Well, Algonquin Power & Utilities Corp (AQN.TO / AQN) sure has seen better days in the past. On November 11, AQN reported their Q3 earnings, and the stock fell by more than 19% that very same day, then another 14% the next day. Clearly, the market did not like what the company said in their latest earnings report.
As you can see from the chart below, AQN has performed extremely poorly year to date.
Down 45.15% year to date. Ouch! As a fellow AQN shareholder, I certainly felt that pain.
In recent days, many readers have left comments and sent me emails asking what I think about AQN. Is AQN still a buy? Is the dividend safe?
I used to believe that at around $15, AQN was underpriced, despite its debt level. I also believed that AQN’s dividend was safe. But do I still have the same beliefs after the Q3 earnings?
Thus, what a better exercise for myself and readers by going through Algonquin Power & Utilities Corp’s Q3 press release, earnings report, and investor presentation and answering the following key questions that many readers, us included, have in mind:
- What happened that caused AQN’s price to tank?
- Is AQN still a buy at the current price?
- Is AQN’s dividend safe?
For those readers that missed it, you might want to take a look at the post I wrote a while ago on how to read annual and quarterly reports. To be able to read annual and quarterly reports and dissect all the info from the reports is a useful and vital skill to have if you want to become a better investor.
AQN Earnings Summary
So what happened in AQN’s Q3 earnings that spooked the market and had investors dumping their AQN shares like hot potatoes and resulting in a massive share price slide?
“It was a challenging third quarter. Despite year-over-year growth in Adjusted EBITDA, our results for the quarter came in below our expectations and were negatively impacted by increasing interest rates and the timing of tax incentives related to certain renewable energy projects. Our underlying businesses remain strong; however, we are not immune to the macroeconomic environment. Our team is focused on identifying and implementing the necessary adjustments while executing on our three pillars of Growth, Operational Excellence and Sustainability to drive shareholder value over the long-term,” said Arun Banskota, President and Chief Executive Officer of AQN.
“Looking ahead into 2023, broadly speaking, we expect pressure from increasing interest rates and broader macroeconomic conditions to impact our earnings. Although we are not providing 2023 guidance, our current view is that we will continue to drive growth in our regulated operating profit, albeit with some regulatory lag, while our renewables business is expected to be relatively flat as new program growth is tempered by lumpiness in our development pipeline. In light of the changing environment, we are reviewing our plans and targets for 2023 and beyond. We expect to provide further details at our upcoming Investor Day in early 2023.”
So from the press release and earnings call, AQN showed some positive things but also clearly stated that there are a lot of challenges ahead. More importantly, AQN painted a very bleak picture with the adjusted earnings per share.
- Earnings per share (EPS) of $0.11, down 27% vs. 2021
- Adjusted Net Earnings of $73.5 million, down 25% vs. Q3 2021.
- Revenue of $666M, up 26% vs. 2021
- Adjusted EBITDA of $276.1 million, up 10% vs. Q3 2021.
- Revised 2022 guidance for EPS – from $0.72-$0.77 to $0.66-$0.69
- Adjusted Net Earnings per common share of $0.11, a decrease of 27% vs. Q3 2021
While adjusted EBITDA, net earnings and revenue are up compared to 2021, the biggest kickers here are the severe decrease of adjusted net earnings per common share (down 27%) and the revised guidance for EPS (down 9.4% if we use the midpoint of the EPS guidance for calculation)
In addition, Algonquin Power & Utilities Corp is working to close the acquisition of Kentucky Power by January 2023.
While this acquisition cost came down from $2.846 billion to $2.646 billion, it will add approximately $1.221 billion in debt for Algonquin Power & Utilities Corp. For AQN shareholders, this basically means more debt, and more shares, which will further dilute the important valuation metric – EPS.
The rising interest rates – How that’s impacting AQN
Unless you’ve been living under a rock, you probably have heard that the Fed, the Bank of Canada, and central banks around the world have been raising interest rates as a way to combat the high inflation rates we’ve been experiencing.
