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Will Exiting Merchant Generation Positively Impact AEP’s Earnings?

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Exit from merchant generation

American Electric Power’s (AEP) intention to exit merchant generation is likely to have a positive impact on the company’s earnings. The volatility contribution from AEP’s Merchant segment is expected to reduce substantially in the next few quarters, with just 2.7 MW (megawatts) of merchant capacity left with AEP.

Of the total 7.9 GW (gigawatts) of merchant capacity, AEP has agreed to sell 5.2 GW to a newly formed joint venture of Blackstone and ArcLight Capital Partners. Although the segment accounts for a smaller contribution to the company’s total earnings, it still generates significant profits during periods of high energy demand.

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Earnings drivers

American Electric Power is projecting 4%–6% earnings growth for the next few years. It’s also expected to spend nearly $15 billion on capital projects through 2018. Half of this budgeted capital spending will likely be spent on transmission infrastructure, which is expected to accelerate EPS (earnings per share) growth. Remember, a utility’s transmission rate base is generally regulated by the FERC (Federal Energy Regulatory Commission) and fetches a higher return on equity.

Meanwhile, AEP expects its total normalized load growth to rise by nearly 0.9% this year. These higher sales may result in improved earnings for AEP in 2016, though economic factors such as GDP and employment growth (which channelizes utilities’ performances) were downbeat for AEP last year. GDP and employment growth drive energy demand. Both have been below the national average in the past few quarters.

For this reason, US utilities (XLU) are expanding their regulated operations to attain stable earnings growth. Exelon (EXC), the largest nuclear power generator, is enhancing its regulated operations with Pepco Holdings. Southern Company (SO), Duke Energy (DUK), and Dominion Resources (D) are also expanding their regulated gas distribution operations through mergers and acquisitions.

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