American Electric Power Company, Inc.

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

American Electric Power (AEP) is a major, regulated electricity provider, transmitting and distributing power across various states, focusing on reliable delivery of electricity and investing heavily into its future.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

AEP’s core business is vertically integrated utilities – Generation, Transmission and Distribution, meaning they generate power, transport it over transmission lines and deliver it to homes and businesses.

  • Revenue Distribution: AEP’s business is divided into several segments, including Vertically Integrated Utilities, Transmission and Distribution Utilities, AEP Texas, and Generation & Marketing.
    • Vertically Integrated Utilities: This segment is responsible for generating electricity and delivering it to end-use customers.
    • Transmission and Distribution Utilities: These units focus on transmitting high-voltage electricity and distributing it to local grids.
    • AEP Texas: A fully-regulated utility focused on delivering electricity in Texas.
    • Generation & Marketing: This division is responsible for power generation, including traditional resources and renewables, and provides wholesale energy trading services.
  • Industry Trends:
    • Demand Growth: Electricity demand has been slowly growing, and is now more dependent on electrification. AEP can capture growth in electricity usage, but increased home generation also adds competition.
    • Shift to Renewables: Increasing need for renewable sources of energy are driving a trend for more investments in renewables. Companies, such as AEP, must balance renewable investment with current infrastructure and regulatory structure. AEP is increasing its renewable generation capacity and moving away from coal.
    • Government Regulation: The industry is heavily regulated, which affects returns and investment strategy. These regulators influence how companies invest in new infrastructure and how they set the prices to deliver electricity. Regulation can change and cause volatility and uncertainty.
  • Margins and Competitiveness:
    • AEP enjoys a natural monopoly in its service areas, which gives it some pricing power. However, it is regulated, and the regulators limit how much profit a utility is allowed to earn. Profit margins are fairly predictable and steady, but are usually lower than those of companies that operate in non-regulated industries.
    • The regulatory structure and regional focus do limit competition. Large utility providers like AEP tend to compete with each other based on factors like service quality and reliability, rather than just price. Competitiveness on the margin varies significantly based on the regulators in the states of operations.
    • Large players, due to their extensive networks and size, enjoy economies of scale. AEP also has a higher percentage of non-regulated business than its peers, due to its exposure to renewable and energy management operations.
  • Company Differentiation:
    • AEP’s large, interconnected, and diverse transmission and distribution network is a moat on its own. This network offers a level of reliability and security to the grid in its operations and makes competition more difficult for new entrants to replicate.
    • AEP is actively expanding in renewable energy, both through organic generation and contracts with developers. A large, geographically diverse, portfolio of renewable projects, like the acquisition of Suncadia power station in 2022, provides them with a more future-proof and versatile operating system.
    • AEP has created a regulated power portfolio that is geographically diverse. However, its exposure to certain regulatory domains (such as Texas) still introduces concentrated risks.
  • Other relevant information:
    • While traditionally, AEP has derived most of its revenues from generation, transmission and distribution of electricity, it has been recently transitioning its portfolio toward renewable sources of energy.

The company’s financial health is decent, but there are some issues that are making its profile a little worse.

*  **Revenues**: AEP's revenue generation is very steady. The last few years, total revenues have ranged from \$17 to \$19 Billion, with a 9 month revenue for 2023 at \$13.5 Billion, an increase of 2.8% year-on-year.
*  **Profitability**: Profitability for AEP has been volatile, going from a profit of \$2.4 Billion in 2021 to a loss of \$0.6 Billion in 2022, followed by a small profit of \$0.2 Billion so far in 2023. ROIC has seen a gradual decline, from about 13 percent in 2004 to about 7 percent in 2022. A big portion of this change was driven by acquisitions and impairments in 2022. The 2023 performance is similar to the 2022 performance, with the profitabilty still fluctuating greatly between quarters.    *  **Cash Flow**: Cash flow from operations for 2023 seems to be better than in previous years, going from a low of $2.2 Billion (2022), to a high of $5.1 billion (YTD in 2023). Free cash flow, however, has been mostly negative in the 2020s.    *  **Debt and Liquidity**: The company has a high amount of debt, with debt to equity being about 120%. The current ratio is below 1 as well, meaning the company may have difficulty meeting short term debts. Cash on the balance sheet is relatively low, which may become a problem. However, management has stated they are committed to maintain liquidity.    * **Capital Expenditures**: AEP has large amounts of capital expenditures, especially into new and upgrade electricity transmission systems, as well as expansion of their renewable generation capacity. This capex can generate good future value, but is a big pressure on the cash flow in short term, especially with a company already high in debt.