Unfortunately, AQN has a lot of debt. The acquisition of Kentucky Power also brings a lot of uncertainties. Just how much the rising interest rates have impacted AQN?
According to AQN, while the company has approximately $2.1 billion of available liquidity, at the end of Q3, approximately 22% of the consolidated debt outstanding is subject to variable interest rates. According to Darren Myers, CFO of Algonquin Power & Utilities Corp, a 100 basis point increase (1%) in the variable interest rate would impact AQN’s interest expense by approximately $16 million annually.
The effect of the rising interest rate is already seen in AQN’s balance sheet. According to the Q3 earnings report:
In the three months ending September 30, 2022, interest expense was $23.3 million. While in the nine months that ended September 30, 2022, interest expense was $38.2 million. So the interest expense almost doubled in Q3 alone ($14.9 million in Q1 and Q2 and $23.3 million in A3)! This, however, shouldn’t come as a surprise given the US interest rates look like below, clearly indicating a sharp increase in the last three months.
To make matters worse, AQN has several term facilities and approximately $100 million of long-term debt maturing throughout 2023. With the rising interest rates, it will mean higher interest expenses for AQN, unless they can find alternative sources of financing at lower rates (probably unlikely).
This brings up a good question, what happens to AQN’s long term debt? When is AQN’s long term debt going to mature? If the long term debt will mature in the near term and AQN needs to refinance at a higher rate than previously, this definitely will result in an even higher interest expenses.
As we can see, AQN has senior unsecured notes of $1.15 billion at a rate of 1.18%. Will the interest rate be below or near 1.18% by the time these notes mature and AQN needs to refinance them? This could be a potential problem for AQN in the next few years.
Selling of renewable assets
In the Q3 earnings press release, AQN also announced it has entered into an agreement to sell ownership interests in a portfolio of operating wind facilities in the US and Canada for $277.5 million USD and $107.3 million CAD (~$358 million USD total) to InfraRed Capital Partners which is part of Sun Life. This is AQN’s way to unlock profit from existing assets and use the proceeds to invest in additional growth.
Because InfraRed has no interest in operating these facilities, AQN will continue to oversee day-to-day operations and provide management services to the facilities. This arrangement should and will allow AQN to generate on-going revenues.
Whenever a company sells assets, it always raises concerns and worries about whether the company is selling assets to pay simply down debt. What is even worse, selling assets or taking on more debt so it can continue to pay out dividends (we’ve seen that in the past, like Encana).
In this case, it is not unusual to see companies making this type of move. I think the selling of these wind energy assets by AQN is actually a smart strategic maneuver. It should help the company to reduce its overall debt. Generating profit from existing assets and using the proceeds to invest in additional growth or pay down debt is a strategic move that many companies deploy.
Is AQN still a buy at the current price?
So we come to the million dollar question – is AQN still a buy at the current price?
Well, I think investors are freaking out because of the reduction in EPS guidance. On top of that the decrease in adjusted earnings per share, the high level of debt AQN is carrying, and the uncertainty over the Kentucky Power acquisition certainly cause a lot more worries and concerns for many investors and analysts.
I believe investors and analysts do have valid concerns. AQN’s financial picture certainly isn’t all that rosy.
But I truly believe the recent steep drop in the share price is a complete market overreaction. A drop of ~9.4% in EPS guidance shouldn’t result in a drop of around 32% in share price. This is a utility company that we’re talking about here and utility companies typically don’t see such steep share price drops. Now if it was a high tech company like Apple, Tesla, or Alphabet, or a highly volatile stock like Zoom, Peloton, or Coinbase, such a price drop would be more expected.
So, is AQN still a buy at the current price?
For us, we already own quite a bit of AQN, over 2,500 shares in fact. And as you could see from our October dividend report, we managed to drip 39 shares of AQN.
Despite owning quite a high number of AQN shares, the actual dollar amount of AQN is only about 2% of our overall portfolio value. In other words, a relatively small position compared to our top 15 holdings in our dividend portfolio.
