- Company’s robust capital investment outlook will fuel rate base and earnings growth.
- Initiatives to reduce earnings volatility through increasing regulated business operations will augur well for stock valuation.
- Potential long term pricing contracts for unregulated operations will add to investor confidence.
- American Electric offers secure dividend yield of 3.7%.
American Electric Power (NYSE:AEP) has been making the right moves to boost its long term growth potential. American Electric's fundamental outlook remains strong, as it has the potential to register steady earnings and dividend growth. The company intends to increase its exposure to regulated operations and to reduce earnings volatility, as the performance of unregulated operations stays volatile because of uncertain future power prices. Also, an impressive capital spending profile from 2014 through 2016, with 95% of the spending directed towards the regulated business, will result in regulated rate base growth. The company's efforts to extract earnings growth through capital investment and rate recovery, along with operational and maintenance (O&M) expenditure discipline and sustainable cost savings will augur well for the stock performance.
Utility companies, including American Electric, Duke Energy (NYSE:DUK), FirstEnergy (NYSE:FE) and Exelon (NYSE:EXC), with exposure to unregulated operations, are scaling up their regulated business operations in an attempt to reduce earnings volatility, as earnings of unregulated business remain volatile. The utility companies are making investments to increase their regulated operations and are considering different options, which include long term pricing contracts and sale of unregulated business, to address the concerns of volatile unregulated operations.
American Electric's capital spending outlook for the next three years displays an attractive picture; it plans to make investments worth of $2.8 billion, $3.3 billion and $4.7 billion in regulated generation, distribution and transmission businesses, respectively. A positive aspect of the planned capital investment profile is that 95% of the capital will be allocated to regulated business operations, which will drive regulated rate base growth. The company anticipates rate base growth of $5.4 billion, $8.2 billion and $10.8 billion in 2014, 2015 and 2016, respectively, which will help achieve its long term earnings growth target of 4%-6%. The table below displays the planned capital spending distribution.
Investment ($ - million)
Percent of Total Investment
Regulated Fossil/Hydro Generation
Regulated Environment Generation
AEP Transmission Holdco
As a result of the company's solid financial performance in the recent first quarter, the management announced an incremental $200 million of transmission investment. In my opinion, the company could further accelerate its transmission spending (given its solid performance continues), as the transmission segment offers impressive growth potential; however, capital allocation is constrained by capital consideration, as the management intends to use internally generated cash rather than using external cash resources for transmission investment.
Other than the robust regulated investment undertaken to increase earnings stability, the optimization of unregulated business operation through possible long term pricing contracts remains among the important initiatives. Ownership of unregulated assets in Ohio does not add notable value to the stock, and neither is it welcomed by investors. American Electric will like to seek lower earnings volatility through obtaining long term price contracts, in which rates are linked to operating costs of plants as well as margin payment. If the company is unable to obtain the desired results through long term contracts, it could opt to sell its unregulated assets. This will help the company direct capital to regulated operations, which have better growth prospects.
In addition to stabilizing its earnings base, cost control initiatives are important for long term earnings growth. Consistent with its cost control efforts, American Electric expects to keep O&M flat through 2016 at $2.8 billion. Also, because of the strong financial performance in the first quarter of 2014, the company plans to shift $60-$70 million of O&M expenses into 2014 from 2015-2016. This will help the company enhance the EPS growth rate in upcoming years. Moreover, the company anticipates realizing pre-tax cost savings through cost reductions in generation, transmission, distribution and supply chain.
The aforementioned initiatives undertaken to stabilize and grow earnings will also strengthen the company's dividends. American Electric offers a yield of 3.7% and has a payout ratio of 57%, based on 2014 analyst EPS estimates, which is at the low-end of its long term target payout ratio of 60%-70%. The company is likely to keep its payout ratio near its low-end of the target payout ratio, as capital investment will remain a priority in generating earnings growth.
American Electric's future growth prospects stay attractive, as a robust capital investment outlook will fuel rate base and earnings growth. Also, initiatives to reduce earnings volatility through the increasing regulated business operations will augur well for the stock valuation. Also, potential long term pricing contracts for unregulated operations or sale of unregulated assets in the future will add to investor confidence and lower the company's risk profile. Furthermore, along with earnings growth potential, the stock offers a secure dividend yield of 3.7%.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.