Algonquin Power & Utilities: Acquisition Indigestion

Summary

• Algonquin Power & Utilities announced an acquisition that dropped its stock.
• We look at what the company is buying and why it may appear at first glance to investors.
• We dissect the valuations and tell you why this deal removes some upside potential in our view.
• We tell you why we still own the stock and how we are playing it.
• I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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When we first covered Algonquin Power & Utilities (NYSE:AQN) we had a slight bullish slant on the stock. Our commentary explained it as follows.

We do own AQN which we bought on the TSX after the swoon associated with the large secondary offering. We did buy it but immediately sold the October covered calls on it. That fits with our thinking that AQN is at the investment threshold and we are happy to own it around this price and make income off the dividends and covered calls

Source: A Renewable Growth Story

The stock was called away on October expiration but we landed up buying it back when it headed south and sold covered calls once more. Of course, we were not remotely expecting the big surprise we got a little later.

Source: AQN Presentation

We review the deal and the implications and tell you where we stand on it.

The Deal

Purchasing regulated utility assets in Kentucky might not be something the green movement might have forecasted for AQN. The graph below will tell you exactly what we are hinting at.

Source: KY GOV

That source of fuel is also perhaps the reason that Kentucky has had one of the lowest electricity prices in the US.

Source: KY GOV

From a green transition point of view, this is probably the most challenging landscape as replacing that level of coal-fired generation will take an armada of renewables. The positive aspects here are two fold. With such a low base, pretty much anything AQN does will improve the mix over time. It is very easy to say you increased renewable energy production 10 fold when your baseline number is under 1%. The bigger advantage here is that Kentucky's rates are so low on a relative basis that the increased costs may not be very hard to pass on. It is far harder to get rate increases when the constituents are already paying top dollar. With Kentucky, AQN can finance the transition perhaps easier than in some other places. The earned ROEs support this assumption as well.

Source: AQN Presentation

Overall, from a just a strategic point of view, this fits in with AQN's longer term vision.

Financing & Credit Metrics

While AQN does equity and pseudo-equity offerings on a regular basis, this one was rather large with a total size of $800.052 million CAD (About $645 million USD). The overallotment option is for an additional 15%. While this is large compared to what AQN has done recently, it is still moderate in relation to its market capitalization (TSX, In CAD shown below).

Data by YCharts

AQN will still need some additional financing in 2022 and it has proposed a few alternatives to get there.

Source: AQN Presentation

The reaction from the credit agencies was mixed.

Fitch Ratings has affirmed Algonquin Power & Utilities Corp.'s (APUC) 'BBB' Long-Term Issuer Default Rating and 'F2' Short-Term IDR and Liberty Utilities Co.'s (LUCo) 'BBB' Long-Term IDR and 'F2' Short-Term IDR.

These ratings affirmations follow APUC's Oct. 26, 2021 announcement that LUCo reached an agreement to acquire Kentucky Power Company (BBB/Stable) and AEP Kentucky Transmission Company, Inc. from American Electric Power Company, Inc. (AEP).

Source: Fitch

S&P Global Ratings said Thursday that it has revised its outlook on Algonquin Power & Utilities Corp. and its subsidiaries, Liberty Utilities Co., Liberty Power, Liberty Utilities GP 1, and The Empire District Electric Co., to negative from stable. The outlook revision reflects the lack of certainty regarding the acquisition's funding plan beyond the announced common equity issuance in 2021, the rating agency said.

Source: S&P (paywall)

We side with S&P here as AQN already has its hands full and this was probably a step too far in its bid for growth.

Valuation & Verdict

AQN is not a cheap stock. It is easy to lose sight of this at a time when companies add a quarter trillion in market capitalization on rumors of additional $4 billion in revenue. When viewed through the traditional PE metrics, AQN is more expensive than the bulk of its US and Canadian peers. On estimated 2022 earnings only Fortis Inc. (FTS) screens as more expensive.

Data by YCharts

When looked at in the renewable energy space, AQN screens a bit better. Its dividend yield is the second highest in the space and the price to adjusted funds from operations (AFFO) is the second lowest.

Data by YCharts

At a blended level one can make the argument that AQN is fairly valued when we split up the assets and value them for their individual segments. The bull case probably comes from arguing that the unregulated renewable assets are being undervalued here when lumped in with the regulated utility side. Certainly that case has some merit when we see the insane multiples people are putting Brookfield Renewable Partners LP (BEP) (BEPC). But we prefer not to justify purchases by pointing at other bubbles which have certainty of becoming money losers. One has to also take into account that AQN is running rather high debt metrics with debt to EBITDA near 6.2X and that number will not improve after the Kentucky acquisition. Overall, we think that AQN is fairly valued and perhaps slightly undervalued. The purchase price is not excessive but AQN has a lot going on and its capex plans were massive even before this deal.

Source: AQN Q1-2021 Presentation

This deal actually removes some upside potential as a result and based on the stretched credit metrics, AQN is in dangerous territory. What this will most likely result in is that AQN will have to issue more equity at bad prices or sell assets at unattractive prices to keep credit metrics stable.

We think it can still be part of a renewables portfolio and it is probable that you can get 7-8% total annual returns from here. We see that probability moving up significantly if one were to use covered calls to enhance those returns and that is precisely what we are doing.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AQN either through stock ownership, options, or other derivatives. 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.