The higher-for-longer narrative playing out over this interest-rate hiking cycle in the last couple of years has claimed many victims in the stock market.
For many companies that got complacent and addicted to debt, gone are the days of zero interest rate policy. Inherently indebted sectors such as utilities have suffered a double whammy from these high interest rates.
As their cost of debt has soared, there is often a lag between these projects and getting general rate cases for higher rates approved (typically a few years). That has temporarily weighed on the business performance of the utility sector.
On the equity side, utilities have plunged from their highs set in 2022. From its peak of around $78 in September 2022, the Utilities Select Sector SPDR Fund ETF (XLU) is down approximately 18%.
That's because of the negative correlation between utilities and interest rates. As interest rates climb, conservative investors have lower-risk substitutes for utilities, and vice versa. This reduced demand for utilities also makes it more difficult to raise capital with share issuances.
The consensus varies from one source to the next on the timing of interest rate cuts. After the latest Producer Price Index or PPI reading came in hot at 0.6% versus the 0.3% consensus, the prospect of rate cuts may be further delayed.
However, the good news to all of this is that what goes up (interest rates) must come down. This too shall pass. And when it does, that could transform former laggards into the new outperformers.
In this article, I'll be focusing on the sixth-biggest holding within XLU. That's American Electric Power (NASDAQ:AEP), comprising roughly 4.6% of the ETF. In my portfolio, it's my biggest utility holding, with a 1.1% weighting.
When I last covered the company in January, I liked its sustainable dividend, decent growth outlook, and A-rated balance sheet. In that time, shares have retreated another 1% as the S&P 500 (SP500) has gained 9%.
Late last month, AEP also shared its fourth-quarter operating results. Today, I'll be examining those results and the stock's valuation to lay out why I'm reiterating my buy rating.
AEP's 4.3% dividend yield is a bit above the utility sector median of 3.9% per Seeking Alpha's Quant System. On top of this decent starting income, the dividend is reasonably well-covered.
AEP's 64% EPS payout ratio is moderately below the 75% EPS payout ratio that rating agencies prefer from the electric utility industry. The company's debt-to-capital ratio is a bit elevated beyond the 60% that rating agencies like to see from the industry at 65%.
As I'll discuss in greater detail, this is why AEP's long-term debt was recently downgraded by S&P from A- on a stable outlook to BBB+ on a negative outlook. That suggests the probability of the electric utility going to zero in the next 30 years is 5%.
The risk of a dividend cut from AEP remains minimal, however. The respective 0.5% and 2% likelihoods in the next average and severe recessions are the lowest values possible in the Zen Research Terminal.
Shares of AEP remain an intriguing value proposition. According to the Automated Investment Decision Score Tool, the company's five-year average dividend yield of 3.4% suggests shares could be fairly valued at $103 each.
AEP's blended P/E ratio of 15.4 is also below its 20-year normal P/E ratio of 15.8 per FAST Graphs. That implies shares could be worth $87 apiece. As interest rates are cut, I believe the valuation could even find support around a multiple of around 17. This is based on the fact that the 10-year average P/E ratio is just above 18 and annual earnings growth remains around 6% to 7%.
Lastly, the following inputs into the dividend discount model show shares of AEP to be fairly valued at $88 each: A $3.52 annualized dividend per share, a 10% annual total return rate, and a 6% annual dividend growth rate. Judging by the most recent 6% dividend raise in the quarterly dividend per share, I think this is a realistic long-term assumption from AEP.
Averaging out these fair values, I get a fair value of $92 a share. That could mean the stock is trading 11% under the current share price of $83 (as of March 18, 2024).
If AEP can hit the low end of its 6% to 7% annual operating EPS growth target and return to fair value, here are the annual total returns that could lie ahead over the coming decade:
- 4.3% yield + 6% annual earnings growth + a 1.2% annual valuation multiple upside = 11.5% annual total return potential or a 197% 10-year cumulative total return versus the 10% annual total return potential of the S&P or a 159% 10-year cumulative total return
Investing Even More In Growth
On Feb. 26, AEP reported its financial results for the fourth quarter that ended Dec. 31, 2023. The electric utility's operating revenue was down 7.1% over the year-ago period to $4.6 billion during the quarter. For perspective, that was $200 million short of the analyst operating revenue consensus according to Seeking Alpha.
AEP's operating revenue miss can be attributed more to external factors than its failings. Throughout much of the company's service areas, the weather was more mild than anticipated. That led to lower demand for its electricity. This is what was behind the 4.7% drop in total vertically integrated utilities electric sales to 24.4 GWh in the quarter.
Moving to the bottom line, AEP's operating EPS surged 17.1% higher year-over-year to $1.23 for the fourth quarter. This was $0.03 less than the analyst operating EPS consensus of $1.26 per Seeking Alpha.
AEP's operating margin expanded by 310 basis points to 13.9% during the fourth quarter. That was due to disciplined operating expense management by the company.
