The utility sector is hardly mentioned as one of the shelters from rising inflation. With the inevitable rate hikes coming, bank stocks are attractive investments. Gold stocks and real estate investment trusts (REITs) are two other safety nets. Market analysts say utility companies are vulnerable to dividend cuts because of higher interest and input costs.
If the assessment is correct, then the 6% annual dividend growth of Fortis (TSX:FTS)(NYSE:FTS) could be in peril. The utility stock is TSX’s top defensive stock owing to 48 consecutive years of dividend increases. It could be Canada’s second dividend king after Canadian Utilities if the company hikes its dividend this year and in 2023.
Reduced profit margins
Because commodities prices are rising during this inflationary period, many businesses are incurring higher input costs. Utility companies could see their profit margins drop since most of their assets are regulated by governments or in jurisdictions where they operate. They may not be able to pass on higher inputs to customers or end-users.
Fortis derives nearly 100% of its revenue from regulated utility assets. Under normal conditions, the business model is low-risk, and cash flows and shareholder returns are steady and predictable. Income investors love this top-tier utility stock because it has proven to be less volatile in down markets. Also, wild price swings are rare.
Higher debt burden
A high interest rate environment is also a threat to utility companies since the business is capital intensive. Fortis’ debt burden could increase significantly and strain the balance sheet. The $27.43 billion electric & gas utility company announced a new capital plan (2022 to 2026) worth $20 billion.
Fortis will continue to focus on transmission and distribution, although 9% of the total capital spending or $3.8 billion will go to cleaner energy infrastructure. Management said it will primarily fund the capital plan through cash from operations. However, there’ll also be debt issued at the regulated utilities plus common equity from the dividend reinvestment plan.
The company expects its rate base to eventually increase to $41.6 billion by 2026, which represents a five-year compound annual growth rate of about 6%. It is for this reason that management has a guidance of 6% annual dividend growth through 2025. Fortis will pursue additional energy infrastructure opportunities after 2026.
2021 financial results
David Hutchens, president and CEO of Fortis, said, “In 2021, Fortis delivered steady growth and made significant progress on our long-term goals. We executed a $3.6 billion capital program, provided strong returns for our shareholders, and further reduced our carbon emissions.” He adds that Fortis outperformed industry averages for safety and reliability performance.
For the full-year 2021, net earnings rose by $22 billion to $1.23 billion versus the full-year 2020. Hutchens cites the unfavourable impact of foreign exchange as the reason for the smaller earnings growth (1.8% year-over-year). With the reduction target in carbon emissions of 75% by 2035, Fortis should attract ESG investors this year.
Exception to the rule
The successful execution of Fortis’ capital plan and diversified utility portfolio plus growth opportunities will enhance shareholder value even more. This utility stock is an exception to the rule. It will hold steady and keep investors whole on the 6% annual dividend growth through 2025.