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Over the past couple of months the Utility Sector (NYSEARCA:XLU) has been quite volatile. Some of the reasons for this uncharacteristic volatility have been the threat of rising interest rates, concerns over future Capex spending and some profit taking after a nice sector run. Having stated that, this recent volatility can provide some excellent opportunities, if you wish to invest or add to your investment in the utility sector. American Electric Power (NYSE:AEP) is a utility company worth further investigation.

There are many advantages to adding utilities to your portfolio. Two main advantages include Lower volatility and high dividends. So, if the market is getting unpredictable or "frothy," a well picked utility can add some stability to your portfolio while paying a solid dividend. As of September 14th 2013, American Electric Power has a beta of 0.45 and a yield of 4.68%.

American Electric Power is one of the largest electric utilities in the U.S., serving over 5 million customers in 11 states. Currently, AEP serves customers in Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia.

Map sourced by (AEP)

AEP's U.S. customers through its subsidiaries are served by one of the world's largest transmission and distribution systems. The company owns and manages nearly 38,000 megawatts of generating capacity with a nearly 39,000-mile electricity transmission network, which is the largest in the nation. As well the company owns and manages 765 kilovolt extra-high voltage transmission lines system which is more than all other U.S. transmission systems combined.

In the section below, I will analyze aspects of American Electric Power's past performance. From this evaluation, we will be able to see AEP's profitability, debt and capital, and operating efficiency and free cash. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future

Profitability

Profitability is a class of financial metrics used to assess a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets, and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $1.214 billion
  • Net income 2011 = $1.946 billion
  • Net income 2012 = $1.259 billion.
  • Net income 2013 TTM = $1.209 billion.

Over the past couple of years AEP's net profits have decreased from $1.214 billion in 2010, to $1.209 billion in 2013 TTM. This represents a 0.4% decrease.

  • Operating income 2010 = $2.663 billion.
  • Operating income 2011 = $2.782 billion.
  • Operating income 2012 = $2.656 billion.
  • Operating income 2013 TTM = $2.463 billion.

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past four years, the company's operating income has decreased from $2.663 billion to $2.463 billion. This represents a decrease of 7.51%.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

  • Net income growth

    • Net income 2010 = $1.214 billion
    • Net income 2011 = $1.946 billion
    • Net income 2012 = $1.259 billion.
    • Net income 2013 TTM = $1.209 billion.
  • Total asset growth

    • Total assets 2010 = $50.455 billion.
    • Total assets 2011 = $52.223 billion.
    • Total assets 2012 = $54.367 billion.
    • Total assets 2013 TTM = $54.979 billion.
  • ROA - Return on assets

    • Return on assets 2010 = 2.41%.
    • Return on assets 2011 = 3.75%
    • Return on assets 2012 = 2.32%.
    • Return on assets 2013 TTM = 2.20%.

Over the past four years, AEP's ROA has decreased from 2.41% in 2010 to 2.20% in 2013 TTM. This indicates that the company is making slightly less on its assets than it did in 2010.

Quality Of Earnings

Quality of Earnings is the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory. To ensure there are no artificial profits being processed, the operating cash flow must exceed the net income.

2010

  • Operating income 2010 = $2.663 billion
  • Net income 2010 = $1.214 billion

2011

  • Operating income 2011 = $2.782 billion.
  • Net income 2011 = $1.946 billion

2012

  • Operating income 2012 = $2.656 billion.
  • Net income 2012 = $1.259 billion.

2013 TTM

  • Operating income 2013 TTM = $2.463 billion.
  • Net income 2013 TTM = $1.209 billion.

Over the past four years, the operating income has been higher than the net income in all years. This indicates that AEP is not artificially creating profits by accounting anomalies such as inflation of inventory.

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $50.455 billion.
    • Total assets 2011 = $52.223 billion.
    • Total assets 2012 = $54.367 billion.
    • Total assets 2013 TTM = $54.979 billion.
    • Equals and increase of $4.121 billion
  • Total liabilities

    • Total liabilities 2010 = $36.833 billion.
    • Total liabilities 2011 = $37.559 billion.
    • Total liabilities 2012 = $39.130 billion.
    • Total liabilities 2013 TTM = $39.442 billion.
    • Equals and increase of $2.609 billion

Over the past four years, the company's total assets increased by $4.121 billion, while the total liabilities have increased by $2.609 billion. This indicates that the company's assets are increasing more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $5.016 billion.
    • Current assets 2011 = $4.182 billion.
    • Current assets 2012 = $4.589 billion.
    • Current assets 2013 TTM = $4.622 billion.
  • Current liabilities

    • Current liabilities 2010 = $6.518 billion.
    • Current liabilities 2011 = $6.611 billion
    • Current liabilities 2012 = $6.823 billion.
    • Current liabilities 2013 TTM = $6.519 billion.
  • Current ratio 2009 = 0.77
  • Current ratio 2010 = 0.63
  • Current ratio 2011 = 0.67
  • Current ratio 2012 = 0.71

Over the past four years, AEP's current ratio has declined. As the ratio is currently under 1, this indicates that the company would not be able to pay off its obligations if they came due at this point.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $9.398 billion / $14.427 billion = 65.14%.
  • Gross margin 2011 = $9.504 billion / $15.116 billion = 62.87%.
  • Gross margin 2012 = $9.665 billion / $14.945 billion = 64.67%.
  • Gross margin 2013 TTM = $9.713 billion / $15.177 billion = 64.00%.

