Sometimes, bad things happen to good stocks. Case in point: Algonquin Power & Utilities Corp.
When I first wrote about the company back in December, 2012, the stock (which I own personally) was trading at $6.66. The shares surged 23 per cent over the next five months – and then promptly collapsed. They closed Tuesday at $6.72 on the Toronto Stock Exchange.
What happened? Well, a couple of things. First, bond yields spiked, creating havoc for interest-sensitive stocks. Both of Algonquin's businesses – power generation and regulated utilities (water, electricity and natural gas) – are vulnerable to rising rates because of the debt they carry and the steady, bond-like cash flows they produce.
Second, in September an independent research firm slapped a "sell" rating on Algonquin's already wobbly shares. Accountability Research Corp. cited "related-party transactions" between Algonquin and private companies controlled by management and warned of "considerably high execution risk in terms of the company's recent acquisition spree."
Judging by the skid in the share price, it's clear many investors were rattled by these developments. However, as much as I don't like watching my stocks tumble, I'm still holding my Algonquin shares because I believe nothing has fundamentally changed in the company's outlook. Algonquin remains a company with good growth potential, a rising and sustainable dividend (currently yielding 5.1 per cent) and a relatively low-risk business model supported by stable cash flows from its regulated utilities and contracted power generation assets.
As for the Accountability report, the concerns it raised are overblown, according to one analyst I spoke with and another who addressed the criticisms in a recent note. For what it's worth, Accountability is the only Canadian research firm with a "sell" on the shares and its price target of $5.25 is well below the Street's average target of $7.90.
"We have examined the report in detail and believe the items are largely either taken out of context, immaterial or wholly without merit," Jeremy Rosenfield of Desjardins Capital Markets wrote in an Oct. 18 note. Referring to the related-party transactions, he said "management has committed to resolving outstanding concerns by the end of the year, finalizing a process that was initiated when the company converted from an income trust to a corporation and internalized management."
In his report, Mr. Rosenfield offered several reasons that he continues to rate Algonquin a "top pick:"
-Earnings per share and cash flow per share are each expected to rise by about 10 per cent annually over the next five years. Driving growth are recent U.S. wind power and gas utility acquisitions, about $800-million of renewable-power growth projects and $300-million (U.S.) of potential utility investments.
-The payout ratio is "conservative" at about 50 per cent of estimated 2014 free cash flow, with "strong upside potential" in the dividend as earnings and cash flow per share grow.
-The balance sheet is strong, with no pressing need to raise additional equity barring an acquisition. Underscoring the company's solid capital structure, Standard & Poor's in October upgraded Algonquin's credit rating to BBB from BBB-minus.
Matthew Akman, an analyst at Scotia Capital who has a "sector outperform" rating on Algonquin's shares, called its valuation "among the cheapest in our coverage universe," with free cash flow yield of 11.5 per cent based on 2015 estimates. That was in mid-September, when the shares were trading at $6.25 (Canadian). They've since rebounded 7.5 per cent, helped in part by a cooling off in bond yields.
The company has "superior visible organic growth. Meanwhile, its balance sheet remains strong, its debt financing risks are contained, and its equity needs are limited," he wrote.
To be sure, if bond yields resume their ascent, Algonquin and other interest-sensitive stocks could come under renewed pressure. But Algonquin's growing cash flow and dividends should help to limit the damage, which is why – as a long-term investor – I'm willing to ride out the short-term volatility.