AEP faces several significant risks to its business and its moat. Most importantly, regulatory uncertainty in the different states it operates in can lead to changes in its prices and return on invested capital. Additionally, severe weather conditions and an increase in operating costs or fuel costs can significantly lower AEP’s profitability. In particular, they are having issues with natural gas contracts which are making the profits fluctuate a lot. As a vertically integrated company, these also make a company susceptible to losses across the entire portfolio, from generation to delivery to the customer. A transition into a renewable energy portfolio may take a long time, and in the middle, some of AEPs plants will be seen as redundant, meaning they will have to take a loss on those plants. A potential reduction in demand by customers may also affect profits.

The business is somewhat difficult to fully understand due to heavy influence of regulation, long cycles and many moving parts.

  • Regulatory Uncertainty: A major factor is how regulation impacts the utility’s returns. Changes to the regulatory structure could potentially impact pricing and how AEP can earn profit. Understanding the rate case process, how much is the cap on profitability, and which is included in the regulated rates can be difficult to track. These processes also vary by the states AEP operates in.
    • Transmission Regulations: This is a big area of focus for the government, and changes in it directly change how AEP can earn money. It is difficult to predict if these regulations will be good or bad for AEP.
  • Long Operation Cycle: Power plants and infrastructure take a lot of planning and investment to create and maintain. This means that they take a long time to become profitable, and is difficult to forecast with precision. The company’s capital spending program is enormous and difficult to track, as well as to predict its impact on overall value.
  • Technological Changes: The industry is facing disruptions from newer technologies, like solar energy, battery storage, and wind power. How AEP can adapt to this and integrate these newer technologies into its portfolio is unpredictable and uncertain. The company also needs to change its infrastructure to properly use the new energy sources.
  • Interconnectedness: While AEP is divided in various segments, they all work together, and depend on each other. Hence, to analyze the company correctly, one has to have a good grasp on all the segments. Understanding the nature of vertical integration and how they are integrated makes this even more difficult.
  • Financials: AEP’s financials are also quite hard to interpret with the complex accounting required to account for all non-cash and non-operating items. Understanding the impact of impairment and goodwill is difficult as well. Also the effect of new regulation and how this might influence numbers makes it harder to have a clear picture of the business performance.

The balance sheet health of AEP is not very strong.

  • High Debt Burden: The debt to equity ratio is over 120%, implying heavy use of debt in the capital structure. A major risk for investors, as interest expense is very significant and reduces profitability and equity valuation. High leverage makes the stock less attractive, unless debt can deliver on growth and profitability.
  • Low Liquidity: Current assets are only slightly higher than current liabilities, implying that AEP may have difficulty meeting short-term debt obligations. Low liquid assets and current ratio may create stress on the company in the future.
  • Cash Flow Generation: Free cash flow is negative for AEP currently, so the company relies on new financing or debt to fund it. The recent trend of increasing operating cash flows gives some hope, but it should have a couple years of sustained positive cash flow to be considered healthy.
  • Sensitivity to interest rates: AEP has a large amount of long-term debt and will be affected by the rising interest rates. The company will have to spend more money on interest payments than previous year.

AEP has been targeted by the Federal Energy Regulatory Commission (FERC) for not properly managing its finances. Also the company’s plan to reduce carbon intensity has been criticized by many. It is under extreme regulatory pressure and how they act on it will be very critical for its business trajectory in the near future.