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Divesting Merchant Generation to Improve AEP’s Risk Profile

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AEP’s operating income

American Electric Power’s (AEP) Vertically Integrated Utilities segment plays a key role in driving its performance, accounting for more than half of its total operating income. Considering the divestment of its Merchant Generation segment, Regulated Operations are expected to grow significantly. As a result, earnings volatility may fall, with growth driven by only its Transmission and Distribution segments.

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Segmental growth

American Electric Power’s (AEP) management is estimating moderate load growth of nearly 1% in 2016, which may improve the performance of its Vertically Integrated utilities. Last year, unfavorable weather—particularly in the fourth quarter—resulted in a nearly 4% fall in total load. The expectations of normal weather in 2016 create room for better earnings this year.

American Electric Power’s Transmission and Distribution segment received the maximum allocation of its planned capital budget. As a result, increased investments in the segment could drive its earnings based on the investment rate recovery mechanism.

The above chart shows the performance of the four biggest operating segments of AEP. Consistent with AEP’s guidance for 2015, AEP’s Vertically Integrated Utilities and Transmission and Distribution segments are realizing healthy growth, driven by continued strong capital investment and growth of the rate base. The rate base is the value of the property on which the utility (IDU) is allowed to earn a specific rate of return according to the rules set by regulators.

Investors can get broad-based exposure to utilities by investing in the Vanguard US Utilities ETF (VPU). American Electric Power has 4.3% weight in VPU. AEP’s peers Exelon Corporation (EXC), Pacific Gas & Electric (PCG), and PPL Corporation (PPL) account for 3.6%, 3.9%, and 3.4%, respectively, in VPU.

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