CA - Fortis: A Stable High-Yielding Utility That Is Too Expensive

2023-06-06 15:42:34 ET

Summary

• Fortis Inc. is one of the few utilities that has operations in multiple countries, but it still has many of the characteristics that investors appreciate in these companies.
• The company has remarkably stable cash flows regardless of economic conditions along with growth over time.
• The company is positioned to continue growing for the near future, and investors can expect an 8% to 10% average total return over the next five years.
• The company is very well financed relative to its peers and its 3.91% yield appears sustainable.
• Fortis looks a bit expensive relative to its peers, but that could improve in the near future.

Fortis Inc. ( FTS ) is a Canadian electric and natural gas utility that provides service to customers over a significant portion of Canada and the United States. This makes the company one of the largest utilities in the world and one of the few that operate in multiple nations. The company still shares many of the same characteristics that have long made utilities one of the most popular investments among retirees and other risk-averse investors. These characteristics include incredibly stable finances in any macroeconomic environment and a relatively high dividend yield.

Indeed, Fortis yields 3.91% as of the time of writing, which should prove reasonably attractive for an income seeker even though it is well below the current federal funds rate. Fortis does have some growth potential though that should result in the yield on cost increasing with the passage of time. Unfortunately, an investor has to pay through the nose for all of these good things, and Fortis looks rather expensive today. It could still be a stock that is worth watching, though, as there may be opportunities to pick it up for a more attractive price in the future.

About Fortis Inc.

As stated in the introduction, Fortis Inc. is a large regulated electric and natural gas utility that operates throughout Canada, the United States, the Caribbean, and Central America. The company owns ten regulated utilities spread across the North American continent:

This makes Fortis one of the largest utilities in the world and certainly one of the largest in North America. However, despite its large geographic size, many of the regulated utilities that it owns are not in the most highly populated areas. As such, the company only has approximately 3.4 million customers. That is still a pretty good size, but any utility serving a single major city could have a comparable customer count. As I have pointed out numerous times in the past though, a utility's size does not change its inherent characteristics and qualities. One of the most important of these qualities is that utilities tend to have remarkably stable cash flows over time. We can see this clearly by looking at Fortis's operating cash flows. Here they are for each of the past eleven twelve-month periods:

As we can clearly see, the company's cash flows generally did not vary much from period to period, although they did grow over time. This is a period of time that included both the pandemic restrictions, the high inflation of 2021 and 2022, and the tightening of monetary policy by both the Federal Reserve and the Bank of Canada. There have also been signs that the economy in both the United States and Canada has been weakening over the past several months, so that is reflected here as well. Fortis clearly was able to handle all of these different situations with ease and indeed the company appears to have been barely affected.

The biggest reason for this overall stability is that Fortis provides a service that is generally considered to be a necessity for our modern way of life. After all, the company provides electric and natural gas service to homes and businesses, and very few people do not have such services in this day and age. As such, most people will prioritize paying their utility bills ahead of discretionary expenses during times when money gets tight. That is something that is important today as we are seeing numerous signs that high inflation has been straining the budgets of numerous households. I discussed this in a recent blog post .

If the economy descends into a recession during the second half of the year, as is currently expected to occur, the pressures on consumers will only get greater. As such, a company like Fortis that will be minimally affected could be a good holding for investors in order to ride through the economic challenges.

Growth Potential

Naturally, most investors are unlikely to be satisfied with mere stability. After all, we like to see a company that we are invested in grow and prosper. Fortis is fortunately positioned to accomplish this going forward. The primary way that the company will do this is by growing its rate base. The rate base is the value of the company's assets upon which regulators allow it to earn a specified rate of return. The allowed rate of return varies by jurisdiction, so Fortis will not be earning the same rate of return in every area in which it operates. However, regulators usually allow a rate of return of around 10%. Fortis has not been able to achieve that level though as the company has had a return on equity of about 6.5% and a return on assets of just over 2.1% during the past three quarters:

This return on assets is somewhat in line with peers such as DTE Energy ( DTE ), although Fortis has a substantially lower return on equity. Fortis has still managed to achieve a 9.5% average annual total return for its investors over the past ten years though, which is reasonable.

