AY - Algonquin And Atlantica: Strategic Reviews Could Be A Major Catalyst

2023-05-29 07:00:00 ET

Summary

• AQN stock has lost more than half of its value since the highs of February 2021 while the dividend has suffered a similar fate.
• AY has also seen its stock sell off quite a bit from previous highs.
• That said, we believe that the sell-offs have been overdone and the stocks now offer compelling value.
• We take a look at the pending strategic reviews and offer our view on how it could potentially unlock value for shareholders.

Algonquin Power & Utilities (AQN) stock has lost more than half of its value since the highs of February 2021 while the dividend has suffered a similar fate.

Atlantica Sustainable Infrastructure ( AY ) has also seen its stock sell off quite a bit from previous highs:

That said, we believe that the sell-offs have been overdone and the stocks now offer compelling value. In this article, we take a look at the pending strategic reviews and offer our view on how they could potentially unlock value for shareholders.

Why AQN & AY Stock Are Undervalued

Why do we think that AQN stock is undervalued today? A simple look at its forward P/E multiple shows that it is trading at 13.57x. In comparison to peers, this looks pretty attractive. For example, Canadian peer Fortis (FTS) trades at a P/E ratio of 19.19x and Canadian Utilities (CDUAF) trades at a P/E of 15.06x. Consolidated Edison (ED) trades at a P/E ratio of 19.58x. A look at a broader set of utilities reveals a similar range. Fair value for a quality investment grade utility in today's market is in the range of 15-20x earnings. AQN trades at a clear discount to that level.

Yes, it just recently cut its dividend and perhaps management has lost some credibility with Mr. Market, but the fact remains that with the cancelation of the Kentucky Power deal, AQN is now on much firmer financial footing and the dividend yield is attractive and sustainable at 5.2%. When compared to peers, this dividend yield looks very attractive, so there is really no justification for AQN to trade at such a meaningful discount to peers. Does it deserve to trade at a small discount to peers given the poor recent management performance? Yes. However, the 25%+ discount that we are seeing today is overblown in our view for something as defensive as regulated utilities backed by an investment grade balance sheet.

Perhaps one of the big reasons for its large discount to peers is that a large chunk of its renewable power segment - the ~40% ownership stake that it holds in Atlantica Sustainable Infrastructure ( AY ) - is deeply undervalued by Mr. Market today. On an EV/EBITDA basis, AY trades at a mere 9.67x multiple whereas peers like Brookfield Renewable ( BEP ), NextEra Energy Partners ( NEP ), and Clearway ( CWEN.A ) trade at much higher EV/EBITDA multiples of 23.58x, 11.04x, and 11.32x, respectively.

As a result of this clear valuation disconnect within AY as well as within AQN's broader business, both AY and AQN are currently undergoing strategic reviews with a focus on finding ways to unlock value for shareholders.

The AQN Stock & AY Stock Strategic Reviews

AQN's strategic review announcement has made clear that it is undergoing a cost-benefit analysis of separating its renewables business from its utilities business. While the utilities business is clearly undervalued relative to most peers and this move may very well help to unlock some value for AQN, the loss of the renewables business would reduce AQN's growth outlook and ultimately its upside potential along with inflicting some dis-synergies for the business.

The interesting thing about this is that AQN's total enterprise value is $15.6 billion, of which a little over 20% of it is the AY stake according to current market valuations. Given that this means that the vast majority of its renewables business is its AY stake, this would leave a pretty small company of standalone renewables assets if it were to spin this portion of its business off.

While management insists that AY's strategic review is an entirely separate process from AQN's, it goes without saying that AQN - as the largest single shareholder of AY by a long-shot - has a very active presence and likely significant influence over AY's strategic review and - given the fact that the AY stake is effectively its renewables business, it is highly improbable that AQN would spin off its renewables assets without some sort of deal being made that involves AY's strategic review as well.

It is also important to note that AY's strategic review has been going on for approximately one quarter longer than AQN's has and AQN - in its announcement of its strategic review - stated that it expects to complete its strategic review no later than its next earnings call. What this seems to signal to us is that AY is likely in a progressed stage of its own strategic review and is likely getting close to some sort of transaction that it believes could help to unlock value for shareholders. Most likely, this involves a sale of part or all of its company, or at the very least a strategic partnership with a larger business that could help to reignite its growth engine and reduce its cost of capital in some manner.

It also seems to suggest to us that - if this deal can be agreed upon for AY - that AQN will likely try to include its other renewable assets in the deal, likely being acquired by whoever is doing the deal with AY along with its stake in AY, thereby effectively separating AQN's renewables business from its core utilities business. Such a transaction would also very likely unlock value in AQN by highlighting the underappreciated value of its renewables assets while also giving it the necessary financial flexibility to reduce its own cost of capital by reducing its dependence on costly capital markets and ultimately command a higher share price for AQN.

Investor Takeaway

It is impossible to know how AY's and AQN's strategic reviews will turn out, and it is very possible that one or both of them will result in little to nothing changing. In such a scenario, we are bullish on both stocks as they offer attractive current yields with decent - if not strong - long-term growth prospects along with the prospect for valuation multiple expansion.

That said, we have good reason to believe a transaction is going to take place for both soon. This is because:

1. As already mentioned, AY's strategic review has been going on for a quarter longer than AQN's and AQN has already provided a timeline for its own strategic review. AQN did not have to provide a timeline, so it doing so likely implies that it thinks something may get done soon.
2. Any spin-off of AQN's renewables business would have to involve AY and AQN has already signaled their approval of, support for, and involvement in AY's strategic review.
3. AY has been linked to acquisition rumors for quite some time now. Last November it was reported that there were takeover bid rumors involving the company, and then in January RBC upgraded AY on a potential sale of the 40% stake that AQN has in the company.

As a result of these factors, we are bullish on both AQN and AY and believe that now is an asymmetrically attractive time to buy one or both stocks.

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