Unloved and Underrated, AEP Is a Long-Term Opportunity

| About: American Electric (AEP)

American Electric Power Co. Inc. (NYSE:AEP) is a unique stock that I have been trading off and on for a couple of years. I have always like the stock, but more as a trade than a long-term hold. With the equity markets in a roiled state and currently nearing high points, I find my portfolio in a rather high cash position, looking for opportunities.

There are a decent amount of companies that are undervalued and disliked by the investment markets, and those are the ones I try to find. AEP is one of those companies.

With AEP trading at $35.28, it has a $1.84 dividend-- or 5.20%. 2011 / 2012 EPS estimates have a mean average of $3.14 and $3.25 or 11.24 and 10.85, respectively. Compared to the industry average and peers it is undervalued-- quite a bit so when you consider what Duke Energy (NYSE:DUK) is fetching.

There are some regulatory risks that may impact AEP's bottom line earnings, as well as increased commodity prices that the company may not be able to pass along to its consumers. Also, with the likely increases in interest rates, the 5.20% dividend yield will be much less attractive against actual inflationary pressures, and AEP is not a growth stock.

So why am I bullish on AEP? I think the current price is understating management's capabilities to handle those risks (regulatory and commodity) and thinking interest rates will rise all too quickly. Also the stock market is chasing high growth stocks that are exceptionally overvalued, even for growth stocks.

Some critics would say that AEP's earnings are not going to grow, but will decline. I could see that happening, but it doesn't carry a high probability on my end. Even if so, a 15% decline in 2011 estimated earnings would still have EPS of 2.618, or a 13.47 PE. Still undervalued compared to other utilities and even the industry average.

In a market downturn resulting from economic downturn or civil unrest in the Middle East, as well as some states in the US, should one be so heavily focused on high growth sectors?

There are broad market risks that are lurking upon which an undervalued utility such as AEP would benefit from-- given the right investment strategy. AEP/ undervalued slow growth companies should be comprising a chunk of a portfolio with the current state of things.

At $35.28, a Tier 1 of 3 tiered entries is an enticing opportunity but could be improved upon with implementing a few safe option strategies.

One strategy is to do a long dated covered call trade while another is to do a split risk reversal.

The split risk reversal would involve selling out of the money puts and buying an in the money call. One example would be selling the January 2012 $30 puts for $1.00 and buying January 2012 $35 calls for $2.00. The margin requirements would like be around $300-$500 at the current time. The breakeven on the trade would be $36 on AEP. A move to $38 though would produce a 40% net profit against the $500 margin requirement (on the high end based on the current time). The one pitfall of this trade is that you wouldn't capture the dividend but the profitability generated is going to be substantially higher (as the puts will carry a fraction of the capital / cash cost of simply being long shares) than the covered call trade. Also there is less "capital" at risk by choosing the $35 strikes.

Either way, a simple covered call trade involving long stock and short January 2012 $40 calls (@ $0.35 bid) would get your cost average to $34.93 without factoring in the quarterly dividends. After one year (assuming the dividends stay at $1.84) the cost average of the stock would be $33.09. This would carry a P/E of 10.53 against the 2011 consensus EPS of $3.14.

As said, AEP looks attractive on a variety of fronts as a segment of an investor's portfolio, and many more strategies than mentioned above could produce good investment returns, even in a flat price environment.

Disclosure: I am long AEP.

Additional disclosure: Short January 2012 $30 puts, Long January 2012 $30 calls.

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