Why AQN Stock Remains a Risky Bet Despite Its 20% Surge in 2023

Should you buy Algonquin stock?

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TSX stocks have gained 6%, while a struggling utility Algonquin Power (TSX:AQN) has soared an impressive 20% this year. AQN stock saw notable value erosion last year – quite rare among utilities – after the company reported an earnings decline in Q3 2022. But with a recent rise, is the stock readying for a new growth chapter? Let’s see.

What’s next for AQN stock?

Utilities is a capital-intensive sector and carry a large amount of debt. As interest rates rose surprisingly higher last year, Algonquin’s interest expenses swelled due to its sizeable variable debt. Its quarterly net income fell remarkably, forcing the company to trim dividends.

As cash retention became necessary, Algonquin cut its 2023 dividend by 40%. While utilities are popular for their less volatile stocks and stably growing dividends, AQN disappointed investors on both fronts. For the current year, AQN is now expected to pay a total dividend of $0.43 per share, implying an annual yield of 4%.

According to the company guidance, its payout ratio for 2023 is around a decent 75%, in line with the industry average.

Although the stock has risen this year, AQN and its investors do not seem out of the woods just yet. As the economy still remains hot, we might see interest rate hikes continue for longer. Moreover, its Kentucky Power acquisition will likely bloat its balance sheet further, raising its interest expenses.

In Q3 2022, Algonquin paid $75 million in interest expenses, 50% higher than in Q3 2021. It expects a $16 million higher interest outgo for every 100-bps interest rate hike. So, even after a dividend cut and stock price surge, AQN does not look fundamentally strong.

Algonquin Power versus peer utility stocks

Some peer utility names like Fortis (TSX:FTS) have seen several rate hike cycles and multiple recessions in the past. It has emerged strong almost after every downturn due to its stellar fundamentals. Fortis has large exposure to fixed-rate debt and derives almost the entirety of its earnings from regulated operations. This makes its earnings and dividends more stable and reliable. As a result, FTS has increased its dividends for the last 49 consecutive years.

When you are investing in utilities, stability is of utmost importance. They are often called “widow-and-orphan” stocks due to their low-risk, moderate return prospects. Algonquin Power still offers a riskier proposition due to concerns over its earnings growth.

Algonquin was among the fastest-growing utilities in the last decade, mainly due to its combination of regulated and renewable operations. Its adjusted EBITDA (earnings before interest, tax, depreciation, and amortization) since 2016 has grown by a handsome 25% compounded annually, far higher than the industry average.  However, how it plays out amid the swift policy tightening cycle this time will be interesting to see.      

Algonquin is set to release its Q4 2022 earnings on March 17, 2023. According to analysts’ estimates, AQN is expected to report earnings of $0.27 per share for the quarter, representing flattish growth year-over-year. Apart from earnings, its management commentary and guidance update will drive AQN stock.

What’s ahead for utilities?

Considering the longer-than-expected rate hike cycle, AQN stock is a risky bet for utility investors. In comparison, peer utility stock Fortis offers decent return prospects with its stable earnings and dividends.

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.

The Motley Fool recommends Fortis. The Motley Fool has a disclosure policy. Fool contributor Vineet Kulkarni has no position in any of the stocks mentioned.

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