HRL - Hydro One: Risks Mount Despite Price Drop And 3 Tailwinds

2023-10-20 17:03:50 ET

Summary

• Hydro One's stock has dropped and validated our earlier Sell rating.
• The company has three massive tailwinds and we discuss those today.
• We go over the big risks and tell you why we still see more downside.

On our last coverage of Hydro One ( H:CA ) we gave a hard pass this revered utility. Our logic was based purely on valuations. Specifically we said:

By the time we last wrote on it, the yield had dropped below comparable government instruments. The situation now makes even less sense. If it even traded at 18X forward PE, the top end of where comparable utilities is currently trading, the price would be closer to $31. Any which way we see it, the longer term trajectory will be down.

Source: Paying Through Your Nose

That call was a victory of sorts as Hydro One finally broke its rising trend.

We go over today why despite the stock having fallen, it has actually become more expensive.

Recent Results

We are almost all the way to Q3-2023 results (early November) for Hydro One. But even the Q2-2023 results are enough to give a glimpse of our thesis. The company remains about as predictable as one can find, even in a low beta sector like utilities. Q2-2023 earnings per share were just a shade over the mark and came in just above consensus estimates of 43 cents a share.

Notable here is that while Q2-2023 was above Q2-2022, year to date the utility has produced lower numbers. Now there were some one-time items that boosted 2022 base line that Hydro One presents in its next slide below. Nonetheless, it reinforces the idea that this has been a slow growing utility.

The bulls are pinning their hopes on the right hand side of that slide, which shows earnings increasing at a 6% average clip for the next four years. If that did pan out, we would be seeing a $2.15 earnings rate (midpoint) in 2027. Can they get there? Well they do have three major tailwinds here. The first being the stake held by the Government of Ontario in the utility. This relationship has generally ensured that there are no surprises from the Ontario Energy Board.

Generally, the Return on equity or ROE, allowances are likely to be steady and capex plans are likely to be approved as is.

The second major tailwind here is that Hydro One has really reduced customer bills. In an era of generalized moderate inflation, it is rare to find a utility which can boast about expense reduction for its customers.

Of course this is not going to repeat, but it is hard to overstate the goodwill this creates on both the customer and the regulator side for future bill increases.

Finally, Canada's massive immigration policy has resulted in a burst of population growth.

This has been focused on, you guessed it, Ontario. The province saw 227,235 immigrants in 2022 and was at the opposite end of Nunavut where we stuck to welcoming just one person every week.

So those were the tailwinds and they are strong.

What Is The Problem Then?

While we acknowledge the bullish forces we don't think they are enough. Hydro One will face mounting interest rate costs here, despite a very well-structured balance sheet.

The front end is slightly overloaded and those rolls are going to be very expensive. Hydro One did factor the numbers in at the time of its Q2-2023 earnings release, but the market is likely far more restrictive today. One quick measure would be the price of the iShares Core Canadian Long Term Bond ETF ( XLB:CA ). It has dropped over 10% in the last three months and reflects rising yields that we are all too familiar with these days.

Current estimates are for interest expenses to rise by about 8% each in 2024 and 2025. While that might sound like it accounts for the issue, we don't believe it does. Total debt should be up by at least 4% in each of those two years as Hydro One executes its growth plans. With the combined impact of current rates and a debt increase, we think earnings could disappoint in 2024 and 2025.

Valuation & Verdict

The growing sustainable dividend is always been a favorite with dividend growth investing crowd.

We don't see any issues with the 5% growth expected in 2024 and 2025 and we believe that will occur even if earnings disappoint. But investors must realize that in chasing that silliness, they often push stocks to ridiculous valuations. Hormel Foods Corporation ( HRL ) was a great example which we recently wrote abou t. At its peak madness, it traded at over 30X earnings and was priced beyond perfection. Hydro One has corrected some of that silliness here with the P/E ratio falling from 24 to 20.4.

But in many ways it has become even more overvalued. For example, Hydro One now yields 1.08% less than the 5-year Government Bond of Canada benchmark yield.

1-2% more than the benchmark yield has been the norm. On the forward P/E ratio side, Hydro One still rings in incredibly expensive relative to Fortis Inc. ( FTS:CA ), Canadian Utilities ( CU:CA ) and Emera Inc. ( EMA:CA ).

Some crossovers like Enbridge Inc. ( ENB:CA ), and TC Energy Corporation ( TRP:CA ), which have both midstream and utility assets, pay huge dividend premiums over Hydro One.

We just don't see the appeal here on a relative or absolute basis. We are reiterating our Sell rating and would get more constructive under $30/share.

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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