CA - Fortis: Preferred Shares Deliver Yield And Outperform Common

2024-01-10 16:32:58 ET

Summary

• On our last update, we gave a buy rating to the preferred shares for Fortis and stuck with a hold for the common.
• The company had a strong Q3 2023, beating consensus estimates with EPS of 84 cents, driven by regulatory approvals and favorable exchange rates.
• We examine the bull case today for both the common and the preferred shares.

Note: All amounts discussed are in CAD. All prices discussed prefer to stocks traded on the TSX in CAD.

On our last coverage of Fortis Inc. ( FTS , FTS:CA ), we made the case that the common shares were likely to give you relatively poor overall returns, driven by valuation compression. We further opined that the preferreds were where the cool kids should hang out and bask in higher yields and better appreciation potential.

While the common shares have become slightly more attractive as we roll in 2024 estimates alongside a lower price point, the preferred shares for Fortis are incredibly good deals today.

We have had four and half months more of data on the company and the macro environment since then. We look at how our suggested ideas worked out and where there is value today.

Q3 2023

Fortis did a heavy beat of the consensus estimates in Q3 , with EPS coming in at a stellar 84 cents versus expectations of 77 cents. The key drivers were the BCUC approval of retroactive application of capital parameters and an exchange rate which went in their favor. The quarter also saw many regulator decisions being put into the rear view mirror. TEP approved the 9.55% return on equity allowance. BCUC allowed 9.65% which was retroactive from January 1, 2023 (that is what allowed the big beat versus estimates). Alberta Utilities Commission also approved recoveries in line with expectations.

Q3 2023 results and conference call were around the time when interest rates were going vertical, and it was no surprise that that was the primary focus of the conference call (emphasis added).

With regards to upcoming maturities, we currently have about $1.7 billion due through the end of 2021, including almost USD 200 million in nonregulated debt at Fortis Inc.

Our primary exposure to elevated interest rates pertains to holding company debt as our regulated utilities ultimately recover changes in interest rates through regulatory mechanisms and the periodic rebasing of customer rates . We'll continue to monitor the debt capital markets and consider interest rate hedges or prefunding opportunities. With proceeds from our debt issuances and the expected sale of Aitken Creek, as well as over $4 billion available on our credit facilities, we remain in a strong liquidity position and are comfortably positioned within our investment-grade credit ratings as we execute our $25 billion capital plan.

There was some further quantification on the conference call, and FTS did not expect those rates to have a large hit to earnings. Of course, since then, rates have gone in the opposite direction.

Our outlook there is that this is a pause in the trend of higher long-term rates. Whether or not the Fed cuts, the yield curve should normalize at some point, and that will most likely result in at least higher rates than what we see today. But in the interim, the credit markets have reopened with a bang, and FTS is no doubt getting the maturities addressed as we write this.

Valuation

As a highly regulated utility that has shown tremendous cost discipline and near perfect execution, FTS tends to carry a premium valuation. On a straight P/E ratio, FTS rings in more expensive than Canadian Utilities ( CU:CA ), and Emera Inc. ( EMA:CA ). Hydro One ( H:CA ) is insanely expensive relative to everything else because of its Ontario Government backing.

If you accept that multiple and assume that is remains the same, it is easy to get behind FTS. You are very likely to see 5% earnings growth for the next 5 years, just based on capital invested. You slap the 4% dividend on top of it and then you are left wondering why would anyone choose a 5 or 10 year bond when you can have utilities like these. Valid question. Here is our valid response with a Canadian Utilities 10 year chart.

CU started the timeline with a near 19X P/E, and now the forward P/E has compressed to 13.72X. Earnings growth was a bit slower than expected and valuation compression gave you negative price returns. Don't get us wrong. Total return was a still positive 35.81% and did actually beat the total return of a 10 Year Government of Canada bond purchased at the time (28% total approximately).

But you always have to be careful when buying at a premium valuation. Our take is that higher long-term yields will force some compression here for FTS and total returns are likely to be poor. As there are no real red flags here, we are reluctant to go to a sell and continue to rate this as a hold.

Preferred Shares

Last time around, we vouched for Fortis Inc. CUM RD 5Y SR G ( FTS.PR.G:CA ) and Fortis Inc. CUM RD 5Y SR K ( FTS.PR.K:CA ). Both have done better than FTS over the past few months along with a far more generous yield.

Our opinion here is that FTS.PR.G is still mildly undervalued despite the rally. Offering a 7.39% yield here for a quality utility is still a good deal. We are removing our buy rating on this, though, and we don't own the shares any more.

FTS.PR.K is interesting for those that share our outlook of rising rates into the next two months. Currently FTS.PR.K would reset to a yield of approximately 5.40% on par (It is a GOC-5 plus 2.05%). That would make it yield about 7.5% for the next 5 years. If rates rise as we anticipate, this should capture an awesome reset. We are tentatively maintaining this at a Buy. We currently own only Fortis Inc. 1ST PREF SER M ( FTS.PR.M:CA ). That one is due to reset on December 1, 2024 at GOC-5 plus 2.48%. If the reset happened today, it would yield about 8.2% at the current $17.86 price. We are holding that and will likely sell over $19.00.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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