AES Corporation: This Highly Leveraged Utility Might Have Potential (NYSE:AES)

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The AES Corporation (AES) is one of the largest regulated electric utilities in the world, boasting operations in fifteen different countries including the United States. As I have pointed out quite a few times in the past, utilities are among the most popular investments among retirees and other conservative investors. This is partly due to the fact that they tend to be highly stable entities with consistent cash flows. They also tend to deliver slow but steady growth on an annual basis. AES is no exception to this, which was showcased by the company’s latest results. These results were released following my last update on the company so I will of course touch on them here but there are certainly other things to discuss, including AES’s increasing focus on renewables and relatively high total return potential over the next few years. Overall though, this remains a solid, albeit risky, utility that could reward its investors quite well.

About AES Corporation

As mentioned in the introduction, the AES Corporation is a regulated electric utility that operates in fifteen different countries. The overwhelming majority of its operations are based in the United States, though:

AES Capacity by Geography

AES Investor Presentation

It is admittedly quite rare to see an electric utility operating in multiple countries but that does not actually change any of its defining characteristics. In particular, electric utilities tend to enjoy relatively stable cash flows. This makes a great deal of sense though since people tend to focus on paying their utility bills above more discretionary expenses during times when money gets tight. After all, electricity is generally considered to be a necessity in today’s world. People typically prioritize covering necessities above simple wants. In addition to this, utilities are typically monopolies in their own service areas so their customer base does not change very often. This could also be a problem when it comes to growth though since the company’s ability to grow by adding new customers is mostly limited to population growth in its respective area. This tends to be a very slow process. Fortunately, there are other ways for a utility to deliver growth, as shown by AES Corporation’s most recent results. As we can see here, the company managed to grow its earnings per share by 5.56% over the 2021 period:

AES 2021 Earnings Growth

AES Investor Presentation

The biggest way in which this is done is by investing in its rate base. The rate base is the value of the company’s assets upon which regulators allow it to earn a specified rate of return. As the rate of return is a percentage, any increase in the rate base allows the company to raise the price that it charges its customers in order to earn that specified rate of return. In order to raise its rate base, the company typically invests money into upgrading, maintaining, modernizing, and possibly even expanding its infrastructure. AES Corporation has been doing this and plans to keep doing it going forward, proposing a $3.8 billion investment program over the 2022-2025 period. Approximately $1.4 billion to $1.6 billion will be invested in 2022 alone, with a substantial proportion of it being into renewables:

AES 2022 Capital Spending Plan

AES Investor Presentation

The company has unfortunately not stated publicly the exact impact that this investment program will have on its rate base but it has stated that this program will boost its earnings per share at a 7% to 9% rate over the next three to five years. This is not difficult to believe as it would be relatively inline with what other utilities deliver. When we combine this to the 2.88% dividend yield then investors should be looking at a 10% to 12% total return over the period, which is certainly not an unattractive return from a conservative investment.

As noted earlier, AES Corporation is investing very aggressively in the development of renewable energy. This is certainly not unusual among electric utilities. In response to substantial pressure from government regulators and customer demands, they are all working to reduce their carbon emissions. One of the common ways that this is being done is to retire old coal-fired power plants because coal is one of the most heavily-polluting ways in which power is produced. AES is being much more aggressive about this than many other utilities as the company expects to retire all of its remaining coal plants by 2025. This will result in the company bringing the percentage of its power generation capacity down from 20% today to 0% in four years. Obviously, this will require the company to replace a great deal of capacity as its remaining coal plants produce about one gigawatt of electricity. As might be expected, renewables will account for a substantial proportion of this replacement capacity, primarily wind and solar:

AES Capital Investment by Generation Type

AES Investor Presentation

We can also see that AES Corporation is also planning to construct a small number of natural gas-driven power plants. This is something that is quite common among electric utilities due to the unreliability of renewables. As I have discussed in various previous articles, one of the biggest problems with renewable sources of power is that they are not reliable enough to support a modern electrical grid given today’s technology. After all, solar power does not work when the sun is not shining, such as at night, and solar panels are less effective on cloudy days. A wind turbine cannot generate any power if the wind is not blowing. Although batteries have been presented as a solution, modern technologies are insufficient to allow them to support the grid for very long and their production is highly polluting. As a result of this, electric utilities have been relying quite heavily on natural gas-driven turbines to support the grid. This is one of the reasons why I have long had a bullish thesis on natural gas.

