On January 30th shares of Fortis Inc. (TSX:FTS) hit an all-time high, closing at $41.91 each. Since then, shares are down 15% to the current price of just above $35.
Investors looking for an explanation don’t have to look much further than the outlook on interest rates. Like so many other utilities, Fortis is primarily a yield play. Since investors have the expectation that interest rates are heading higher in the short term, suddenly Fortis’s dividend isn’t so attractive—at least compared with alternatives. This has caused shares to decline.
Of course, Fortis is a much more complicated story than just the dividend. Let’s take a closer look at this stock to see whether now is a good buying opportunity.
Valuation
On the surface, Fortis looks prohibitively expensive. Google Finance has it trading at 25 times earnings, which is a lot for a utility company that doesn’t have much in the way of internal growth prospects.
But looking out to the future, the valuation is more reasonable. According to analysts, the company is projected to earn $2.03 per share in 2015, and $2.15 per share in 2016. That puts the stock at approximately 17 times forward earnings, which is about where the average stock on the TSX Composite trades.
Looking backwards, Fortis has had a hard time growing earnings without the benefit of a major acquisition. From 2011 to 2014, earnings actually declined each year from $1.70 to $1.38 per share. Earnings are only expected to be higher this year because of its acquisition of UNS Energy, which is performing well, especially when converted back to Canadian dollars.
Balance sheet
Fortis has taken on a lot of debt over the past few years.
At the end of 2011 Fortis owed $6.4 billion in debt, as well as $912 million in preferred shares. By the end of 2014 that debt had ballooned to $11.5 billion and $1.8 billion in preferred shares. Even for a utility with equity of approximately $8 billion, that’s still a fair amount of borrowing. Management has also issued approximately 35 million new shares during that time.
I think investors have to question just how effective management has been when it comes to borrowing. Total debt has gone up by more than $4 billion since the end of 2011, yet earnings will have only increased by approximately $150 million if we believe the 2015 earnings projections.
Dividend strength
Everybody looks at Fortis’s dividend history in awe, and for good reason. A dividend that’s gone up each year since the Nixon administration is an accomplishment worth bragging about.
But when you dig a little deeper, I’m not sure I’d list Fortis’s payout as one of the most secure out there. A company needs free cash flow to be more than a dividend to have a truly sustainable payout. And since 2010, Fortis’s dividend has exceeded its free cash flow every year. In fact, free cash flow has been consistently negative.
Essentially, at least some of that $4 billion in excess debt over the last little while has gone towards paying shareholders.
Outlook
One reason why investors aren’t concerned about the company’s negative free cash flow is because Fortis has several new projects in the works, including a large hydroelectric plant and a LNG terminal in British Columbia. Between all these new projects and organic growth, management predicts earnings could grow as much as 7.5% annually over the next five years.
For a utility, that’s pretty solid growth. But for my portfolio, I just can’t get over the company’s high debt load and the negative free cash flow, which is projected to continue over the next couple of years. Considering these warts, Fortis would have to become even cheaper before I’d consider it for my portfolio.
