Utility stocks typically represent a lot of stability in the stock market. Due to the defensive nature of the underlying businesses, TSX utility stocks offer growth to investors through dividends supported by virtually guaranteed cash flows. However, Algonquin Power & Utilities (TSX: AQN) has disappointed investors for a while.
As of this writing, Algonquin stock trades for $9.09 per share, up by 34% from its 52-week low but down by almost 60% from its February 2020 levels. Investors who own the stock from a few years ago might be worried whether holding its shares is still a good idea.
Stock market investing is about looking ahead to see whether the investment can continue delivering returns in the long run. To this end, we will discuss how it might fare as a long-term holding.
Source: Getty Images
Interest rates and Algonquin’s troubles
Due to historically low interest rates, downturns in the broader economy did not impact shares of utility stocks drastically for many years. However, the key interest rate hikes from the Bank of Canada (BoC) had a major impact on them this time around.
Utility companies generate stable cash flows due to the essential nature of the services they provide. Regardless of how much consumers cut costs during an economic crunch, they cannot cut off utility services. It typically allows utility companies to earn virtually predictable revenues. However, utility companies also rely on heavy debt loads to support their businesses.
With higher key interest rates, companies with variable interest debt loads suffered drastically. Algonquin took on too much variable debt to fund its aggressive strategy to grow its utility business and invest in renewable energy.
When its dividends yielded 8.2%, Algonquin slashed its payouts by 40% along with firing its executive team to cut costs. Despite these measures, its dividend yield is creeping up again. As of this writing, it has a 6.48% dividend yield. Its payout ratio is estimated to be around 84% of its adjusted earnings this year. It means the company is less likely to slash dividends further.
Central banks in the U.S. and Canada are expected to announce a reduction in key interest rates next month. If the company’s earnings remain stable, it can maintain a sustainable payout ratio.
New management on the horizon
It is clear that Algonquin has to make several changes to avoid being forced to cut dividends. Reducing its variable debt might be necessary, along with reducing its aggressive capital programs. Algonquin’s largest shareholder who owns around 9% of the company, might deliver a notice to nominate three director candidates in the company’s Annual General Meeting in June.
Likely, the company will also sell off its renewable business to reduce debt and buy back shares. New management will likely be good for the company, as it opens the doors for fresh ideas to help improve business. Buying back shares right now can benefit the company due to its arguably undervalued share prices.
Foolish takeaway
Suppose you own shares of Algonquin stock from much higher levels a few years ago. It might not make sense to sell your holdings. The possibility of an improvement in its fortunes is there. However, it remains to be seen how the new management will enact changes.
Until that happens, you can continue getting returns through its high-yielding dividends. Once the situation improves, you can also enjoy growth through capital gains. There is a risk that it might face more short-term challenges. If the uncertainty feels too risky to stay invested, finding other alternatives in the same industry might be a better idea.
