Over the past few weeks, I’ve discussed all the utilities I love except for two. One of them is NextEra Energy (NEE), the other is American Electric Power (NASDAQ: AEP), the star of this article. The Columbus, Ohio-based electric utility giant is posting a 3.3% return after adding about 8% in capital gains year-to-date. Like its peers, the stock is in the midst of a transition to clean energy sources, which will require tens of billions in the coming years. However, the company should accelerate earnings growth and provide investors with a satisfying return and decent dividend growth. It’s one of those stocks that lets you sleep well at night, and the only reason I don’t own it anymore is because I bought competitors a few years ago. I want to come back, and in this article I will tell you why.
Whenever I recommend high yield investments, I stress the need to buy something that also comes with expected capital gains. It’s not just because I don’t expect to retire for at least a few decades, but because I don’t want readers to buy stocks that pay high returns but come with high risks of loss. in capital. For example, some mortgage REITs, small and volatile energy stocks, or risky consumer stocks and REITs, in general.
The same goes for utilities. I just want people to buy high quality utilities that also offer good performance.
The utilities I’ve covered so far are:
Stocks I haven’t covered recently are:
The graph below shows the equal weight performance of the five utilities I just mentioned. They are rebalanced annually and dividends are reinvested. The combination of utilities above shows strong long-term outperformance versus the Utilities ETF (XLU), which is very important to me. The market correlation is lower, the Sharpe ratio is higher and the maximum drawdown is “only” 33%. These 5 investments have generated annual returns of 10.4%, which is truly remarkable. I did not expect this before testing it.
That’s what I call “quality” performance.
AEP has significantly outperformed the XLU ETF over the past 10 years, including dividends. Moreover, it has come close to the performance of the S&P 500 as it only lags 600 basis points.
Additionally, the yield is above the XLU yield and about 190 basis points above the S&P 500 yield. The yield delta is slightly above the 10-year average.
Now the question is: will it last?
To answer that, we have to take a look under the hood.
AEP’s growth is impressive
American Electric Power has a market capitalization of $48.5 billion. The company employs 16,700 people, serves 5.5 million customers in 11 states and has nearly $90 billion in assets.
The company aims to deliver a 9-10% return to shareholders, which rules out a higher share price valuation as it is based on 3% dividends and 6-7% annual dividend growth . In the past, the company has achieved these returns. Going forward, management expects more opportunities in renewable energy.
In 1999, AEP produced 66% of its energy from coal. Back then, the world was different. The railroads made a lot of money on coal shipments, and environmental standards were much looser. Now we’re in a situation where the “world” has agreed on net zero by 2050, which means companies need to aggressively reduce pollution – whether we like it or not. In the case of AEP, management made the decision to focus on hydro, wind and solar. By 2030, this is expected to represent 53% of the total energy supply. On top of that, coal and natural gas will remain essential, which I think is a good strategy because an energy transition that is going too fast is hurting consumers – Germany is currently an infamous example of how to not getting rid of “pollution”.
Either way, this means that the company will increase its capital expenditure. Between 2022 and 2026, it will spend nearly $38 billion. Renewable energy will use 21%. 65% will be allocated to wires, that is, to the maintenance and extension of the company’s network.
The graph below shows some financial indicators: AEP’s capital expenditure (“CapEx”), operating cash flow (“OCF”) and net debt. 99% of the dividend stocks I cover have an OCF well above CapEx, allowing them to distribute dividends, which utilities cannot.
AEP has increased its CapEx from $4.8 billion in 2016 to over $7.6 billion in 2022 (expected). In 2024, this figure could be 8.2 billion dollars. It makes sense, and it follows on from the capital budget that I just mentioned briefly. The problem is that the OCF does not cover these investments, which leads to a large increase in net debt. In 2016, net debt was $21.4 billion. In 2024, we are looking at net debt of $43.8 billion. That’s over 100% in 9 years (or 8.2% CAGR).
However, do not worry because the business generates value. These capital investments are by no means wasted. They add assets to the asset side of the balance sheet, generating outperformance over liabilities (including net debt).
While net debt has grown from $18.8 billion in 2012 to $36.5 billion in 2021, total equity (total assets minus liabilities) has grown from $15.2 billion to $22.7 billion. billions of dollars. I’ve also added the net debt to EBITDA ratio to the chart below, unfortunately it’s barely visible and just a number on the x-axis. What we see is that the net leverage ratio peaked in 2019. Since then, EBITDA growth has also exceeded net debt growth.
As a result, the company has a Baa2 rating from Moody’s, a BBB+ rating from S&P and a BBB rating from Fitch, which is just one notch below A- and lower-medium grade debt.
In 2023, AEP’s net income is expected to grow 7.7%, followed by 8.7% growth in 2024. In this case, analysts agree the company can and will drive earnings growth.
Note that EPS also outperforms stock dilution. In 2017, the company had 491.8 million shares outstanding. At the end of 2021, this number was 500.5 million. That’s a CAGR of just 0.4%. It’s the lowest number I’ve seen this year – among utilities – which is good news because low stock dilution means earnings growth has a bigger impact on existing shareholders.
AEP’s dividend scorecard is excellent. Dividend consistency is A, dividend safety is B+, dividend growth is also a B. Dividend growth is a C+, which I disagree with.
According to the company, it has paid 111 consecutive years of quarterly dividends. Between 2010 and 2015, dividend growth was 5% per year. Now it is close to 6% with an increase to 7%.
Given the expected earnings growth, this is entirely possible. It is also a rather juicy return for a title that is already yielding 3.3%. 3.3% with a growth of 6% per year translates into a return on cost of 5.9% within 10 years. Until then, investors are likely sitting on plenty of gains, as AEP is not a stock that will return 5.9% anytime soon – unless the broader market implodes for some reason. And even then, it’s unlikely.
As for valuation, we are dealing with a market capitalization of $48.5 billion. Net debt is expected to be $40.3 billion in 2023. Pension liabilities and related liabilities are only $330 million. All of this gives us an enterprise value of $89 billion.
Next year, AEP is expected to achieve $7.3 billion in EBITDA, which gives us a multiple of 12.2x. It’s not overvalued, and it’s not a deep value either.
This is a decent price for anyone looking to buy a decent dividend yield. However, I have also added the ratio of utilities to basic materials stocks (XLB) in the lower half of the chart below. The ratio between these two sectors is very handy as it shows the sentiment of the investors. In times of rising inflation, XLU underperforms. When economic growth peaks, XLU outperforms. Note that the valuation of AEP increases during uptrends. Currently, XLU is somewhat “weak” compared to XLB due to high inflation. At times like these, it makes more sense to buy boring yield games like AEP.
That said, here is my…
American Electric Power is one of my top five electric utilities in the United States. The stock strikes a near-perfect balance between yield and industry growth. It has a decent dividend yield >3% and annual dividend growth of 6-7%. Additionally, investors are not subject to significant equity dilution as the bulk of AEP’s funding comes from debt. The company is accelerating its investments in renewable energy and generating a tone of value along the way. Total equity is steadily increasing while earnings growth is improving.
The valuation is correct and its balance sheet is healthy.
I think AEP is a good choice for dividend growth investors looking to add quality yield as well as income-oriented investors who don’t want to miss out on potential capital gains. After all, if history is any indication, AEP will outperform its peers in XLU and stay close to the performance of the S&P 500.
(Disagree? Let me know in the comments!