Power and utility stocks have struggled amid the recent uptick in interest rates, but instead of avoiding this dividend-rich sector, investors should be taking advantage of the bargains that are emerging.
That's the recommendation of one analyst who says valuations have become more attractive even as the growth outlook has remained solid.
"Beware rising yields? We say buy on weakness for the long term," Jeremy Rosenfield of Industrial Alliance Securities said in a March 14 note to clients.
Rising interest rates pose a challenge to utilities and power producers for a few reasons. As borrowing costs rise, companies may become reluctant to make major investments or acquisitions. Rising yields on fixed-income securities also attract funds that otherwise might flow to dividend-paying companies in the sector, causing stock prices to fall.
So far in 2018, the S&P/TSX power and utilities indexes have skidded by about 6 per cent and 7 per cent, respectively, Mr. Rosenfield said. That's worse than the roughly 4-per-cent decline for telecom stocks and the 1-per-cent drop for real estate investment trusts.
But rising bond yields aren't all bad for the sector. Higher interest rates affect a utility's cost of equity calculation and the return on equity that is authorized by the regulator, which translates – with a lag – into higher earnings for investors, Mr. Rosenfield said. For power producers that sell their electricity under long-term contracts, the agreements generally include price increases that are linked to inflation, which is usually correlated with interest rates.
Even as stock prices have declined in the sector, earnings estimates have held steady – or even increased for some companies – over the past three months, Mr. Rosenfield said. This indicates that analysts still see sustained growth ahead. The difference now is that investors can purchase this growth at a lower price than before the sell-off.
Here are his three favourites in the power and utilities sector, all of which he rates a "strong buy."
Northland Power Inc. (NPI)
Yield: 5.3 per cent
With more than $10-billion of assets, Northland Power operates wind farms (about 50 per cent of estimated 2018 generating capacity), gas and biomass plants (45 per cent) and solar facilities (5 per cent) that produce stable, contracted cash flows. Offshore wind is a major source of growth: Northland's Gemini and Nordsee One projects in the North Sea came into service last year; its Deutsche Bucht offshore facility, also in the North Sea, is expected to begin commercial operations by the end of 2019; and the company is pursuing longer-term opportunities in Taiwan and elsewhere. Even after raising its dividend by 11 per cent in November – the first increase in more than a decade – Northland Power has a comfortable payout ratio of less than 70 per cent of estimated free cash flow (FCF) for 2018. That, plus the fact that FCF per share is expected to rise by 8 per cent to 10 per cent annually through 2022, suggests there's room for the dividend to grow.
Innergex Renewable Energy Inc. (INE)
Yield: 5.1 per cent
Innergex operates hydro, wind, solar and geothermal power facilities in Canada, the United States, France and Iceland. Mr. Rosenfield cites the company's "unparalleled low-risk investment profile" backed by high-quality hydro assets (about 45 per cent of generating capacity) with an average remaining contract life of 18 years. The company, which in February completed the acquisition of Alterra Power Corp. for $1.1-billion, has raised its dividend at an annual compound rate of 3.2 per cent over the past five years. With several development projects coming on line, free cash flow per share is expected to rise by 8 per cent to 10 per cent annually through 2022. "We expect INE's FCF payout to be in the 60- to 70-per-cent range in 2018, leaving significant room for the company to continue to increase the dividend in the future as it executes on its pipeline of growth projects," Mr. Rosenfield said in a Feb. 23 note.
Algonquin Power & Utilities Corp. (AQN)
Yield: 4.7 per cent
Algonquin operates both a regulated utility business (about 68 per cent of 2017 earnings before interest, taxes, depreciation and amortization) and a non-regulated power subsidiary (32 per cent of EBITDA). That diversification is a plus, Mr. Rosenfield said, as is the company's expected cash flow per share growth of 15 per cent and dividend growth of 10 per cent annually through 2021. International expansion provides another platform for growth: On March 9, Algonquin completed the previously announced formation of Abengoa-Algonquin Global Energy Services (AAGES), a joint-venture with Spain's Abengoa SA to develop renewable energy and water infrastructure assets globally. It also closed the purchase from Abengoa of a 25-per-cent stake in Atlantica Yield PLC, which operates solar and wind facilities, electrical transmission lines and desalination plants in Europe, South America and Africa.
Disclosure: The author owns shares of AQN personally and in his model Yield Hog Dividend Growth Portfolio.