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Canadian Utility Stocks: 1 Stock I Like and 1 to Avoid
Just because it's a boring sector doesn't mean you need to make boring returns
They say with real estate you make 90% of your money by buying right. I think the same thing is true with stock market investing too.
Here’s what I do. I keep an eye on hundreds of companies and dozens of sectors pretty much all the time. I can’t tell you the details of all 100+, but I know enough about them that I can ramp up research quickly if the price declines.
This is a lot easier if you limit your investing universe to just Canadian stocks, btw.
A consistently performing sector suddenly in the toilet will almost always get my attention. Take power utilities as an example, the subject of this post. If the whole sector suddenly sells off 20-30%, did the business of generating power suddenly get a quarter or a third shittier? Or is it short-term noise, the exact thing that benefits a long-term investor?
(Hint: it’s almost always short-term noise)
Veteran market participants also have the advantage of seeing all this before. You see the whole sector falls, just like it did in 2018 and then 2014 before that. You also know dividends are secure, which helps protect the downside and make holding easier.
I think that exact situation is playing out in the Canadian utility sector today. Here’s one beaten-up stock I think is a buy and another I’m looking strongly at selling.
TransAlta Renewables - what the hell happened?
TransAlta Renewables (TSX:RNW) — or just Renewables for the rest of this post — was cruising along, trading at near the $20 per share level, for seemingly an entire year. I held my small position, continued to collect my monthly dividend, and paid attention to literally every other company.
Then the stock started to sell off a bit based on general weakness in the overall utility market. Again, I didn’t pay much attention, and instead focused on adding to my position in Algonquin, the kind of company I think could be a solid portfolio stalwart for decades to come.
Finally, last week, the you-know-what really hit the
fan turbine for Renewables. The company revealed the investigation into a tower collapse at its Kent Hills 2 wind site found foundation issues with all 50 turbines. The foundations are shot and must be replaced, a process that will cost between $75 and $100 million. It’ll take up to two years to replace every foundation.
The stock tanked on the news. After falling from $19 to $18 in the weeks leading up to the announcement, shares promptly fell to $16 each. They recovered a bit as the week went on, and closed Friday at $16.49.
I don’t know much about replacing wind turbine foundations — I was absent that day in engineering school, a place I’ve totally been — but I would think you replace a foundation and immediately the windmill goes back in service. But let’s be conservative and assume the whole site is down for two years.
Revenue from the project is $3.4 million a month, or $40.8 million annually. And because EBITDA closely tracks revenue — the nature of renewable power is most of the operating expenses are paid for in the construction phase — we can estimate 90%+ of the missing revenue translates into EBITDA. Let’s assume EBITDA for the project is $40M on an annual basis.
Based on the first three quarters of 2021 — the last quarter is finished but results aren’t out yet — Renewables should generate around $450M in EBITDA on an annual basis. Take out Kent Hills and we end up at $410M in EBITDA for 2022 and 2023, ignoring the contribution of new projects adding to the bottom line.
Once the company pays the very real interest and tax expenses, distributable cash ends up being approximately 2/3rds of EBITDA. So if EBITDA falls to $410M, distributable cash checks in between $250M and $270M. Let’s use the bottom number and assume is $250M for the next two years and then it pops back up to $300M as Kent Hills and other projects come online.
The market cap today is $4.4B. That puts us at just under 15x 2024 earnings, which is okay. But not as sexy as what we normally like.
Renewables has also been busy buying assets. It bought a 122MW solar farm in North Carolina. It bought the Skokumchuck wind facility and the Windrise wind project, which will add some 250MW to the portfolio.
Put it all together, and Renewables should be able to surpass $550M in annual EBITDA in 2024 once Fort Hills is back producing power, which translates into some $350M in distributable cash flow. That puts us at 12.5x 2024’s cash flow.
It’s a decent valuation for a utility. And there’s definitely room for multiple expansion as the sector becomes sexy again and Renewables fixes its problems. The stock easily traded at 20x cash flow back 1-2 years ago. Meaning the stock does have 25-50% upside if you think a portfolio of renewable power assets are worth 20x cash flow.
To sum it up, if you’re looking for a boring dividend payer, Renewables likely offers some upside for the patient investor. Just don’t look for any dividend hikes until 2024 at the earliest. The current yield of 5.6% is attractive, and makes it easier to wait for a raise.
I might nibble and buy a little more here. (Disclosure: small position I bought in 2018 in the $10 range)
This week Canadian Utilities (TSX:CU) cemented itself as the dividend growth champion in Canada, raising the payout for the 50th consecutive year.
Personally, I couldn’t give two rips how many consecutive years a company has increase the dividend. There are plenty of strong companies — like Canadian banks, BCE, and others — who were forced to suspend dividend raises through no fault of their own. They should not be excluded from consideration because they don’t have a magical dividend streak behind them.
But looking at the dividend champion list (which consists of all the companies who have raised their dividends for at least 25 consecutive years) is still a good exercise. It’s littered with good businesses that produce plenty of cash flow. The list is filled with the kind of businesses I want to own over the long-term. I pick and choose the cheaper stocks from it and leave the rest.
However, I’m less bullish on Canadian Utilities. The latest increase was a paltry 1%, and that was after a 1% raise in 2021 and only a 3% raise in 2020. You have to go back to 2019 and its 7.5% raise for the last increase to actually outpace inflation.
Earnings have also gone down as the company as sold assets. 2019’s adjusted earnings were $608M. The adjusted bottom line fell to $535M in 2020. That’s not the direction we want to see.
It is investing in various greener power generation projects, including a big push into solar. $3.2 billion will be spent between 2020 and 2023, increasing the asset base from $14 billion to $14.8 billion. That’s 2% growth per year. And it doesn’t look like it’s doing much for the bottom line. Yawn.
2% growth????? Is the fainting couch available? Cause I’m going to need it!
It’s little wonder why Canadian Utilities yields 5% today. The market sees it as a slow-growth mature company with very limited growth opportunities. The assets are solid, they’re not going anywhere. But they’re not getting much better, either. Expect token dividend increases in the 1-2% range until things change.
I’d much rather put my money into Capital Power (better growth, far better valuation), the aforementioned TransAlta Renewables, or even Fortis. I’ve been buying Algonquin lately too. All better opportunities today than Canadian Utilities, at least in this humble writer’s opinion.
(Fun fact: on the now defunct Canadian Dividend Investing blog, right around a year ago I predicted Fortis was pretty much a guaranteed 10% annual return. Comments called me a maroon for “only” settling for 10%. Including dividends, it’s up about 16% over the last year. I guess I haven’t had to settle for “only” 10%. So far, anyway.)
(Fun fact #2: Fortis underperformed many other assets in my portfolio last year, so maybe I’m actually the maroon)
Let’s wrap it up
Not really sure what the conclusion of this post should be. Sell Canadian Utilities, buy TransAlta Renewables? Shrug. Make your own decisions, dammit.
Personally, I’m not going to sell Canadian Utilities quite yet. I like to give these decisions more time in my head to percolate, and often as I do the stock starts to stir and come back to life.
Canadian Utilities has basically been dead money for five years now. The stock has done nothing and all you’ve earned is the dividend. That’s not ideal, and I wouldn’t blame you for selling. I’m sure thinking about it. Even after it made the dividend king list.