Looking at full-year 2023, AEP's operating EPS rose by 3.1% over the year-ago period to $5.25. According to interim CEO Ben Fowke's opening remarks during the Q4 2023 Earnings Call, this was within the company's guidance range for 2023. That marked the 14th consecutive year that AEP came in within or above its guidance range. What makes this even more impressive is that it came despite $0.37 of weather headwinds and $0.45 of additional interest costs versus 2022.
For 2024, AEP's midpoint guidance of $5.63 ($5.53 to $5.73) would represent a 7.2% growth rate over 2023. Besides its track record of delivering results within or above guidance, this appears to be a reasonable forecast in my opinion.
That's because favorable rate cases in both its vertically integrated utilities and transmission and distribution utilities business are expected to contribute $0.71 of growth operating EPS. This makes up for a higher depreciation base stemming from AEP's growing rate base and higher interest costs from its increasing absolute debt load.
Over the next five years, AEP anticipates that it will spend $43 billion on capital projects. This is up $3 billion from the last time that I covered the company.
This increased spending has to do with rolling over from 2023 to 2027 to 2024 to 2028. As more capital spending opportunities become available, AEP's capital spending will likely keep growing larger in absolute terms each year. The company should have the funding for this capex spending plan as well. That's because $38 billion in forecasted operating cash flow will be able to fund nearly half of the spending plan. This includes refinancing $10.9 billion in long-term debt maturities and $3.4 billion in equity issuances. Additional debt issuances will bridge the funding gap.
The electric utility is projecting that its rate base could compound at 7.2% annually during its current five-year capital spending period. This could also support its 6% to 7% annual operating EPS growth target (all details in this subhead sourced from AEP's Q4 2023 Earnings Press Release and AEP's Q4 2023 Earnings Presentation).
As I noted in the opening, S&P downgraded the company's debt. This was because of both the higher spending forecast and a consolidated FFO-to-debt ratio of 12% in 2023. S&P stated that if the company can reliably maintain its FFO to debt above 13% and manage its regulatory risk, the negative outlook could be upgraded to stable (info according to S&P's AEP rating downgrade page linked in the intro).
Plenty More Dividend Growth Could Be Ahead
I believe that AEP's 6% dividend raise last October could set the tempo for dividend growth over the next few years.
This is because the electric utility's midpoint operating EPS guidance is $5.63. Against the $3.57 in dividends per share that I expect to be paid in 2024 (assuming a Q4 dividend per share of $0.93), that would be a 63.4% operating EPS payout ratio. This would be on the low end of the targeted operating EPS payout ratio of 60% to 70%, which leaves a sufficient cushion to support future dividend growth.
Risks To Consider
AEP remains a solid business but has risks that are especially worth monitoring in the quarters and years ahead.
One of the most noteworthy risks to the company right now is that it is on credit watch with S&P. According to CFO Chuck Zebula, AEP's FFO to debt metric should improve as 2024 unfolds. That could get S&P to upgrade the outlook from negative to stable.
If the company's FFO to debt metric doesn't improve as anticipated, its debt could be downgraded to BBB. That would hurt AEP's cost of capital and could put its $43 billion capital spending plan in jeopardy. This would also weigh on the electric utility's growth prospects.
Another risk to AEP that was behind S&P's credit downgrade is the recent wildfires in the Texas Panhandle. According to Xcel Energy (XEL), its facilities played a role in the ignition of the Smokehouse Creek fire. This event destroyed 47 occupied homes in Hemphill County and up to 17 occupied homes in Roberts County.
S&P points to these wildfires and believes that AEP must improve its wildfire mitigation efforts to avoid causing a catastrophic wildfire in the future. If such an event happened and AEP was found liable, damages sought and awarded could be into the billions of dollars. That would also harm the company's fundamentals.
Summary: Intriguing Medium-Term To Long-Term Total Return Potential
Despite its credit downgrade, AEP is still a fundamentally solid business. The company should be poised to grow operating EPS at a mid to high-single-digit rate annually.
Operating on the conservative assumption that AEP returns to its 20-year normal P/E ratio of 15.8 and grows as anticipated, 35% cumulative total returns could be possible through 2026. Such total return potential makes the electric utility attractive enough to be a buy in my view.
Kody's Dividends
Hi, my name is Kody. Aside from my articles here on Seeking Alpha, I am also a contributor to Dividend Kings and iREIT on Alpha. I have been investing since September 2017 and interested in dividend investing since about 2009.Since July 2018, I have ran Kody's Dividends. This is a blog that is documenting my journey towards financial independence using dividend growth investing as the means to transform the dream of financial independence into a reality. It's also the inspiration of my pseudonym here on Seeking Alpha.By God's grace, I owe everything to my blog for introducing me to the Seeking Alpha community as an analyst. That's my story and I hope you enjoy my work examining dividend growth stocks and the occasional growth stock!
Analyst’s Disclosure: I/we have a beneficial long position in the shares of AEP either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
