Neutral on AES Corp.

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We remain Neutral on The AES Corporation (AES) given its focus on long-term supply contracts, exposing the company to commodity price risks and making it unable to pass on any escalation in prices of coal and natural gas to its customers. The company's power generation portfolio is also skewed toward coal and gas, thereby increasing the burden of green investments.

AES Corporation reported first quarter 2011 adjusted earnings per share (EPS) of 40 cents, above the Zacks Consensus EPS estimate of 28 cents and an improvement over the EPS of 29 cents in the year-ago quarter. The results were driven by a favorable one-time arbitration settlement at Cartagena partially offset by financing costs related to the acquisition of DP&L. Total revenue in the quarter was $4.7 billion versus $4.3 billion in the year-ago quarter.

AES Corporation’s businesses encompass 27 countries across 5 continents representing a highly diversified earnings base. Geographic diversity has resulted in a portfolio that is well-positioned for capitalizing on regional differences in power prices and weather-driven demand. This also insulates the company from specific risks in any single region or country.

The company is investing a substantial chunk of funds for capacity expansion in the power hungry regions of Latin American and Asia, putting the company in an advantageous position compared to its peers who remain focused on North America. Steady economic growth and power demand in the emerging markets provide an avenue to offset to some extent the continued erosion of profitability in North America.

AES Corporation has a strong balance sheet compared to its peers with a low long-term debt-to-capitalization of 65.4% at the end of the first quarter of 2012. The company closed the first quarter of 2012 with cash and cash equivalents of $1.7 billion. The company continues to be a strong cash generator, having generated operating cash flows of approximately $2.9 billion in 2011. We expect AES Corporation’s strong liquidity to stand in good stead for any earnings accretive acquisitions, investments for organic growth, and its ongoing share buyback program.

On the flipside, AES Corporation’s focus on long-term supply contracts exposes the company to commodity price risk. The company would be unable to pass on any escalation in prices of coal and natural gas to its customers. Profitability at its regulated utilities depends on regular rate relief around the globe from their service countries. Further, the company’s substantial generation capacity under construction in emerging countries may face cost escalation and over-runs. This will impact the company since its earnings are fixed given its long-term delivery contracts for utility projects.

AES Corporation’s power generation portfolio is skewed toward coal and gas. Thus, the company is compelled to invest in renewable energy to meet stringent regulation standards. The company is also rapidly increasing its generation capacity and significantly focusing on fossil fuel plants. Coal prices are not only on the rise because of increasing demand in the emerging economies of China and India, but are also attracting supplies from across the world. This invariably puts the additional burden of hedging on the company’s ability to smoothly run its coal-based generation assets.

Arlington, Virginia-based AES Corporation is a global power company and is involved in the generation, distribution, transmission and selling of electricity to end-customers in the residential, commercial, industrial and governmental sectors. It competes with Edison International (EIX) and Duke Energy Corporation (DUK). The stock retains a Zacks #4 Rank (short-term Sell recommendation).

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