American Electric Power Needs Some Ideas

 | Jul 29, 2013 | 6:45 PM EDT
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American Electric Power (AEP) is not going anywhere. With a market capitalization of $22.6 billion and an enterprise value of over $41 billion, AEP is the nation's sixth-largest investor-owned utility. It has strong and sustainable earnings. Its dividend is 4.2%, it has a healthy payout ratio of 78.7%, and it trades at a less-than-stratospheric price-to-earnings ratio of 18.8.

That is the crux of the company's problem: AEP is not going anywhere. This is an old utility with old ideas. Its management team seems transactional, and it seems to lack a strategy.

AEP's competitors are brushing off the past, and some are developing unique and forward-thinking strategies. Some strategies are interesting. Others are risk-averse. Still others are uncharacteristically risky.

Here is a sample of a few. Duke Energy (DUK) has a strategy of owning vertically integrated and state-regulated assets. Southern Company (SO) has the strategy of building massively large nuclear power plants with government guarantees. NextEra Energy (NEE) is building the nation's largest fleet of wind and solar power facilities. Dominion Resources (D) is exiting deregulated markets and building regulated assets to support power and natural gas infrastructure. Exelon (EXC) owns the nation's largest fleet of unregulated nuclear plants.

AEP's strategy is to do all of the above.

Unlike its competitors, AEP owns one incredibly valuable asset: its system of interstate transmission lines. The company owns almost 25,000 miles of high-voltage transmission lines. These lines are operating in interstate commerce, and, as such, they are economically regulated by the Federal Energy Regulatory Commission (FERC). Under FERC, rates are determined on a cost-plus basis. AEP cannot lose.

It also cannot lose on its investments in distribution lines. Like its competitors, AEP owns local distribution company subsidiaries, which are economically regulated by individual state utility commissions. AEP owns nine separate local distribution companies that have over 225,000 miles of distribution equipment in 11 states. While state utility commissions also provide distribution companies with cost-plus rates, they are less predictable. In addition, as Duke and Pepco Holdings (POM) can attest, states can be fickle with it comes to cost recovery. Nevertheless, the local distribution business is low-risk enterprise.

AEP's power plants are another story. When states such as Ohio restructured, AEP could have jettisoned its high-cost power plants. Instead, AEP tries to keep legacy plants, even if those plants struggle to provide earnings.

Of course, some of AEP's service areas remain fully regulated. Power plants operating in those regions are an integral part of the state's rate base.

Here is the big picture. According to AEP's 10-Q filed last week, AEP owns and operates about 37,600-megawatts of power plant assets spread over 10 states. Some assets are more than 100 years old. Almost 30% of its capacity is 50 years old or older, and 55% is almost 40 years old or older.

Over 80% of AEP's fleet is composed of steam plants (two are nuclear). Steam plants are by definition traditional plants. Very few of those plants are competitive. In fact, system wide, the average AEP power plant operates less than 50% of the time.

The important point for investors is AEP's competitive advantage. These assets are largely uncompetitive. Management can blame regulatory uncertainty and the EPA all it wants, but AEP's generating assets are largely uncompetitive.

More important, on a mark-to-market basis, these plants appear to have little value. The evidence is in the company's 10-Q. AEP reported its intention to retire, not sell, 6,033 megawatts worth of coal units. In that report, AEP also claimed that, "the net book value of [those] units is zero."

Looking at AEP's balance sheet, we see a book value for all of its plants of $26.183 billion, or about $696,500 per megawatt. AEP's book value of $26.2 billion for its generating assets is unrealistic. There could be some write-downs in the future.

They may come sooner than expected. AEP may be forced to retire more plants than it is announcing presently. While the company may use regulatory arguments or blame EPA, the current challenge will be economics. Many of their plants cannot compete in their regional markets.

Finally, AEP needs a bold plan. it might consider shedding non-core assets. Its river operations are a distraction. Unregulated power plants are another.

Many analysts like AEP. Their reasoning is usually solid. However, if you want to invest in a company that has a niche or a clear future, AEP may not be your first choice.

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