Capital-intensive utility stocks have trailed the broader markets by a wide margin in the last two years. As interest rates have spiked since early 2022, the cost of debt has risen significantly for utility companies.
Typically, utility companies experience steady demand across market cycles, allowing them to generate predictable cash flows and pay shareholders a dividend. In the past decade, a lower interest environment allowed utilities to fuel their expansion plans at a low cost.
But as central banks tightened the supply of money to offset inflation, a debt-heavy balance sheet has exacerbated the risks for utilities this year.
Basically, utilities have to generate enough cash flows to reinvest in capital projects, maintain dividend payouts, and make regular interest payments. However, a majority of utility stocks have a dividend payout ratio of over 70%, which might be too high if cash flows deteriorate.
For instance, Algonquin Power & Utilities was forced to slash its dividend payout by more than 50% due to rising interest expenses. So, let’s see if AltaGas (TSX:ALA) is a good buy, given it currently offers you a dividend yield of 4.1%.
The bull case for AltaGas stock
Valued at $7.9 billion by market cap, AltaGas has two primary business segments: utilities and midstream. It transacts over 1.5 Bcf/d (billion cubic feet per day) of natural gas and provides producers an opportunity to move natural gas and natural gas liquids to overseas markets. AltaGas has an ownership interest in Petrogas and investments in natural gas pipelines in the U.S. and Canada.
Moreover, AltaGas delivers clean and affordable natural gas to 1.6 million customer homes and businesses through its regulated natural gas distribution utilities and regulated natural gas storage utilities in the U.S.
AltaGas expects demand for natural gas to remain stable and even grow at a consistent pace in the upcoming decade, providing it with an opportunity to expand its base of cash-generating assets over time.
A debt-heavy balance sheet
AltaGas’s total long-term liabilities have risen from $5 billion in 2015 to almost $13 billion in 2022. The company ended the third quarter (Q3) with more than $9 billion in debt, and rising interest expenses have weighed heavily on profit margins.
Its funds from operations per share stood at $0.50 in Q3, while it paid shareholders a dividend of $0.28 per share, indicating a payout ratio of less than 60%. AltaGas has enough flexibility to sustain its operations, given its low payout ratio and robust cash flows, amid an uncertain macro environment.
It now aims to lower its net debt to normalized EBITDA (earnings before interest, tax, depreciation, and amortization) multiple to 4.5 times. AltaGas also expects to reinvest additional EBITDA toward increasing investment capacity in the future.
Additionally, the company expects to grow dividends in line with growth in earnings. Analysts expect AltaGas to increase adjusted earnings by 5% annually in the next five years.
The Foolish takeaway
AltaGas is a diversified energy infrastructure platform that provides stable and growing cash flows. It continues to experience solid demand for natural gas and natural gas liquids. The company’s low-risk commercial frameworks allow it to generate predictable cash flows, as 70% of earnings are regulated or backed by take-or-pay contracts.
In addition to its dividend yield of 4.1%, AltaGas stock trades at a discount of 11% to consensus price target estimates.
