Five severe warning alerts. That's what the GuruFocus system has given to American Electric Power Co. Inc. (AEP, Financial). Should investors run away in fear?
A better approach would be to step back and carefully assess the company. After all, it is a S&P 100 company and attracts four good alerts.
American Electric (including subsidiaries) is one of the country's largest, investor-owned providers of electricity generation, transmission and distribution. It serves more than 5 million retail customers in 11 states.
It gets about 45% of its capacity from coal, and the remainder from natural gas (28%), renewables (17%), nuclear (7%) and demand response (3%).
In its second-quarter earnings release, the company provided this guidance for the remainder of 2020:
With the outlook, it provided lists of factors that could positively or negatively affect those projections. Chief among them is the timing of a recovery; an early recovery would be good for business, while a late recovery would hurt it.
But what are we to think of the company from a long-term perspective, five to 10 years in the future? While we cannot know what that future will be, we can assess how well management might be expected to respond to it by finding out how well they ran the company over the past decade.
Let's start with those five severe warning signals:
- Long-term debt: Keeps issuing new debt.
- Operating margin: Declined.
- Revenue per share: Declined.
- Financial strength: Poor.
- Altman Z-Score: Distress.
And there are four good signals:
- Price-book ratio : Close to two-year low.
- Price-earnings ratio : Close to one-year low.
- Price-sales ratio : Close to one-year low.
- Dividend yield: Close to three-year high.
Long-term debt
It's not surprising that a power utility would have a lot of debt, considering that it must invest very large amounts of capital upfront to generate earnings. As we saw in the guidance above, American Electric expects to invest $6.3 billion this year in capital expenditures.
But how does its financial structure compare with others in the industry? The financial strength table provides some answers:
As we can see at a glance, it underperforms its peers on five of five debt metrics. What's more, its debt obligation compares poorly with its own past performance.
Operating margin
While there is a severe alert about American Electric's declining operating margin, closer examination shows its margin is higher than almost two-thirds of companies in the utilities – regulated industry. And, regarding that decline, when we check the company against its own industry, we find the 10-year median is 19.55%, while the current rate is 19.01%. That's not too significant when the margin has ranged between 17% and 21.95% over the past decade.
Revenue per share
This alert tells us that revenue per share is declining. This chart tells us by how much, and in what context:
At the same time as we look at the revenue growth rate, including negative growth, we should also check the profitability measures, Ebitda growth and earnings per share (without non-recurring items):
The last two lines in this table show the company increasing two key measures of profitability, despite a declining amount of revenue. That indicates the company is finding efficiencies more quickly than its revenue is decreasing.
Financial strength
As we saw in the financial strength table above, American Electric performed poorly on debt, one of the reasons for the low rating. The other key metric pulling down the rating is its Altman Z-Score, which we will examine next.
Altman Z-Score
The company's score on this metric was 0.82, which puts it in the distress zone. However, that score is not far off its 10-year median. GuruFocus reports: "During the past 13 years, American Electric Power Co's highest Altman Z-Score was 1.68. The lowest was -0.04. And the median was 0.92."
And apparently, having a low Altman score isn't fatal in the industry. This chart shows that the biggest company in the industry (by market cap) has a score that is just 0.83:
Getting back to financial strength, it appears we are getting a mixed message. The debt situation makes us pessimistic, while the Altman Z-Score does not seem as serious as it did on the surface.
Price-book ratio
Turning to the "good" alerts, there are three that fall into the valuation category: price-book, price-earnings and price-sales.
While the price-book ratio is near a two-year low, it is still not competitive with its peers:
It's much the same story with the price-earnings ratio:
And the story is the same once again when we examine the price-sales ratio:
All three are less attractive than their industry peers, which is not good news.
Dividends
This alert tells us the dividend yield, at 3.58%, is close to a three-year high, which is good.
The board of directors has consistently grown the dividend, which means the company has had improvements in its free cash flow over the past decade:
Still, those increases haven't been enough to maintain the yield, which has been going in the wrong direction. Over the past 10 years, it has slipped from more than 5% to less than 3.6%.
Conclusion
We began this assessment of American Electric Power with the observation that it has no less than five severe warnings, which is quite worrying for investors considering the name.
In going through the alerts individually, both severe and good, I ended up with a more positive perspective on the company than when I started.
Debt still doesn't look good to me, while the operating margin, revenue situation and Altman Z-Score concern me less now that I've examined them in more detail. Financial strength is weak, but not necessarily seriously.
On the good alerts, the three ratios are improvements when compared with their own history, but are still weak when compared with peers. The dividend yield may be near a three-year high, but has been heading down over the past decade.
While my perspective on the company has improved, it's still not enough to make me interested in its stock.
Despite its monopoly or near-monopoly, American Electric will not be attractive to many investors, even those searching for defensive names that will get them through near-term turbulence. Whether investors are searching for capital gains or income, this one won't make it onto many shortlists.
Disclosure: I do not own shares in any companies named in this article.
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