AEP - American Electric Power: One Of The Best Buys In 2023's Devalued Utility Sector

2023-10-25 05:25:40 ET

Summary

• This is a large cap electric utility with 5.6 million customers in 11 states.
• The current dividend is 4.46%, but an increase is expected in November; I estimate a 6.0% raise in line with forecasts.
• American Electric Power looks on track to meet its 6-7.0% EPS growth target for 2023.
• Like other utilities, its coal power generation is being reduced to meet the Paris Climate Accords goals. Currently, it is 42.0%.
• At today’s prices, with a 14.2 P/E, I estimate that shares are 10.0-15.0% undervalued.

American Electric Power ( AEP ) is a holding company for several regulated utilities with 5.6 million customers across 11 states. There are two zones – the south (Texas, Oklahoma, Louisiana and Arkansas) and the mid-west (Ohio, Illinois, Michigan, West Virginia, Kentucky, Tennessee and Virginia). The company has a generating capacity of 25,000 megawatts and a current market cap of $37.8 billion. At the end of September the market cap was $41.0 billion; utility shares have declined that much of late. According to Edison Electric Institute , AEP is the fifth largest investor owned utility in the US by market cap. The company’s current Standard & Poor's senior unsecured credit rating is BBB+, or medium investment grade, placing it in the upper half of all regulated utilities.

During the last year, the peak share price was $98.62 on December 2022. The current share price of $74.50 is 24.5% below that peak. At the current estimated earnings per share of $5.25 for 2023, the company’s P/E Ratio is 14.2. According to Morningstar , the “median 16.0 P/E (for utilities) is at its lowest since exiting the 2008-09 recession.” Share prices in the sector are down 13.0-17.5% since the beginning of 2023 (see below), as 10-year treasuries have risen to 4.875% and money market funds are paying in excess of 5.0%, making them a defensive dividend stock alternative.

AEP’s Dividend

The yield at the current share price of $74.50 is 4.46%. AEP currently pays a quarterly dividend of $0.83 per share and it has paid a dividend for 112 years. Recently, the company has increased its payout for 19 consecutive years, beginning in 2005 after a dividend cut in 2001. During these years, the dividend has grown from $0.35 to $0.83, a compound annual growth rate of 4.6%, above the rate of inflation for most of those years, but not for the last two or three. AEP states that the company’s goal is to grow the dividend 6-7.0% per year, at the same rate it would like to grow earnings per share. The next increase should be announced any day now (likely when Q3 results are reported on November 2). I’m thinking that the next increase will be 6.0% to $0.88 per quarter . At the current share price that would be a yield of 4.72%. By comparison, large cap utility peer NextEra Energy ( NEE ) has a current yield of 3.63%, Duke Energy ( DUK ) is paying a comparable 4.68%, and Dominion Energy ( D ) is paying a higher but riskier 6.75%. Below are payout ratios over time for AEP earnings per share and cash flow per share.

The current payout ratio based on EPS is 63.81% for 2023, based on the consensus earnings estimate for the year of $5.25. The cash flow payout ratio is 30.45%. These are both low and very sustainable for a utility. The company says that its targeted long-term payout ratio is 60.0-70.0%. Southern Company ( SO ) has a current payout ratio of 97.51% while Dominion Energy has a payout ratio of 98.89%. According to the Edison Electric Institute, the industry wide average was 73.0% for 2022.

Earnings Performance

In its Second Quarter 2023 earnings report, AEP reaffirmed EPS guidance of $5.19 to $5.39 per share, with a $5.29 mid-point. The analyst consensus, though, is $5.25 to $5.26. Over the last 14 years, AEP has generally met or exceeded guidance with the exception of 2012, as presented below.

In the second quarter 2023, revenue was $4.4 billion, down slightly from $4.6 billion in the same period 2022. Earnings per share were $1.01, also down slightly from $1.02 in 2022. These numbers were the result of “milder temperatures from year to year.” Both residential and commercial customers of AEP were also reported to have been adversely impacted by inflation as a whole and tried to curb spending.

Total revenues in 2022 were $5.51 billion, up 22.7% from $4.49 billion in 2021. Commercial usage for the year grew 7.5% while residential usage increased 2.5%. Earnings per share in 2022 was $4.49, down from $4.96 in 2021. However, these earnings were adversely impacted by a one-time loss of $363.3 million on the sale of various Kentucky operations. This lowered EPS by $0.71; otherwise the number would have been $5.20 per share. There were also higher storm costs and higher interest costs during the year.

