On Thursday, August 3, 2023, international electric utility The AES Corporation (NYSE:AES) announced its second quarter 2023 earnings results. At first glance, these results appeared to be somewhat disappointing, as the company missed the expectations of its analysts in terms of both revenues and earnings. The stock market was also not particularly impressed with these results, as it bid the company’s stock down by a whopping 7.54% over the past few days following the results:
Indeed, the results were not especially impressive, as the company’s earnings and cash flow were both down relative to the prior-year quarter. This runs contrary to the normal expectations that we have for utility companies. After all, this is a sector in which financial stability is very much the normal state of affairs. Then again, as regular readers may recall, I have long expressed some concerns about AES Corporation’s high level of debt, and indeed the company did have much higher interest expenses this year compared to the same period last year. This was naturally a drag on the company’s earnings.
It did manage to make some progress on its rather ambitious renewable energy goals though, so some investors might like that. The market seems to be pricing in the problems though, and as of the time of writing this company has one of the most attractive valuations in the utility sector. While most utility sector investors tend to be highly conservative, those of you willing to take on some risks may find something to appreciate here.
Earnings Results Analysis
As regular readers are likely well aware, it is my usual practice to share the highlights from a company’s earnings report before delving into an analysis of its results. This is because these highlights provide a background for the remainder of the article as well as serve as a framework for the resultant analysis. Therefore, here are the highlights from The AES Corporation’s second-quarter 2023 earnings results:
- The AES Corporation reported total revenue of $3.0270 billion in the second quarter of 2023. This represents a 1.66% decrease over the $3.0780 billion that the company reported in the prior-year quarter.
- The company reported an operating income of $426.0 million in the reporting period. This represents a 17.44% decline over the $516.0 million that the company reported in the year-ago quarter.
- The AES Corporation signed new contracts for 2.2 gigawatts of renewable energy in the first half of the year.
- The company completed the retirement of a 415-megawatt coal power plant in Indiana and announced the retirement of two more coal power plants that it intends to complete by 2025.
- The AES Corporation reported a net loss of $39.0 million in the second quarter of 2023. This compares quite favorably to the $179.0 million net loss that it reported in the second quarter of 2022.
It seems certain that the first thing that anyone reviewing these highlights will notice is that AES Corporation’s revenue and operating income declined compared to the prior-year quarter. The company provided no explanation for this in either the earnings press release or the conference call, opting to focus instead on discussing the progress of its renewable deployment plans. While discussing forward plans is always nice, it would have been nice to have some insight into the revenue and earnings decline as that reflects rather poorly on the company today.
With that said, DTE Energy (DTE) reported that overall temperatures during the second quarter of 2023 were lower than in 2022. That could be an explanation for the company’s weaker revenue and operating income performance if it was true for AES Corporation’s service territory as well. The company does state that unfavorable weather conditions in Ohio and Indiana had a negative impact on its results, but it did not elaborate on that. These two states are fairly close to Detroit, so it is possible that the company is referring to colder-than-normal temperatures in these areas as a drag on earnings. It would be nice to have some more details though.
One of the things that have made utilities among the favorite holdings of risk-averse investors such as retirees is that they tend to enjoy remarkably stable cash flows over time. The AES Corporation did manage to deliver on this during the quarter despite the weakness in year-over-year revenue and operating income. This chart shows the company’s operating cash flows during each of the past twelve-month periods:
As we can clearly see, the company’s operating cash flows were generally pretty stable during the past eleven twelve-month periods. This is a period of time that includes the pandemic-related lockdowns and the resultant economic collapse, along with the inflationary period that followed it. Recently, the leading economic indicators have been strongly stating that the United States is either in a recession or near it, and economic conditions in many other nations are not really any better. Thus, we see a variety of economic environments reflected in the chart above yet none of them appear to have had a significant impact on the company’s cash generation ability. That is something that we very much like to see right now as it should indicate that this company should weather whatever may happen in the near future.
The reason for the company’s general stability should be fairly obvious. After all, The AES Corporation’s primary business is the provision of electricity to homes and businesses and most people consider that to be a necessity. As such, they will usually prioritize paying their utility bills ahead of discretionary expenses. After all, nobody is going to go to a restaurant for dinner or buy a new smartphone if they cannot keep the electricity on at their homes. For the most part, a household’s consumption of electricity does not change much over time so their bills will generally be for similar amounts regardless of the broader economic conditions. That results in very stable revenues over time for the utility company, allowing for very easy budgeting and general financial stability regardless of the conditions in the broader economy.
