AEP Offers Reasonable Compensation For Its Risks

| About: American Electric (AEP)
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Utilities don't get much attention unless the topic concerns dividend investing or some major disaster. That's unfortunate, as the utility sector is seeing some pretty interesting developments in terms of mergers, deregulation, environmental rules, and fuel economics. As one of the largest utilities in the country, American Electric Power (NYSE:AEP) is seeing the impact of all of these on its operations, but perhaps none so much as the oncoming deregulation in Ohio.

While investors ought to shop around and consider other dividend-heavy ideas like pipeline operators, this utility isn't a bad option for those content to sit tight and collect dividends.

Making The Best Of A Difficult Environment

All things considered, AEP produced a respectable quarter in a trying environment. Revenue fell modestly (3%), with utility revenue down 4%. On a normalized basis, total electricity sales dropped 0.4% this quarter, as good industrial growth (2.2%) was outmatched by residential (2.8%) and commercial (0.4%) declines.

Gross margin slipped about half a point, while "ongoing earnings" declined 1%.

Looking at earnings a little differently, saw a $0.12 headwind from the milder weather this spring, a $0.06 impact from ongoing customer switching (cumulative load lost is now 28% in Ohio), and $0.05 in lost POLR revenue (provider of last resort). On the positive side, AEP saw an extra penny from transmission operations, $0.08 from new rate increases, and $0.11 from better cost containment.

The Switch Is On

Like other utilities, AEP is taking advantage of low natural gas prices by switching more production to this fuel. Whereas coal generation was 61% of capacity a year ago (and natural gas 22%) in the company's Eastern operations, they balanced out at 47% each this quarter. The company has done far less switching in its SPP operations.

Judging by AEP's report, there's no pressing reason to expect coal demand to pick up for producers like Arch Coal (ACI) or carriers like Norfolk Southern (NYSE:NSC), as it doesn't look like the company is in any hurry to switch back. What's more, this is a phenomenon that's repeating at other utilities like Pinnacle West (NYSE:PNW) (parent of Arizona Public Service), Duke Energy (NYSE:DUK) and Southern Co (NYSE:SO) to various extents.

Whither Ohio?

What happens in Ohio is going to shape AEP in the years to come. Though AEP operates in 11 states, Ohio produces about one-quarter of the company's earnings, and the state is in the process of transitioning to a deregulated market-based system.

That's creating problems now, and will create more in the future. For starters, AEP has had to go back to the drawing board with a new rate plan for Ohio, as citizens protested the expected increases in the plan. Looking ahead, AEP may well need to relocate generating assets, sell generation capacity, or shut down plants if deregulation leads to unsatisfactory returns. Given the experience of independent producers like NRG Energy (NYSE:NRG), Calpine (NYSE:CPN) and GenOn (NYSE:GEN) over the years, it will, at a minimum, be interesting.

What AEP does have going for it, though, is a large and diverse asset base, including valuable transmission and distribution assets. This is likely to be a growth opportunity for the company, and I would not be surprised to see additional ventures along the lines of Transource Energy - an LLC created by AEP and Great Plains Energy (NYSE:GXP) that will look to build transmission projects in multiple RTOs.

The Bottom Line

My valuation approach for utility companies is a little unusual relative to how most investors value these companies. I prefer to use an excess return model similar to the kinds often used to evaluate bank or insurance companies. In such models, the most important variables are generally the discount rate and the assumed returns on equity over time.

To that end, I expect AEP to earn a 10% ROE on a long-term basis - a little less than the company's five-year average, largely on the basis of developments in Ohio. I'm also assigning a slightly higher discount rate (8.5%) than I normally would for a utility, given the significance of Ohio to AEP's current business and the uncertainty over AEP's long-term plans for the area.

Using those inputs produces a fair value of around $40 - just a bit above the current price, but not significantly so. Factoring in the slightly above-average dividend yield, and AEP stacks up as a decent utility investment option even with the ongoing uncertainties.

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