Algonquin Power: Adequate Yield and Growth Potential

Includes: AQN, EMRAF
by: George Fisher
Algonquin Power and Utilities (AQUNF.PK) is a small-cap Canadian electric generation company focused on renewable, clean power and water utilities. The company manages a billion dollars in utility assets in the US and Canada. AQN in the process of transforming itself from a Canadian income unit trust to a growth oriented cross-border utility. As with some Canadian unit trusts, the transformation is creating an opportunity for investors to capture acceptable yields along with capital gains potential.
Last decade, Canadian tax laws created favorable tax treatment for companies altering their corporate structure to a pass-thru entity that bypasses corporate taxes, similar to master limited partnerships in the US. The advantages were so pronounced that a large number of companies were making the change and tax revenues were being negatively impacted. To offset the decline in tax revenues, the gov’t changed the pass-thru requirements and will begin taxing unit trusts as standalone corporations. Many unit trusts are converting back to corporations as the tax advantages evaporate. AQN is one such company.
To recoup some of the tax advantages lost in the conversion, Algonquin has purchased/merged with a struggling fuel cell manufacturer that offers a loss carry-forward benefit. It is estimated that AQN will have reduced tax liabilities until 2014. By that time, the concept of carbon tax credits and investment incentives could be enacted, encouraging renewable electric generation.
The corporate conversion has created some shareholder pain beyond just tax issues. As a unit trust, AQN was structured to generate a high tax-advantaged yield for investors. With this option going away, AQN has changed its business strategy from an income focus to a growth focus. The first task in the 3rd quarter of 2008 was to slash its annual dividend from C$0.91 to C$0.24, paid quarterly as of Jan 2010. As might be expected, this change was accompanied by a collapse of the share price from C$9 to a 2009 low of C$2. Share prices have since recovered to C$4.
Algonquin owns 67 electric generation facilities in Canada and the US, comprising of 44 hydro-electric, 12 thermo-electric, and 1 wind farm. In addition, AQN operates 18 water utilities in Illinois, Arizona, and Texas. About 50% of revenues are derived from renewable facilities, 25% from water utilities, 18% from thermo-generation (mainly natural gas) and 7% from bio fuel plants.
AQN manages about 460 MW of installed capacity, about two thirds of which are from renewable sources, mainly generated at smaller plants. AQN continues to add to its portfolio of alternative energy assets. For example, it recently purchased 3 hydro-electric and 5 diesel/oil thermo-electric (standby reserve use only) plants in Maine and New Brunswick, expanding overall generating capacity by 8%.
Canada has been a proponent of hydro-electric long before it became fashionable. It is estimated that 55 to 60% of current Canadian electric generation is from hydro, making a substantial inventory for AQN to choose from for further acquisitions. AQN will continue to grow its portfolio of renewable electric generation assets over time, expanding both its earnings base and its dividend potential.
Revenues in 2009 were C$187 million. Stock market capitalization is C$382 million, and long-term debt is C$241 million. There are 91 million shares outstanding, and an additional 35 million shares will be issued from convertible debentures in 2014 to 2017. Net earnings per share for 2009 were C$0.38, with cash flow from operations of C$0.63, making the current C$0.24 dividend payout ratio of 63% comfortable for a utility. EPS is estimated at between C$0.30 and C$0.35 for 2010 and between$ 0.35 and C$ 0.40 in 2011.
2009 was a down year for Algonquin in revenues and EBITDA, with revenues falling 12% and EBITDA falling 11.7%. The reason for the decline is lower demand for power and lower electricity prices. Both should strengthen as economic growth improves.
There are several positive aspects of Algonquin that utility investors should focus on:
  • Management has, so far, demonstrated their ability to develop and execute a new growth strategy. While the conversion from a unit trust was difficult for high-yield investors, the opportunities for EPS and eventual dividend growth in renewable power generation are quite good.
  • Algonquin is developing a strong relationship with Canadian Maritimes electric utility Emera (OTCPK:EMRAF). AQN and EMA are acquiring the assets and will jointly operate an electric generation and transmission system in Lake Tahoe, California. Closing is expected late 2010, and will add 47,000 customers. In connection with the Lake Tahoe acquisition, EMA has agreed to purchase 8% of AQN stock. AQN’s newly acquired hydro assets will utilize EMA energy marketing services when current contracts expire this year and next. EMA will also assist in marketing excess generation from AQN’s Windsor Locks facility. The strategic alliance being built between EMA and AQN should be beneficial to both companies over time.
  • Energy consumption, and pricing, has declined along with general economic activity. As the economy picks up stream in the US and Canada, energy prices will improve. While AQN’s attractive steady cash flow is based on long-term supply contacts, there are several contracts that are up for renewal this year and next. A strengthening electricity market would assist cash flow going forward.
  • Anticipated operating cash flow after dividend payment could allow for investment in new capacity of upwards of C$35 million annually. This could fund one 25MW wind farm a year, or about 4 to 5% capacity growth, without adding much additional dilution or leverage.
  • The strength of AQN’s electric generation is the renewable and sustainable energy aspects of 45 of its facilities. AQN is well positioned to benefit from carbon credits / offsets if a cap and trade type system is developed, and could be eligible for renewable energy investment tax credits if they become available, increasing after-tax returns for future investment and income. It is possible AQN’s portfolio of assets could become more valuable due to tax incentives / carbon offsets for renewable electric generation.
  • Since the dividend cut in late 2008, more than 100% of the outstanding shares have traded hands, with the safe assumption that unit trust investors seeking high yields have exited. The profile of the current investor is in tune with management’s new focus of growth. The current yield of 5.6% should be sufficient to reward income-seeking utility investors as assets and earnings grow over time. While not forecast to increase, the trend should allow for dividend enhancements in the future.
  • The conversion from unit trust to a corporation is not exclusive to Algonquin. The stock price trading history of some previous unit trust conversions implies that once management proves their ability to execute a new business plan, share prices tend to recoup. It takes time and patience though. TransCanada (NYSE:TRP) is one such example, albeit a different industry.
  • There are several pending water utility rate cases for 2010. It is anticipated that usually favorable decisions should generate upwards of 8 to 9% revenue growth split between 2010 and 2011, and could add about C$0.15 to cash flow over the next 18 months.
Investors looking for small-cap electric utilities should consider Algonquin. There should be a reasonable opportunity for share prices to recoup to the C$6.00 range, 15 x 2011 C$0.40 EPS estimates, for a 40% potential capital gain. The current yield, while not overly substantial, should be sufficient to reward shareholders looking for the combination of income and growth. While C$6 would be richly valued at 15 times earnings and a 4.0% implied yield, AQN is uniquely positioned in the renewable power generation business. If any surprises are announced, they should be to the upside.
Disclosure: Author long AQUNF.PK