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American Electric Power (NYSE:AEP)($35.50) is a large-cap, Midwest-focused regulated electric utility offering investors stability of earnings and dividends. Heavily concentrated on the regulated side of the industry, about 95% of operating income is generated from their regulated utilities.

AEP is one of the largest electric utilities in the U.S., with total generating capacity of 38,000Mw and serving over five million customers in 11 states. AEP is also one of the largest transmission system owners with over 39,000 miles of transmission assets. The company is also the largest regulated coal-fired power operator in the country.

Structured as a holding company, the following is a descriptive list of regulated public utility subsidiaries of the company:

  • Appalachian Power Company (APCo),
  • Columbus Southern Power Company (CSPCo),
  • Indiana Michigan Power Company (I&M),
  • Kentucky Power Company (KPCo),
  • Kingsport Power Company (KgPCo),
  • Ohio Power Company (OPCo),
  • Public Service Company of Oklahoma (PSO),
  • Southwestern Electric Power Company (SWEPCo),
  • AEP Texas Central Company (TCC),
  • AEP Texas North Company (TNC),
  • Wheeling Power Company (WPCo), and
  • AEP Generating Company (AEGCo).

The service areas of AEP covers portions of the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. The subsidiaries of AEP provide electric service, consisting of generation, transmission and distribution, on an integrated basis to their retail, commercial, and industrial customers.

American Electric Power has provided investors with a consistent dividend. AEP’s dividend has been increasing by 3.8% a year. The five year average yield is 4.4%, with a current forward yield based on the most recent dividend hike of 5.1%. Payout ratio is a middle-of-the-road 68%. Current valuation puts AEP with a relatively expensive PE of 13 vs. industry average of 9, but the stock sports a low beta of 0.59. Management has generated a 5-yr average return on invested capital of 4.8%, with a bit lower trailing 12 month numbers at a challenging 4.0%. Institutions own 68% of outstanding shares. Total debt is pegged at $18.1 billion and market capitalization is $17.0 billion.

AEP announced 1st quarter operating earnings per share of $0.82, and were slightly above consensus of $0.80. A 7% pick up of industrial demand is credited with the revenue gains, but its eastern footprint remains weak. Earnings for this year are estimated at $3.12, with $3.25 expected next year and $3.40 in 2013.

From 2012 to 2020, the company may face $5 to $11 billion in environmental related capital expenditures. While probably recouped in future rate decisions, this level of cap ex could hamper future growth in production and transmission spending. However, AEP is not alone in this level of potential environmental spending liabilities.

The company operates nearly 25,000 Mw of coal-fired power generation. Based on the economics of conversion to alternative fuels, it is anticipated about 25% of coal-fired capacity will be permanently shut down. Replacement natural gas-fired facilities could add 1,000 to 2,000 Mw, reducing overall coal-fired power generating capacity by 12% and total generating capacity by 7%.

Nationwide shut downs of coal-fired plants and a corresponding reduction in the output of electrical power will be one of the results of the proposed EPA regulations. On April 14, the Tennessee Valley Authority (TVA) announced it was closing 18 coal-fired power plants as part of an EPA settlement. In addition, the TVA agreed to spend $3 to $5 billion in pollution control upgrades over the next ten years.

Based on EPA’s final regulations, management is looking to spend for upgrades in the following areas:

  • Water - $55 million.
  • Coal Ash - $1.1 to $1.8 billion.
  • Air Rules - $3.0 to $7.4 billion.
  • Replacement Generation: 5,500 Mw taken off line with 1,000 to 2,000Mw replaced - $1.0 to $1.8 billion.

While representing only about 5% of current income, management believes transmission assets is where their growth potential lies. Transmission investments have been generating above the regulated electric utility target of 11% ROI. Management has earmarked $500 million in core transmission investments for 2011 and again in 2012.

Although electric demand in the eastern sections of their service areas have not yet rebounded, overall load and demand growth is expected to be consistent in the low single digits. Ohio remains an important service area for AEP, representing 35% of operating income, and rate decisions greatly impact earnings. There are several currently pending rate cases that should be decided this year.

Management has been reducing its leverage with debt to capital ratios falling from 60% in 2008 to 50% currently. The 2011 capital expenditure budget is over $2 billion, with half going for environmental upgrades. As these are considered rate-regulated assets, cap ex investments should be incorporated in future rate decisions. Management’s conservative approach to its balance sheet will allow the company to continue to finance current and future cap ex.

Industrial electrical usage has increased 5.3% year to date. Industrial demand represents about 35% of total revenues and as the general economic growth drives industrial demand higher, it will help offset sluggish retail and commercial demand. AEP has a higher than averege exposure to a continuing rebound in industrial demand.

Earning should increase by at least 4% to 6% annually over the next few years, and improving in 2013 as the company begins to generate a return on its environmental upgrade investments. This steady expansion in earnings will allow for a continuation of a 4% dividend growth while maintaining a 70% payout ratio. With a reasonable price target of $40, total stock returns should be in the 12% to 14% range.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Source: American Electric Power: Heavy Regulated Exposure Will Assist in Coal-Fired Upgrades