Debt and Shift Toward Renewables

AEP has plans to add 17,000 megawatts of new electric generating capacity between 2023 and 2032, with a 47.0% reduction in coal generation. Like other utilities, the short-term goal is an 80.0% reduction in CO2 emissions from the 2005 baseline established by the Paris Climate Accord . The ultimate goal is net zero carbon emissions by 2045. The company has outlined a five-year plan for capital investments between 2003-2007, with $8.6 billion out of a total $40.0 billion to be spent on renewable infrastructure (see chart below).

Currently, in 2023, power generation is about 42% coal-based, 27.0% natural gas, 8% nuclear, and 21.0% renewable (hydro, wind and solar) with 2.0% demand response. The goal is to shift this mix by 2032 to 19.0% coal, 19.0% natural gas, 8.0% nuclear, and 54.0% renewable.

During 2022, AEP had increases in interest expenses due to higher market interest rates (a product of Federal Reserve changes) and rising debt balances. This has been the case at many utilities in the last two years. During 2022, interest expense increased by $128 million, largely due to higher rates on short-term debt. While the overall level of total debt has risen slightly over the last few years, it is considered to be at manageable levels.

Rate Increases Helped in 2022

The holding company AEP consists of a large number of regulated utilities – I counted at least seven major subsidiaries. The current rate base of the overall company (the value of property on which a utility is allowed to earn a rate of return) is $61.0 billion as of the end of calendar 2022. During that year, the company had favorable rate outcomes in Arkansas, Indiana, Virginia and Texas. These rate cases increased revenues by $227.0 million, per the Q4 Investor Presentation . Rate increases in the company’s vertically integrated businesses added $0.36 to the EPS for 2022, and new transmission and distribution subsidiary rates added another $0.20. As of October 2023, the allowed return on equity for AEP subsidiaries was 9.25% and above, depending on the entity and the state, as outlined in the table below.

Once there Were Preferred Shares

American Electric had a series of preferred shares, AEP.PRB, these were issued at $50 each with a yield of 6.125%. These were redeemed in March and Investor Relations says the company does not anticipate issuing another preferred series near term, but they have had a pattern of doing so in the past.

Valuation of Shares

Again, according to Morningstar , the “median 16 P/E (of utilities) is at its lowest since exiting the 2008-09 recession.” Morningstar also estimates that the sector is 15.0% undervalued. P/E Ratios by utility type, as tracked by Gabelli Funds are presented below.

The Second Quarter 2023 operating earnings release reaffirmed the guidance range for annual earnings at $5.19 to $5.39 per share with long-term growth rate of 6.0 to 7.0%. Using the consensus number of $5.25 for 2023, the likely value of the shares today is 16.0 P/E x $5.25 = $84.00. At their current price of $74.50, they would be about 11.0% undervalued. This is confirmed by the Gabelli generated forward P/E ratio of 16.3 x $5.25 = $85.58 per share, or 13.0% undervalued by this metric. Yardeni Research also has utility P/E data and estimates the forward P/E multiples of electric utilities as 14.7. Using the forward EPS estimate of $5.60, the value of the shares here would be 14.7 x $5.60 = $82.32, reinforcing the value range.

Below, by way of comparison, are current P/E ratios for several other important large cap utilities, calculated using their current share prices and 2023 average consensus earnings.

Risks to Outlook

One of the risks that all utilities face right now, and which impacted winter 2022 - 2023, is unseasonably warm weather. This can lower electric demand and adversely impact earnings per share. The other risk facing all utilities could be further increases in interest rates, which could result in higher debt carrying costs and make a 4.0-5.0% paying dividend stock less attractive than a 5.25% paying money market fund. Still, a further risk is that the company is unable to meet its targeted 6-7.0% growth rate. This would be only due to lower demand as the electricity returns are regulated and set by state agencies. In the plus column, AEP has no direct competitors in most of its territories, and warmer temperatures overall could mean higher summer electric usage.

Conclusion

The current P/E ratio of 14.2 is well below the indicated industry multiple of 16.0, and below the forward utility multiple estimated at 14.7. AEP stock is also trading at a significant discount to its large cap peer utilities. Operating earnings are forecast to grow at 6-7.0% per year and it appears that the company will achieve this target. At the current price I believe the shares are a “buy” and the current dividend of 4.46% will almost certainly be increased in November for December’s payout, which would make AEP more compelling and competitive as a high yielding alternative. In summary, there is a lot to like here, with potential for dividend upside and share price appreciation.

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