After second dividend cut, Algonquin aims to leave its rocky past behind

What is your opinion of Algonquin Power & Utilities Corp. AQN-T now that the company has cut its dividend again and agreed to sell its renewable power assets? Is the worst over, or do you see more problems ahead?

To refresh people’s memories, I punted Algonquin from my model Yield Hog Dividend Growth Portfolio in November, 2022, before the company cut its dividend by 40 per cent in January, 2023. I have since sold all of my shares personally as I was concerned that the bloodletting – triggered by a sharp rise in the cost of Algonquin’s variable-rate debt – was not over.

My fears were confirmed on Aug. 9 when the company slashed its dividend by another 40 per cent. Concurrently, Algonquin also announced an agreement to sell its renewable power business – excluding hydro assets – to U.S.-based LS Power for up to US$2.5-billion. The price consists of US$2.28-billion of cash at closing and up to US$220-million under a long-term “earn out” agreement tied to the performance of certain wind assets.

Algonquin also plans to sell its hydro-generation business, which could bring in approximately US$400-million, analysts estimate.

Cutting the dividend and selling the renewables assets are prudent moves for Algonquin, which aims to become a pure-play regulated utility operator. The moves will allow Algonquin to strengthen its balance sheet, improve the predictability and stability of its earnings and potentially achieve a higher valuation for its share price. However, the market reacted negatively to the news, sending the stock down more than 12 per cent that day.

Why such a cool reception from investors?

In a note to clients, analyst Nelson Ng of RBC Dominion Securities Inc. cited several possible reasons.

First, the renewables sale proceeds were lower than anticipated after taking into account higher-than-expected levels of off-balance-sheet construction debt.

Second, management’s near-term focus is deleveraging Algonquin’s balance sheet, which may have disappointed investors who were hoping for share buybacks.

Third, Algonquin indicated that more than US$1-billion of utility investments are not yet reflected in the rates it charges customers and are therefore not earning a regulated return.

In utility speak, this is known as “regulatory lag” – the time between a utility’s request for new rates and the approval of the rates by a public utility commission. In Algonquin’s case, the lag was longer than expected.

“Although we see a clear path to a pure-play utility by early 2025, we were surprised to hear that it could take several years for the utilities business to achieve its regulated allowed return on rate base,” Mr. Ng said. (Rate base is essentially the value of assets on which a utility is permitted to earn a regulated rate of return.)

“We believe [the shares] could be range-bound in the near term due to execution risk” related to asset sales and the outcomes of pending rate cases, he said.

Mr. Ng lowered his price target on Algonquin’s shares to US$6 ($8.22), from US$7 ($9.59) and reiterated his “sector-perform” rating. Most other analysts are also taking a wait-and-see approach. Six other brokerages have a “hold” or equivalent rating on the shares, with just one “buy” recommendation, according to Refinitiv data. The average price target is US$6.70 ($9.18).

Algonquin’s shares closed Friday at US$5.35 on the New York Stock Exchange and $7.32 on the Toronto Stock Exchange.

The good news is that Algonquin’s reduced annualized dividend of 26 US cents (35.6 cents) a share appears to be sustainable. (Algonquin is based in Oakville, Ont., but reports results and declares dividends in U.S. dollars because of its extensive U.S. operations.)

Brent Stadler, an analyst with Desjardins Securities, projects a payout ratio of 87 per cent based on estimated 2025 earnings, falling to between 60 per cent and 70 per cent as rate cases are decided and the regulated earnings are reflected in Algonquin’s results.

“AQN is restraining growth capex as it looks to recover on prior investments and execute on rate cases – a rare capital-light growth model, which investors might find attractive,” Mr. Stadler said.

The bad news is that the dividend, which yields about 4.9 per cent, likely won’t rise anytime soon, in my opinion.

On Algonquin’s second-quarter conference call, chief executive officer Christopher Huskilson said the company is at “the beginning of a multiyear journey to unlock the value of our regulated business.”

Algonquin is also aiming to become more financially self-sufficient and less reliant on capital markets, as it focuses on recovering its previous investments and reducing regulatory lag while trimming its capital expenditures next year.

“As part of our objective to be more self-sufficient, the board has decided to right size the dividend so we’re not chasing a high payout ratio and … excessive equity raises. These are necessary steps that we expect to unlock more value in the long term for our shareholders,” Mr. Huskilson said.

Bottom line: Algonquin is taking the right steps to improve its balance sheets, focus on regulated utilities and create a stable platform for prudent growth. The dividend now appears to be safe, but investors hoping for capital gains and dividend increases will need to be patient as the company continues to work through its issues.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.