How Much Power Is Left in AEP?

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With Mother Nature's blessings, power provider American Electric Power's (NYS: AEP) second-quarter bottom line surged more than twofold from last year. Unfortunately, the company belongs to an industry facing strong regulatory changes. Let's see what this stock has to offer.

The numbers
Ridiculously hot weather, along with higher average rates, pushed AEP's revenue up by 7% year over year, to $3.6 billion. Wholesale off-system market sales also rose significantly, by $37 million, on high volumes. These sales help AEP even when retail customers switch to other electricity providers, since AEP has the option of selling the additional power those departing customers no longer use to the wholesale market.

Though operations and maintenance expenses rose, other costs remained under control. These savings led AEP's operating income to spike more than 80% from the year-ago quarter, to $717 million. As a result, net income surged to $352 million, more than doubling year over year.

On the balance sheet, AEP's total-debt-to-capitalization ratio has hit a five-year low of 56.6%. High levels of debt are not uncommon to this industry, but this drop is nonetheless a good thing. With an interest coverage ratio of 3, and unlevered FCF jumping to $282.1 million from negative $7.8 million year over year, the company seems decently positioned to service its debt obligations.

AEP has also maintained a dividend of $0.46 per share for the past two quarters. The current dividend yield stands at 5%, which is nothing to sneeze at. But curious investors should learn more about this company before considering opening a new position.

Switching threat
AEP's recent rate equalization proposals, which could result in significantly higher costs for residential customers, face flak from all sides. According to Ohio Consumers' Counsel (OCC), the changes could lead to a 31% increase in summer generation charges, and an even higher increase in the winter.

If the proposals pass, even more consumers may switch to a different provider. According to energy services provider Brakey Energy, AEP's rate hikes in the past few years have propelled switching in some regions. But again, the company should still make money for the power it is generating -- just not as much.

In the latest quarter, AEP's sales in Ohio declined $35 million to $658 million, as 7% of its Ohio customers switched. The company hadn't expected this defection. One city with nearly 7,000 customers switched from AEP to rival First Energy (NYS: FE) . Further departures would definitely hurt AEP.

A dirty job
Electric utilities face an even bigger challenge from the EPA's pollution-related regulations. Duke Energy (NYS: DUK) may close six units to get back in compliance with the agency's revised rules. AEP will have to shut down nearly 25% of its aging coal-fueled generating capacity in the next few years, costing the company somewhere between $6 billion and $8 billion through end of the decade. Shutting down these plants could diminish AEP's off-system sales.

AEP faced another setback recently when it had to shelve plans to continue with a carbon-capturing technology plant nearly two years after the Department of Energy (DOE) gave the go-ahead. AEP was to receive $334 million from DOE, but before the shelving announcement, it had received just $11.5 million of it.

The Foolish bottom line
Though AEP's revenues have grown in all segments, regulatory changes and switching issues are now looming large. It might seem prudent to watch from the sidelines till a clearer picture on the proposals front and EPA's final form of regulations emerge.

At the time this article was published Neha Chamaria does not own shares of any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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