As the allowed return on the rate base is a percentage, any increase that Fortis makes to its rate base allows it to increase the amount that it charges its customers in order to earn that allowed rate of return. The usual way that a company increases its rate base is by investing money into upgrading, modernizing, and possibly even expanding its utility-grade infrastructure. Fortis is planning to do exactly this as the company recently unveiled a plan to invest $22.3 billion over the 2023 to 2027 period into its rate base:

We can see that the company's capital spending plan is almost evenly split between transmission and distribution. Many people may consider these to be the same thing as both carry electricity from one place to another, but there is a difference in the industry. A transmission line is a very high-voltage line that carries electricity from the power plant to the local substation. These are the lines that you will normally see traveling over open areas without homes or buildings:

A distribution line is a much smaller and lower-capacity wire that carries electricity from the electric substation to homes and businesses. These are what most people picture when thinking of electric lines. The fact that Fortis's investments are evenly split between the two is interesting but not necessarily indicative of a particular trend. However, the fact that the company is spending 67% of its investment capital over the next five years on new electric transmission and distribution systems is a sign that the company expects that the demand for electricity will grow much more than the demand for natural gas.

This is not especially surprising considering that both the United States and Canada are trying to push electrification upon their populations. This conclusion is reinforced by the fact that Fortis is planning to direct $5.9 billion of its $22.3 billion capital investments directly to renewable energy generation and supporting infrastructure for such generation.

Fortis' capital spending program as presented should be sufficient to expand the company's rate base to $46.1 billion by the end of 2027 compared to $34.1 billion today. This represents a 6.2% compound annual growth rate, which is roughly in line with what many of the company's peers are likely to accomplish in terms of their own rate base growth.

While this is roughly in line with peers, some readers will almost certainly point out that the $12 billion expected increase is substantially less than the $22.3 billion that the company will need to spend to achieve that increase. There are two reasons for this:

1. Depreciation is constantly reducing the value of the company's assets. Thus, something that is put into service in 2023 will be worth less in 2027 and contribute a lesser value to the rate base. Fortis needs to spend sufficient money to cover this reduction in value and still grow the rate base.
2. Some of the assets that the company will be placing into service are intended to replace older assets that will be removed from service. Those retired assets will have their value removed from the rate base upon their retirement, offsetting some of the capital spendings.

Curiously, Fortis has not provided any guidance regarding the earnings growth that it expects this rate base development to achieve. However, it has stated that the dividend can be expected to grow at a 4% to 6% annual rate over the projection period. We can likely assume that its earnings per share will grow at a similar rate. This gives us a projected average total return of 8% to 10% annually when we consider the current 3.91% dividend yield. That is a reasonable total return for a conservative utility stock that is in line with what most of the company's peers are positioned to deliver.

Financial Considerations

It is always important that we investigate the way that a company finances its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is usually accomplished by issuing new debt and using the proceeds to repay the existing debt. This can cause a company's interest expenses to increase following the rollover in certain market conditions, which has an adverse impact on its cash flow. That is something that could be a concern today as interest rates in both the United States and Canada have been increasing fairly rapidly over the past twelve months.

In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. As such, an event that causes a company's revenue or cash flow to decline could push it into financial distress if it has too much debt. Although utilities like Fortis tend to have remarkably stable finances, bankruptcies have occurred in the sector so we should not ignore this risk.

One metric that we can use to evaluate a company's debt load is the net debt-to-equity ratio. This ratio tells us the degree to which a company is financing its operations with debt as opposed to wholly-owned funds. This ratio also tells us how well a company's equity will cover its debt obligations in the event of a liquidation or bankruptcy, which is arguably more important.

As of March 31, 2023, Fortis had a net debt of $21.4255 billion compared to $17.0793 billion in shareholders' equity. This gives the company a net debt-to-equity ratio of 1.25 today. This is in line with the 1.22 figure that the company had the last time that we discussed it, which is a good sign as it indicates that Fortis has not been making any significant changes to its financial structure. Here is how the company's ratio compares to some of its peers:

As we can clearly see, Fortis appears to be less reliant on debt than most of its peer group. This is a good sign as it should mean that the company's current leverage should not pose an outsized risk for its shareholders.

