AEP - American Electric Power: Attractive Transmission Assets

2023-12-19 07:34:47 ET

Summary

• American Electric Power is a large electric utility company, serving over 5.6 million customers.
• AEP operates in four groups and has been affected by competitive rate pressures in the utility sector.
• AEP's regulatory environment varies across the 11 states it operates in, with some states offering better regulatory support than others.

American Electric Power (AEP) is one of the largest electric utility-holding companies serving over 5.6 million customers. After selling its non-regulated renewable power business in Aug 2023 for $1.2 billion in cash, AEP is mainly an 11 state and FERC regulated electric utility. AEP operates in four groups including Vertically Integrated Utilities (45% of 2022 earnings), Transmission and Distribution Utilities (21%), AEP Transmission Holdco (24%), and Generation & Marketing (10%). As a stalwart in the utility segment, AEP share price has followed the sector down due to competitive rate pressures, but this pressure could abate by mid-year 2024. Looking ahead, AEP should continue to reward shareholders on a total return basis.

State public utility commissions oversee most AEP assets, except for AEP Transmission Holdco which is regulated by the Federal Energy Regulatory Commission. This is important for investors as the 11 state regulatory bodies offer different approved returns on equity ROE, and most are lower than the returns allowed by the FERC. The states overseeing AEP include Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia, and West Virginia.

As the ultimate gatekeeper to utility profitability, S&P offers a proprietary rating of the regulatory environment in each state as part of their credit analysis. Regulatory Research Associates, a group within S&P Global Commodity Insights, offers nine levels for assessing the regulatory environment in a state, three major (Above Average (1), Average (2), Below Average (3)) and three sub-levels (Above Average (1), Average (2), Below Average (3)). The best rating is 1-1 and the lowest is 3-3 with the "Average" being 2-2. A worthwhile investor goal should be to have as much exposure to the most accommodative state utility regulatory environments as these have the best chance of offering improved regulatory financial support. A google search of "Regulatory Research Associates" brought up a Dec 2022 State Assessment table, as offered with a utility filing to the Kansas Corporate Commission, the state utility regulatory agency. I found the listings offered by RRA in the mid-2000s and have used it as a primary due diligence tool ever since. The ratings change slightly over time, but at what appears to be glacial speed.

On its website , AEP offers a list of operating companies, the states served, and the number of customers. From this list, a table of regulatory oversight ratings can be developed.

Investors should focus on the states on the right side of the Regulatory Research Associates' list which carry an RRA rating of 1-1 to 2-1, as those offered the best regulatory support for the utilities under their jurisdiction, in the opinion of RRA. More than 47% of AEP customers reside in states rated as Average - Below Average (2-3) and below. While a greater percentage than what could be considered as ideal, most of the states served by AEP are rated in the major Average category for regulatory oversight. However, investors should not consider AEP as possessing one of the best regulatory environments, unlike Southern Company (SO) or Duke Energy (DUK).

Offsetting this average regulatory exposure is AEP Transmission Holdco AEPTH, which is the largest operator of high-voltage electric transmission lines in the US. AEPTH owns 40,000 miles of high-voltage transmission assets. It is widely reported the US has ~240,000 miles of high-voltage transmission lines, making AEPTH a substantial operator. The advantage to AEP is high-voltage transmission assets are regulated by the FERC, which historically offers a higher ROE than many states, especially those states rated on the lower end of RRA's rating. For example, as offered in the most recent Investors Presentation , during the last 12 months ending 9/30/23, AEP earned an 11.3% ROE on its AEPTH rate base, which is the highest return of all its rate bases. Thee graphic below outlines the TTM ending 9/30/23 for earned ROE by subsidiary.

In the same presentation, AEP management offers an interesting slide comparing earned ROE vs allowed ROE for its underachieving subsidiaries. In addition, management outlines steps being taken to improve profitability to the approved levels. As shown, five subsidiaries are under-earning their allowed profitability, with Kentucky Power offering the worst returns. In 2023, AEP attempted to offload KPCo to Algonquin Power (AQN), but the sale was nixed by regulators. AEP has developed a turnaround plan for KPCo and investors should watch closely how it is implemented.

AEP plans on capital spending of $40 billion from 2023 to 2027, with 90% focused on regulated utility operations. The largest components of spending include electric distribution (27%), electric transmission (23%), regulated renewables (22%), and high-voltage transmission (15%). For example, 31% of AEPTH high-voltage wires will be past their expected life expectancy of 70 years and will need replacing. The combined capital investment budget is anticipated to expand AEP's overall rate base by 7% to 8% a year.

AEP has earned an A- for 10-yr consistency in earnings and dividend growth from CFRA. As a continuation of the S&P Quality Ranking which has a 50-year history, CFRA's SPGMI rates companies by their earnings and dividend growth over the previous 10 years, with A+ considered the best and B+ considered as average. Of the 56 utilities rated, none were rated A+, 11 were rated A, and 16 were rated A-. AEP management has adequately performed in generating earnings and dividend growth to be considered as one of the better utilities in the sector.

Longer term, management has stated they are comfortable with a 6% to 7% EPS growth rate, driven by its expanding rate base, and is in line with most sector expectations. According to Seeking Alpha, AEP earnings per share are expected to be $5.28 this year, $5.60 in 2024, and $5.96 in 2025. These results support both the current $3.52 dividend and the 5.6% to 5.9% historic annual dividend growth. The dividend represents a 66% payout ratio, which is about industry average and sustainable.

As most utility investors know, the sector has been beaten like a ragdoll with rising competitive interest rates. AEP is no different. However, if rates are peaking and actually decline sometime in 2024, the utility sector, including AEP, should regain its luster. Currently trading about mid-range from its 52-week high/low of $70 to $100, the current share price of $82 and yield of 4.28% should be considered as an adequate entry level. AEP's lows of $70 a share was reached in the depths of the Covid Crash of March 2020 and earlier this year. AEP has traded as high a $104 twice in 2020 (Jan and Feb) and 3 times in 2022. I have a few CDs maturing in Jan and Feb 2024 along with a preferred share call. I anticipate putting some of those proceeds to work in a new long-term position of AEP.

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