Dividends And Price Potential Make AEP A Good Buy

Oct.25.13 | About: American Electric (AEP)

American Electric Power (NYSE:AEP) offers stable earnings, as approximately 90% of the company's earnings are earned from regulated operations. I recommend a 'buy' rating on the stock, as the company has been spending heavily on its transmission business, which remains a key earnings growth driver for AEP. Also, the company has been undertaking cost reduction measures, which will have a positive impact on the stock price. Moreover, based on my price target of $52 (calculations shown below), the stock offers investors a potential total return of approximately 16%.

AEP is involved in the generation, distribution and transmission of electricity in 11 U.S. states. The company serves more than 5 million retail customers and has a generational capacity of 38,000MW, out of which approximately 24,000MW is generated by using coal.

Financial Performance
Earlier this week, the company reported a healthy financial performance for 3Q2013. AEP reported an EPS of $1.10 for the recent third quarter, up approximately 8% year-on-year, beating consensus estimates of $1.07. Earnings for the quarter were positively affected by lower operational and maintenance (O&M) expenses, lower interest, reduced depreciation and new rates in several jurisdictions. New/increased rates were the main drivers for the recent third quarter's earnings, as the rates had a positive impact of $0.15 on the EPS for the quarter.

Despite an impressive earnings beat for the quarter, AEP's quarterly revenues of $4.2 billion fell short of consensus estimates of $4.6 billion; however, the quarter's revenues were in line with revenues of the corresponding period last year. Revenues for the quarter were adversely affected by a drop of 1.5% in total normalized electricity sales. Total normalized sales for the quarter were negatively affected by a 3.9% decrease in industrial sales, followed by a 1.8% decline in residential sales, partially offset by a 1.3% increase in commercial sales.

AEP is believed to have a shareholder-friendly management, which has been sharing AEP's success with shareholders through dividends. The company currently offers a solid dividend yield of 4.4%. Earlier this week, the company announced that its board of directors has approved a dividend increase of 2%, resulting in an annualized dividend rate of $2. The new quarterly dividend of $0.50 is payable as of December 10 to shareholders of record as of November 8, next month. The recent dividend increase was the second in six months, resulting in a total dividend increase of 6.4% for the year (2013).

The company narrowed its full year (2013) EPS guidance range; the company now expects the 2013 EPS to be in a range of $3.15-$3.25, up from the prior EPS guidance range of $3.05-$3.25. Also, the company continues to expect its earnings to grow by 4%-6% per annum through 2015. Growth in the company's transmission business and cost control efforts are likely to fuel the company's earnings in the upcoming years. In contrast to the management's expectations, analysts have estimated an EPS of $3.16 for 2013 and projected a next five years growth rate of 4.25% per annum.

Stock Price Catalysts
Important stock price catalysts and earnings growth drivers for AEP include transmission growth opportunities and cost reduction efforts under the Continuous Improvement Program.

AEP has been increasing its investment spending, which is directed towards its transmission business. AEP's transmission business is likely to become a more important earnings contributor in upcoming years; transmission business earnings' contribution towards the company's total earnings is expected to increase by 11% to 14% by 2017. Also, the company is committed to improving its cost structure in the future, which portents well for the company's future bottom line. I believe the company will provide more details on November 10, next month, at the Edison Electric Institute conference regarding its plans for cost reduction measures and how the management expects to achieve its earnings growth target of 4%-6%. The abovementioned factors, growth in transmission business, and cost reduction efforts will help the company offset a negative impact on future earnings due to lower-than-expected future power prices associated with reliability pricing model (NYSE:RPM) capacity auction prices announced in May.

Conclusion
AEP is a high quality regulated utility company. The company's regulated transmission growth opportunities and possible cost savings under the Continuous Improvement Program remain a key driver for the company's future earnings, and portent well for the stock price. Also, the company has a shareholder-friendly management, which has been sharing its success with shareholders, and AEP offers a solid dividend yield of 4.4%.

Moreover, based on my price target of $52, the stock offers a potential price appreciation of 12% and a potential total return of 16% (including a dividend yield of 4.4%). I calculated a price target of $52, using the utility sector's forward P/E of 15.75x and an EPS analysts estimate of $3.32 for 2014. Due to the aforementioned reasons, I am bullish on the stock.

Forward P/E

15.75x

EPS est. 2014

$3.32

Price Target

$52

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.