Utilities are often viewed as the type of stock that a conservative investor might own. Obviously, though, not all utilities are created equal, so even conservative types need to dig more deeply before picking one. AES Corporation (AES -1.27%) is most certainly not your typical boring utility -- but dividend investors willing to take on just a little more risk might actually find it, and its 4.6% yield, quite appealing. Here's what you need to know.
Going a little further
The type of utility that conservative dividend investors gravitate to owns regulated assets. In this framework, a utility is granted a monopoly in a service area in exchange for government regulation of the rates it can charge. That generally puts a cap on the growth that utilities can achieve, but also a sort of floor under the businesses, since they have locked in customers. Moreover, the regulated aspect means that spending plans, which are key to a utility's earnings and dividend growth, generally operate outside of the ups and downs on Wall Street. Deals with regulators are the bigger determinant of spending and growth. Only around 15% of AES's business is tied to utilities that might fall into this category.
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So, what's the rest of AES' business look like? It's what is often called merchant power, meaning the company owns generating assets and sells the power under contract to others. About 15% of the company's business is derived from short-term deals, with the remaining 70% coming from long-term power contracts. Selling electricity under long-term contracts is generally a pretty consistent business, and most large U.S. utilities do the same thing. It's just that the size relationship between merchant power and regulated utility is switched: AES's heavy reliance on contracts increases risk, since contracts can and do get broken.
Then there's another little wrinkle here. AES operates in 17 countries, with only about one-third of the business tied to its U.S. and utilities division. That's even an overstatement of the company's domestic exposure because the U.S. and utilities division also includes utilities in El Salvador and Puerto Rico. In other words, the vast majority of AES' business is foreign. The risks here have been highlighted by Argentina's decision to fall into default on some of the country's bonds (which is not the first time this has happened). AES operates in the country and was forced to take one-time charges in 2018 and 2019 related to the country's economic troubles. Based on the decision to default in early 2020 it looks like it may have to take additional charges this year, as well. At the end of the day, this is not the type of utility that a widow or orphan should own, but that doesn't mean it isn't a good investment option for the right kind of dividend investor.
Shifting for the future
What's so interesting about AES is that it's set to take advantage of a number of long-term trends. The first is globalization. It has exposure to a number of regions that are growing, most notably Central and South America. Together these two regions make up around half of the utility's business. As the countries in these regions move up the socioeconomic ladder, AES can grow with them. There will be inevitable ups and downs, but the long-term picture is for higher growth than what you'll likely find available in mature markets like the United States.
The next big trend that AES has been quick to jump on is renewable power. By 2024 it expects roughly half of its generating capacity to be tied to renewables. Right now it has signed agreements to build 5.3 gigawatts of renewable power capacity, of which about a third is currently under construction. Although COVID-19 has put some plans on hold, there's still a pretty clear backlog of work to support AES' long-term growth, and most of its construction is still moving forward as planned. But if the idea of investing in the global shift toward renewables with a focus on less developed markets sounds like a winner to you, then AES is a good way to do so.
Clearly, this isn't a risk-free approach. AES has increased its dividend every year for nine consecutive years at this point, including a hike in the first quarter of 2020. That's not bad -- but that streak doesn't match up to those of some of the traditional U.S. utilities, many of which have decades of regular hikes behind them. In fact, AES' streak basically traces its recovery from the deep 2007-to-2009 recession. A bad global downturn would likely stress AES' business much more than it would a domestic utility.
AES Financial Debt to Equity (Quarterly) data by YCharts
AES has also made more aggressive use of leverage than traditional utilities. Its roughly 1.9 times financial debt to equity ratio is well above those of most domestic utilities, including some that are in the middle of big spending sprees. The same trend holds true for the company's debt to EBITDA ratio, which has historically been at the high end within the utility group. This isn't necessarily a bad thing, but it does increase risk.
An acquired taste
When you step back and look at the big picture here, AES is not a great option for most investors looking at utilities. However, it provides exposure to growing markets and renewable power in a way that you won't get from a traditional conservative utility, and that might be attractive to more aggressive dividend investors looking to create a portfolio that reaches beyond the U.S.'s borders. If that sounds like you, then a deeper dive is in order.
