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Interest rate cuts are underway. Since June, the Bank of Canada has reduced its policy rate by 75 basis points, or 0.75%. As a result, financing costs are going down — not only for homeowners, but for businesses as well.
Many Canadian companies have high levels of debt. The lower interest rates go, the cheaper servicing that debt becomes. For this reason, the ongoing interest rate cuts should have a positive effect on many Canadian companies.
Of course, there are other benefits of lower interest rates. A big one is that low interest rates reduce the discount rate used in discounted cash flow calculations, which increases asset values. That’s a positive for pretty much all assets, but highly indebted companies respond to lower discount rates even more than the average asset does.
Which brings us to the topic of utilities. Utilities are some of the most indebted companies in the world, which can be a bad thing when rates are high but usually results in their value increasing quickly when interest rates fall. They are among the best assets to own in economic conditions like the current one.
In this article I will explore two Canadian utility stocks that are worth a good look as interest rates decline.
Canadian Utilities
Canadian Utilities (TSX:CU) is, as the name implies, a Canadian utility company that supplies power all across the country. It also has operations in Australia, Mexico, Puerto Rico and other foreign jurisdictions.
As I mentioned earlier, utilities tend to benefit from interest rate cuts because of their high debt levels. Canadian Utilities should benefit from this phenomenon if interest rates keep coming down. As of its most recent reports, the company had $10.725 billion in debt against $7.153 billion in shareholder’s equity, for a 1.49 debt/equity ratio. That debt-to-equity ratio is fairly high, but it becomes less of a problem as interest rates decline.
In the last 12 months, CU’s interest expense was $484 million and its net income (profit) was $612 million. If the company’s interest expense declines by 13.6% and nothing else changes, then its net income will increase to $678 million. 13.6% is about the level we’d expect interest rates on variable rate debt to fall given the 75 basis point cut (75 is 13.6% of 550, the level we were at before the rate cutting began). So there’s a possibility that Canadian utilities’ earnings will increase in the year ahead, even if revenue doesn’t grow.
Beyond the factors just mentioned, Canadian Utilities has other things going for it, namely a fairly cheap valuation. Trading at 15.5 times earnings, 1.8 times book value and 5 times cash flow, it’s one of the cheaper utilities out there.
Fortis
Fortis (TSX:FTS) is another Canadian utility. Like Canadian Utilities, Fortis has a high debt load, with a 1.25 debt/equity ratio. So, FTS should gain from interest rate cuts just like CU.
On the whole, Fortis is a higher-quality company than Canadian Utilities. It has a lower debt/equity ratio, less interest expense as a percentage of earnings, and a lower dividend payout ratio. Because it’s less indebted than CU, it shouldn’t respond as swiftly to interest rate cuts as that company should. However, it’s overall a better-run company, so it might be worth keeping in mind as a long-term hold.
