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American Electric Power’s Evolution Into A Fully Regulated Utility Company Assured

Company is strategically making all correct decisions and augmenting its power assets portfolio. ROE will improve in future, driven by rate increases and costs savings. AEP’s attempt to increase regulated operations will provide cash flow stability and will support dividend growth. American Electric Power (NYSE: AEP ) remains a compelling investment prospect for investors. The company has been making correct strategic decisions to strengthen its business operations and improve its risk profile. The company has been working to improve its earned ROE, increasing its regulated business operations, and scaling down its un-regulated operations, which I think will augur well for its stock valuation. Recently, AEP filed a settlement agreement with the Public Utilities Commission Ohio (PUCO), regarding its proposed Power Purchase Agreement (NYSEARCA: PPA ) plan for its 3GW of merchant power generating assets; I think this is a positive development, as it would provide more stability to its revenues, earnings and cash flows. Moreover, the company might plan to sell its remaining 5GW of merchant assets, not included in the PPA plan, which will allow it to use sale proceeds to make more investments in regulated transmission business. In addition, the stock valuation stays attractive, as it is trading at discount to its peers. Growth Catalyst AEP has been aggressively working to strengthen its business by increasing its regulated business exposure. In this regard, the company filed an agreement with PUCO, and PUCO is expected to provide a ruling on the settlement agreement in early 1Q2016. The agreement calls for 8-year PPAs at a 10.4% ROE for its 3GW of merchant power generation. In addition, the agreement includes converting coal plants to gas, building 900MW of renewable energy portfolio and up to $100 million in customers’ credit over the 8-year period. The agreement will provide stability to the company’s merchant power assets, as in the past these assets performance was negatively affected by low and volatile power prices. The agreement filed by AEP is very similar to the recent settlement agreement for FirstEnergy (NYSE: FE ). Other than the recent agreement filling for its 3GW of merchant assets, I think the company will opt to sell its remaining 5GW of merchant assets, not covered under a settlement agreement, to become a full regulated utility company. The sale of the remaining 5GW of merchant assets will not only provide stability to the company’s revenues and earnings, but will also give AEP an opportunity to use the sale proceeds to the sale to reinvest in the business, and grow its regulated operations. If the company opts to sell its remaining 5GW of merchant assets, it could generate $1.8-$2.35 billion in sale proceeds, which it could re-invest into its regulated transmission business. Also, the company can use the sale proceeds to buyback shares, but I think, this is an attractive option, as redeploying sale proceeds to expand regulated operations as it will strengthen its business model. In the long run, the company could also consider to undertake acquisitions, which will provide offer incremental transmission business opportunities. In addition, if the company opts to sell its 5GW merchant assets and re-invest proceeds in transmission business, long-term earnings could grow in a range of 5%-7%, better than its management long-term earnings guidance of 4%-6%, which is based on its transmission planned capital investments of $5.7 billion over the next three years. AEP has a plan to make capital investments worth $13 billion over the next 3 years, out of which 96% will be directed at regulated operations, which will strengthen its regulated business, and increase its regulated rate base. The graphs below displays planned capital investments and regulated rate base growth for AEP. (click to enlarge) Investors Presentation Separately, the ROE of the company is likely to improve in the coming years because of rate increases. The company received $45 million and $99 million rate increases at its two subsidiaries, Kentucky Power and APC’s, respectively. In additions, the company’s earnings growth will be supported by its on track cost savings measures; it is expected to save $205 million in costs, as displayed below. Investors Presentation Summation AEP is strategically making all correct decisions and augmenting its power assets portfolio in a way that will strengthen its long-term performance. The company’s ROE will improve in the future, driven by rate increases and costs savings. Also, the company’s attempt to increase its regulated operations will provide cash flow stability and will support its dividend growth; AEP offers a yield of 4.1%. Furthermore, the stock valuation currently remains compelling, as it is trading at a forward P/E of 15x , versus the industry average forward P/E of 16x . I think the stock valuation will expand, and the valuation gap will close as AEP will evolve into a fully regulated utility company.

