On the surface, American Electric Power Company, Inc. (NASDAQ:AEP) is a pretty simple business to understand -- it generates and distributes electricity. But when you dig under the surface a little, you start to see that its business has changed materially in recent years. More important, AEP is now positioned to take advantage of industry shifts taking place in the power sector. Here's how AEP makes most of its money and why its prospects for slow and steady growth are so strong.

The breakdown

AEP's main business is its collection of vertically integrated utilities, which make up around 65% of its rate base. Transmission and distribution utilities make up around 25% of the rate base, and the company's AEP Transmission Holding Company accounts for the remainder. Overall, AEP serves 5.4 million customers across 11 states. It owns 26 gigawatts of power generation assets. And it has 40,000 miles' worth of transmission lines. It's a huge electric utility.   

A man in a hard hat standing with wind turbines in the background

Image source: Getty Images.

It's also made material changes in recent years to adjust to shifts taking place in the industry. For example, coal made up 70% of its power capacity in 2005 but sits at around 50% today. The goal is to keep pushing its share down to roughly 33%. Offsetting that drop was an increase in the company's use of natural gas and a huge leap in AEP's renewable power base, which more than tripled from a scant 4% to 13% over that time span. The long-term goal is to increase renewables like solar and wind to 33% of generation.   

This shift has also included the sale of assets that no longer fit with the company's long-term plans. For example, it recently jettisoned competitive power assets in Ohio, including one powered by coal. The news release from the company made a point of highlighting that the proceeds from the sale would be used to invest in regulated assets, notably transmission and renewable power.   

The opportunity ahead

AEP's shifting portfolio is projected to fuel 5% to 7% annual earnings growth through 2020. Dividends are expected to grow roughly in line with earnings. Backing these numbers is an $18 billion capital spending plan that will unfold over the next three years. All of that spending is going to be on regulated or long-term contracted renewable assets, with 72% scheduled for transmission.   

Renewables are a key expansion opportunity as the utility industry shifts toward cleaner power generation. Such projects also tend to be relatively low-risk because the power is sold under long-term contracts. And the runway here is huge, with AEP's plans calling for 5.3 gigawatts of wind and 3.1 gigawatts of solar construction through 2030. It has renewable power construction plans set for every single year over that span, which should provide growth opportunities well beyond the current capital budgeting plans.   

A timeline showing that AEP has plans to build solar and/or wind power facilities every year through 2030.

AEP has big plans for solar and wind. Image source: American Electric Power Company, Inc.

The focus on transmission, meanwhile, is keying in on a couple of important trends. First, these assets help to move power from where it is generated to where it gets used. That's increasingly valuable since solar and wind facilities are often located great distances from where the power they generate is most needed. Second, regulators are currently very open to transmission spending.

This is notable because much of AEP's business is regulated. That means it needs to get its rates approved by the government, the trade-off for being awarded a utility monopoly. The best way for a utility to get rate increases approved is to spend money on its assets. Clearly AEP is doing that. However, with issues like grid modernization and storm hardening becoming increasingly important, AEP's focus on transmission should position it well with its regulators and supports its earnings and dividend targets.

Still a work in progress

American Electric Power has made great strides as it shifts its business along with the changing utility market. While a lot of the capital intensive projects already been completed, there's still a lot of expensive work to be done. That's good news at this point, because much the spending will be on capital projects in the regulated and renewable spaces. That, in turn, should help AEP get rate hikes approved and increase its scale in the growing clean-energy segment of the industry.

On the surface, AEP makes its money by moving and selling electricity -- but there's a little bit more to the story that you need to know if you are interested in buying the stock. With the background you now have, however, you can do a deep dive into the financials to see if AEP is worth the price of admission.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.