American Electric's Valuation Gives Me Pause

The company pays a solid yield, but the valuation is above its long-term average

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Sep 09, 2020
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Utility stocks can offer excellent dividend yields, especially when the average yield of the S&P 500 is less than 1.8%. That doesn't mean investors should buy just any utility stock, though.

Case in point is American Electric Power Co. (AEP, Financial), which offers a very solid yield but trades with a valuation above both its long-term average and my personal target.

Company background and recent quarterly highlights

American Electric operates utilities on both sides of the Mississippi river. The company provides electricity to 5.5 million customers in Arkansas, Kentucky, Indiana, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia and West Virginia. Residential customers account for slightly more than 40% of revenue, but American Electric also has a sizeable commercial, industrial and wholesale business. The company is valued at $40.5 billion today.

The company reported second-quarter earnings results on Aug. 6. Revenue declined 3% to $3.5 billion, missing analysts' estimates by $471 million. Adjusted earnings per share improved 8 cents, or 8%, to $1.08, which was 3 cents above what the market had expected.

The Vertically Integrated Utilities segment added $1.05 to results, 5 cents better than the previous year. Lower operations and maintenance costs along with higher transmission revenue aided growth.

Transmission and Distribution's earnings per share declined 5 cents to 53 cents due mostly to a reversal of a regulatory provision in Ohio. Higher deprecatios and the roll off of legacy riders in Ohio also attributed to the decline.

AEP Transmission Holdco contributed 47 cents to results, but this was 10 cents lower than the previous year.

Generation and Marketing added 18 cents to earnings per share, up 4 cents year over year due to land sales and strength in the renewables business

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Source: American Electric's Second-Quarter Earnings Presentation, slide 10.

Normalized load was down almost 6% in the quarter, which was near expectations. Residential sales increased 6.2% as customers were home more often during the quarter due to social distancing directives in response to the Covid-19 pandemic. Weather normalized sales were still higher even after states began lifting restrictions.

These same restrictions negatively impacted commercial and industrial sales. Commercial sales fell 10.1%, while industrial was down 12.4%. Prior to the pandemic, commercial had been a solid performer, but the closing of schools, churches, restaurants and hotels all significantly impacted results. Industrial was hampered by the drop in economic activity, especially in the areas of transportation, manufacturing and mining. On the other hand, pipeline transportation, petroleum and coal have been areas of growth.

Following second-quarter results, American Electric expects residential sales to grow 3% (compared to down 1.4% previously), commercial to decline 5.6% (compared to down 0.4% previously) and industrial to decrease 8% (compared to up 3.2% previously).

Weather also was a benefit to American Electric during the quarter and the company has now guided toward weather being less of a negative in 2020.

The company also announced it received the required approvals related to its $2 billion North Central wind project. This project will add nearly 1,500 megawatts of capacity of renewable energy in Arkansas, Louisiana and Oklahoma. The project will come on line in three phases in 2021. American Electric is using $1.3 billion of stock and $700 million of long-term debt to fund North Wind. Analysts expect that the project will be accretive by 2022.

In total, American Electric has a five-year capital plan of $35 billion, including the North Central wind projects. The company has stated that these investments will allow for earnings per share to grow at a rate of 5% to 7% annually. One last note on capital expenditures, American Electric had moved $500 million to 2021, but moved $100 million of this back into this year's investment plan.

American Electric also has several rate cases that are pending. The company is seeking $41 million in rate increases, which reflects a return on equity of 10.15%. It is seeking rate raises of $65 million in Kentucky, which is based on a return on equity of 10%. In Virginia, the raise is expected to be $65 million on a ROE of almost 10%. The rates are likely to go into effect in January in Ohio and Kentucky and in January for Virginia.

Finally, the company expects to earn $4.25 to $4.45 of earnings per share this year, which would be a 3.8% improvement from the prior year.

American Electric navigated a difficult quarter as well as could be expected. Restrictions led to more people using more electricity at home, but also lessened commercial and industrial activity. The company has planned some heavy investments that should lead to at least mid-single-digit growth. This should help the dividend continue to grow.

Dividend and valuation analysis

Shareholders of American Electric have received a dividend increase every year for the last decade.

The company has raised its dividend by an average of:

  • 6.1% per year over the last three years.
  • 5.9% per year over the last five years.
  • 5.2% per year over the last 10 years.

As you can see, the dividend growth rate has been accelerating over time. The most recent raise, however, bucked this trend as it was 4.5%. Given that management has forecasted a 5% to 7% growth rate going forward, shareholders can likely expect a similar type increase for the upcoming December payment.

American Electric's stock pays a 3.5% dividend yield today, matching the five-year average yield of 3.5%, but is below the 10-year average yield of 4%.

Shareholders should receive at least $2.80 of dividends per share in 2020, which would reflect a payout ratio of 65% of the midpoint of the company's guidance. The average payout ratio since 2010 is more than 81%, but this includes one year (2016) where earnings per share declined considerably. Removing this year from the equation, and the average payout ratio is 63%. This is a solid payout ratio for a utility company, one that likely means dividend growth can continue in future years.

Shares of American Electric trade around $81 at the moment. This gives the stock a forward price-earnings ratio of 18.6 when using the midpoint of the company's guidance. The five- and 10-year average price-earnings ratios are 17.9 and 15.9, respectively. Valuations for many utilities have expanded in recent years.

The company's investments, especially in the area of renewable energy, should drive solid gains. Therefore, I believe a target price-earnings ratio of 18 is appropriate as it takes into account this potential investment and annual earnings growth.

Final thoughts

Quarterly results were mixed, as revenue came in weaker than expected while earnings per share increased. Weather and more people at home was a benefit to results, though the other areas of American Electric's business were down.

The stock offers a solid dividend yield that appears safe, but the valuation is above my threshold for purchase. Using my target valuation and the midpoint for expected earnings, I would look to purchase shares of American Electric below at least $78.

Disclosure: The author does not maintain a position in any stocks mentioned in this article.

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