Because we already own such a large number of AQN shares, we do not plan to add more at the current price. And because we are enrolled in DRIP, our plan is to dollar cost average AQN shares via DRIP. If AQN’s share price were to stay low at around $10 or even below, it’d allow us to drip more shares and dollar cost average quicker.
But what about other investors that may not have as many AQN shares or just starting to look at AQN?
Well, if you fall into this category, I think the current price may be an attractive entry price but do know the associated risks as I’ve outlined above. If we were to hold only a few hundred shares of AQN, I would seriously consider adding more shares to bring down my cost basis. Overall, I still believe that AQN is a strong company with a lot of future growth.
I would like to point out that I cannot predict the future, so I have no idea what the share price will do in the next little while. Who knows, AQN’s share price can continue to drop like a falling knife. It can also stop falling and hold flat for the next little while. Or it can surprise everyone else and go up quickly (very unlikely).
Having said that, if you’re in for the long term, I think eventually you will be rewarded.
Is AQN’s dividend safe?
Now for the biggest question on every dividend investor’s mind – is AQN’s dividend safe?
Unlike typical dividend stocks, for utility companies, you can’t just divide dividends by earnings per share to get the payout ratio. This is because utility companies like Algonquin Power & Utilities Corp, Fortis, Emera, and Enbridge for that matter, typically invest a lot of money in assets each year, so earning per share isn’t a good metric to use when calculating the payout ratio.
Don’t believe me? Let’s quickly calculate the payout ratio for these four companies mentioned:
- AQN – 105.6% (using mid point of EPS guidance and $0.713 per share for dividends)
- FTS – 83.7%
- EMA – 92.5%
- ENB – 126.9%
You certainly wouldn’t expect any of these companies to raise dividends every year given the high payout ratios. But they continue to do so.
To figure out the true payout ratio for AQN, we must look at adjusted funds from operations or AFFO.
In other words, if we are to calculate the payout ratio for 2022 and 2021, using the numbers provided in AQN’s Q3 earnings report, we get a payout ratio of 59.7% for 2022 and 57.4% for 2021. Here’s a nice summary table:
Around 60% payout ratio is relatively normal for dividend-paying stocks. For example, Rogers (RCI.B) has a payout ratio of 64.2%, Power Corp (POW.TO) has a payout ratio of 65.3%, and Transcontinental Inc (TCL.A) has a payout ratio of 65.1%.
So, based on the payout ratio calculated from AFFO divided by the dividend, I’d say that AQN’s dividend is safe. I wouldn’t expect AQN to cut its dividend, I also wouldn’t expect AQN to raise the dividend payout in the next little while. Even if AQN does decide to increase the dividend payout to keep its dividend streak next year, I would expect the raise to be very little.
But given the high dividend yield of over 9%, raising dividend payout by a very little amount is totally expected.
Interestingly, CFO Darren Myers stated this in the earnings call.
“We have previously stated a target of 80% to 90% payout and there is always going to be, and I think the company has done a nice job of talking about this in the past. So there can be dislocation from year to year on where that target comes in — where it comes in relative to that target.”
I’d assume that Myers wasn’t referring to the AFFO payout ratio but another payout ratio calculated by AQN internally. But from what Myers stated, it seemed that the current payout ratio is roughly in line with the company’s target. So even with the lowered EPS guidance, the dividend should be still within the 80-90% payout target.
Having said that, RBC analyst, Nelson Ng forecasted a 38% dividend cut in 2023 while a TD Bank analyst forecasted zero dividend increase for a few years (from a reader comment).
I searched the internet further and found some analysts’ reactions (from Globe and Mail).
Per Nelson Ng:
“Management has an opportunity at its upcoming Investor Day to reset its strategy,” said Mr. Ng. “We believe Algonquin will need to cut its dividend, reduce its capital program and growth targets, explore additional asset sales, and keep equity needs to a minimum. The shares of AQN could be range-bound until there is more visibility. We are downgrading our rating to Sector Perform (from Outperform) and reducing our price target to $12 (from $17) to reflect the many uncertainties, including a potential dividend cut.”
