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Introduction

American Electric Power (NYSE:AEP) is one of the largest utilities in the US, with 38 GW of power capacity. It provides electricity to 5 million customers in 11 US states. The company also owns a 39,000 mile long gigantic network of electricity transmission lines. The company gives a dividend yield of 4.2% which is around the same level given by other big utilities, such as Southern Company (NYSE:SO), Duke Energy (NYSE:DUK) etc. American Electric Power has been a source of stable and growing dividends which has made it a favorite for yield hungry investors. There is frothiness in most utility stocks as there are very few fixed income alternatives, which give decent dividend yield in the current low interest rate environment. This has led to a moderate overvaluation in the utility sector. The biggest risk that we see with AEP is it's over dependence on coal, which fuels almost 2/3 of its power generating capacity. With coal facing increasing pressure in the West because of its deleterious effects on the human health and environment, companies are being forced to look to alternative fuel sources. AEP agreed to spend $4.6 billion in 2007, to install emission reduction equipment due to a DOJ lawsuit for Clean Air Act violations.

Why we don't want to buy American Electric Power

  1. Coal Dependency - As we have said before, AEP depends on coal for almost ~63% of its power generation capacity. While this has helped AEP in costs, the risks for thermal power plants are increasing. There is a growing backlash against coal as it the most polluting form of fossil fuel. It causes thousands of deaths each year, both due to pollution as well as coal mining. While Southern Company is taking steps to reduce the carbon footprint through clean coal technologies, AEP is not doing anything much on this front. The company is already being forced to close 5.1 GW of coal capacity by 2016, due to stricter environmental regulations. With the Obama administration looking to prop the renewable energy industry, this is a big threat for AEP's operations.
  2. Ohio Deregulation - AEP gets almost 85% of its revenues from regulated utility operations which make it a safe stock. However, one of its major markets, Ohio, is going to undertake major reforms which will be implemented by 2015. There is uncertainty about how the utility will make this transition and how it affects the overall earnings. The company will have to face competitive electricity markets which are subject to volatility. One of the main reasons that Exelon (NYSE:EXC) has declined is because most of its revenues are generated in non-regulated markets.
  3. Growing Threat from Solar and Wind Energy - AEP has very little solar or wind energy capacity and is not making too much effort to increase its renewable energy capacity. The company generates just 8% of its power from hydro/wind/soar resources. If legislation is passed which either imposes a carbon tax or a cap and trade system, then AEP will be one of the worst affected utilities.
  4. Slowing US Electricity Growth - AEP is suffering from a declining demand in electricity and its earnings have fallen mainly due to this reason. The US economic growth is slowing down compared to the past decade and AEP will be badly affected as most of its sales are generated in the US. The effect on earnings from this trend was apparent in the Q312 results. Both industrial and retail sales decreased during that quarter.

AEP Positives

  1. Decent Margins - AEP has managed to keep the gross margin at a decently high level in the low 60s range, with an Operating Margin between 15-20% since 2004. The Company has managed to increase net margins which are now in the 10-12% range. The company's current (TTM) net margin is 10.5%
  2. Growing Dividends - AEP has managed to raise dividends since 2004, with the annual dividend growing from $1.4 in 2004 to $1.85 in 2011. The payout ratio at 60% is not high for a utility, given that its cash flows are generally safe and consistent.
  3. Regulated Power revenues - AEP sells almost 85% of its power under regulation. The company has not been involved in any big M&A in the last decade and has mostly grown organically. The company has benefited from falling natural gas prices, converting a lot of its plant to run on gas. However, that advantage may not remain much longer as natural gas prices are rising.
  4. Large Transmission Network - The company owns one of the largest electric networks in the US and this asset will become increasingly important, as more renewable energy capacity is installed. The flip side is that the earnings from the transmission segment are too small to make a big difference to the overall earnings.

Stock Performance

AEP has traded in a range of $20 to $50 in the last decade, hitting a low of ~$25 during the market crash in March 2009. The company is currently trading very near to its 52 week high of $45, in line with the stock markets hitting multi year highs. AEP has underperformed its peers SO, Dominion and Duke which have returned between 20-30% in the last 5 years, compared to AEP's ~4% return. The stock has gone up by ~14% over the last year (roughly same as the S&P 500) and is now touching its 52 week high price.

Valuation

American Electric Power trades in line with the industry average, with a P/B of 1.4x and a P/S of 1.5x. The trailing P/E ratio at 14x is somewhat cheaper than the industry average. The slightly lower valuation is due to the uncertainty regarding its earnings once the Ohio market is deregulated. Utility stocks are judged mainly by the stability and growth of their dividends. AEP gives a 4.2% yield, which is exactly equal to the industry average of ~4.2%.

Summary

AEP is an average large utility stock with a decent dividend yield; however the company, like Duke Energy and Southern Company, faces risks due to slowing US electricity demand. These companies also do not have enough renewable energy assets to offset potential climate change legislation effects. Besides this, the AEP faces the additional risk from deregulation of the Ohio electricity market. AEP is trading at just 10% shy from its all time peak stock price of ~$50. We would look to buy better utilities such as Dominion (NYSE:D), which have lesser risks and more upside.

Source: American Electric Power - Coal Dependency Is A Concern