2023-05-29 04:25:53 ET
Summary
- Hydro One has drifted higher since our last coverage.
- Steady results should not get investors too comfortable.
- Valuations are extremely demanding for a non-zero rate world.
All values are in CAD unless noted otherwise.
The Company
Hydro One Limited ( OTCPK:HRNNF ) transmits and distributes electricity within the Canadian province of Ontario. With close to 1.5 million customers, it is the largest one at that.
The business is regulated and looks rosy based on the company's outlook.
The province has a 47.2% ownership in the company.
Prior Coverage
We passed on it each of the three times we covered it in the past. There was no doubt about it being a quality company but we were also unequivocal about it being too expensive. In our most recent piece back in January, we downgraded it from being neutral to a sell as the upward move by the stock price was not supported by valuation metrics. Trading at over 19X forward price to earnings or PE, lower dividend yield compared to its peers, and a comparatively higher debt ratio, it was not a hard case to make.
As much as we would like to embrace investing in Hydro One, these valuations don't support it. With any kind of modest valuation compression, you are likely to get negative total returns over 4-5 year periods. Within utilities, there are far better options designed to provide better income and better total returns. At a 3% yield, Hydro One is likely to be one of the most sensitive to any new tremors in the bond markets. We had rated it a "Hold" the last time, but the current valuation puts its squarely in the Sell zone.
Source: Hydro One: Valuation Moves Into A Different Zone For This Utility
The stock continued its upward trajectory rewarding its investors for their confidence.
It also continues to outperform most of its peers. Those noted below are:
1) AltaGas Ltd. ( ALA:CA )
2) ATCO Ltd. ( ACO.X:CA )
3) Emera Inc. ( EMA:CA )
4) Fortis Inc. ( FTS:CA )
And the market continues to pay through the nose.
Let's dig into the first quarter results.
Q1-2023
Hydro One witnessed a lower average monthly peak demand and energy consumption, but OEM approved increase in transmission rates propelled the revenues higher on a year over year basis.
The OM&A expenses followed suite and were also higher year over year resulting in a comparatively lower bottom line. The management however noted that around 75% of the increase was timing related, offset of which will be reflected in the subsequent quarters of this year.
Turning to OM&A, what can we expect and why were we up this quarter? We're up 40 million, about half of that was corporate support costs.
That is timing. That will come back. About a 25% is around our work programs. Again, timing and the last 25% is all to do with the regulatory account. So our OM&A was higher, but also our revenue was higher. So I would say three quarters of the OM&A was all timing. That will come back in the back part of this year.
Source: Q1-2023 Earnings Call Transcript
Unlike the OM&A expenses, the rising interest costs are a real and present drain to the company's financial resources. This increased by $19 million or 16.2% year over year. This increase is after an offset from the higher weighted average interest earned on the short-term investments. Nonetheless, good move by the management to take advantage of the inverted yield curve.
Mark Jarvi
I guess I'm just thinking that sometimes there's a quarter or two while you use the commercial paper before you come to market to determine. I just wonder if there's any alternatives to just shave off some of that borrowing cost.
Chris Lopez
Yeah. So right now, the way it's working for us, Mark, is that if you borrowed longer term, you could invest in that short-term market itself and you either offset the borrowing costs or you end up with a slight gain. So that's the reason why we're out ahead this year thinking about pre-funding next year. So that's a does that answer your question, Mark? I'm trying to understand.
Source: Q1-2023 Earnings Call Transcript
Hydro One had higher capital spend for both the transmission and distribution segments of its business.
Resulting in higher associated expenses of depreciation and amortization. Some of the increase on the distribution side pertained to storm-related asset replacements.
On the dividend front, the company increased it from $0.2796/quarter to $0.2964/quarter right on schedule in keeping with the trend since its initial public offering.
Hydro One targets a payout of around 70%-80% of the net income. At the current price, the yield is a little over 3%. Comparatively, AltaGas is 4.85%, ATCO is 4.46%, Emera is 4.88% and Fortis is 3.88%.
Valuation
Government backing coupled with consistently strong results have made this company a fan favorite. It commands a higher P/E than its peers and investors are willing to settle for a lower yield, even lower than the government bonds.
When we started coverage on this company, it was yielding 1.9X the benchmark bond. 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. We see this very similar utility like company, TELUS Corporation ( TU ) in early 2022 (see, One Growth Bubble Waiting To Implode ). Slapping high multiple on low growth stocks works for a while but there is always hell to pay eventually. We continue to rate it a sell and see far more compelling opportunities in other utilities.
For further details see:
Hydro One: Paying Through Your Nose