Fortis: A Utility To Buy For The Long-Term (NYSE:FTS)

1.23K Followers

Summary

Utilities are under pressure in a rising rate environment and trading at the lower end of their valuations.
Analysis of the underlying fundamentals.
Strengths and weaknesses that may cause volatility in an otherwise stable company.
Dividend growth at least through to 2022 coupled with lower-than-average payout ratio.

As the Bank of Canada has recently moved up on interest rates and the Fed is expected to move two or more times in 2018, is this the time to load up on utility stocks? My answer is "probably not". Having stated that, for the long-term investor as I am, who is looking for value, stability and income growth, I expect 2018 will provide some opportunities.

With interest rate sensitive companies such as Fortis, Inc. (NYSE:FTS), rising interest rates should create downward pressure on the stock price. As many investors of utilities, REITs and other sensitives are looking for stable income coupled with income growth, some of the competition or drain on the stock price will come from investors pulling their cash out of sensitives placing it in riskier asset classes such as cyclicals.

Even though I do believe this is a decent idea for the next year or so, if the BOC or the Fed raises rates too sharply, this will have a dampening effect on the economy. This dampening effect will be visible through an inverted yield curve. As the inverted yield curve is where the short-term yields are higher than long-term yields, this would display a recessionary environment. So, it is my opinion that the BOC (Bank of Canada) and the Fed have a tricky situation on their hands. They have to raise rates to curb inflation as the economy seems to be doing well, but if they raise rates too fast, they could create a recessionary environment. I believe if an inverted yield curve were to take place, then I think money would rush out of cyclicals and back into sensitives and defensive stocks. This is why I believe this is an opportune time to be overweight cyclicals, but analyzing and preparing yourself to add more sensitives and/or defensive stocks to your portfolio as their prices weaken.

The backdrop of rising interest rates also poses another issue for the utility stock price pressure. As with all regulated utilities, rising interest rates will raise the cost of financing thus putting pressure on these companies' bottom lines. As this looks to be the backdrop moving forward, I am looking for a well diversified utility with lower debt ratios and strong fundamentals. I am also looking for companies that look to grow their businesses organically. I want this coupled with a history of consistent dividend growth throughout different market cycles and a drip to ensure stable income growth within my portfolio.

Fortis is a Canadian utility company.

"Fortis Inc. has its origin in the formation of St. John's Electric Light Company in 1885 in the province now known as Newfoundland and Labrador. Fortis was incorporated in 1987 with just $390 million in assets. Today, our diverse affiliated companies include ten electric and gas operations with approximately $47 billion in assets serving over 3 million customers in Canada, the United States and the Caribbean." - Investor Relations

Fortis is the largest investor-owned utility in Canada by assets and one of the top 15 in North America.

Profitability

Profitability is a class of financial metrics used to assess a business's ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at three tests of profitability. They are net income, operating cash flow, and the return on assets. From these metrics, we will establish if the company is making money as well as gauge the quality of the reported profits.

Net income FY 2014 = $379 million
Net income FY 2015 = $805 million
Net income FY 2016 = $660 million
Net income FY 2017 = $1.028 billon

Over the past three and a half years or so, Fortis' net income has increased significantly. It has increased from $379 million in 2014 to $1.028 billion in the trailing 12 months.

Operating Income

Operating income is the cash generated from the operations of a company, generally defined as revenue, less all operating expenses, but calculated through a series of adjustments to net income.

Operating income 2014 = $1.023 billion
Operating income 2015 = $1.429 billion
Operating income 2016 = $1.483 billion
Operating income 2017 = $2.500 billion

Much like the net income, the operating income has also significantly increased.

Return on Assets (ROA) = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage.

The return on assets is especially relevant to Fortis as the company's management has been acquiring assets mainly south of the 49th to support the growth. Some have stated that management paid too much for ITC and Central Hudson over the past few years. The return on assets will demonstrate if the acquired assets are paying off regarding the top line.

Net income FY 2014 = $379 million
Net income FY 2015 = $805 million
Net income FY 2016 = $660 million
Net income FY 2017 = $1.028 billon

Total Asset Growth:

Total assets 2014 = $26.628 billion
Total assets 2015 = $28.804 billion
Total assets 2016 = $47.904 billion
Total assets 2017 = $47.822 billion

Return on Assets:

Return on assets FY 2014 = 1.43%
Return on assets FY 2015 = 2.79%
Return on assets FY 2016 = 1.38%
Return on assets FY 2017 = 2.15%

Based on the results above, we can see that on the top line, the newer assets have not changed the results of the ROA.

Debt and Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

As Fortis has been acquiring assets such as ITC and Central Hudson over the past few years to support growth, analyzing the debt will determine if the management is overextending itself. Looking forward to rate increases, I do not want this part of my portfolio to be overly volatile?