In my previous article on AES Corporation, I stated that one of the company’s biggest problems is its incredibly high debt load. In fact, AES is one of the only utilities that have a speculative-grade credit rating. Fortunately, management appears to recognize this and has been using a portion of the company’s cash flow to reduce the outstanding debt. This has naturally improved the company’s credit rating, although not by nearly as much as we really want to see. As of December 31, 2021, AES has BBB- ratings from both Standard & Poors and Fitch, while Moody’s has the company rated somewhat lower. This is a steep improvement over the ratings that the company had back in 2016:

AES Debt Ratings 2016-2021

AES Investor Presentation

A BBB- rating is investment-grade, albeit the lowest possible one. Moody’s Baa1 rating is speculative-grade, albeit the highest possible junk rating. A company with a speculative-grade rating is considered to be at a fairly high risk of default and considering that bondholders sit ahead of the common stockholders during any bankruptcy proceeding, there is a reasonable risk of loss in such a situation. With that said, the official rating scale describes a company with a Ba1 rating as possessing “obligations with substantial credit risk.” Thus, Moody’s appears to believe that there are still significant risks here, although all three rating agencies state that things are improving in this area.

The market does not appear to agree though as it has been bidding the stock down over the past several months and indeed AES Corporation is down 20.69% over the past year compared to the generally positive performance of several peers:

AES Stock Price vs. Peers

Seeking Alpha

This sort of market performance would ordinarily be indicative of a general concern about the company, although it is not a large enough decline to indicate bankruptcy fears. The company’s price-to-book ratio is substantially higher than the sector median, though:

AES

Sector Median

Price-to-Book (TTM)

7.42

1.96

Price-to-Book (Forward)

3.39

1.90

This could be a sign that the company’s stock is substantially overvalued relative to its assets. With that said though, the price-to-book ratio does not always work very well as a valuation metric for companies with high levels of debt. This is because the high debt boosts the company’s liabilities to the point that they wipe out the book value of the company’s hard assets and thus boosting the price-to-book value. As AES Corporation is quite leveraged compared to its peers, this could easily be what we are seeing here. This possibility of underperformance is something that should always be considered before making an investment in the company, though.

Fundamentals Of Electricity

Electric utilities as a whole have been in the news a great deal recently. This is because of the concept of electrification, which has been widely promoted by many government officials and futurists lately. This trend refers to the conversion of things that are traditionally powered by fossil fuels to the use of electricity instead. The most commonly considered things are transportation (electric cars) and space heating but there are certainly other things that could be converted. As this process unfolds, it would substantially increase the consumption of electricity (I detailed the impact from electric cars alone here), which would naturally greatly increase the revenues and profits of electric utilities. Unfortunately, the U.S. Energy Information Administration does not believe that this scenario is likely to play out. According to the government agency, the national demand for electricity will only grow at a 1% to 2% rate over the next thirty years:

EIA 2022 Electric Growth

EIA 2022 Annual Energy Outlook

This is nowhere close to the demand growth that would be expected were wide swathes of the economy to convert from fossil fuels to electricity. Thus, the agency does not appear to believe that this process will progress nearly as quickly as its proponents expect. This is likely due to the prohibitive costs of expanding the grid to the degree needed to support this process as well as the fact that electricity is significantly more expensive than other fuels for heating purposes.

Financial Considerations

As was mentioned earlier in this article, AES Corporation has a relatively high debt load, which could pose a very real risk. As such, we should take a look at this because debt is a riskier way to finance a company than equity. This is because debt must be repaid at maturity and if interest rates are higher at maturity than at the time of the debt issuance, the refinancing may increase the company’s costs. In addition, a company must make regular payments on its debt if it is to remain solvent. Thus, an event that causes the company’s cash flows to decline could push it into insolvency if its debt is too high. While utilities do tend to have reasonably stable cash flows, bankruptcies are certainly not unheard of in the sector.

One metric that we can use to analyze the company’s financial structure is the net debt-to-equity ratio. This tells us the degree to which the company is financing its operations with debt as opposed to wholly-owned funds. It also tells us the degree to which the company’s equity can cover its debt obligations in the event of a bankruptcy or other liquidation event, which is arguably more important.

As of December 31, 2021, AES Corporation had a net debt of $17.838 billion compared to $4.627 billion in equity. This gives the company a net debt-to-equity ratio of 3.86. Here is how that compares to some of its peers:

Company

Net Debt-to-Equity Ratio

The AES Corporation

3.86

NextEra Energy (NEE)

1.19

DTE Energy Company (DTE)

2.09

Eversource Energy (ES)

1.37

FirstEnergy Corporation (FE)

2.62

Exelon Corporation (EXC)

1.22

As we can quite easily see here, AES Corporation is substantially leveraged compared to its peers. This is a very clear sign that the company’s debt is likely quite high and thus poses a substantially higher risk to investors than the debt of other utilities. This could easily put it at a higher risk of bankruptcy and thus investors should be demanding higher returns than they normally would out of its peers in order to compensate for this higher risk.

