American Electric Power Isn't Pricing In Risks

Summary

• AEP shares have recovered nicely since the panic low.
• However, with inherent risks to the company's forecast, I see the valuation as a bit steep.
• I'd like to see a pullback to at least $76 before recommending.

Image source

One interesting development of the significant turmoil that COVID-19 caused in the financial markets back in March is that companies with seemingly little or no correlation to economic growth saw their stocks pummeled. One such example is American Electric Power (NASDAQ:AEP), one of the largest regulated utilities in the entire country. Shares fell from $103 to just $64 at the height of the panic, and have since rebounded back to $86.

AEP was very expensive, in my view, before the crash, and while the valuation has improved, it appears to me the risks to AEP’s revenue and earnings are meaningful enough that a reset is needed. As such, while AEP is a very attractive business to own long term, I think it needs a pullback.

The stock rebounded hard into the upper-$80s off of the crash low, only to oscillate since then, trying and failing in right about the same area we’re in today. With the stock at $86 as of this writing, and right at the same spot where resistance has proven too much to overcome a few times since the crash low, I think we’ll get the chance in the coming weeks to buy AEP lower.

Earnings show potential risks

AEP has an attractive mix of business, as we can see below. The company is huge in the utility world, a sector dominated by a few large players, with myriad smaller, regional players. AEP is firmly in the former group, with its $43 billion market capitalization. This is one of the reasons why the company is attractive; it has scale in an arena where scale is difficult to achieve.

Source: Investor presentation

The mix of business is interesting as half of AEP’s total revenue comes from residential customers, while the other half is mostly from commercial and industrial customers. In the environment we’re in today, that mix is helping keep AEP’s 2020 from being a complete disaster because residential customers are still paying their bills for the most part. The commercial/industrial portion of the business isn’t faring as well.

The company said in the Q1 earnings release that load projections for the year have been revised down sharply. Residential load is now expected to grow 3% for 2020, but commercial and industrial loads are now slated to decline 6% to 8%. Given that is nearly half of total revenue, these declines are severe.

In response, AEP is cutting operating and maintenance expense by $100 million and shifting $500 million of planned capex to future years to avoid a credit event. The company did reiterate its plan to spend $33 billion on capex over the next five years, so management seems to believe the return to normal will be swift, but I’m not so sure.

Below, we have revised guidance for this year following management’s digestion of Q1 results.

Source: Investor presentation

Earnings are still slated to be in the range of $4.25 to $4.45 per share despite the weakness from the company’s load projections. Cost savings will help, but if we look at the risks section in the bottom portion of the slide, that is where I start to get concerned.

AEP lists risks as a prolonged recovery rather than a sharp one, increased infection rates that would cause lower sales than projected, mild weather, and storm-related expenses. With ~40 million people in the US having been newly unemployed, with countless others having been furloughed or having their wages cut, I simply cannot see the case for a V-shaped recovery.

Further, states all over the country are reopening even though there is no vaccine for COVID-19, which in my view, means we are facing a second wave of infections.

In addition to that, the weather has been unkind to utilities all across the country so far in 2020, and AEP is not immune.

Source: Investor presentation

Weather took $0.10 of EPS from the vertically integrated utilities business and a fractional amount of earnings from the transmission and distribution utilities business, highlighting the exposure the company has to the weather. Importantly, there is nothing AEP can do about this and mild weather is a demand-killer for a utility. Should we continue to see mild weather in its service territories, earnings guidance will be at risk.

All of these factors are very real risks to the company’s earnings forecast, which I believe is already pricing in a swift recovery. Unemployed residential customers cannot pay their utility bills for long, and with commercial and industrial demand drying up for AEP, there won’t be anything to stop a meaningful decline in revenue. These are the things that make me think $86 is a bit too dear for this stock at this point, but it isn’t all bad news.

A silver lining

On the plus side, AEP continues to achieve positive results in its rate cases, some of which we can see below.

Source: Investor presentation

EPS was positively impacted by nine cents in Q1 from rate cases across its businesses, and there are more rate cases still in the hopper, yet to be implemented. This is a nice, steady tailwind to earnings over time for AEP as it continues to work with its various regional authorities on fair pricing for both it and the customers it serves.

In addition, at least so far, residential customer demand has been holding up during lockdown conditions.

Source: Investor presentation

Residential customers produced 6% higher load for AEP in April, which is the most recent month for which data is available, as stay-at-home orders saw customers using more electricity in their homes. The offsetting decline in demand from businesses, however, was more than enough to send total load change to -4.3%. As stay-at-home orders are lifted, we should see this normalize, but I’m still cautious on how quickly total power demand will return.

The bottom line

While I don’t think AEP is egregiously expensive today, I also don’t think it is cheap. Shares trade for 20 times this year’s earnings, and 18.6 times next year’s projection of $4.63 in EPS.

Source: Seeking Alpha

AEP has spent most of the last decade at 16 or 17 times earnings, with recent years being closer to 19 or 20. With projected growth in the mid- to upper-single digits, 19 or 20 times earnings seems a bit steep to me. And given the risks to earnings I laid out above, I think AEP needs a reset somewhat lower before it is a buy.

I’d like to see AEP retest $76 before calling it a buy, which would be just under 18 times this year’s earnings. That’s closer to fair value in my view than today’s price, and would provide the margin of safety I would need to feel comfortable given the risks facing AEP today.

This continues to be a strong company with a great track record, but I cannot help but think there are macro risks that may keep it from achieving projected growth, at least in the shorter term. The stock doesn’t appear to be pricing those risks in, so I’m cautious.

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.

Comments

[jimoc]

Another who missed it, HD was $142