Image Source: American Electric Power Company Inc - IR Presentation
By Callum Turcan
American Electric Power (AEP) and its subsidiaries provide electric utility services to over 5 million retail customers in Midwestern, Southeastern, and Southern markets in the United States. That includes generation, transmission, and distribution services, most of which are rate-regulated utilities whose cash flows tend to be very predictable and stable. As one of the largest electric utilities in the United States, American Electric Power has the scale required to be very competitive, particularly when it comes to the ability to grow. In this article, we will cover why we see American Electric Power having a very nice dividend growth story, with shares of AEP yielding 3.0% as of this writing.
Management is targeting medium-term operating EPS growth of 5-7% CAGR, a sustainable payout ratio of 60-70% (of operating EPS), and we appreciate that American Electric Power has paid out a dividend for over 105 years. American Electric Power's forecasted operating EPS growth and relatively modest payout ratio will enable meaningful payout growth on a per share basis, a trajectory that would become greatly enhanced if the US Fed pushes interest rates lower (considering American Electric Power's large net debt load and need to tap capital markets).
We expect American Electric Power will keep growing its renewable energy portfolio by continuing to build out its green power generation footprint. However, most of the utility's expected capital expenditures from 2019-2023 are targeted towards transmission and distribution investment programs. In part, this strategy involves ensuring electricity produced by green power plants that are operated by third-parties can reach end buyers. That's on top of American Electric Power's plan to upgrade aging infrastructure to improve reliability and reduce potential liabilities (i.e. removing the possibility that old equipment and wires won't function properly by replacing outdated infrastructure with modern technology, equipment, and new wires).
Image Shown: American Electric Power is investing heavily in distribution networks, transmission systems, and renewables as the utility positions itself for the 21st Century. Image Source: American Electric Power - IR Presentation
Strong rate base growth, a product of its massive capital expenditure budget, is expected to drive American Electric Power's operating earnings per share higher by 5-7% CAGR over the medium term if not longer. Operating EPS came in at the high point of management's guidance last year, touching $3.95, and the company reaffirmed its 2019 forecast calling for $4.00-4.20 in operating EPS this year.
Image Shown: American Electric Power is forecasting 5-7% CAGR in its operating earnings per share over the medium-term. Image Source: American Electric Power - IR Presentation
Operating EPS growth combined with a payout ratio of 64% (in 2018 on an operating EPS basis) will allow for decent dividend growth per share over the coming years, and we are supportive of American Electric Power's investment-grade credit rating as well (BBB+/Baa1). Maintaining access to capital markets at attractive rates is an essential part of American Electric Power's business model as the utility pays out a large portion of its earnings back to investors, requiring the firm to tap capital markets for funds to grow.
At the end of the first quarter of 2019, American Electric Power had a net debt load of $26.1 billion when viewed as cash & cash equivalents (we aren't including restricted cash here) less total short-term debt and net long-term debt. We would like to note here that due to its large net debt load, American Electric Power would be a major beneficiary of a lower interest rate environment.
Image Shown: American Electric Power's dividend growth rate has picked up pace during the second half of the 2010s decade. Image Source: American Electric Power - IR Presentation
In February 2019, American Electric Power agreed to buy Sempra Renewables from Sempra Energy (SRE) for $1.1 billion in a deal that closed in April. This transaction included paying $0.6 billion in cash, taking on $0.4 billion in existing project debt, and recognizing a non-controlling $0.1 billion in tax equity interest associated with some of the wind farms. Sempra Renewables had 724 MW of net operating wind generation and battery assets according to the press release. That included stakes in seven wind farms (718 MW in net electricity generation capacity) and one battery installation (6 MW in net storage capacity).
Those wind farms had an average capacity factor of ~37%, meaning that those turbines have historically generated just over a third of their nameplate electricity production capacity. Note that according to the United States Energy Information Administration, the average capacity factor of domestic wind farms had grown from 32.4% in 2013 to 37.4% in 2018. That growth continued into 2019, averaging 40.6% during the first four months of 2019.
100% of the electricity produced by those seven wind farms is sold under PPAs, power purchase agreements, to investment-grade utility companies. Furthermore, American Electric Power notes that the "project PPAs have an average remaining life of 16 years." This transaction closed during the second quarter of 2019, and American Electric Power expected to finance the deal with a combination of debt and equity, which we should get more color on during its upcoming earnings release.
Additionally, American Electric Power entered into an agreement in December 2018 to purchase 75% of the Santa Rita East Wind Project, which is currently under construction. That asset, when operational, will have the capacity to generate 302 MW of electricity at its peak on a gross basis. When completed sometime in the middle of this year, American Electric Power will acquire its share in the venture. Net to American Electric Power, that asset will add 227 MW of green energy generation capacity to its operations.
Combined with American Electric Power's existing renewable energy asset base, which is rather small at just 351 MW of capacity (includes solar and wind power gen assets in Texas, California, Nevada, and Utah), the closing of these transactions would see American Electric Power become the seventh largest owner of competitive wind generation in America. With 1,302 MW of pro forma green power generation capacity across 11 states, most of which (~93%) is represented by wind farms, American Electric Power is quickly becoming a much more serious player in the renewable energy space.
Image Shown: An overview of American Electric Power's pro forma renewable energy operations, which includes wind farms, solar plants, and battery storage assets. Image Source: American Electric Power - IR Presentation
There remains plenty of room for upside on this front due to asset retirements, particularly at coal plants, oil-fired plants, and older gas-fired facilities. Older gas-fired and oil-fired power plants are only economically viable as "peaker plants," meaning they feed electricity to the grid during times of elevated demand when wholesale electricity prices are high. Merchant power generation assets (especially older plants that aren't competitive) aren't a good fit for regulated utilities unless the cash flows of those assets are secured under PPAs or something similar, as the financials of those operations are quite volatile. For coal plants, those assets are contending with an abundance of domestic natural gas supplies and green energy projects stealing away market share in the power generation business, which on top of environmental regulations is forcing many into retirement.
However, wind farms and solar plants aren't baseload power generation facilities either, which is why battery storage investments are required in order to make those operations more viable (here we are talking about green energy going from supplementing existing baseload power generators such as; nuclear, hydro, new gas-fired plants and coal plants, towards becoming the main source of electricity generation). That is a long-term story and one that will slowly unfold over the coming years, considering technological improvements are required in order to bring down high-sky battery costs (relatively speaking).
American Electric Power plans to continue growing its renewable portfolio over the coming years. During the utility's first quarter of 2019 conference call, management responded to a question on its planned green energy investments with this statement:
In regards to the investment in the renewables portfolio, we had talked about a five-year spend of about $2.2 billion with certain projects, including the renewables portfolio from Sempra. We've spent about $1.5 billion of that commitment, so we have roughly $700 million left, and we're looking at opportunities as they become available. We feel the Sempra transaction was at a very good value to the company considering both the existing projects and the developmental projects, and we were able--by making that acquisition early in the five-year period, we were able to solidify and de-risk that $2.2 billion forecast of spend. We're on our way to meeting the $2.2 billion commitment, and we're evaluating development projects with the portfolio and looking at other opportunities as well.
With investment-grade credit ratings, a nice payout buffer, strong forecasted operating EPS growth, a growing green energy footprint, and a nice growth runway in the rate-regulated utility space, American Electric Power is very well positioned to take advantage of a lower interest rate environment. However, we caution that shares of AEP are trading right around the top of our range of fair value outcomes, indicating shares are richly valued by the market as of this writing. That's likely due to optimism regarding a potential US Fed interest rate cut, which would drive down the cost of debt and behoove the financial performance of most if not all domestic utilities.
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.
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