Why AEP May Be the Most Attractive Utility Stock in America

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After years of enjoying dividend growth and investor demand, the U.S. electric utility group finally took a breather in 2016. After all, the post-election rally favored growth over income and defensive stocks. American Electric Power Co. Inc. (NYSE: AEP) is one of the top utilities in America, with a $30 billion market value, and it has a yield of close 3.75% to boot. This was one of the top 10 stocks to own for the decade, and now Wells Fargo is saying that American Electric Power is again one of the most attractive utilities in America.

The Wells Fargo team of Neil Kalton, Sarah Akers and Glen Pruitt have upgraded the AEP rating to Outperform from Market Perform. They also raised the official valuation range to $70 to $71 from the prior $68 to $69 range. What really stands out here is that Wells Fargo is actually more cautious on utilities as a whole, rating the entire sector as Market Weight.

Wells Fargo believes AEP warrants a premium valuation considering a few factors: better than peers earnings per share (EPS) growth prospects, a premier transmission strategy, a strong financial position and a financially disciplined management team. In simple terms, Wells Fargo is attracted to AEP’s strong EPS and dividend growth prospects, organic investment opportunities and healthy financial position.

The company is targeting a 5% to 7% EPS compound annual growth rate (CAGR) through at least 2019 (and likely beyond). Wells Fargo estimates that AEPTHC, which houses AEP’s FERC regulated electric transmission businesses, will account for 70% of AEP’s EPS growth during the period 2018 to 2020. For further context, the bank projects AEPTHC’s 2016-to-2020 EPS CAGR will be over 20% (off the 2015 EPS of $0.39) and that AEPTHC’s overall contribution to AEP’s consolidated EPS will increase from roughly 10% in 2015 to nearly 25% by 2020.

From a strategic standpoint, CEO Nick Akins and CFO Brian Tierney have consistently communicated an intention to remain highly disciplined when evaluating potential M&A opportunities. Since Akins ascended to the helm of the company in late 2011, AEP has been quiet in what has been an active utility M&A arena. That being said, at AEP’s November 2016 analyst event, management introduced a new contracted renewables strategy.

Wells Fargo described this strategy as follows:

AEP plans to invest up to $1 billion in contracted renewables during the period 2017-19 via AEP Renewables and AEP Onsite Partners with an emphasis on wind generation. We think the decision to execute a renewables IPP (independent power producer) strategy is primarily based on the belief that the company’s scale and financial position makes it an attractive long-term partner for renewable developers (AEP plans to acquire development projects). In addition, AEP enters 2017-19 with excess funding capacity of $1 billion due, in part, to $1.8 billion of expected proceeds in 2017 from the sale of non-core assets. As of late last year, AEP had signed letters of intent for projects representing approximately $250 million of investment. If successful, we estimate that that renewables investment would contribute approximately $0.10, or 2%, of annual EPS by 2020E (assumes equity financing of 40% and an ROE of 9-10%). While AEP’s foray into the renewable IPP business is small in the context of the entire company, we are mindful that the business is a moderately higher risk profile than the core regulated operations.

Shares of AEP were trading relatively flat at $62.35 on Tuesday, with a consensus analyst price target of $67.03 and a 52-week trading range of $56.75 to $71.32.