How the Case for Owning American Electric Power for the Next Decade Has Changed

July 11, 2019 by Jon C. Ogg

Source: WendellandCarolyn / Getty Images
With a new decade on the horizon, investors need to be considering what worked over the past decade and whether they should expect the same or different outcomes for what will work in the decade ahead. It seems almost impossible to expect another 350% rally in the S&P 500 from the start of the bull market when shares bottomed out in March of 2009. That said, some of the performance over the next decade may depend on how much the market and sectors pull back when and if that next recession arrives, as the media has warned us about year after year.

American Electric Power Co. Inc. (NYSE: AEP) is a stock selected as one of 10 stocks to own for the next decade way back in November of 2010. AEP remains one of the largest publicly held electric utilities in America, but the difference in 2019 is that it was valued at $17.8 billion in late 2010 and was worth almost $45 billion on last look. Without adjusting for dividends, AEP’s price was $37.05 in late 2010 when we named it among the 10 stocks to own for the decade, but more recently the stock was at $90.00. That’s a gain of more than 140%, without factoring in the dividends, though the dividend is perhaps the primary reason so many investors have bid up utilities in the past decade. 24/7 Wall St. even went as far during the zero interest rate climate as calling out utilities stocks as the replacement for bank-issued CDs (certificates of deposit).

Most stocks and asset classes should not be thrown out or given poor future ratings just because they have performed quite well. After all, great companies have risen and risen over the decades. AEP and other major utilities probably will have to expect much more modest returns ahead. If you add in close to $20 worth of dividend payments over almost nine years, without even considering reinvesting on the way up, AEP has a total return profile of closer to 200%.

To be considered a stock to own for the next decade back in 2010, a company had to be highly established with a solid outlook for secular trends. None of the companies had business models that were going to implode under the “new normal” or “post-new-normal” regulatory climate of the time. There was no effort to pick the companies with the highest risk and reward because so many investors were still deeply entrenched into recession-mode. After all, U.S. unemployment was over 9% then, and U.S. gross domestic product has risen by more than one-third to $21 trillion since that time.

Those 10 picks were a novice investor’s watch list of go-to stocks to consider adding to their portfolios when a buying opportunity presented itself. The “buy and hold” strategy was gutted during the Great Recession, but it has proven to be far better than the “trade-in and trade-out” strategy that many investors employed during the past decade. While AEP still seems to fit within the “buy and hold” and “safety trade” strategies heading into 2020 as a stock to own for the next decade, there are some obvious additional risks now compared with a decade ago.

One reason AEP was selected over other utilities in 2010 was that it always seemed to be very dividend friendly, with years of rising payouts. It even had a 4.9% yield back in 2010, and the company was promoting a “Defend My Dividend” campaign that was fighting against potential tax increases on dividends and gains at that time. Since late in 2010, AEP’s per share payout is up almost 50%, but a massive rise in its share price creates a dividend yield of just under 3% in 2019. Its revenue was just over $16 billion in 2018, up from about $14.4 billion in 2010.

AEP’s valuation metrics also have risen along with the broader utility leaders over the past decade. These stocks have become defensive safety trades whenever the stock market is weak or when long-term Treasury yields head rapidly lower. Investors are still throwing money into these stocks during any period of uncertainty, but there seems to be more market-risk and sector-specific risk heading into 2020.

With a good portion of the country honed in on climate issues, AEP and other utilities could face drastically higher environmental and regulatory costs in the next decade, if the economy becomes more demanding than it was under the Obama administration. AEP and other utilities also have benefited from the cut in corporate tax rates, which plays right into dividends and excess income that can be reinvested. And in 2010, AEP was valued at only about 12 times expected earnings per share, versus about 21 times forward earnings heading into 2020. That is a major safety premium, and it means that the sector went from being valued at a market discount to a market premium.

AEP provided power generation, transmission and distribution services to more than 5.0 million customers in 11 central states back in 2010. Its footprint has grown to almost 5.4 million customers in 2019 in the same coverage areas. The regulated utility and transmission player has maintained a diversified strategy of its power generation over time from coal and natural gas, along with hydro, wind and solar.

Back in 2010, AEP’s coal and lignite exposure accounted for 80% of AEP energy generated, and it was 65% of AEP’s generating capacity. In 2010, its 2020 projection of AEP generating capacity was for 52% to come from coal/lignite. Its energy generation in 2019 was noted as having coal-fueled power plants account for roughly 47% of generating capacity, and natural gas represents about 28% and nuclear energy represents about 7%, with the remaining capacity coming from wind, hydro, pumped storage and other sources (14%), as well as energy efficiency (4%).