Total Liabilities to Total Assets, Or TL/A, Ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

Total Assets:

Total assets 2014 = $26.628 billion
Total assets 2015 = $28.804 billion
Total assets 2016 = $47.904 billion
Total assets 2017 TTM = $47.822 billion

Total Liabilities:

Total Liabilities 2014 = $17.937 billion
Total Liabilities 2015 = $18.924 billion
Total Liabilities 2016 = $33.307 billion
Total Liabilities 2017 = $32.819 billion

Over the past four years, Fortis' total assets have nearly doubled. In 2014, its total assets were calculated at $26.628 billion while the company's most recent data suggest it now has $47.822 billion in total assets. We also see that the company's total liabilities have also ballooned up from $17.937 billion to $32.819 billion.

As we can see, the total assets and total liabilities have both increased significantly over the past four years. So does Fortis have the ability to cover expenses?

Working Capital

Working capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current Assets / Current Liabilities

Current Assets:

Current assets 2014 = $1.963 billion
Current assets 2015 = $1.857 billion
Current assets 2016 = $2.166 billion
Current assets 2017 = $2.075 billion

Current Liabilities:

Current liabilities 2014 = $2.684 billion
Current liabilities 2015 = $2.638 billion
Current liabilities 2016 = $3.944 billion
Current liabilities 2017 = $3.962 billion

Current Ratio:

Current ratio 2014 = 0.73
Current ratio 2015 = 0.70
Current ratio 2016 = 0.55
Current ratio 2017 = 0.52

Over the past four years, Fortis' current ratio has been decreasing. For me, this is a point to watch. As the company is increasing its debt, the current ratio has also declined. When a recession does take place, I want my investments' pricing to remain stable. As Fortis' current ratio is declining and below 1, this indicates that the company could face some financial difficulties if its obligations come due at this point. I believe this could be a point that could add volatility to my portfolio in the face of a declining market.

Common Shares Outstanding

Common shares outstanding 2014 = 226 million
Common shares outstanding 2015 = 285 million
Common shares outstanding 2016 = 313 million
Current shares outstanding 2017 = 419 million

Much like the company's assets and liabilities, the number of shares outstanding has also increased. This has been due to the recent acquisitions. This issue will almost double the amount of shares outstanding compared to 2014.

Operating Efficiency

Operating efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further towards the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than their competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

Gross margin 2014 = $3.204 billion / $5.401 billion = 59.32%
Gross margin 2015 = $4.166 billion / $6.727 billion = 61.93%
Gross margin 2016 = $4.497 billion / $6.838 billion = 65.76%
Gross margin 2017 = $5.940 billion / $8.301 billion = 71.55%

Over the past four years, gross margin has increased nicely. The ratio has increased from 59.32% to 71.55% over the selected time frame.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement, and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

Revenue growth:
- Revenue 2014 = $5.401 billion
- Revenue 2015 = $6.727 billion
- Revenue 2016 = $6.838 billion
- Revenue 2017= $8.301 billion
- Equals an increase of 34.93%
Total asset growth:
- Total assets 2014 = $26.628 billion
- Total assets 2015 = $28.804 billion
- Total assets 2016 = $47.904 billion
- Total assets 2017 TTM = $46.845 billion
- Equals an increase of 43.15%

Over the past four years, revenue has increased by 34.93% while assets have increased by 43.15%. This is an indication that the company from a percentage point of view has been less efficient at generating revenue.

Dividend

One of the attractive aspects of Fortis has been its 44-year trend of raising its dividends.

Source: Presentation

As the payout ratio is in the 64% range, this is below the historical average and will give the company room to grow the dividend. The dividend growth is expected to continue as the company is suggesting 6% annual growth through to 2022.

Valuation

Historically, Fortis has traded between 11X and 13X EV/EBITDA. At the current valuation, I have calculated the company to be trading at 10.8X EBITDA. With the added debt and rates beginning to rise, I believe the trading range will be at the lower end of its historical average valuation metric.

Based on a 2018 forecast, Fortis having an EBITDA of $3.871 billion and trading at the current value of 10.8 * EBITDA, using my DCF formula, I have a target price in the $45 range for 2018.

Looking at the criteria above, we can see why there was some volatility during the most recent market correction. Above we can see that a large debt load coupled with the anticipation of rising rates has created some pressure on the stock price. Based on this, I would expect more volatility coming if the market were to correct again. On a personal note, I am adding on weakness; I like the long-term dividend growth coupled with decent valuations. During the last correction, I added a small amount and will continue to use this volatility to add smaller amounts on weakness.

This article was written by

Jeff Williams

1.23K Followers

Jeff is a published author and educator. He is a value/dividend investor who specializes in long term growth. He lives in a beautiful seaside town just outside Vancouver BC Canada with his wife and two children.

Analyst’s Disclosure: I am/we are long FTS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I may initiate a stock purchase in the next 72 hours.

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