Risk Alerts At American Electric Power, PPL Corp.

| About: American Electric (AEP)
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While utilities are well known for offering defensive plays, American Electric Power (NYSE:AEP) and PPL (NYSE:PPL) showcase the sometimes limited upside in the industry. From consolidation elsewhere, inflationary costs, and regulatory headwinds, these companies are rightfully rated a "hold" on the Street. Based on my multiples analysis and DCF model, I find unfavorable risk/reward for both firms.

From a multiples perspective, PPL is the cheaper of the two, trading at a respective 10.6x and 11.3x past and forward darning. AEP, meanwhile, trades at a respective 12.7x and 13x past and forward earnings while offering a 50 bps lower dividend yield at 4.5%. Duke Energy (NYSE:DUK) trades higher than both at 15.4x past earnings and offers a dividend yield of 4.7%. All of these firms have very little volatility with a beta around 0.5 or less.

At the third quarter earnings call, PPL's CEO, Bill Spence, noted a strong quarter but some challenges and disappointments:

"[R]etail sales for the quarter were relatively in line with the prior year on a weather-normalized basis, but remain challenged by lackluster economic conditions. Residential and commercial volumes both declined somewhat over the most recent 12-month period. Customer growth has not materialized, and usage rates per customer have also declined. Industrial sales are generally driven by specific plant issues. For the 12-month period, we saw increased production at some of our larger industrial customers compared to the prior 12-month period…

Weather-normalized residential sales were higher for the quarter compared to the prior year due to modest slow growth and the addition of new customers. Commercial industrial sales were lower for the quarter, reflecting slower economic recovery in the region from levels experienced in 2010".

The company may benefit from Pennsylvania legislation that will allow for alternative rate-making systems and improved margins, but the EPA's recent Air Toxics rule will result in caps effective in 2015. As PPL will inevitably try to push for higher rates, it may provoke the ire of onerous regulators. With that said, three-quarters of EBITDA will come from predictable markets in Pennsylvania, Kentucky, and regulated operations, there is greater certainty going forward. PPL further has an attractive portfolio of low-cost operations that are strong in efficiency. 11.2K megawatts of electricity are being generated from the supply segment. And with two-thirds of business coming from busload operations, PPL is well positioned to gain from fuel cost spreads.

Consensus estimates for PPL's EPS forecast that it will decline by 16% to $2.63 in 2011, decline by 7.2% in 2012, and then grow by 4.1% in 2013. Assuming a multiple of 14x and a conservative 2012 EPS of $2.30, the rough intrinsic value of the stock is $32.20, implying 14.6% upside. If the multiple were to just hold steady and 2012 EPS turns out to be 11.9% below consensus, the stock would fall by 18.9%. The latter scenario is not to be entirely discounted, since analysts have historically overestimated by around 11% and even more so recently.

AEP is substantially improving its financial profile. At the third quarter earnings call, the company noted $3.1B in net liquidity and support from 2 revolving credit facilities. The debt to market capitalization dropped to its lowest since the last 8 years. Even still, the consolidations between Duke and Progress (PGN), as well as between Exelon (NYSE:EXC) and Constellation (NYSE:CEG), will drive up cost pressures. Add in the Cross-State Air Pollution rule and the company may struggle with margins beyond what the market acknowledges.

Consensus estimates for AEP's EPS forecast that it will grow by 2.6% to $3.11 in 2011 and then by 2.6% and 4.1% more in the following two years. Assuming a multiple of 14x and a conservative 2012 EPS of $3.12, the rough intrinsic value of the stock is $43.68, implying 5.6% upside. Modeling a CAGR of 3.1% for EPS over the next three years and then discounting backwards at a WACC of 9% yields an even figure of 5.6%. Accordingly, in my view, Wall Street is accurate with its "hold" rating.

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