Renewable Energy Ambitions
As I mentioned in past articles on The AES Corporation (see here), the company of the most aggressive in the utility space when it comes to the deployment and use of renewable sources of power. We can see this quite clearly in the second quarter of 2023. The company reported that it entered into power purchase agreements totaling 2.2 gigawatts year-to-date. Nearly all of those contracts were signed since early May:
A power purchase agreement is one of the only ways to make renewable energy generation economical. After all, one of the biggest problems with wind and solar generation is that they do not consistently and reliably generate electricity. For example, solar panels do not work at night and wind turbines do not work when the wind is not blowing. Thus, in the absence of a power purchase agreement, the power producer could only charge during periods in which the wind turbines or solar panels are actually generating electricity. That may not be at a time in which the electricity is needed on the grid and obviously, nobody wants to pay for electricity that is not needed. A power purchase agreement basically means that the electric buyer is paying for electricity whether it is actually generated by the renewable facility or not. It is not really a great deal for the buyer, so frequently the owner of the renewable generation facility sells the electricity for a lower price than the buyer would pay in the absence of the contract. The owner of the renewable facility receives a stream of cash from the renewable plant that is generally consistent from period to period. This provides the kind of stability that we like to see from conservative plays in our portfolios.
The AES Corporation has power purchase agreements for far more than the 2.2 gigawatts that it has secured since the start of the year. The company stated in its earnings press release that it has secured contracts from electric buyers totaling 13.170 gigawatts, which is substantially more than the 5.389 gigawatts of renewable generation capacity that it currently has under construction. The company will have to construct significantly more renewable generation facilities to satisfy the requirements of these contracts, which provides it with a pipeline of growth that will likely appeal to those investors that are focused on a company’s “green credentials.” It should also result in cash flow growth going forward, which should appeal to anyone. The company states that the majority of the capacity to satisfy these contracts should come online within the next three years. Thus, AES Corporation appears to be very well positioned for growth over the near to medium-term.
One of the advantages of the company having a signed pipeline of new renewable projects is that it knows roughly how profitable each project will be. As such, it can make a pretty good estimate of its own growth rate. As I stated in previous articles on The AES Corporation, the company expects to grow its earnings per share at a 7% to 9% compound annual growth rate over the next five years. That is in line with analysts’ estimates as well. When we combine this with the current 3.37% dividend yield, shareholders can expect a total return of about 10 to 12% annually over the next five years. That is higher than most of the company’s peers, although it is not especially jaw-dropping for an actual growth company. This is certainly a very reasonable return for a conservative utility stock, though.
It is always important to investigate the way that a company finances its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is normally accomplished by issuing new debt and using the proceeds to repay the existing debt since very few companies have sufficient cash to completely repay their debt as it matures. This can cause a company’s interest expenses to increase following the rollover, depending on the conditions in the market. As interest rates in many developed countries are currently at the highest levels that we have seen in more than a decade, this is a very real concern today. In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. As such, an event that causes a company’s cash flows to decline could push it into financial distress if it has too much debt. While utilities like The AES Corporation tend to have remarkably stable cash flows, there have been bankruptcies in the sector before so this is not a risk that we should ignore.
One ratio that we can use to evaluate a company’s financial structure is the net debt-to-equity ratio. This ratio tells us the degree to which a company is financing its operations with debt as opposed to wholly-owned funds. It also tells us the degree to which a company’s equity will cover its debt obligations in the event of bankruptcy or liquidation, which is arguably more important.
As of June 30, 2023, The AES Corporation had a net debt of $24.5080 billion compared to $6.0470 billion of shareholders’ equity. This gives the company a net debt-to-equity ratio of 4.05 today. This is substantially higher than other electric utilities, as we can clearly see here:
|Net Debt-to-Equity Ratio
|The AES Corporation
|NextEra Energy (NEE)
|Exelon Corporation (EXC)
|FirstEnergy Corporation (FE)
The AES Corporation has substantially higher leverage than its peers, but this has been the case since we began following this company. It may have finally begun to see the consequences of this debt catch up with it, as the company’s interest expenses in the first half of 2023 totaled $640 million compared to $537 million during the same period of last year. This had an adverse impact on the company’s net income during the period, and will likely get worse going forward unless rates decline in the near future. That scenario is looking less and less likely with the passage of time. As such, we can expect that the company’s debt will weigh on its earnings growth for quite some time.