Over the past four years, AEP's gross margin has remained relatively steady. The ratio has decreased from 65.14% in 2010 to 64.00% in 2013 TTM. As the margin has decreased slightly, this indicates that AEP overall has been slightly less efficient.

AEP Gross Profit Margin Quarterly Chart

AEP Gross Profit Margin Quarterly data by YCharts

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $14.427 billion.
    • Revenue 2011 = $15.116 billion.
    • Revenue 2012 = $14.945 billion.
    • Revenue 2013 TTM = $15.177 billion.
    • Equals an increase of 5.20%.
  • Total Asset growth

    • Total assets 2010 = $50.455 billion.
    • Total assets 2011 = $52.223 billion.
    • Total assets 2012 = $54.367 billion.
    • Total assets 2013 TTM = $54.979 billion
    • Equals an increase of 8.97%.

Over the past four years the revenue growth has increased by 5.20% while the assets have increased by 8.97%, this indicates that the company from a percentage point of view has less efficient at generating cash from its assets.

Free Cash Flow = Operating Cash Flow - Capital Expenditure

Over the past four years we can see that the company has posted positive free cash each year except 2009. In a business that is looking to spend a lot of cash in upgrades to increase efficiency and keep up with increasing environmental standards this is a positive. This indicates that the company is growing at a pace that it can support, without adding additional risk to the company and ultimately the shareholder.

  • 2010 - $2.662 billion - $2.436 billion = $226 million
  • 2011 - $3.788 billion - $2.775 billion = $1.013 billion
  • 2012 - $3.804 billion - $3.226 billion = $578 million
  • 2013 TTM - $3.607 billion - $3.456 billion = $151 million

Even though the company's fundamentals are strong, the analysis above indicates a degradation in many aspects of the company's efficiency and profitability. This statement is supported by the decline in the company's ROA and net income and operating income. Having stated that, the other ratios are indicating stability within company.

Forward Looking, Coal to Natural Gas

To increase profitability while reducing costs, AEP is looking to move to a more economical and environmentally friendly footprint. AEP is moving toward a more balanced fuel mix. By the beginning of 2016, AEP's goal is to reduce coal capacity by 27%, while increasing natural gas capacity by 64% compared to 2005 standards.

Currently, 60% of the company's fleet capacity comes from coal generation. By 2020, AEP's goal is reduce fleet capacity from coal to 46%. In anticipation of meeting this goal, AEP released a list of plant retirements and retrofits. Over the next seven years, AEP is estimating spending $4 - $5 billion in Capex to meet with rising environmental standards and to increase company profitability.

(click to enlarge)

Chart sourced by (AEP)

Even though natural gas plants are more expensive to run than coal powered plants, government incentives and regulations will even out the playing field. An excellent article by Tim Lucas explains the cost advantages and disadvantages of focusing on natural gas for power creation. He states, "The stricter regulations on sulfur dioxide, particulate matter, nitrogen oxide and mercury may make nearly two-thirds of the nation's coal-fired power plants as expensive to run as plants powered by natural gas". The article also states, "A transition to natural gas for electricity generation will require the construction of a much larger network of pipelines and other infrastructure to transport and store the gas, assuring power plants of a reliable supply."

As all of these upgrades and retirements are designed to increase power, stay within environmental regulations, reduce costs and increasing profitability. The results of these upgrades are displayed within the analysts estimates.

Analysts' Estimates

Analysts at MSN Money are estimating an EPS for FY 2013 at $3.14 while moderate growth is expected to continue into 2014 as EPS estimates increase to $3.31.

Bloomberg Businessweek supports this idea as it expects the company's revenues to be around $15.7 billion for FY 2013 and increase to $16.0 billion for FY 2014.

Price Targets

  • Finviz has a price target for American Electric Power at $49.35.
  • Recently, UBS gave the company a "hold" rating with a target of $45.
  • In July, Argus gave the company an "Buy" rating with a target of $52.

With a estimated FY 2015 EPS of $3.44 and a forward P/E of 12.89 this would give AEP a current price target of $44.34.

Dividend

AEP has a long history of paying dividends. Over the past 10 years the company has increased the dividend an average of 3.69% year over year.

(click to enlarge)

With increasing earnings estimates on the horizon, the history of dividend increases looks to continue. As the company's dividend philosophy is to maintain a payout ratio in the 60 - 70% range, the future for dividend increases looks bright. In 2014, with an estimated EPS of $3.31 and a dividend payout ratio of 62%, this would give the shareholder a dividend of $2.05. A dividend increase to $2.05 would equal a 5.67% increase over the 2013 dividend payout of $1.94.

Over the past couple of months the Utility sector has been indicating some uncharacteristic volatility. This volatility is due to increasing interest rate pressure, worries over future Capex spending and general profit taking. The above analysis does reveal that American Electric Power is a fundamentally sound utility. The company's focus on improving efficiency while maintaining environmental standards will prove to be profitable in the future. Many analysts are predicting growth for the company based on these factors. As it is estimated that AEP will report an EPS in FY 2014 of 3.31, I predict an increase well above the current 10 year bond rate of 2.9%. An EPS of $3.31 along with a payout ratio of 62% would equate to an attractive dividend increase of 5.67%. Currently, AEP has an attractive yield of 4.68%, with growth prospects in the future. As the stock price has declined over the past month or so and price targets in the upper $40's to low $50's, this could prove to be an attractive point to look at the utility sector. If patience is used and the price begins to form a bottom, it could prove to be an excellent opportunity to invest in a company with dividend and capital appreciation growth potential in the future.

Source: American Electric Power: A 4.68% Yield With Capital Appreciation On The Horizon