It's Time To Revisit American Electric Power Company
- I analyzed the company four years ago and found it attractive.
- Over the past four years, the stock has doubled its price, and it's time to revisit it again.
- In this article, I will analyze the company looking at its fundamentals, valuation, opportunities and risks.
I am not necessarily looking for an additional company in the utilities sector right now. I am revisiting American Electric Power Company (NASDAQ:AEP), because I analyzed it several years ago, and saved it in my watch list. Back then, I found an attractive company, and in a comparison with its peers, I found it to be even more attractive.
I found an attractively valued company with growth prospects and decent fundamentals. Even the valuation was attractive. I am not 100% committed to invest according to my capital allocation. The allocation is fluid and changes daily, and since I have decades to add to my portfolio, if I find a company that I believe is attractive, I will buy it and balance it later.
In this article, I will reanalyze American Electric Power Company using the graph below that I created several years ago. The graph represents my methodology when looking at companies. In the following paragraphs, I will analyze the fundamentals, the valuation and the risks and opportunities in this company trying to determine whether it’s a worthy investment right now.
(Graph made by author)
According to Seeking Alpha:
American Electric Power Company, is an electric public utility holding company, engages in the generation, transmission, and distribution of electricity for sale to retail and wholesale customers in the United States. The company generates electricity using coal and lignite, natural gas, nuclear, hydroelectric, solar, wind, and other energy sources. It also supplies and markets electric power at wholesale to other electric utility companies, rural electric cooperatives, municipalities, and other market participants.
American Electric Power is a regulated utility and therefore its ability to raise prices is very limited. We shouldn't be surprised that as energy costs went down, the company didn't achieve significant top line growth. Yet, the company is still making some ground.
The bottom line is obviously more impressive. As a regulated utility, the company is practically a monopoly, so we can expect a stable return on equity and profit margins. In the last decade, the company made significant growth, which is more impressive than we see in the graph below as it takes into account one-time expenses.
The company is a stable dividend payer with 10 years of consecutive growth, and 15 years of growing or frozen payments. The current payment of $2.7 a year is equivalent to a payout ratio of 70% when using GAAP EPS or closer to 60% when using non-GAAP EPS. In any case, with the nature of the business, this yield is safe.
Another use I like for the company's excess cash is share buyback programs. However, the company is not only not buying back its stock, it's diluting its shareholders. I can understand when REITs and MLPs tend to do it, as they raise capital for projects, but in this case, I see this minor dilution as a negative sign.
The current P/E ratio is a little bit on the high side. With a forward P/E ratio higher than 20, it is hard to find any margin of safety. The recent sell-off as fear of the Coronavirus is growing may serve as an opportunity. I would be more comfortable at a P/E ratio closer to 17.5. Sure, as a regulated utility, the downside is limited, yet with such a rich valuation, future returns are not too promising.
Even when we look at the following graph from fastgraphs.com, we see how the current price disconnected from the fundamentals. The normal P/E ratio is lower than 15, but with the current interest rate environment, I can justify some premium. However, the current premium makes no sense to me with the current fundamentals.
When I look at the fundamentals and valuation, I find AEP a little bit risky. The company is a monopoly so it enjoys a comfortable business environment. However, with the implied EPS growth, the current valuation seems unjustified. In the coming paragraphs, I will look at the growth opportunities, and try to figure out whether they justify this premium.
The company is shifting towards renewable sources of energy. At the same time, the company is retiring its highly polluting coal power plants. These are major investments, and once the company completes its shift away from coal, it will be a more environmentally-friendly company, and the need for massive investments in its infrastructure will decline.
The company is operating in some of the faster-growing markets in the United States. States like Oklahoma and Texas are growing rapidly thanks to their booming economy. As the population grows, the demand for power will grow, and AEP will be able to capitalize on it, and grow its net income in the long term.
We now see how the markets can be volatile because of the Coronavirus. Many investors have forgotten how volatility feels like and tend to recommend the volatile companies with a higher growth rate, but higher betas. AEP has a low beta, and therefore low volatility. In addition, it is a regulated monopoly so it enjoys a rather comfortable environment. In times of uncertainty, low volatility and more stable companies enjoy higher demand.
AEP may enjoy strong future growth in states like Texas and Oklahoma, but it also has significant exposure to states with more struggling economies. The rust belt, which used to be the steel belt was a crucial manufacturing area in the United States. As many manufacturing jobs moved overseas, these states suffered from a declining population. This is a risk for the demand for energy.
The company also has a large amount of debt. The debt is used mainly for expansion and bringing new projects online. However, debt is always a risk, and companies with higher debt levels should offer a larger margin of safety. Luckily, for AEP, it enjoys a high credit rating. If interest rates go up in the medium term, or the credit rating is lowered, it will have an impact on the bottom line.
Another problem in the current environment is the lack of margin of safety. We saw how the market can lose over 10% in a week. I try to purchase companies with a decent margin of safety and this isn’t the case here. The dividend yield is lower than the average in the last years, the valuation is high, and in general, the company is priced for more than perfection.
American Electric Power is a decent company. It’s a regulated utility that offers modest EPS growth and decent dividend. It also has several growth prospects as it positions itself to take part in the possible renewable energy revolution. The risks in my opinion are manageable, and the company has what it takes to deal with them.
However, the valuation is simply too high. Every time I find a valuation that is higher than usual I try to explain. Sometimes I can with faster growth, or amazing future opportunities, but this time, I simply can’t. I will gladly consider this company with a forward P/E lower than 17.5 which implies a price lower than $74. I know it seems far away, but with recent volatility, I wouldn’t rule it out.
This article was written by
Analyst’s 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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