One of the biggest reasons why investors purchase utility stocks like AES Corporation is because of the very high yields that these companies frequently possess. As of the time of writing, AES Corporation yields 3.37%, which is substantially higher than the 1.45% yield of the S&P 500 Index (SP500) so it is certainly not an exception to this rule. In addition to a yield that is higher than the market, the company has a history of raising its dividend on an annual basis:
This is something that is very nice to see during inflationary periods, such as the one that we are in right now. This is because inflation is constantly reducing the number of goods and services that we can purchase with the dividend that the company pays out. This can make it feel as though we are getting poorer and poorer with the passage of time, which is an especially big problem for anyone that is depending on their portfolio for the income that they need to pay their bills. The fact that the company increases the amount that it pays its shareholders each year helps to offset this effect and ensures that the dividend maintains its purchasing power over time.
As is always the case though, it is important that we ensure that the company can actually afford the dividend that it pays out. After all, we do not want to be the victims of a dividend cut since that would reduce our incomes and almost certainly cause the company’s stock price to decline.
The usual way that we judge a company’s ability to pay its dividends is by looking at its free cash flow. The free cash flow is the amount of cash that was generated by a company’s ordinary operations that is left over after it pays all of its expenses and makes any necessary capital expenditures. It is therefore the amount that is available to do things that benefit the shareholders such as reducing debt, buying back stock, or paying a dividend. In the twelve-month period that ended on June 30, 2023, The AES Corporation reported a negative levered free cash flow of $3.5160 billion. That was obviously not enough to pay any dividends, but the company still paid out $433.0 million to its shareholders over the period. At first glance, this will almost certainly be concerning as the company is not generating enough cash to cover its capital spending and dividends.
However, it is not unusual for a utility to finance its capital expenditures through the issuance of debt and equity. The company will then pay its dividends out of operating cash flow. This is done due to the incredibly high costs of constructing and maintaining a utility-grade infrastructure network over a wide geographic area. If the company had to fund everything solely out of free cash flow, it would either have to charge prices that are far beyond the ability of most households to afford or never provide any sort of return to its shareholders.
During the trailing twelve-month period, The AES Corporation had an operating cash flow of $3.0370 billion. That was obviously more than sufficient to cover the $433.0 million that was paid out in dividends with a substantial amount of money left over for other purposes. Investors should overall not need to worry too much about the safety of this dividend.
It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return from that asset. In the case of an electric utility like The AES Corporation, we can value it by looking at the price-to-earnings growth ratio. This ratio is a modified version of the familiar price-to-earnings ratio that takes a company’s forward earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 is a sign that a stock might be undervalued relative to the company’s forward earnings per share growth and vice versa. However, there are very few companies that have such low ratios in today’s richly valued market. As such, the best way to use this ratio today is to compare AES Corporation to its peers in order to see which stock offers the most attractive relative valuation.
According to Zacks Investment Research, The AES Corporation will grow its earnings per share at an 8.76% rate over the next three to five years. This is in line with the company’s own guidance and seems pretty reasonable. This growth rate gives the company a price-to-earnings growth ratio of 1.32 at the current stock price. Here is how that compares to the company’s peers:
|The AES Corporation
It appears that The AES Corporation offers a very attractive valuation relative to its peers right now. This may be due to the market’s disappointment with the company’s second-quarter earnings report as well as concerns about the risks associated with its high leverage. For those investors willing to stomach that risk though, there could be an opportunity here.
In conclusion, The AES Corporation’s most recent results were weaker than the market wanted and unfortunately, we are beginning to see its high leverage weigh on profitability. That will likely weigh on the company’s earnings for a while, particularly if no rate cuts are forthcoming. The company does have very significant opportunities in the renewable energy space along with a reasonable valuation. Overall, an investor that can stomach the risks associated with the company’s debt load might find some things to like here.