assets in the United States alone. This is a considerable increase from less than $100 billion in 2018:

However, European funds in this category have significantly higher assets. As of the same date, European environmental, social, and governance funds commanded $2.231 trillion. The sheer size of these funds may help to explain why a growing number of companies have been devoting an increasing amount of management attention to delivering on the particular goals that these funds possess. This is because any company that attracts this attention could begin to see its stock price increase if funds begin buying its shares.

This is something that may benefit American Electric Power as well since given the relatively high percentage of renewable generation capacity the company will have at the end of this decade. Unfortunately, though, the fact that this company will still have 19% of its power coming from coal could result in its market performance lagging a bit compared to fellow utilities that have a lower carbon footprint. This is one reason why the company may have a relatively more attractive valuation than many peers, as we will see later in this article. Thus, the company may still have some things to offer to the correct investor even if its stock performance may not be quite as strong.

Fundamentals Of Electricity

Over the past few years, electric utilities have gotten a great deal of attention relative to other types of utility. The reason for this is mostly the concept of electrification, which has been widely promoted by politicians, futurists, and media personalities. At its core, electrification refers to the conversion of things that are historically powered by fossil fuels to the use of electricity instead. The most common things cited for conversion are transportation (electric vehicles) and space heating but there are some other things that could be converted as well. This can be expected to greatly increase the demand for electricity, which should prove to be very profitable for electric utilities. Indeed, I discussed the increase that could be expected from electric cars alone in a recent article .

Unfortunately, the United States Energy Information Administration does not believe that this scenario will play out nearly as strongly as proponents of electrification do. In fact, according to the agency, the national demand for electricity will only grow at a 1% to 2% rate over the next thirty years:

This is nowhere close to the growth rate that we would expect if wide swathes of the economy were to be converted from fossil fuels to electricity. Thus, it appears that the electrification trend is likely to be oversold. This may be particularly true when it comes to the use of electricity for space heating. As I pointed out in various previous articles, it is considerably more expensive to use electricity to heat a home than it is to use natural gas, or indeed any fossil fuel:

When we consider that heating a structure with electricity is nearly four times as expensive as heating with natural gas and nearly twice as expensive as heating with fuel oil, it seems rather unlikely that very many people will be willing to pay the higher costs or pay the cost to convert. This is particularly true among people in cold climates or people that have somewhat limited means. While it is possible that eventually, things will change, the Energy Information Administration appears to not expect this to happen within the next thirty years.

Thus, we are able to conclude that it does not make any sense to purchase an electric utility simply because one is hoping to make a profit from the electrification trend. It does, however, still make sense for a conservative investor to purchase an electric utility as many of the fundamentals that have always been true about the industry remain so today. As we discussed over the course of this article, we can expect American Electric Power Company to continue to deliver a somewhat slow but steady growth rate coupled with a reasonably high dividend yield.

Financial Considerations

It is always critical that we analyze the way that a company finances itself before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. This is usually accomplished by issuing new debt to repay the maturing debt. This could cause a company’s interest costs to increase following the rollover, depending on the conditions in the market at the time. In addition to this, a company must make regular payments on its debt if it is to remain solvent. Thus, any event that causes a decline in cash flow could push a company into bankruptcy if it has too much debt. Although utility companies like American Electric Power usually have reasonably stable cash flows, bankruptcies are certainly not unheard of in the company so this is still a risk that we should consider.

One metric that we can use to evaluate a company’s financial structure is the net debt-to-equity ratio. This ratio tells us the degree to which the company is financing its operations with debt as opposed to wholly-owned funds. It also tells us how well the company’s equity will cover its debt obligations in the event of a bankruptcy or liquidation event, which is arguably more important.

