If the Bank of Canada keeps cutting interest rates, it will presumably be good news for most Canadians, financially speaking. Lower interest rates mean lower borrowing costs, and the bank cutting them would presumably mean that progress is being made in the fight against inflation.
For homeowners and other average Canadians, interest rate cuts would be a blessing. They would be a blessing for most stock investors, too; however, there are certain individual stocks that would suffer in a lower interest rate scenario. Many financials would report lower net interest income, for example. Certain types of stocks benefit from the capital cheapening/opportunity cost-lowering effects of interest rate cuts more than others. In this article, I will explore one TSX stock that would likely respond very positively to a fall in interest rates.
Fortis
Fortis (TSX:FTS) is exactly the kind of stock you want to be holding in a scenario where the Bank of Canada continues cutting interest rates. As a regulated utility, it has a high level of debt, and all that debt becomes cheaper to service when rates go down. As a result, Fortis can reasonably be expected to deliver higher earnings if interest rates come down further. Its stock should also rise in the markets in the same scenario.
Good revenue growth offset by high interest expense
Although Fortis’s sales have increased considerably over the last five years, its stock has barely risen. This has occurred despite the company’s revenue rising in the same period.
One reason for this is that the company’s admittedly growing revenue has been offset by rising interest expenses. Over the last five years, Fortis’s revenues grew at 5.5% per year, but its finance charges (a category that includes interest and lease payments) grew at 6% per year. A consequence of this was that the company’s earnings per share grew more slowly than revenue, at a 4% compounded rate. Some dilution (increase in the number of shares) also contributed to earnings lagging revenue.
The above partially explains Fortis’s lacklustre stock performance over the last five years. However, it also points to a potentially better future. Because Fortis’s earnings have taken a hit from rising interest expenses, said earnings should see an improvement from interest rate cuts. Falling interest rates result in an immediate reduction in the cost of variable rate debt and an eventual decrease in the cost of fixed rate debt, as it is eventually re-financed at a lower interest rate. Fortis will benefit from both of these effects if the Bank of Canada keeps cutting rates.
A decent balance sheet
Another big thing that Fortis has going for it right now is a good balance sheet. It has $27.5 billion in debt to $20.5 billion in common equity for a 1.35 debt-to-equity ratio. The ratio of debt to total equity is 1.15. These numbers are pretty modest for a utility stock. On a less flattering note, the company has more current liabilities than current assets for a sub-one current ratio. That isn’t a positive, but the ratio (0.59) is not so bad that investors should fear immediate liquidity issues.
Considerable dilution
On a less positive note for Fortis, the company has diluted its equity considerably over the years, with the share count rising by 2.7% per year over the last five years. This isn’t such a good thing, although earnings have grown faster than the share count, resulting in the already mentioned 4% growth rate in earnings per share. The earnings growth rate has more or less been adequate to support the company’s dividend hikes. On the whole, Fortis appears to be a reasonably sensibly run company and a potential beneficiary of future rate cuts.
