5 Reasons to Like Algonquin Power

05/22/2013 10:15 am EST

Focus: STOCKS

John Heinzl

Reporter and Columnist, GlobeInvestor.com

The company's protected dividend and strong balance sheet make it worth hanging onto, writes John Heinzl, reporter and columnist for Globe Investor.

In December, I wrote a favorable column about Algonquin Power & Utilities (Toronto: AQN), calling it a "relatively low-risk stock with a solid yield...good growth prospects and a 'green' halo to boot."

Since then, the stock has appreciated by about 21%. In another pleasant surprise for investors, the renewable energy and regulated utility company announced an earlier-than-expected dividend increase of 9.7% with its first-quarter results on May 9—its fourth increase since converting to a growth-oriented corporation from an income trust.

Even though the price has increased substantially, I have no plans to sell my shares. If anything, I would consider adding to my position on any weakness. Here are five reasons I still like Algonquin.

The Dividend is Rock Solid
Based on the new dividend rate of 34 cents annually, Oakville, Ont.-based Algonquin yields about 4.2%. Yet the payout ratio is a conservative 50% of estimated 2014 free cash flow, says Jeremy Rosenfield, an analyst with Desjardins Securities, who has a "top pick" rating on the stock.

The low payout ratio provides a nice cushion for the dividend, and also means there's ample cash available to reinvest and expand the business.

Based on Algonquin's expected growth through utility acquisitions and new power projects, Rosenfield projects that earnings, cash flow and dividends per share will increase by an average of more than 10% annually over the next five years.

The Business Is Conservative
Algonquin is actually two companies, both of which provide relatively predictable cash flows.

Its Liberty Utilities subsidiary operates regulated electric, gas, and water utilities in Arizona, Arkansas, California, Georgia, Illinois, Iowa, Missouri, New Hampshire, and Texas. Liberty expects to have close to 500,000 customers in 2013—halfway to its goal of one million regulated utility customers.

The other subsidiary, Algonquin Power, has direct or indirect interests in hydroelectric, wind, thermal, and solar generating facilities in Canada and the United States.

Although unfavorable weather can have an adverse impact on the renewable power business, most of the electricity output is contracted under long-term agreements, which provides a degree of stability.

The Balance Sheet Is Strong
Last fall, Standard & Poor's assigned Algonquin Power & Utilities a BBB-minus credit rating. That's the lowest notch of investment grade, but S&P also gave Algonquin a "positive" outlook.

S&P would consider raising the rating based on the growing contribution from the regulated—and more stable—utility operations, which are expected to account for about 45% of earnings before interest, taxes, depreciation, and amortization (EBITDA) in 2013.

The Valuation Is Reasonable
Algonquin trades at about seven times estimated cash flow from operations, which is lower than some comparable companies, Rosenfield says. The stock also trades at a discount to its instrinsic value based on a discounted cash flow analysis, he says.

"So there's still a fairly significant discount for Algonquin relative to its peers," says the analyst, who has a 12-month target of $8.50.

There's More Growth Ahead
For the first quarter, Algonquin—which is 24.5% owned by Emera (Toronto: EMA)—reported adjusted EBITDA of $61 million. That was below expectations, but well above adjusted EBITDA of $23.4 million a year earlier.

The increase, driven primarily by acquisitions of US utilities and wind power facilities, "supports our thesis that earnings growth will accelerate as utility acquisitions are integrated," Matthew Akman, an analyst with Scotia Capital, said in a note in which he raised his one-year price target to $9 from $8.

Algonquin has closed $168 million of utility acquisitions so far in 2013, with another $74 million deal for the New England Gas Co. expected to close in the second half. On the power side, more than $800 million of Canadian renewable energy projects are expected to come online in the next three years, he added.

Final Thoughts
No stock is without risks. An increase in interest rates could hurt the shares of Algonquin and other dividend-paying companies.

Algonquin also has to manage its expansion prudently, because growth is central to the company's mission of increasing shareholder value. Regulatory decisions—which affect allowed returns for utilities—are another source of uncertainty.

Keeping those risks in mind, Algonquin's growing earnings and well-protected dividend offer a nice combination of offense and defense for income-seeking investors. As always, be sure to do your own due diligence before investing in any security.

The author owns shares of Algonquin personally. Read more from Globe Investor here...

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