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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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