So far, I would not say it has been a great start for Canadian utility stocks in 2023. Year to date, the TSX Utilities Capped Index is down 2%, whereas the benchmark S&P/TSX Composite Index is up 4%.
In 2021, we saw a few highly notable utility or renewable stocks take a serious hit. Algonquin Power and Utilities got caught taking on too much variable-rate debt. Earnings collapsed, the stock tanked, and the company had to reduce its dividend. It is down 41% over the past year.
TransAlta Renewables was also considered steady-as-it-goes renewable power operator and developer. Yet the company got caught with a large wind project that had serious structural/safety issues. Rising operating costs are also putting pressure on earnings. With the stock yielding close to 8%, there are some questions as to how sustainable its current monthly dividend really is.
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Many utilities and renewable stocks are facing headwinds
Typically, utilities are meant to be very safe investments with very little volatility compared to the broader market. However, some utilities (like Algonquin) began aggressively investing in renewable power projects to spur additional growth. Cost inflation, supply chain challenges, and the rising cost of capital have all been near-term headwinds.
In a low interest rate environment, where capital is plenty, this is okay. Companies can issue both debt and equity to fund their growth plans and pay their dividends. However, when interest rates rise as rapidly as they have, financing costs have also drastically increased.
Debt-servicing costs can quickly eat up earnings and cash flows (especially if they are variable rate), leaving utility companies with less cash to fund their businesses and ultimately pay their shareholders.
Institutions may start to prefer bonds over utilities
The other dynamic to consider is the transition of fund flows. Utility stocks are a bond proxy. They provide a nice income stream generally at a lower risk to the broader market. However, as interest rates rise, bonds start to become a more attractive investment (especially for big institutional investors).
Bonds have a contractual obligation to pay interest. Stocks have no obligation to pay a dividend. As a result, the income from bonds is generally deemed much safer and more reliable than dividends. Unfortunately, investments flowing to bonds take away from investments in safe equities like utilities.
Is now the time to buy utility stocks?
So, is now the time to buy utility stocks? Well, as is often the case, it really depends. I would not exactly call utility stocks cheap. Many are trading above 18 times earnings. With the stock market being so volatile, the highest-quality utilities, fortunately, continue to maintain strong investor demand.
Fortis (TSX:FTS) for example, is fairly pricey at 18 times earnings. However, with nearly 50 years of consecutive dividend growth, it is an elite utility and an elite dividend stock. Fortis is not a fast growth story. It plans to invest around $4-5 billion every year with the expectation to grow its customer rate base by around 6% annually.
Fortis is a gold standard for utility stocks
Most of its capital plan is focused on smaller, lower-risk projects. Likewise, its capital expenses are diversified across its utility portfolio. Fortis has a good balance sheet where most of its debt is locked in and long dated. Likewise, it plans to only issue incremental equity to fund its growth program. That means current investors should maintain their earnings power.
Fortis pays a 4% dividend today. It plans to grow that annually by 4-6%. This utility stock is not cheap, but it is quality. If you want to own a very safe utility for many years, Fortis is one of your best bets today.
