Why American Electric Power’s Recent Rally Will Continue, In 4 Charts
Summary Oversupply in the natural gas market will keep prices under pressure, and this will act as a catalyst for AEP since it is increasingly using the fuel for power generation. The company’s increasing usage of natural gas and other renewable sources will help it reduce costs by 13% this year and 28% next year as compared to 2014 levels. American Electric will benefit from an increase in retail electricity prices and an increase in electricity consumption going forward, which will allow it to arrest the decline in its top line. AEP’s valuation indicates bottom-line growth going forward while its payout ratio of 59% and aggressive cost reductions will allow it to sustain its dividend. Utility company American Electric Power (NYSE: AEP ) has gained some momentum in the past one month after releasing its second-quarter results at the end of July, with the stock gaining almost 3%. This is despite the fact that American Electric had posted mixed results , as its top line declined year over year and missed the consensus estimate by a wide margin. However, the company’s bottom-line performance was stronger than expected, which can be attributed to costs of electricity generation. Looking ahead, I believe that the company will be able to sustain its recent momentum going into the remainder of the year. Let’s see why. Lower natural gas prices will lead to better margins On account of massive oversupply in the U.S. natural gas market, the price of the fuel is not expected to rise anytime soon. There is news that the U.S. is considering increasing the exports of LNG, which could lead to higher prices. But, in the short run, the oversupply in the market will keep prices down. For example, on July 31, natural gas inventory stood at 2,912 Bcf, which is 23% higher than the prior-year period. The EIA believes that this level of inventory will go up to 3,867 Bcf at the end of October, up 1.8% as compared to the five-year average. Thus, higher inventory will keep natural gas prices, which are already down 11% in 2015, under more pressure. This will help American Electric to improve its margins going forward, as natural gas has turned into the largest source of electricity generation in the U.S. Given the dynamics in the natural gas market, it is not surprising to see why American Electric will increase the use of the fuel in electricity generation. As shown in the following chart, apart from natural gas, American Electric will use more renewable resources to eliminate extra costs associated with coal. (click to enlarge) Source: Investor relations As a result, by reducing its dependence on coal and using more of natural gas along with other energy sources, American Electric’s costs are expected to decline 13% this year and 28% next year as compared to 2014 levels, as shown below. Source: American Electric Higher electricity retail prices and demand will aid revenue growth The EIA expects the retail price of electricity in the U.S. for the residential sector to average 12.8 cents per kilowatt hour in fiscal 2015. This is approximately 2.5% higher than the average price in fiscal 2014. Also, it is expected that the retail price for commercial as well as industrial sectors will grow by 2% and 0.4%, respectively, in fiscal 2015. More importantly, the trend is expected to continue going into 2016 as well, with prices in all three sectors expected to rise. This is shown in the following chart: Source: EIA Along with the improvement in electricity rates, consumption is also slated to increase this year. For instance, residential consumption is expected to average 1,044 killowatthours per month during June, July, and August. This is about 3.7% higher than the consumption level last year. The increase in the consumption level will be driven by an expected 14% increase in summer cooling degree days in 2015. All in all, retail sales of electricity to the residential sector during 2015 are expected to grow by 0.4% from 2014 levels. In addition, American Electric expects reasonable sales growth for its commercial as well as industrial retail classes. The following illustrates its sales estimates for the fiscal-year 2015: (click to enlarge) Source: Investor presentation Hence, American Electric is well positioned to benefit from both an increase in electricity consumption and higher pricing. This will allow the company to improve its financial performance going forward. Valuation and takeaway Apart from strong end-market prospects, American Electric also has an impressive valuation that indicates earnings growth in the future. Its forward P/E of 15.4 is lower than the trailing P/E of 16.1, indicating positive bottom-line growth going forward. Additionally, the company carries a strong dividend yield of 3.60% at a payout ratio of 59%. Now, American Electric Power is reducing its costs by using natural gas while it will also benefit from better demand and pricing conditions. As a result, the company should be able to sustain its dividend in the future. Thus, according to me, investors should continue holding American Electric Power as the stock’s recent run will continue going forward. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.