As of June 30, 2022 (the most recent date for which data is currently available), American Electric Power had a net debt of $37.4658 billion compared to $24.297 billion in shareholders’ equity. This gives the company a net debt-to-equity ratio of 1.54. Here is how that compares to a few of the company’s peers:

As we can see, American Electric Power Company appears to have a very reasonable debt load relative to its peers. In fact, of the companies shown above, only Eversource Energy has a lower debt load. This is a sign that the company is probably not using too much debt with respect to its financial structure so there is not likely to be a particularly outsized risk with respect to this debt.

Dividend Analysis

As stated a few times throughout this article, one of the things that attracts investors to utilities is that they typically have a higher dividend yield than most other things in the market. Indeed, as of the time of writing, American Electric Power Company has a 3.76% yield compared to the 1.70% yield of the broader S&P 500 index ( SPY ). In addition to this, the company has a long history of consistently raising its dividend over time:

This history of dividend increases is something that is quite nice to see given today’s inflationary environment. This is because inflation is constantly reducing the number of goods and services that an investor can purchase with the dividend that the company pays out. As a result, it can feel as if one is getting poorer and poorer with time. A company that raises its dividend with time helps to offset this effect as the fact that the company gives you more money each year allows the investor to at least somewhat maintain their purchasing power with each passing year. As is always the case though, it is critical that we ensure that the company can actually afford the dividend that it pays out. After all, we do not want to find ourselves in a situation in which the company is forced to reverse course and cut the distribution. That event would, of course, devastate our income and likely cause the stock price to decline.

The usual way that we analyze a company’s ability to maintain its dividend is by looking at its free cash flow. The free cash flow is the money that is generated by a company’s ordinary operations that is left over after the company makes all necessary capital expenditures and pays all its bills. This is the cash that is therefore available to perform things such as paying a dividend, buying back stock, or reducing debt. Unfortunately, over the past twelve months, American Electric Power Company reported a negative levered free cash flow of $4.204 billion. This is obviously not enough to pay any dividend, let alone the $1.5642 billion that the company actually paid out over the period. This may appear concerning at first.

However, it is not unusual for a utility to finance its capital spending primarily through the issuance of debt and, to a lesser extent, equity and use its operating cash flow to finance the dividend. This is mostly due to the enormous expenses involved in constructing and maintaining utility infrastructure over a wide geographic area. Over the trailing twelve-month period, American Electric Power Company had an operating cash flow of $5.7867 billion. This is more than sufficient to cover the $1.5642 billion that the company paid out in dividends over the same period with a considerable amount of money left over that the firm can use for other purposes. Overall, this dividend appears to be reasonably sustainable and investors probably do not have to worry about a cut.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a sub-optimal return on that asset. In the case of a utility like American Electric Power Company, one metric that we can use to value it is the price-to-earnings growth ratio. This ratio is a modified form of the familiar price-to-earnings ratio that takes a company’s forward earnings per share growth into account. A price-to-earnings ratio of less than 1.0 is a sign that the stock may be undervalued relative to its forward earnings per share growth and vice versa.

According to Zacks Investment Research, American Electric Power Company will grow its earnings per share at a 6.20% rate over the next three to five years. This is reasonably in line with the 6% to 7% that we used earlier in this article to calculate the total return so the figure appears to be relatively solid. This gives the stock a price-to-earnings growth ratio of 2.68 at the current price. Here is how that compares to the firm’s peer group:

American Electric Power Company appears to have a reasonable valuation based on this analysis. Admittedly, the company does not have the absolute lowest ratio in the industry but both Entergy and CMS Energy have significantly higher debt, as we established earlier. As such, both of those companies are likely to be somewhat riskier. Overall, American Electric Power Company appears to be offering a reasonable risk-reward tradeoff and thus may be worth considering for an investor.

Conclusion

In conclusion, American Electric Power Company appears to have a lot to offer a conservative investor looking for a utility stock. The company is positioned to continue the growth that it has historically provided and overall deliver a 10% to 11% total return over the next five years. The company admittedly does not currently have some of the “green” credentials that its peers have but it is working on it and this may even be contributing to its very reasonable valuation. Overall, this company is worth considering.

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