Dividend Analysis

One of the reasons that investors purchase utility stocks is that they tend to have higher dividend yields than many other things in the market. This is a direct result of the fact that utilities in general have lower growth than other companies, which results in them delivering a higher proportion of their total return in the form of dividends as opposed to capital appreciation. The AES Corporation is not an exception to this as its current 2.88% yield is quite a bit higher than the 1.34% yield on the S&P 500 index (SPY). As is the case with most utilities, AES has a history of raising its dividend annually:

AES Dividend History

Seeking Alpha

A consistently rising dividend is something that can be especially attractive in inflationary environments like we have in the United States today. This is because inflation reduces the number of goods and services that we can buy with our dividend income. If the company increases its dividend then it helps to maintain the purchasing power of the dividend and thus helps to prevent those people that are depending on dividends to finance their lifestyles from feeling steadily poorer with time. As is always the case though, it is critical to ensure that the company can actually afford the dividend that it pays out. After all, we do not want it to be forced to reverse course and cut the dividend since that would reduce our income and almost certainly cause the stock price to decline.

The usual way that we judge a company’s ability to afford its dividend is by looking at its free cash flow. A company’s free cash flow is the money that is generated by its ordinary operations after it pays all of its bills and makes all necessary capital expenditures. This is therefore the money that is available to undertake such tasks as reducing debt, buying back stock, or paying a dividend. In the fourth quarter of 2021, The AES Corporation had a levered cash flow of $2.8 million, which is not nearly enough to cover the $100 million that the company paid out in dividends over the period. As this is somewhat concerning, let us look at the company’s free cash flow on an annual basis. During the full-year 2021 period, The AES Corporation had a negative levered free cash flow of $760.6 million, which is obviously not enough to pay any dividend, let alone the $401.0 million that it paid out over the same period.

It is, however, not usual for a utility to finance its capital expenditures through the issuance of equity and especially debt and use its operating cash flow to cover the dividend. This is mostly due to the very high cost of constructing and maintaining utility-grade infrastructure over a wide geographic area. In the full-year 2021 period, The AES Corporation had an operating cash flow of $1.902 billion, which is easily enough to cover the $401.0 million dividends and still leave the company with a considerable amount of money to partially cover its capital expenditures and other costs. Overall, this dividend is probably sustainable.

Valuation

It is always critical that we do not overpay for any asset in our portfolio. This is because overpaying for any asset is a surefire way to generate a suboptimal return off that asset. As we have already discussed, The AES Corporation appears to be substantially overvalued in terms of its price-to-book value. However, the fact that the company has much more leverage than its peers also makes this less useful as a valuation metric. An alternative valuation metric that we could use is valuing the stock relative to its earnings per share growth. This is typically accomplished by looking at the company’s price-to-earnings growth ratio, which is an alternative form of the familiar price-to-earnings ratio that also takes the company’s earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 could be an indicator that the stock is undervalued relative to its earnings per share growth and vice versa. It is very rare to find any stock with such a low ratio in today’s market, particularly a slow-growing utility stock. As such, the best way to value the company in this manner is to compare it to its peers and see which has the most attractive relative valuation.

According to Zacks Investment Research, The AES Corporation will grow its earnings per share at a 5.74% rate over the next three to five years. This is in the same ballpark as the growth rate that we used earlier to calculate the total return potential so it seems pretty solid. This gives the stock a price-to-earnings growth ratio of 2.35 at the current price. Here is how that compares to its peer group:

Company

PEG Ratio

The AES Corporation

2.35

NextEra Energy

3.27

DTE Energy Company

3.51

Eversource Energy

3.29

FirstEnergy Corporation

2.48

Exelon Corporation

2.88

This appears to indicate that the market could be very wrong with the way that it is reacting to the company’s stock right now. If AES does actually deliver the earnings growth that analysts are predicting, then the stock is looking quite undervalued and could easily be a buy today.

Conclusion

In conclusion, The AES Corporation is a highly renewable-focused utility that is unloved by the market. The company’s lack of market favor does appear to be a very real cause behind it as it is certainly more leveraged than we really like to see. However, it has a sustainable and growing dividend that, combined with earnings per share growth, gives it a fairly attractive potential total return. There may be some potential here for an investor that is willing to take on the risks of the company’s debt load.



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