In 2018, AEP announced new intermediate and long-term CO2 emission reduction goals. It was targeting a 60% intermediate coal reduction from 2000 CO2 emission levels from AEP generating facilities by 2030. Its long-term goal is for an 80% reduction of CO2 emissions from AEP generating facilities from 2000 levels by 2050. AEP said in its 2018 annual report that its total estimated CO2 emissions in 2018 were approximately 69 million metric tons, a 59% reduction from AEP’s 2000 CO2 emissions of approximately 167 million metric tons.

An attractive portion of AEP is that its center-of-America footprint comes with less natural disaster risk than companies located in Florida, solely on the Gulf of Mexico, or just along the eastern seaboard. That implies that it has less risk around the would-be or actual infrastructure damage from climate change and storms. That said, this issue may still be a longer-term one than many investors are willing to debate about using today’s dollars and cents. More recently, American Electric Power was recognized by 2020 Women on Boards for having 20% or more board seats held by women, and the company has been active in diversity and inclusion efforts.

AEP is deemed to have a safe dividend for the current economic snapshot, and that should hold up even in the next economic downturn, barring any drastic changes or unforeseen issues. With an annualized per share payout of $2.68 in 2019, AEP’s consensus earnings estimates are $4.13 per share in 2019 and $4.40 per share in 2020.

Investors also have to consider what is happening with other major electric utilities and wholesale power generation leaders. Valuations are higher against earnings by almost all historical standards for the group as a whole. Investors have bid up the shares to the point that they are now forcing new investors to take lower dividends than used to be expected. Many sector leaders, like NextEra (the former FPL) and Duke, may be considered as having riskier geographic footprints if storms become more frequent or more powerful. Investors should know better than to chase certain west coast power utilities (like PG&E) that are rightfully at risk of facing endless billions on billions of dollars in liabilities from forest fires on top of past environmental issues.

An additional issue that has to be taken into consideration is that AEP’s long-term debt was $21.6 billion at the end of 2018. That was up from $17.7 billion at the end of 2015, and that’s up from $15.5 billion at the end of 2010. Its total long-term liabilities were counted as $41 billion at the end of 2018, after having risen gradually almost every year from the $30.3 billion in total long-term liabilities at the end of 2010.

S&P and Moody’s both have investment-grade credit ratings (BBB+ and Baa1, respectively) with stable outlooks for the parent company. Its ratings are mixed among operating subsidiaries, but their outlooks are all shown to be stable and investment-grade. If those ratings change, or if major utilities become deemed more at-risk, then it could pose additional challenges for AEP common shareholders as the risks trickle down.

It has become ever harder to use historic comparisons of the prior 50 years now that industry valuations have changed so much and after a period of nearly zero percent interest rates lasted years longer than it should have done. But think about returns without considering dividends, which is not really a fair evaluation but has to be done using historical charts data. A gain of close top 150% in AEP this past decade compares to a round-trip zero for long-term capital gains in the prior decade. AEP’s share price nearly doubled in the 1980s, but it was range-bound in the 1990s and did next to nothing for long-term gains, without considering its dividends.

AEP shares have outperformed the S&P 500’s 19.5% gain so far in 2019 (and a 15% gain in the Utilities SPDR ETF) with a total return of 21%. Trading at $90.00, it has a 52-week range is $68.13 to $91.99, and its consensus target price from Refinitiv was last seen under the current share price at $88.31. Merrill Lynch is an exception to the norm among Wall Street analysts, recently reiterating its Buy rating and raising its price objective to $98 from $93.

Investors used to see value in utilities stocks, and they used to see much higher dividend yields. Many of the balance sheets have grown over time. Between now and 2029 to 2030, there will have been three more presidential elections, the power in Congress may have shifted once or twice, there may have been one or two recessions, the tax code for corporations and investors may have changed and the regulations and structure of the economy may be up for grabs. That’s a lot to stomach for the utilities sector. It’s a difference of night and day from where we sat at the end of 2010.

AEP still may be considered a stock to own for the next decade if an investor has been a long-term holder and might be considering whether to lock in gains to reinvest into another solid utility operator that’s also at a market premium and with the market at all-time highs. That doesn’t mean that new investors who are trolling for new ideas should be piling into AEP — and likely the same goes for AEP’s rivals.

The utilities sector largely has become harder to commit new capital into at current high share prices and valuations. That said, long-term shareholders don’t necessarily need to run for the exits.

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