Shares of most of Canada's independent power companies, often favoured by conservative investors because of their stable cash flow and relatively high yield, have had a dismal year.
Over the past 10 months, almost all of these power producers have seen their stock prices slip, some dramatically. The biggest of the group, Brookfield Renewable Energy Partners LP, has fallen by about 10 per cent so far this year, while Atlantic Power Corp. has plunged a whopping 56 per cent.
The main culprit for the soft performance of this group, analysts say, is the shift upward in long-term interest rates. Most of the independent power producers (IPPs) are yield plays, and many dividend-paying stocks have slid because of expectations that rates are on the rise.
Indeed, among the mid-sized IPPs, the only one with a still-rising stock price is Boralex Inc., which does not yet pay a dividend. It has risen 17 per cent so far this year.
Boralex, which owns wind, hydro and solar projects in Canada, the United States and France, has said it would not consider paying a dividend until after the first phase of its giant Seigneurie de Beaupré wind power project in Quebec – now under construction – is complete. The company focuses on reinvesting its cash, rather than paying it out, a strategy that has freed it from some of the yield pressures that have hurt other power companies.
John McIlveen, research director at Jacob Securities Inc. in Toronto, says while many investors expect Boralex to eventually pay a dividend, at the moment "it is valued more like a growth stock than a dividend stock," an advantage in the current environment.
While the movement of each stock in the IPP group depends on many factors, Mr. McIlveen said, there is no question the group's overall performance has been influenced by the spread between their yields and the yield of long bonds, such as the five-year Canada bond.
In fact, he said, the yields on the IPP group have shifted as much as they would need to if the five-year bond was currently yielding about 2.5 per cent – a level it is not expected to hit until next year. Currently, the yield on that bond is around 1.9 per cent. Unless the bond yield exceeds 2.5 per cent next year, he said, the yield and price shift on the stocks "is already baked in." Essentially, investors have pushed the stocks down further than they need to go, in anticipation of further interest-rate increases.
Mr. McIlveen said he expects a handful of the power producers, including Brookfield Renewable and Algonquin Power & Utilities Corp., to boost their payout in 2014. "To protect yourself against rising interest rates, you are best to hold those that you expect to increase dividends, because that should somewhat offset things over the long haul," he said.
Rupert Merer, an analyst at National Bank Financial, said he thinks investors who are concerned the upward interest-rate movement is putting downward pressure on these stocks should focus on the companies that have the strongest growth in their free cash flow.
"That should overcome the increase in yield that will be expected," he said, citing Innergex Renewable Energy Inc., Algonquin Power and Boralex as his favourites. "If you focus on companies like that, the equities should keep up with the rising bond yields."
The sensitivity of these stocks to dividend yield was demonstrated earlier this year when Atlantic Power announced a sharp dividend cut and the stock immediately went off a cliff, plunging from above $10 to about $6.
Greg Payne, vice-president of portfolio management at fund manager Greenchip Financial Corp., said part of the problem with the focus on dividends is that "these companies were just valued on yield in comparison with artificially depressed interest rates, so it made investors value the companies at an overall premium to the cash they were generating."
It is that cash generation that is key, he said. The best companies produce consistent levels of cash because of the fixed-price long term contracts they have in place to sell their power. It is even better if those contracts come with inflation adjustments. And because many of IPP projects are in the renewable sector, there is limited exposure to commodity price movements.
Mr. Payne said he thinks investors should also look for power producers with strong balance sheets, relatively low debt, a strong growth outlook and a track record of getting new projects built. Essentially, "do they have a good pipeline of realizable projects at reasonable cost?" he said.