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American Electric: Risks Outweigh Rewards

February 20, 2012 | About:

All good things come to an end.

Given the opportunity to put money in a company that produces steady and increasing revenues and earnings from a largely captive consumer base buying a product that is a necessity, I guess most investors would say "What’s the catch?"

The same question might arise if told the share price volatility would be low over the longer term and that returns by way of dividend would be in the region of 4 to 5% per year with a little capital growth thrown in for good measure.

But this has been the case for investors in utilities throughout. Investors could buy the shares, and then go to bed at night and sleep soundly. Dividends would roll in at regular intervals, to be either saved, spent or reinvested. Valuations would fluctuate, but less so than the wider market. A fall in price would be a great opportunity to buy more stock for the subsequent rise.

American Electric Power Company (NYSE:AEP) reported fourth quarter earnings that were in line with in line with expectations.

Highlights of its statement included:

· It benefited from favorable weather conditions;

· Industrial volumes picked up by 4%;

· It has settled legal challenges regarding its Arkansas power plant, which it sees beginning operations in late 2012;

· The Public Utilities Commission has allowed it to securitize funds from the earlier Texas Supreme Court decision, giving an extra $800 million expected later in the first quarter

· Cash proceeds of the securitization will be used for business growth and reduction of liabilities;

· Including dividends, investors received a return greater than 20% during the year.

American Electric has the country’s largest electricity transmission system, and supplies over 5 million customers across 11 states.

Its dividend of $1.88 per share, twice covered by its earnings per share of $3.76, means the shares yield 4.6% at the current price of $40. Shareholders have seen the share price increase from $36 at the end of 2010 to today’s level, with a low of $33.09 seen in March.

It has $622 million in cash on its books, and its debt/ equity ratio of 120 is about average amongst its peers such as Duke Energy (NYSE:DUK) and CenterPoint Energy (NYSE:CNP). These numbers will be helped with the receipt of cash due from the Public Utilities Commission decision mentioned earlier.

With quarterly revenue growth at 6.6%, and a dividend of 4.6% backed by steady earnings, such a fall would seem highly unlikely, particularly when the strengthening balance sheet is taken into consideration.

However, the cloud on the horizon is the requirements placed upon the sector to come into line with pollution regulations. The company, in reaction to the regulations last year, stated that it believed the timelines were unrealistic as the industry moves toward a lower-pollution environment.

American Electric will need to close and replace many of its coal fired plants. This will take money, and plenty of it. Such demands on its capital and revenue will alter its earnings matrix. In turn this could hold back increases in the dividend. Earnings in 2011 were positively impacted by favorable weather conditions for much of the year: The company cannot rely on the weather to be earnings positive. Industrial usage increased, though there are doubts about ongoing strength across the U.S. economy as the European situation impacts the business further.

Overall, I think that these doubts outweigh the balance sheet. American Electric’s earnings could come under pressure in the new lower-pollution environment, and this may negatively impact the dividend and shareholder returns. The company will announce its full year 2012 guidance on February 10: Perhaps management needs this time to fully reflect on the problems it could be facing.

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