Dividend Analysis

As mentioned earlier in this article, one of the biggest reasons why investors purchase shares of utility companies is because these stocks typically have higher yields than many other things in the market. This is because utility companies tend to have lower growth rates than companies in other sectors, so they pay out a significant percentage of their cash flows to the investors in order to provide an acceptable total return. Fortis is certainly no exception to this as the company's stock yields 3.91% at the current price, which is substantially higher than the 1.51% yield of the S&P 500 Index (SP500). Fortis also has a higher yield than the U.S. Utility Sector ETF ( IDU ) as the index fund only yields 2.57% at the current price. Thus, Fortis certainly looks to be an attractive income investment on the surface.

Fortis also has a long history of growing its dividend over time, which adds to its appeal as an income investment. In fact, the company has increased its dividend on an annual basis every year for the past 49 years:

This is something that is especially nice to see during inflationary periods, such as the one that we are in today. This is because inflation is constantly reducing the number of goods and services that we can purchase with the dividend that the company pays out. This can make it feel as though an investor is getting poorer and poorer with the passage of time, especially for those that are depending on their portfolio income to pay their bills and support their lifestyles. The fact that the company increases the amount that it pays out every year helps to offset this effect and ensures that the dividend maintains its purchasing power.

As is always the case though, it is critical that we ensure that the company can actually afford the dividend that it pays out. After all, we do not want to be the victims of a dividend cut since that would reduce our incomes and almost certainly cause the company's stock price to decline.

The usual method through which we judge a company's ability to afford its dividend is by looking at its free cash flow. The free cash flow is the amount of money that is generated by the company's ordinary operations and is left over after it pays all of its bills and makes any necessary capital expenses. This is therefore the amount that the company has available to do things such as repaying debt, buying back stock, or paying a dividend. In the twelve-month period that ended on March 31, 2023, Fortis reported a negative levered cash flow of $1.1115 billion. That is obviously not enough to pay any dividends, but the company still paid out $552.7 million in dividends over the period. At first glance, this could be concerning as the company has insufficient free cash flow to cover the dividends.

However, it is not uncommon for a utility to finance its capital expenditures through the issuance of debt and equity. It will then pay its dividends out of operating cash flow. This is because the enormously high costs of constructing and maintaining utility-grade infrastructure frequently result in the company's capital expenditures exceeding its operating cash flows. That makes it impossible for most utilities to pay any dividends out of free cash flow, which would mean that there would be no reason to invest in them.

In the trailing twelve-month period that ended on March 31, 2023, Fortis had an operating cash flow of $2.3499 billion. That is more than sufficient to cover the $552.7 million that the company paid out in dividends during the period with a great deal of money left over for other purposes. Thus, it does appear that the dividend is probably sustainable going forward and we probably do not have to worry about a near-term cut.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a sure-fire way to earn a suboptimal return on that asset.

In the case of a utility like Fortis, one metric that we can use to value it is the price-to-earnings growth ratio. This ratio is a modified version of the familiar price-to-earnings ratio that takes a company's forward earnings per share growth into account. A price-to-earnings growth ratio of less than 1.0 is a sign that a stock may be undervalued relative to its forward earnings per share growth and vice versa.

However, there are very few stocks that have such a ratio in today's overheated market . This is particularly true in the utility sector, which tends to be very low growth. As such, the best way to use this ratio is to compare Fortis to some of its peers in order to see which stock offers the most attractive relative valuation.

According to Zacks Investment Research , Fortis will grow its earnings per share at a 5.57% rate over the next three to five years. This is right in line with the company's projections of its dividend growth rate so it seems pretty reasonable. That gives the stock a price-to-earnings growth ratio of 3.55 at the current price. Here is how this compares to the company's peers:

This is somewhat unfortunate for Fortis, as it appears that the stock is incredibly expensive compared to that of its peers. This is not a new problem though as Fortis has been fairly expensive for a while, as I pointed out when we last discussed the company nearly a year ago. As such, it may make sense to watch the stock while waiting for a better entry price.

Conclusion

In conclusion, Fortis Inc. is one of the only utilities that operates across multiple countries but it still has many of the characteristics that investors have long appreciated in domestic utilities. The company could prove to have a certain appeal over the next few months as the economy is almost certain to continue to worsen. When this is combined with an attractive dividend yield and respectable forward growth potential, we have all the makings of a good investment.

Unfortunately, Fortis stock looks rather expensive given its forward earnings per share growth. It is possible that a more attractive entry price will appear in the near future as the debt ceiling deal ensures that the United States Federal Government will suck over a trillion dollars of liquidity out of the market, adversely impacting stock prices.

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