Algonquin Power Stock: Challenges Could Weigh on Investor Returns

Although Algonquin Power stock has returned 30% this year, but it remains a risky buy.

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Utility, wind power

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Growth stocks offer relatively less stability but can compound your money at a fast clip. Defensives, on the other hand, provide stability but can take decades to double your money. What if you could find some middle ground that offers a combination of both?

Algonquin Power (TSX:AQN) did just that in the last decade. It was thus investors’ darling stock till it hit the wall last year. Algonquin grew almost double the industry average in the last decade and offered a juicy dividend yield with reasonable stability. However, things upturned amid one of the rapid interest rate hike cycles last year.

What’s next for AQN stock?

After correcting 35% in November 2022 – that’s way too much for a utility stock – AQN plunged almost to its decade-low levels. Fast forward to today, it has somewhat stabilized in the last couple of months and has gained 30% this year.

According to Algonquin’s management guidance, the company expects to report adjusted earnings of $0.58 per share, implying a 13% decline compared to 2022. Amid the earnings decline, it has also announced a 40% dividend cut for 2023.

Utilities generally grow stably in almost all kinds of business cycles, and that’s why they are perceived as defensives. So, the double-digit earnings drop and a steep dividend cut is quite concerning for conservative investors. However, that has already been priced into the stock.

Rising interest rates and a bloating balance sheet

More surprises like these could do more harm to the stock, though. As rates rose rapidly last year, Algonquin’s interest expenses also significantly went up. It spent $279 million in interest expenses in 2022, a substantial 33% increase compared to 2021.

Utilities are capital-intensive businesses, and companies carry a large pile of debt on their books. However, in the case of Algonquin, a large part of the debt carries a floating interest rate, which did more damage compared to its peers.

Algonquin’s higher debt pile is indeed concerning. At the end of Q4 2022, it had net debt of $7.5 billion and a net debt-to-EBITDA ratio of 8x. That’s much higher than the industry average. Net debt-to-EBITDA (earnings before interest, tax, depreciation, and amortization) is an important leverage metric that shows how many years a company would take to repay its debt.

Moreover, if interest rates continue to increase further this year, Algonquin might see more pressure on its bottom line. The management has been working on moving the variable rate to fixed-rate debt. However, if rates rise higher than expected, AQN stock might see some action like last year.

AQN stock is currently trading 20 times its 2023 earnings. That does not look significantly discounted compared to peers. Some of the top TSX utility peers offer stable earnings growth prospects and are trading at a relatively appealing valuation. AQN yields 5%, marginally higher than the industry average.

Bottom line

In a nutshell, AQN stock does not seem all bad. Its regulated and renewable operations could drive stable earnings in the next few years. However, considering its higher exposure to rates, it is still a risky bet for safety-seeking investors. There are a couple of options in the TSX utility space that offer superior stability along with juicy yields and decent return prospects.

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

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