As AEP plans exit from tough Ky. environment, Algonquin sees potential

American Electric Power Co. Inc.'s plans to exit a challenging regulatory environment and find a new funding source for its growth with the sale of its Kentucky assets have been received positively on Wall Street.

Oakville, Ontario-headquartered Algonquin Power & Utilities Corp., meanwhile, told investors it sees an opportunity to improve the regulatory relationship in Kentucky and build out renewable generation.

AEP on Oct. 26 announced an agreement to sell its Kentucky operations to Liberty Utilities Co., an indirect subsidiary of Algonquin, in a deal with a $2.85 billion enterprise value and $1.5 billion equity value.

Under the deal, AEP will offload its Kentucky Power Co. regulated utility and its AEP Kentucky Transmission Co. Inc. business to Liberty. Liberty will acquire all of the stock of the Kentucky assets and assume about $1.3 billion in debt at close.

"The move will increase the share of AEP's earnings from the ultra-valuable/stable transmission business from 30% of overall earnings closer to 35% and eliminate the ongoing equity overhang from underearning in [Kentucky]," CreditSights analyst Andrew DeVries wrote in an Oct. 26 research report. CreditSights views the deal as a "slight positive for bondholders."

The sale is expected to be slightly accretive to AEP's 2022 earnings.

The Columbus, Ohio-headquartered utility said it expects to net about $1.45 billion in cash after taxes and transaction fees. The company said the proceeds from the sale will be used to eliminate about $1.4 billion in forecast equity needs in 2022 and help fund its robust renewable energy additions over the next decade.

"It's quite a move for AEP to get to a point where we're managing our portfolio in a way that, first of all, we became fully regulated and then we start to look at that portfolio to determine ... what's the best approach to fuel $20 billion in potential renewables investment," AEP Chairman, President and CEO Nicholas Akins said Oct. 28 on the company's third-quarter earnings call.

Analysts believe the sale reflects current utility valuations.

"Kentucky earnings weren't given but we expect the sale was around 20x, in-line with overall utility multiples vs. premiums paid in previous utility M&A in the last [two] years and we note buyers continue to want three things in utility M&A: coal, coal and more coal," DeVries wrote. "The buyers in all these cases then work with regulators to retire the mostly depreciated coal plants and replace them with new gas, wind, solar and/or storage in a move that resets the rate-base and earnings stream higher."

That is what Algonquin did when it acquired southwest Missouri utility Empire District Electric Co. in a $2.3 billion acquisition in 2017. It has since moved up the retirement of Empire District's 200-MW Asbury coal plant and completed the purchase of three wind farms totaling 600 MW as part of the utility's clean energy transition.

Morningstar analyst Andrew Bischof said the deal represents "a fair price."

"I think Kentucky Power has, at times, struggled to earn its allowed ROE and I think if you kind of look around at some of the multiples, it's a fair price," Bischof said in an Oct. 27 phone interview.

KeyBanc Capital Markets put the sale at a 25x price-to-earnings multiple on an assumed 6.6% earned return on equity in Kentucky.

"The deal allows AEP to eliminate [$1.4 billion] in equity needs and resulting share dilution, thus making it effectively earnings-neutral," KeyBanc Capital Markets analysts wrote in an Oct. 26 alert to investors. "We expect the deal to be received positively by investors and for the shares of AEP to close some [year-to-date] underperformance."

Funding the transition

AEP in late April announced a strategic review of its Kentucky assets as management continued to voice concerns about the utility's lower returns.

AEP on Oct. 28 said the earned ROE, or regulated return, for Kentucky Power as of Sept. 30 was 6.9%, below the company's overall operations ROE of 9% and the lowest earned ROE of the company's seven electric utilities and AEP Transmission Co. LLC. The earned return is an improvement from Kentucky Power's ROE of 4.8% as of March 31.

Management also has said it would issue equity and could sell assets to finance the $2 billion investment in the North Central Wind projects in Oklahoma the company is acquiring from Invenergy LLC. AEP recently acquired the second of the three wind projects, which was brought online in early September.

The third project, the 999-MW Traverse Wind Energy Center in Custer County, Okla., is under construction and expected to come online in early 2022.

"The Traverse wind project is about a $1.3 billion investment," AEP spokesperson Tammy Ridout said in an Oct. 27 email. "We expect the wind farm to come online prior to the close of the Kentucky operations sale, so we will use other funding mechanisms available through [Public Service Co. of Oklahoma, Southwestern Electric Power Co.] and AEP to bridge that timing gap."

Glenrock Associates LLC analyst Paul Patterson noted that AEP is among the utilities with a "pretty aggressive" capex plan that needs to be funded and agreed that the Kentucky asset sale is "a way of raising capital in a market that has been pretty friendly to utility valuations."

AEP plans to add more than 16,500 MW of renewable capacity from 2021 through 2030. The company said about 10,000 MW is proposed through 2025 as part of its $37 billion capital plan that earmarks 72% of spending to transmission and distribution.

"I think it's a question of what the opportunity is in respect to your other ways of raising capital, whether it be an equity issuance or what have you," Patterson said in an Oct. 27 phone interview. "I don't think they were the most excited about that particular utility property compared to others."

Algonquin's opportunity

Algonquin's management team in an Oct. 26 presentation to investors on the Kentucky deal said it sees "significant opportunities to transition the existing rate-based fossil fuel generation with rate-regulated renewables sources."

The Canadian company also said it sees the potential to improve regulatory outcomes in Kentucky along with opportunities for transmission and distribution investments.

"Anticipated transfer of or retirement (for rate-marking purposes) of Kentucky Power’s 50% ownership interest (representing 780 MW) in the Mitchell coal plant in 2028 allows opportunity for rate-regulated renewables to be added to Kentucky Power's rate base," Algonquin said.

This ties into the company's overall "greening the fleet" strategy, which it has already applied to Empire District.

At Kentucky Power, Algonquin also sees an opportunity for rate-based renewables investment when a long-term contract for 390 MW from AEP's coal-fired Rockport plant expires in 2022.

"I think broadly when you look at coal generation, there [are] opportunities to transition that portfolio, but you have to have the regulatory support to do that," Bischof said.

Algonquin also sees the acquisition of the Kentucky businesses enhancing its scale and regulated business mix. The acquired entities will add about 1,100 MW of generation capacity, $2.2 billion in rate base and 11,152 miles of transmission and distribution lines, according to the investor presentation.

Kentucky Power is a generation, transmission and distribution utility serving about 165,000 electricity customers in eastern Kentucky, while AEP Kentucky Transco is a regulated transmission business with operations exclusively in Kentucky. Algonquin Power said it would maintain the utility's headquarters in Kentucky.

Algonquin Power, under the Liberty brand name, provides regulated electricity, natural gas, water and wastewater services to more than 1 million customers primarily in 13 U.S. states and Canada.

The Kentucky Power and AEP Kentucky Transco sale is expected to close in the second quarter of 2022, pending state and federal regulatory approvals.