American Electric Power (AEP) is one of the oldest and largest US electric utilities. Based in Ohio, AEP began serving customers over 100 years ago and grew steadily and responsibly until the mid 1990s when it embarked on a poorly executed and very expensive acquisition binge. This binge included the purchase of several large Texas and Colorado electric utilities, a UK retail operation, an Australian utility, two huge merchant coal stations in the UK, two gas pipelines and a related gas storage facility in Texas, and off balance sheet debt guarantees. It culminated in an Enron-style energy trading fiasco and liquidity crisis in the fall of 2002.
The opportunity in AEP is that underneath all the craziness sit three very valuable and highly profitable assets: (1) a set of integrated, regulated utilities, (2) a large regulated transmission and distribution network, and (3) the largest and lowest cost generating fleet in the United States (predominately coal with some nuclear power). These core assets should conservatively earn $2.82 per share in 2006 and could exceed $3.10 per share with a few breaks. Because of the regulated nature of the integrated utilities and the transmission and distribution network and the unassailable cost advantage of the generating assets, this core earning power is sustainable even in a world of continuing deregulation. The stock currently pays a $1.40 per share dividend that could comfortably be increased up to $1.90 per share in 2006 assuming $2.90 per share in earnings.
The stock trades for $27.50 with a 5.1% dividend yield and a P/E of 12 based on current street estimates of $2.28 per share in 2003 and $2.29 per share in 2004.
The Misunderstanding (aka Catalysts)
There are several things masking AEP’s earnings power today.
1) An expense reduction program that is on-track and targeted to achieve $200mm in annual operations and maintenance cost savings net of increases in health care, benefits and pension costs was implemented in Q1 of this year and hasn’t fully manifested.
2) The Texas utilities acquisitions had obsolete generating stations and a troublesome jointly owned nuclear plant which are break-even at best for AEP. AEP is in the middle of a complex regulatory process to sell these generating assets and recover stranded costs (the difference between book value and market value of assets). The first phase of this process began in 1999 and was concluded successfully. The second and larger phase should be complete by mid 2005. No one on the street really understands this regulatory process and focuses on the impending loss (Q4 2003) of the first phase benefits which amount to approximately $200mm per year in pre-tax earnings. If successful (given the success of phase I, success is likely), this stranded cost true-up should produce at least $1.4 billion in cash.
3) AEP’s merchant assets, in particular the two UK merchant coal plants and the Texas gas pipelines have produced negative $0.37 per share earnings in 2002 and are on track to produce negative $0.33 per share in 2003. This loss will disappear entirely by 2006 and the sale of these assets should produce at least $1 billion in cash after repayment of off balance sheet debt.
4) AEP’s efficient coal and nuclear generating fleet produce significant excess power above what is needed to service regulated utility customers. This power is available to be sold to the grid as pure pre-tax profit. The strength of this earnings driver was masked over the last two years by very low natural gas prices which now determine the spot price of power due to the proliferation of natural gas cogeneration plants. Current natural gas prices of $5.00/mmbtu are twice the level of 2002 and should remain above $4.25/mmbtu for the foreseeable future. This pricing umbrella coupled with much higher availability of the 2,000 MW Cook Nuclear plant which was down for repairs during much of 2001, 2002 and Q2 of 2003 will boost pre-tax earnings by over $100mm from 2002 levels.
5) Interest payments on AEP’s debt which stood at over $14.5 billion ($13.2 on balance sheet, $1.3 off) at the end of 2002 will be reduced significantly when debt falls to less than $9.5 billion near the end of 2005.
6) Valuations on utilities are driven by an income substitution effect. A no-growth utility typically pays out 75%-80% of its earnings as a dividend. Historically when interest rates were over 6% this would have implied a PE of 12.5 (6% / 75% = 8% earnings yield = 12.5 PE) which matches up pretty well with the observed range of 11 to 14. With 10 year interest rates at 4.5%, the indifference point on a PE multiple basis should be closer to a 16 PE once income investors get comfortable with the quality names in this sector. This PE adjustment is exclusive of the current dividend tax break which makes utilities even more attractive relative to bonds.
Summary Financials (base case) – more detailed financials avaialable
My base case assumptions are for (1) no revenue growth in the regulated utilities and system sales coupled with a total loss of Texas generating revenues by 2006, (2) no free cash flow to pay down debt, (3) debt pay down only through asset sales and equity-linked security conversion (4) no future operational cost savings other than those being implemented this year and those associated with the sale of Texas generating assets.
The assumptions in the base case analysis are highly conservative given that the company is on track to generate $130 million in free cash flow during 2003 which will grow in successive years even after the CAPX required for environmental retrofits on the coal plants. The assumptions are also highly conservative given that AEP’s utility revenues have continued to grow even during the recession despite the loss of a significant amount of industrial demand. Even in my low case estimates, which assume declining utility revenues, increasing operations and maintenance costs and no asset sales, the company still earns $2.25 per share in 2006 (declining from prior years) and can comfortably support its current $1.40 per share dividend.
For the conservative income-oriented investor a buy-and-hold strategy to capture the 5.1% current dividend with a target price of $37 (13 PE on base case earnings) in January 2006 produces an 18% annual return including dividends with upside potential from increased dividend payout and better potential earnings.
For the aggressive investor, this investment is ideal for an option reversal executed by writing Jan 2006 puts with a 25 strike and buying Jan 2006 calls with either a 25 or a 30 strike. Depending on the calls selected trade can be executed cashlessly and have multiple exposure on the upside for the put exposure on the downside. Given an almost inconceivable alignment of bad outcomes, the low scenario above still produces a stock price target of $25 in January 2006 which protects the put position.