Do This Simple Check Before Investing in Fortis Inc.

Fortis Inc. (TSX:FTS) has a current yield of 3.7%, which makes it the largest investor-owned utility in Canada. But before you buy it, you’ll want to do a little math.

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A couple of days ago I happened to be reading an article by contributor Nelson Smith about the three reasons to avoid Fortis Inc. (TSX:FTS), one of Canada’s best-performing utility stocks over the past 20 years.

Smith notes that there aren’t many stocks that have delivered 15.9% annually over the past 20 years, utility or otherwise. And he’s right. The TSX over the same period managed only single-digit returns.

Great stock, right? Not so fast.

He then goes on to mention three reasons to avoid Fortis stock; one being its level of debt, which has basically doubled in less than four years. With interest rates eventually set to rise, Fortis could be in a heap of trouble if it continues down this path.

However, there’s a simple check you can do that will tell you more about its ability to handle any interest rate increases and other unforeseen expenses.

It’s the funds-from-operations-to-debt ratio. It’s used by credit rating agencies to measure a company’s financial risk, including its ability to repay its debt using funds from operations.

It’s one thing to have $14 billion in debt; it’s another to have $14 billion in debt and no way to service the interest and principal costs on that debt. It’s a surefire path to going out of business.

Now, be forewarned. Some companies’ financial reports make it easier than others to find this information. Take Montreal-based utility Valener Inc. (TSX:VNR). It puts the information right there on page 40 of its Q3 2016 earnings report.

At the end of June Valener had $495.6 million in funds from operations over the trailing 12 months and total debt (less cash) of $3.1 billion for a ratio of 16%.

In other words, Valener generates 16 cents of funds from operations for every dollar of debt. Here, a higher percentage is definitely better.

Now, let’s take a look at Fortis. Unfortunately, it doesn’t provide this number, so we have to do a little digging.

Funds from operations are generally defined as cash flows related to operating activities less the net change in non-cash working capital items. Total debt is any bank loans, long-term debt, and the current portion of long-term debt less cash and cash equivalents.

Fortis has reported on two quarters this year, so we need to go as far back as Q3 2015 to get the 12-month number for funds from operations. That comes to $1.62 billion. Total debt less cash at the end of June was $11.3 billion.

This means Fortis generates 14 cents of funds from operations for every dollar of debt. A quick calculation of Emera Inc (TSX:EMA), a big rival to Fortis, shows that it’s got approximately 17 cents of funds of operations for every dollar of debt.

While a two- or three-cent difference might not seem like a lot, when you’ve got more than $11 billion in net debt compared to $3-4 billion, as is the case for Valener and Emera, you ought to at least consider the extra risk you’re taking owning its stock.

Track record and all.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Will Ashworth has no position in any stocks mentioned.

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