Algonquin Power & Utilities (TSX:AQN) stock has declined close to 20% from its high in May. It has some near-to-medium uncertainties. First, it plans to sell its renewable power portfolio. Second, it is exposed to interest rate risk. Third, the company is currently led by an interim chief executive officer (CEO). So, there is higher risk in investing in Algonquin stock today.
Selling its renewables portfolio
Last month, after a strategic review, Algonquin announced that it planned to sell its renewable power portfolio, which would turn it into a pure-play regulated utility that has the potential for valuation expansion. However, as you probably have noticed, the valuations of renewable assets have come down since 2022 from higher interest rates (To be fair, the valuation contraction applies to many other assets as well, as rising interest rates have increased the cost of capital and made investments less attractive.).
Upon a successful sale, management anticipates using the proceeds for debt reduction and share repurchases, which can help drive a higher stock price. It also plans to maintain its dividend and investment-grade credit rating of BBB.
For your reference, Algonquin’s renewables business contributed to almost 13% of its revenues last year. It believes that a focus on lower-risk investment opportunities in regulated utility assets would be a better path for the company.
After selling its renewable assets, Algonquin would be left with a regulated utility rate base that’s divided across roughly 58% in electric, 22% in gas, and 20% in water utilities. About 89% of the portfolio would be in North America with the majority in the United States.
Exposed to higher interest rates
As mentioned earlier, Algonquin’s credit rating of BBB is not as high as some of its peers. Therefore, it would have a higher cost of capital than its higher-quality peers when it makes new debt offerings or needs to refinance its debt.
In 2022, Algonquin’s interest expense jumped by 40% to US$293.7 million. From 2021 to 2022, its debt-to-asset ratio and debt-to-equity ratio jumped from 54% and 55%, respectively, to 59% and 2 times. At the end of the second quarter, the ratios were 60% and 2.1 times, respectively.
Interim CEO
Last month, Algonquin appointed energy industry veteran, Christopher Huskilson, who has been a member of its Board of Directors since 2020, as its interim CEO. We have no way of knowing when a more permanent CEO may come in or whom they may be. And, of course, there’s no way of knowing if they will be any good until in hindsight.
For now, Algonquin is a “show me” story. These three factors will weigh on its valuation in the near term, preventing it from trading at a multiple that’s similar to its higher-quality peers.
Valuation, dividend, and returns potential
At $9.65 per share at writing, Algonquin trades at about 13 times its forward adjusted earnings. Management projects its regulated utilities business can grow its adjusted earnings per share by 4–7% per year. Assuming AQN maintains its current dividend yield of 6.1% and grows its adjusted earnings per share by 4%, Algonquin stock could deliver annualized returns of about 10%.
Algonquin’s larger regulated utility peers trade at forward valuations of about 16–18 times. It may be reasonable for investors to target a longer-term multiple of about 15 times in Algonquin, which can drive additional upside of about 15% over the next five years.
The utility stock is obviously a higher-risk investment in the regulated utility space. Also, the stock remains in a downward trend. Therefore, it may be smart of interested investors to wait for a bottom or consolidation before considering a position.
