American Electric Shapes up Its Risk Profile

Investor confidence hinges on American Electric getting a long-term pricing agreement.

Jul 7, 2014 at 2:09PM

Utility companies in the US offer attractive dividend yields, which is why they remain attractive investment options for dividend-seeking investors. American Electric Power Company (NYSE:AEP) is among the leading utility companies with exposure to both regulated and unregulated business operations; the company offers a dividend yield of 3.7%.

American Electric has been undertaking initiatives that include increasing its regulated capital investment and lowering the volatility of its unregulated business earnings to stabilize its cash flows and earnings. Duke Energy (NYSE:DUK) and Exelon (NYSE:EXC), two other utility companies, are also working to increase their exposure to regulated business operations in attempts to stabilize their earnings and cash flows.

A robust capital spending profile
As the unregulated power market remains volatile because of fluctuations in forward power prices, the company plans to increase its exposure to the regulated market through robust capital investment. American Electric has an impressive capital spending profile for the next three years, which will provide it with earnings growth and stability.

The company plans to make capital investments of almost $11.5 billion from 2014-2016. It will allocate 95% of the planned capital investment to regulated operations, with $2.8 billion allocated to regulated generation, $3.3 billion to regulated distribution, and $4.7 billion to regulated transmission. This is consistent with the company's efforts to increase its regulated business operations in an attempt to stabilize its cash flows and earnings.

The capital investment planned by the company will result in regulated rate base growth of $10.8 billion by 2016, which augurs well for the company's growth rate; the company targets a long-term growth rate of 4%-6%. Also, the company expects the earnings contribution from its transmission business segment to increase from $0.16 per share in 2013 to $0.67 per share by 2018 as a result of capital investment in the transmission business.

Similarly to American Electric, Exelon is also undertaking initiatives to increase its regulated business exposure, as its margins and cash flows in the recent past were challenged by weak commodity and power prices. Exelon has proposed the acquisition of Pepco for $6.8 billion in an all-cash transaction; it will finance 50% of the acquisition with debt and the remainder with equity issuance and the sale of non-core assets.

Once Exelon completes the acquisition, the earnings contribution from regulated operations will increase from its existing level of 55%-60% to 60%-65%. The increase in regulated operations for Exelon will result in higher revenue, earnings, and cash flow certainty. Also, Exelon's risk profile will improve with an increase in regulated business exposure.

Achieving earnings stability
Aside from increasing its capital investments, American Electric also intends to optimize its unregulated business operations in an attempt to achieve earnings stability. The company is seeking a long-term pricing agreement for its unregulated operations in which its rates will be connected to the operational cost of the unregulated generational fleet plus margin payment.

The long-term pricing agreement will reduce earnings and cash flow fluctuation for American Electric and stabilize its unregulated operations. If the company fails to obtain a long-term pricing contract or achieve the desired results, it could consider the sale of its unregulated assets. Therefore, the company remains committed to bringing stability to its operations.

Duke Energy also has exposure to unregulated operations, from which its earnings remain weak and volatile. Duke has decided to sell its unregulated assets in the Midwest and exit from the unregulated power market. Consistent with its plans to exit from the unregulated market, the company registered an impairment charge of $1.4 billion in the first quarter of 2014.

Duke is expected to generate $2.1 billion through asset sales. Bidding for the assets is expected to be completed in 2014, and a deal is expected to be closed in the first half of 2015. The company will use the proceeds from the sale of assets to pay off debt or repurchase its shares, which augurs well for its EPS growth in the future.

Final take
American Electric has been taking the right measures to improve its business performance and risk profile. The company's robust capital investment outlook for the next three years will result in rate base and earnings growth in upcoming years. Also, the company's efforts to get a long-term pricing agreement and its possible sale of unregulated assets will increase its value and investor confidence. 

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Furqan Asad Suhail has no position in any stocks mentioned. The Motley Fool recommends Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Keeping it simple.

Aug 7, 2015 at 11:26AM

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