Wait For A Pullback Before Going Long On American Electric Power

Nov.21.13 | About: American Electric (AEP)

With a high degree of regulated and geographical diversification, American Electric Power (NYSE:AEP) is a high quality regulated utility. The company offers a solid dividend yield of 4.2% and has a secure earnings base, as nearly 85% of its earnings are derived from its regulated operations. Also, the company has been expanding its regulated operations, which will provide more earnings visibility and stability in the coming years, which will bode well for the stock price. Also, I foresee notable upside earnings potential for AEP because of a recovery in power prices as natural gas prices rise going forward. Therefore, I reaffirm my bullish stance on the stock. However, I recommend investors to wait for a pullback before initiating a buy position in the stock, as the stock is up 12% since my last article on AEP last month.

Key Growth Drivers

As forward power prices remain soft due to weak capacity prices declared earlier this year in May, the company has started to consider an option to scale down its merchant business. Last week, AEP presented at the EEI Conference and an important focus area centered on the Ohio Genco split as it considers exiting the merchant generation assets in Ohio. However, I believe the exit from Ohio might not happen in the near term and remains more likely a long-term possibility for AEP. As the company will scale down its merchant generation exposure, its regulated business earnings as a proportion of total earnings will increase, which will provide more earnings visibility and stability.

To offset the impact of weak forward power prices, the company has been making efforts to improve its operational and maintenance (O&M) expenditures, which I believe is a key growth driver in the upcoming years. Also, AEP has been looking up to its plant efficiency programs, which will have a positive impact on its future earnings. In the EEI Conference, AEP disclosed that it anticipates flat O&M expenditures, at $2.8 billion a year, from 2013 through 2016. The cost improvement efforts will positively affect the stock price in the future.
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Source: Company's Presentation Slides

Moreover, AEP has been aggressively spending to expand its transmission business (includes transmission and wires operations), which remains the key earnings growth driver for the future; AEP's transmission business operations are regulated and provide stable earnings. AEP plans to incur capital expenditure (CapEx) of $10 billion through 2016, of which 95% will be allocated to its regulated businesses, including the transmission business operation. As the company plans to expand its transmission business, the EPS of the business segment is expected to rise by more than 300% (base case scenario), from $0.16 in 2013 to $0.65 in 2018. The following table shows EPS growth for AEP's transmission business segment and the chart shows the forecasted rate base growth.

2013

2014

2015

2016

2017

2018

EPS - Contributed by Transmission Business

$0.14

$0.29

0.36

0.43

0.56

0.65

Click to enlarge

Source: Company's Presentation Slides
(click to enlarge)Click to enlarge
Source: Company's Presentation Slides

Consistent with the company's plan to expand its transmission business and regulated operations, I believe AEP can undertake strategic merger and acquisition transactions related to wires and transmission assets.

Financial Highlights

AEP has a solid track record of financial performance in the past. It reported revenues of $4.2 billion for 3Q'13, flat YoY. The company experienced a healthy EPS growth for 3Q'13, as earnings increased by almost 8% YoY to $1.10. New rate cases and reduced O&M expenses had a positive impact on AEP's earnings for the quarter.

Also, AEP has been taking measures to strengthen its balance sheet and credit outlook. AEP has experienced a notable reduction in its total debt to total capitalization in the last five years, as it decreased to 54.4% by Q3 2013 down from 57.2% in 2009. Also, to mitigate the pension liability funding risk, AEP has increased its pension funding to 98% by 3Q'13 up from 74% in 2009. These measures have strengthened the company's balance sheet and provided financial flexibility, and the company currently holds investment grade credit ratings assigned by different rating agencies. The following tables show total debt to total capitalization, pension liability funding and credit ratings.

2009

2010

2011

2012

3Q'13

Total Debt/Total Capitalization

57.2%

57%

55.3%

55.2%

54.4%

Pension Liability Funding

74%

82%

88%

92%

98%

Click to enlarge

Source: Company's Presentation Slides

Moody's

S&P

Fitch Ratings

Credit Ratings

Baa2

BBB

BBB

Click to enlarge

Source: Company's Presentation Slides

AEP currently offers a healthy dividend yield of 4.2%, backed by a 16.5% operating cash flow yield, which makes it an attractive stock for income-seeking investors. It has consistently increased its regular dividends over the years; dividends have increased by 3.63% on average since 2004. The company has consistently paid dividends since the last 414 quarters and has a decent targeted payout ratio of 60%-70%. I believe AEP's solid dividend yield of 4.2% provides downside stock price protection in the long term.
(click to enlarge)Click to enlarge
Source: Company's Presentation Slides

Final Words

I believe AEP remains a good long-term investment prospect for income-seeking investors. AEP's cost reduction efforts, aggressive capital spending outlook and transmission business expansion are key to future earnings growth. However, I will recommend investors to wait for a pullback before initiating a long position in the stock; the stock is up 12% since October 8, 2013.

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.