Regulated utilities can be an excellent high-yield source of income in retirement.

However, thanks to eight years of record low interest rates many of the best high dividend stocks (including utilities) are trading at unappealing valuations that can make for a higher degree of risk than many investors realize.

[ad#Google Adsense 336×280-IA]Let’s take a look at American Electric Power Company (AEP), which currently offers a 3.3% yield and potential 5% to 6% long-term dividend growth, to see if this high-yield utility has what it takes to make an appropriate investment for low risk investors in this time of historically high market valuations and rising interest rates.

Business Description
Founded in 1906 in Columbus, OH, American Electric Power Company is one of America’s largest electrical utilities.

Its 26 Gigawatts of power production capacity, 40,000 miles of power lines, and 224,000 miles of distribution lines serves 5.8 million customers in 11 states including Kentucky, Michigan, Texas, Oklahoma, Indiana, West Virginia, and Ohio.

Source: AEP

Over the decades AEP did dabble into non-regulated businesses, including wholesale merchant power plants and barge rentals; however, in recent years management has begun selling off such non-core assets in order to get back to its steadier, regulated roots. Over 70% of the company’s cash flow comes from regulated businesses today.

Source: AEP Earnings Release

Business Analysis
The reason that so many low risk investors like utilities is that they are the epitome of wide moat businesses. That’s because they are government sanctioned monopolies that enjoy very predictable cash flow, steady profitability and returns on capital, and are able to raise plenty of cheap debt capital to help them grow.

Source: Simply Safe Dividends

Note that the apparent decline of profitability in 2016 is an artifact resulting from two large one-time charges. The first is a legal settlement, and the second is the restructuring costs associated with the sale of the utility’s commercial barge subsidiary. Neither issue should affect AEP’s long-term earnings power.

The key to AEP’s growth in revenue, earnings, and cash flow is to increase its rate base over time. As you can see, the company is growing its regulated transmission businesses the most over the next few years.

Source: AEP Investor Presentation

AEP expects to enjoy strong rate base growth in the coming years thanks to its good relationships with regulators, who are willing to allow it medium to high returns on equity (ROE) in exchange for investing in much needed infrastructure growth.

Source: AEP Investor Presentation

This is especially true for its various electrical transmission businesses, which are benefiting from a need to improve aging infrastructure as well as connect fast growing solar and wind power to the grid. For example, management is currently requesting regulatory approval to increase its permitted ROE for Southwestern Electric Power Company (SWEPCO) from 7.2% to 10.0%, which would translate to a 12% rate increase.

And as environmental regulations have become more stringent over time, regulators have proven willing to allow the company generous returns in exchange for improving its emission profile, specifically shifting from dirtier coal to cleaner burning natural gas and renewable power.

Source: AEP Investor Presentation

AEP plans to take advantage of these favorable regulatory conditions and invest $17.3 billion into highly profitable opportunities in the coming years, especially projects that connect America’s booming renewable power generation capacity to the grid.

In fact, AEP plans to invest $3 billion a year into its most profitable transmission and distribution businesses, which are regulated and make for very attractive and steady cash flow. Analysts expect this business to grow at a 17% annual rate over the next five years, according to Morningstar.

Source: AEP Investor Presentation

In the meantime, the company plans to continue to sell off non-core (i.e. non-regulated) businesses such as competitive power plants (which have far lower profitability), including the $2.2 billion sale of four plants in Ohio. This is because in Ohio deregulated its electricity generation market in 2001, forcing utilities such as AEP and Duke Energy (DUK) to compete with smaller merchant power producers.

While this saved customers an estimated $3 billion a year between 2011 and 2016, it also made it harder for big utilities such as AEP to compete with newer rivals. That’s due to the fact that AEP has a large number of older, legacy power plants, mostly running on coal.

The cost of complying with more stringent emission regulations, combined with the a glut of cleaner natural gas (courtesy of the Shale fracking revolution) has resulted in AEP and other Ohio utilities such as FirstEnergy (FE) to lobby for a re-regulation of the state’s electricity market, which state legislators are now considering.

However, regardless of how that particular issue plays out, AEP is confident that its long-term growth plan should allow it to increase its operating earnings per share by around 5% to 7% in the coming years which should be great news for dividend investors.

Source: AEP Investor Presentation

Key Risks
While utilities are generally lower risk investments, nonetheless there are several things to keep in mind before investing in AEP.

The first is regulatory risk, meaning that political and legal decisions can materially affect the company’s business. For example, in April of 2016 the Federal Energy Regulatory Commission (FERC) blocked Ohio’s use of subsidies to AEP’s aging power plants, which was part of its deregulatory plan. This forced the utility to write off the majority of the value of these plants and sell them to recycle the capital into its more profitable regulated transmission and distribution businesses.

While it’s true that AEP’s geographic diversification means that no single regulatory regime can affect its cash flows that much, the company’s struggles in Ohio shows that even the regulated utility industry isn’t without its challenges.