And per BMO Nesbitt Burns’ Ben Pham:
“After dropping almost 20 per cent on Friday following the reduction in 2022 EPS guidance (and signals around an upcoming reset of long-term 7-9-per-cent EPS CAGR), AQN shares are trading at depressed levels that offer attractive value (approximately 12.5 times P/E vs. 17x times utility peers),” said Mr. Pham. “This is despite its diversified mix of essential service utility and renewable power plants. However, there are likely increasing risks of a ‘strategic’ dividend cut and funding needs are still high. Given this balance, we are lowering our rating.”
What do I truly think? Well, despite what the AFFO payout ratio tells me, and what AQN’s CFO said in the earnings press call, I truly believe a small strategic dividend cut early in 2023 is the responsible and the right thing to do.
Yes, a dividend cut would hurt all AQN shareholders, us included, but it’s way better to make sure the company is in good financial shape with a strong balance sheet.
It simply doesn’t make sense to continue paying dividends when the balance sheet is completely out of whack. That’s like trying to build a skyscraper with a poor foundation… it’s not going to work in the long run.
Even if AQN were to cut dividends by 50%, at the current share price, it’d still be yielding at more than 4%. This is certainly attractive enough for many dividend investors.
Furthermore, I believe a dividend cut by AQN will help the stock price to recover over time.
In fact, I’d actually be more concerned if AQN management decides to keep its current dividend payout. Even worse if AQN management decides to raise the dividend payout slightly in 2023. This would demonstrate that the AQN management is completely out of their mind! If this does happen, I will probably look for ways to sell our shares and close out our position in AQN, unless something convinces me otherwise.
So where do we go from here?
As mentioned, we plan to continue to hold our AQN shares and dollar cost average via drip. I want to see AQN finish the Kentucky Power acquisition and integrate the company successfully. Since the acquisition is expected to close in January 2023, we should be able to get a better view by early 2023.
Given AQN has successfully finished many acquisitions in the past few years, I’d give AQN management the benefit of the doubt that the Kentucky Power acquisition will be a successful one.
I also want to see AQN showing ways on how it can reduce its debt and cut down its interest expenses. This will be key to improving AQN’s balance sheet. As the company has shown with the selling of wind facilities that resulted in millions of proceeds, I’d love to see AQN continue to explore such strategic sales of its existing assets (it’d be best if AQN can continue the day-to-day operations to bring in revenues). Hopefully over time, this will drive a stronger guidance, maybe not in 2023 but perhaps in 2024.
Most importantly, investors need to remember to ignore short term noises and look at the long term picture.
Overall, I think there are a lot of risks associated with AQN but it’s certainly not as risky as holding cryptocurrency in one of the sketchy crypto exchanges (sorry I couldn’t resist).
Algonquin stated that it will host an investor and analyst day in early 2023 so hopefully we will get a better view of the company by then as well. I suspect there’s going to be a big stock price movement on investor day as the market gets more clarity about the company’s direction.
The AQN situation reminds me a lot of what Inter Pipeline went through not too many years ago. I’m certainly having a bit of a deja vu moment. In case you don’t recall, Brookfield Infrastructure ended up acquiring Inter Pipeline at a discounted price. If AQN’s share price stays at $10 or below for an extended period of time, who knows, maybe someone may just decide to acquire AQN.
Last time I checked, Brookfield has a tendency to gobble up companies that are severely undervalued and are in a financial tailspin. If I have learned one thing through my DIY investing career is to never say “never”. Stranger things have happened in the past and they probably will continue to happen.
I hope you enjoyed this analysis on AQN. Let me know what you think by leaving a word or two in the comment section.
Note: I’m not a professional advisor. What I’ve written here is purely my opinion. Please always make buying and selling decisions on your own after proper research.