AES Corporation: Focusing on Expanding Utility Operations

Includes: AES, DPL
by: George Fisher
AES Corp (NYSE:AES) is a global electric utility that is posed to expand earnings over the next few years. Investors, however, have to acknowledge the risks of its high leverage and the lack of dividends. The investment thesis is focused future capital gains as a result of an expansion of its utility operations, a growing free cash flow, a redeployment of non-core assets, and a current undervaluation, along with substantial international exposure.
Investment Underground has a good synopsis of the 2011-2012 earnings potential in a May Seeking Alpha article.
AES currently operates 34,000MW of power generation in 28 countries. The company continues to build up its merchant power generating capacity with an additional 2,010MW under construction, of which 95% is contracted by long term power purchase agreements (PPA). Included in these projects is one facility in Bulgaria and two in Chile. In the US, AES generates 13,500MW mainly from natural gas and oil. PPA contracts and large utility power purchases have accounted for upward of 80% of overall EBITDA, with 40% of company-wide generation fueled by coal, 40% by natural gas, 15% by wind and solar, and 5% by hydro.
In addition, AES provides electric distribution networks to 12 million people.
Current international mix is 46% from South America power generation and utility operations, 35% from North America power generation and utility operations, 9% from power generation in Europe and 6% from power generation in Asia. Management has stated their key market going forward are the US, South America, Turkey, SE Asia and India.
Consensus earnings per share for this year are $1.00 (range $0.98 to $1.14), $1.26 in 2012 (range $1.24 to $1.38) and $1.33 in 2013 (range $1.29 to $1.48). US operations will contribute about 40% of earnings. Going out a bit further, AES should be able to sustain a 10% growth rate. By 2015, AES could be generating $1.65 to $1.75 in earnings.
How does the company plan to generate these achievements? Management recently announced a $5.5 billion 2011 – 2015 expansion plan, with $2.2 billion anchored in the acquisition of Ohio-based regulated electric utility DPL. Turkey is in the process of privatization its electric utility sector and management is looking to invest $400 - $500 million. Assuming a 10% return on this expansion plan, successful implementation could generate an additional $0.60 - $0.70 in EPS over this year’s level. Free cash flow could rise from $721 million in 2011, to $2.3 billion in 2015, representing a 44% annual growth.
How will this expansion be paid for? $2.0 billion could be from the cash balance of $3.2 billion, $1.2 to $2.0 billion from free cash flow, with the balance in additional debt. AES operates a relatively small amount of solar and wind generating capacity that could be sold for around $1.2 billion. In addition, the company has a large Net Operating Loss carry forward that will reduce future taxable income, improving cash available for investments.
AES is waiting for regulatory approval to acquire DPL, the Dayton, Ohio, based utility. Just up Interstate 70 from its other electric utility in Indianapolis, IN, this acquisition is recently gaining better acceptance on the Street. Set to close by year-end, DPL is anticipated to be accretive to earnings by about $0.12/shr in 2012. The reason for the optimism is higher cost-cutting potential and a recent successful electric auction for future PPA rates that may signal a bottoming of merchant electric prices.
There are 721 million shares outstanding and AES has a stock market capitalization of $10 billion. Insiders own 16% of shares.
AES is leveraged with about $20 billion in total debt and represents a 75% debt-to- capitalization ratio. Long-term debt is pegged at $16 billion. There are heavy principal payments due over this time frame as well with $3 billion due this year, $0.70 billion due next, $1.0 billion due in 2013, and $3.9 billion in 2014 and 2015. It is anticipated that these can be rolled over when required. The majority of debt is project/facility specific and is non-recourse to the parent. With the amount of leverage on the balance sheet, this important feature tends to insulate shareholders against a few worst case events.
Historically, AES stock has traded around a 13 PE ratio. Its current 2011 PE is around 12.5, but its 2012 PE is only 10.5, representing a potential 20% undervaluation. Based on successful integration of DPL, implementation of management’s expansion plans, and a return to its historic PE ratio, share prices should trade up to around $16 to $18, with a potential of $22 a few years out.
For speculative utility investors willing to risk current yield for improved future capital gains potential, AES is well worth your due diligence time. Like most utility investments where staying power is rewarded with acceptable total stock returns, AES should pan out over time but patience will be required.
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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.