[ad#Google Adsense 336×280-IA]One of those challenges is the fact that, despite a big push into renewable energy, a large portion of AEP’s power generation fleet uses dirtier energy sources.

In fact, coal makes up 47% of its power production today, and even in the future that is expected to only decline to 33%.

Current environmental regulations are expected to cost the company $4 billion to $5 billion through 2021 to retrofit those plants.

In addition, future changes, such as a proposed carbon tax, could significantly ding the utilities profit growth potential.

And we can’t forget that the uncertainty around tax reform could have a large negative impact on U.S. utilities, which currently benefit from the ability to deduct interest expenses, thus lowering their taxable income.

Should tax reform do away with this deduction than AEP stands to see a potentially large short-term dip in its earnings. However, it’s far too early to make any assumptions about tax reform.

Finally, we can’t forget that like all capital intensive industries, as well as high-yield sectors, utilities can be highly sensitive to interest rates, due to their large debt loads that need to be refinanced as debt matures. For example, AEP has $7.2 billion in debt maturing over the next five years. Thus, even a relatively small increase in rates, 2.25% by the Federal Reserve’s latest guidance, could result in nearly a 20% increase in annual interest costs.

AEPs Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

AEP’s Dividend Safety Score of 70 indicates that it’s payout is likely highly secure and dependable.

That’s not surprising given that AEP has paid an uninterrupted quarterly dividend for the past 100+ years. And as you can see, the utility has a strong track record of growing its dividend at a very steady rate over the past decade.

Note that the dividend cut in 2003 and 2004 was due to the company selling off the majority of its unregulated merchant power business. Today AEP derives 75% of its cash flow from regulated businesses and is working on becoming a pure-play regulated utility.

Source: Simply Safe Dividends

The key to AEP’s dividend safety is twofold. First, except for 2016’s artificially high EPS payout ratio (due to those one-time charges previously discussed), management has remained highly disciplined in ensuring that the payout is very well covered by earnings. That’s one reason why AEP’s dividend remained safe even during the great recession.

Then there’s the company’s disciplined approach to debt. At first glance you may not think that’s the case, given the utility’s high absolute amount of leverage, including almost $21 billion in total debt.

While it’s true that even for a utility AEP’s balance sheet is highly leveraged, with a higher than average Debt / EBITDA ratio, keep in mind that its relative debt levels have actually been declining over time.

AEP Debt/Capital over time

Combined with a recession-resistant business model (consumers and businesses still need electricity when times get tough) and highly predictable recurring cash flow, this explains why AEP continues to enjoy strong and stable investment grade credit ratings that help ensure AEP and its subsidiaries will continue to enjoy plentiful access to affordable growth capital.

Source: AEP Investor Presentation

Overall, AEP’s dividend appears to be quite safe thanks to the company’s reasonable payout ratio (65% based on 2017 earnings estimates), regulatory-driven cash flow, investment-grade credit rating, and management’s generally low-risk capital allocation plan.

AEP’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

AEP’s Dividend Growth Score is 14, indicating below average dividend growth potential. That’s mostly do to two factors. First, prior to AEP refocusing itself purely on its regulatory business, its dividend didn’t grow much (although it was consistent). In addition, thanks to its 2003-2004 payout cut, AEP’s 20-year dividend growth record is poor.

That being said, over the past 13 years AEP’s dividend growth has been far more impressive. Perhaps not equal to the 5.8% 20-year median growth rate of the S&P 500, but still among the higher growth rates in the regulated utility industry.

Given management’s long-term growth plans, which should allow for long-term (i.e. 10-year) EPS growth of around 5% to 6% per year, income investors can probably expect this more recent payout growth trend in the mid-single-digits to continue.

Valuation
In the past year, AEP’s stock has been a very strong performer. However, while good for existing shareholders, this also means that today’s valuation appears to be a bit high.

For example, AEP’s forward P/E ratio of 19.5 is significantly higher than the S&P 500’s forward P/E ratio of 17.3, the median utility’s 17.3, and its own historical median P/E of 15.1.

In addition, AEP’s dividend yield of 3.3%, while better than the S&P 500’s 1.9%, is far below AEP’s historical norm of 4.1%.

In other words, while investors might expect around 8.3% to 9.3% total returns in the coming years (3.3% yield + 5% to 6% dividend growth), AEP shares appear to be trading a bit richly at the moment.

A stock price near $60 per share (from $72 today) would put AEP’s dividend yield and P/E ratio closer to their historical norms.

Concluding Thoughts on AEP
Regulated utilities often make excellent core holdings for a conservative retiree portfolio. That being said, valuation still matters and though AEP has impressive long-term growth potential, the seemingly high current valuation means that investors are better served waiting for a correction before adding AEP to their own diversified dividend growth portfolios.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends