Algonquin Power: Forget About The Dividend; Is There Value There?

A few of you asked me to cover Algonquin Power and Utilities (TSX:AQN)(NYSE:AQN) on the ol’ Substack over the last couple months, something I avoided doing for a number of reasons:

1. I wanted to wait for the proverbial dust to settle and look at it after all the hot takes had been taketh

2. I was looking for more clarity on the Kentucky power takeover situation (more on that later)

3. I’m always curious to see what fellow analysts have to say and because I’m a rat, default to the contrarian position

4. I wanted to spend a decent amount of time on it, a luxury I didn’t have when I was working full time

But first, an intro for those of you who aren’t wholly familiar with Algonquin.

Intro

Algonquin has grown — primarily through acquisitions — into one of Canada’s largest utility companies. The business essentially has two parts. The first part owns regulated utilities in North America and the second part owns power plants that sell their energy to the highest bidders, generally through long-term contracts called power purchase agreements (PPAs).

Let’s begin with the regulated business. In 2001, the company begun its expansion into the regulated utilities business with the acquisition of water treatment facilities in Arizona. In 2009 it further expanded with another water acquisition when it acquired Liberty Water.

2010 was when the company started getting into the electric utility business, buying California Pacific Electric, located in Lake Tahoe. By 2011 it had acquired natural gas utilities in various states including New Hampshire, Missouri, Iowa, Arkansas, Georgia, Massachusetts, and Illinois.

The next major utility acquisition was in 2017, when the company purchased the Empire District Electric Company, which had assets in places like Kansas and Arizona. 2019 saw the company buy New Brunswick Gas and St. Lawrence Gas, the latter which operates in upstate New York.

Finally, in 2022, the company acquired an additional 125,000 water customers on Long Island through New York Water.

In 2021 the company announced it had agreed to buy Kentucky Power for $2.846B, a number that was later renegotiated to $2.646B because long-term interest rates had increased. This deal appears to be in doubt after the federal utility regulator denied the sale, but the two parties are still trying to do what they can do gain regulator approval.

Put it all together and Algonquin’s regulated businesses have more than 1.2 million combined customers across North America, Bermuda, and Chile.

Onto the power generation business. Algonquin has been focusing on renewable energy generation for years now, and has built up a business with 4.2GW of capacity. 75% of the assets are invested in wind power, 21% in solar, and the rest mixed between hydro and “other”. Assets are spread across North America.

Here’s a map of Algonquin’s assets:

The story today

Algonquin was a market darling for years, making acquisitions that all seemed to perform up to expectations. It was a growth name in a sector that isn’t usually associated with that.

The market loved the regulated utility business, of course. If you want water in Long Island, gas in New Brunswick, or power in Bermuda, you don’t have much choice. Your product is coming to you through assets owned by Algonquin. The moats on these businesses are fantastic, although regulators do cap the upside.

Regulators. When have they even been good for anybody?

Lately, however, the company has stumbled a bit. In November it announced quarterly earnings that were below analysts’ expectations and below the previous year’s results. Adjusted net income came in at US$0.11 per share, compared to US$0.15 per share a year earlier. Once you take adjustments away the results look much worse with the quarterly loss coming in at US$0.29 per share. (Algonquin reports in US Dollars, so all financial info from now on will be in USD unless I say otherwise)

Algonquin also took the opportunity to cut full year guidance, slashing its outlook for 2022 from a range of $0.72 to $0.77 per share to a $0.66 to $0.69 range.

A closer look at the earnings revealed this nugget, which explains the big difference in adjusted earnings (11 cents per share) and the actual earnings (negative 29 cents per share)

You’re telling me that you just happened to mark up certain assets by $300M? When the business as a whole is struggling? Jennifer Lawrence, what do you think about that?

Investors were already a little nervous about the stock because of higher interest rates, and the quarterly results didn’t help. Shares absolutely cratered on the news, not finding a bottom until weeks later. See if you can spot when the disappointing earnings were released.

One of the hallmarks of dividend investors is despite telling everyone they’re patient, long-term thinkers is they’re as prone to overreaction as the rest of the market. They take one look at a struggling operation like Algonquin, declare the dividend is toast, and hit the sell button. After that wave came the tax loss sellers, who clean up their portfolios at the end of the year to offset any owed tax or, more likely in 2022, to get rid of the crummy parts of their portfolio.

I’ve often called myself a value investor who just happens to insist on dividends, so let’s take a closer look at what Algonquin looks like today. First up, dividend safety.

Will Algonquin maintain its dividend?

At first glance, the 10.9% dividend appears to be toast. There are no other utilities that pay out something so aggressive, so why would Algonquin?

Hell, there are no other stocks that pay out nearly 11% dividends that could be thought of as sustainable. What chance does Algonquin have?

I tend to agree with these statements, and think this is a wonderful opportunity for the company to cut the payout 50% and put that money to work solidifying its balance sheet. But for the sake of argument, let’s explore the other side of the coin.

The numbers say the company isn’t going hugely backwards if they maintain the current payout. The dividend is 72 cents per share (U.S. dollars). 2022’s adjusted earnings expectations are 66 to 69 cents per share. That puts the payout ratio at slightly above 100% of adjusted earnings.

But what will adjusted earnings do next year? According to analyst estimates collected on the always helpful Tikr, Algonquin’s EBITDA is projected to increase by 17% in 2023 compared to this year. After increased interest costs, normalized income is expected to increase around 10%.

In other words, Algonquin is expected to earn approximately 75 cents per share in 2023. That would put our payout ratio above 90%. That’s still high, but Algonquin has maintained a high payout ratio for a few years now, and it wouldn’t be hugely out of line compared to other similar stocks, like Canada’s largest telecoms. At least from a payout ratio perspective.

Algonquin has also been a dividend growth stock for over a decade now, increasing its payout each year since 2009. Although, in fairness, the company did cut its dividend during the financial crisis. Stocks with such a long streak are usually loathe to cut the payout, especially ones with pretty obvious growth paths. The company could simply wait for earnings to catch up to dividends, giving investors token raises in the 1-2 years it takes for that to happen.

(Note: the payout in USD is consistently higher over the last decade. This is the payout converted to CAD, which explains the dip. The point is the payout has consistently gone higher)

Overall, I’ll say this. If I was running Algonquin I’d cut the dividend. The balance sheet could use the extra cash flow to put towards debt, and the market is acting like the dividend is cut already. The stock has already been punished. You might as well cut the payout.

You should assume the payout will be cut a minimum of 50%. If it isn’t, consider it a massive bonus. Still, that’s a 5%+ dividend today. That’s an excellent payout.

What about the business?

If Algonquin can right the ship and get the debt a little more under control, the company could end up being a big winner for patient investors who nibble today.

The debt is the biggest issue I can see. The company has a market cap of approximately $6B on the TSX. But enterprise value is closer to $19B. They need to improve the balance sheet.

A dividend cut should help. Close to $500M goes out the door in dividends each year. Cut that back to $250M and that alone gets you $1B worth of debt payoff in just four years. Hey, it all helps.

The company also has an asset recycling program, where it sells off non-core assets to help improve the balance sheet. This program has just begun, but it has already generated nearly $400 million in proceeds. It’s a start, although these programs sometimes sell off the good stuff and leave more of the mediocre assets, since the former sells for more. Still, it’s a promising start.

Algonquin is quick to point out it doesn’t think the balance sheet is a huge issue, saying out it has ample liquidity to close the Kentucky Power deal and have an additional $2B+ in dry powder for additional transactions. Also, this position of 33% equity 66% debt isn’t entirely foreign to it, although we must keep in mind having that much leverage is much easier in a lower rate environment.

The stock is pretty damn cheap from an earnings perspective. Let’s assume it earns $0.70 per share in 2022 and $0.75 per share in 2023. Convert those to Loonies and you have earnings expectations of $0.95 and $1.02 per share in 2022 and 2023, respectively.

Shares currently trade hands at $8.82 on the TSX. Meaning this company trades at a mere 8-9 times earnings. No matter how you slice it, it’s cheap. Especially when compared to other utilities.

For a minute, let’s compare Algonquin to Fortis. The latter will generate $2.76 per share in 2022, at least according to analyst projections on Tikr. It currently trades at $54.18, giving it a P/E ratio of just under 20x.

I realize Fortis is a finer company than Algonquin, in many ways. But does it deserve a valuation TWICE as high as Algonquin? Or should it trade at a high teens P/E and Algonquin trade in the mid-teens? And remember, Algonquin was a market darling just 24 months ago. It traded at a similarly high valuation, and could easily do so again.

Remember, something like 80% of Algonquin’s revenues come from the regulated utilities part of the business. The other 20% is merchant power, which I’ll agree isn’t the greatest of businesses. Other merchant power generators (like Capital Power and TransAlta) trade at lower price to earnings ratios, and deservedly so. But still, most of the business is what you’d call moaty, and perhaps should trade at a premium valuation.

There’s also the growth aspect to the story. I’d argue a stock that’s done this over the last decade (with potential to do something similar over the next decade) is worth far more than 8-9 times earnings.

First, revenues:

Then, normalized earnings:

You’ll notice a couple years of analyst projections thrown in there at the end of the earnings graph there. Take those with a grain of salt, obviously, but I put those in to illustrate how earnings are expected to grow over the next couple years. They shouldn’t collapse, anyway.

The point is this. Algonquin has done a good job over the last decade growing the business while also increasing per share earnings. This is relatively rare for a utility company, and I argue they are worth at least a market valuation because of it. This isn’t an unreasonable take, especially if you consider the stock has spent most of the last five years trading at a premium valuation.

If the stock trades at 15x earnings, we’re looking at a share price in the $15 to $16 range, or a return north of 50% from today’s price. Plus any dividends. Not bad on a two or three year time horizon. You get any optionality on acquisitions (like Kentucky Power) thrown in for free.

A quick word on Kentucky Power, and why I think it’s important. If federal regulators are blocking deals like this, it’s a big deal not only for Algonquin but for many of its peers as well. I think that’s also pushing the stock down. If regulators are going to block acquisitions, that’s ultimately going to impact growth for the best part of the overall business.

But Kentucky Power could be a win for Algonquin if they can can a) win the right to acquire it and then b) turn it around. It’s allowed to earn close to a 10% ROE from regulators. The current ROE is closer to 7%. And Algonquin has plenty of assets in surrounding states. It’s not like they’re expanding into Europe or Asia for the first time. There’s a certain amount of expertise there.

The bottom line

The last time I went fishing in the “busted utility that’s about to cut its dividend” pool was Altagas in 2018, when it was about to cut its dividend. It had a bloated balance sheet, lots of debt, and was about to close on an acquisition the market hated.

Sound familiar?

(As an aside, Altagas bottomed right before it cut the dividend. The stock had a nice pop on the news, and I think Algonquin could have a similar pop)

Ignoring the dividend, Algonquin is a quality business that trades at a cheaper valuation than its peers, despite better growth potential. Two years ago investors were paying for a cheery outlook, and the valuation reflected that. Now the valuation is cheap, and nobody wants it. That doesn’t make sense to me.

Many of you refuse to buy stocks that have any chance of cutting the dividend. That, at least in my opinion, is an unwise strategy. Analyze each situation individually and sometimes, like with Algonquin, you’ll see good quality businesses that just happen to be in a position that they have to cut the dividend.

Disclosure: Long Algonquin and currently buying more