Fortis (TSX:FTS) is up 25% in the past year. Investors who missed the rally are wondering if FTS stock is still undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio focused on dividends and long-term capital gains.
Fortis share price
Fortis just hit a record high above $67.50 per share.
The latest surge extends a recovery that kicked off in June last year when the Bank of Canada started to cut interest rates. The rate cuts halted a slide in Fortis that began in the spring of 2022 when the market realized that aggressive rate hikes were on the way in Canada and the United States as the central banks faced soaring inflation.
Why are interest rates important for utility stocks?
Utility companies like Fortis use debt to fund part of their growth programs. Projects often cost billions of dollars and can take years to complete. The sharp rise in interest rates over such a short period of time in 2022 and 2023 drove up debt expenses on variable-rate loans and made borrowing new funds more costly. A jump in interest expenses cuts into profits and can reduce the cash that is available for distributions to shareholders. Higher borrowing costs can also force companies to shelve some projects, which can slow down growth.
Rising interest rates also give income investors other alternatives to generate decent returns on savings. The jump in Guaranteed Investment Certificate (GIC) rates to as high as 6% in 2023 likely caused a shift of funds out of utility stocks to safe alternatives.
Rate cuts have now reversed that trend. Borrowing costs are down, and the drop in GIC rates has investors moving back into dividend-growth names.
Outlook
The Bank of Canada and the U.S. Federal Reserve are currently in a wait-and-see position with regard to additional rate cuts. On one hand, they are worried that tariffs will be passed on to consumers. This would drive a new surge in inflation, which would warrant rate increases. At the same time, a trade war could cause a recession in Canada and the United States. In that scenario, the central banks would be under pressure to cut rates to stimulate economic activity.
Analysts widely expect the central banks to cut rates to support the economy, even if it means living with inflation that is higher than the target rate. In that scenario, lower rates would likely provide an extended tailwind for utility stocks.
Growth
Fortis is working on a $26 billion capital program that will raise the rate base from $39 billion in 2024 to $29 billion in 2029. The company has other projects under consideration that could be added to the plan. Fortis also has a good track record of making strategic acquisitions.
Dividends
Fortis raised the dividend in each of the past 51 years and plans to increase the payout by 4% to 6% annually through 2029, supported by cash flow expansion coming from the capital program. Investors who buy FTS stock at the current level can get a dividend yield of 3.7%.
Time to buy Fortis?
Any indication that the central banks are considering raising rates to combat tariff-induced inflation could send utility stocks into a new downward trend. This isn’t the most likely outcome, but investors need to keep it in mind. That being said, Fortis should be a solid buy-and-hold pick today for income investors. Any downside would be viewed as an opportunity to add to the position.
