American Electric Power: Shares Look Tempting At These Valuations

| About: American Electric (AEP)

Summary

AEP is correctly exploring options to exit from merchant power operations and increase focus on regulated operations.

Increased focus on regulated operations will provide stability to financial performance.

Stock is trading at a relatively cheap forward P/E of 18x, versus its peers average P/E of 19x.

American Electric Power (NYSE:AEP) is an attractive investment option for long-term investors. The company not only offers a solid dividend yield of 3.3%, which makes it attractive for income hunting investors but also has a strong earnings growth prospects. Also, the company has a diversified regulatory footprint, and as AEP will successfully execute its transmission operations growth plan, its earnings growth will improve, which will have a positive impact on its stock price. Moreover, the company's efforts to increase its regulated business operations will improve its cash flows, revenues and earnings growth, which will in return improve its business risk profile and result in the stock valuation expansion. Despite the fact the stock is up almost 17% YTD, backed by its strong performance, the stock valuation remains compelling, as the stock is trading at a forward P/E of 18x, in comparison to its peers average P/E of 19x.

Financial Performance and Growth Catalysts

The company has been delivering healthy financial performance, and the momentum is expected to continue in the coming quarters. AEP reported operating EPS of $0.95 for 2Q16, ahead of analysts' estimate of $0.90. Also, reported operating EPS for 2Q16 increased by 8% YoY. Moreover, operating expenses decreased in 2Q16 to $1.71 billion, from $1.77 billion in 2Q15. The company's performance for the quarter was positively affected by its investment directed towards regulated business operations, and also due to growth in commercial and residential customers' sales. The company expects operating EPS for 2016 to be in a range of $3.6-$3.8, and also targets long-term EPS growth in a range of 4%-6%. The company's EPS growth can improve and exceed the management target of 4%-6% if AEP successfully implements its transmission business growth plan.

The company is taking initiatives to increase its regulated business operations, as unregulated business operations performance remains weak due to low and volatile power prices. Also, ongoing regulatory uncertainty over generation subsidies makes unregulated business operations unattractive. The company's efforts to increase its regulated operations will allow it to become 'premium regulated utility', and improve its business risk profile as its exposure to low return and high-risk unregulated operations will reduce.

Consistent with its efforts to increase regulated operations, AEP is taking a second strategic review of four Ohio coal plants (which have 2,700MW of generation capacity) after FERC's verdict to review generational subsidies granted by state regulators. I think, AEP is most likely to opt for the sale of the coal plants, rather than appealing against the verdict, as the unregulated market remains weak. Moreover, AEP is also conducting another strategic review of its competitive generation assets with a capacity of 5,000MW, and it is most likely opt for the sale of the competitive generation assets, which I believe will augur well for its long-term performance. The company can fetch almost $2.5 billion to $3 billion from the sale of its merchant asset portfolio. And it can use the sale proceeds to reinvest in its transmission business and also to repurchase shares. Also, the company can use the potential sale proceeds to develop and expand its wind generation capacity. If the company plans to use the entire sale proceeds to reinvest in regulated operations, it will positively affect its EPS by $0.05-$0.10 in 2018 and 2019. AEP already has the plan to make $15 billion of growth investments focused on regulated operations in the next three years.

As the company will continue to move towards increasing regulated utility operations its cash flows will improve, which will augur well for the stock valuation. The stock's current valuation stays attractive despite 17% YTD increase in the stock price. The stock is trading at a forward P/E of 18x, in comparison to its peers average of 19x. I believe, as the company will announce the sale of its merchant assets, its stock valuation will expand.

Summation

AEP is correctly exploring options to exit from merchant power operations and increase focus on regulated operations. The company's increased focus on regulated operations will provide stability to its financial performance, which will support its dividend and earnings growth. Also, the stock valuation will expand as its business risk profile will improve. The stock is trading at a relatively cheap forward P/E of 18x, versus its peers average P/E of 19x. Moreover, the stock offers a solid dividend yield of 3.3%, which is backed by its strong cash flows. Therefore, I think, the stock is an attractive investment option for long-term income investors.

Disclosure: I/we 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.