Duke Energy And Southern Company Set To Soar In 2016

Unregulated utility companies’ performance likely to stay challenging in 2016 because of weak and volatile power prices. DUK and SO making correct strategic attempts to strengthen regulated operations. Stock valuations for DUK and SO are cheap, as both are trading at discounts to peers and the industry average. 2015 has been a tough year for the U.S. utility sector, mainly because of concerns regarding the Fed interest rate increase; the utility sector ETF (NYSEARCA: XLU ) is down 10% year-to-date. Moving into 2016, given the decline in the power and natural gas prices, U.S. unregulated utility companies’ performance will stay volatile and weak; however, I think U.S. utility companies with significant and growing regulated business operations will stay an attractive investment option for income-hunting investors. Duke Energy (NYSE: DUK ) and Southern Company (NYSE: SO ) are the two U.S. utility companies that have large regulated business operations and are further working to strengthen their regulated business operations, which will provide stability to their revenues and cash flows, and support dividend growths. Moreover, valuations for both the stocks stay compelling. Two Utility Stocks: DUK and SO In recent years, low power and natural gas prices has adversely affected performance of unregulated business operations. As the power and natural gas prices continues to stay weak, I think, 2016 will be another challenging year for the unregulated utility companies. In the volatile unregulated business environment, the U.S. utility companies are working to lower their unregulated business operations, which will positively affect their performance. DUK is among the leading utility companies of the U.S., and has been working to strengthen its regulated business operations by making regulated capital investments; the company is expected to make capital investments of $20 billion in the next four years, which will result in increase in its rate base and support earnings growth. The company is not only upgrading its existing regulated infrastructure, but also diversifying the power generation assets by focusing on renewable energy sources, which will improve its business risk profile and allow it to comply with changing environmental regulations. DUK plans to spend to $3 billion on renewable energy in the next four years. Moreover, in 2016, if the company decides to sell its international unregulated business operations, it will positively affect its stock price and will make its cash flows more stable. Also, once the company successfully closes acquisition of Piedmont Natural Gas (NYSE: PNY ), which is consistent with its efforts to grow regulated earnings, it could opt to undertake more regulated gas business acquisitions to strengthen its gas business. Given the company’s aggressive efforts to strengthen its regulated operations, its cash flows will improve, which will allow it to increase its dividend growth consistently in the coming years. The stock has yield of 4.75% , which is supported by its 14% operating cash flow yield, and makes it an impressive investment option for income investors. Also, investors should keep track of yearly earnings call in February, in which the company will provide update on its 5-year growth expectation, synergies related to PNY acquisition and rate case outlook. Southern Company is another utility stock which stays an attractive investment option for income investors, as it offers a solid yield of 4.7% , which are backed by its operating cash flow yield of 15% . The company generates almost 90% of its earnings from regulated operations, which provides stability to its cash flows. Similar to DUK, SO also is working aggressively to modernize and strengthen its power generation assets. Moreover, once the company’s two construction projects, Kemper and Vogtle Power plants, are completed it will portend well for its long-term earnings. Also, the company has been actively increasing its renewable energy asset base. The company spent more than $2 billion on renewable in 2015, and plans to spend another $1.3 billion in 2016, which is expected to increase its renewable energy portfolio capacity to 2,600 MW. Consistent with its renewable generation assets base growth, the company acquired almost 600 MW of solar assets from First Solar (NASDAQ: FSLR ). And also, completion of SO’s and AGL Resources (NYSE: GAS ) in the later half of 2016 will augur well for the stock price. The company’s efforts to improve its regulated power asset base will support its long-term earnings growth, and its business risk profile will improve, as it will complete pending acquisitions and ongoing construction projects. Also, the company’s cash flows will stay strong to support its dividend growth, which will improve investors’ confidence. Valuation and Summation Unregulated utility companies’ performance is likely to stay challenging in 2016 because of weak and volatile power prices. However, companies like DUK and SO, which are making correct strategic attempts to strengthen their regulated operations, will deliver healthy performances in future years. Both DUK and SO offer solid yields of 4.7% and 4.75%, respectively, which makes them attractive investment prospects for income-hunting investors. Moreover, stock valuations for DUK and SO are cheap, as both are trading at discounts to their peers and the industry average. DUK and SO are trading at forward P/E of 14.8x and 15.7x, respectively, versus the utility sector’s forward P/E of 16.5x .