Canadian Utilities: One Of The Better Utilities With A 6% Dividend Yield (CDUAF)

Note: All amounts discussed are in Canadian Dollars, all prices refer to the TSX.

On our last coverage of Canadian Utilities (TSX:CU:CA) (OTCPK:CDUAF), we explained what we liked about this company but landed moving up the chain to the parent instead. The discount at ATCO Ltd. (ACO.X:CA) was just too juicy to hold CU, and we rated CU as a hold while putting a strong buy on ATCO.

We rate Canadian Utilities as Hold as it is pointless to buy it directly as long as the discount persists. We continue rating ATCO a strong buy and think it will provide strong risk-adjusted returns.

Source: A Cheap Utility With A Growing Dividend, But Consider A Better Option

That was definitely a mixed call. While moving to ATCO would have been a saving grace of sorts, but did rather poorly. The returns below are after counting dividends.

We tell you why that happened and why we are now upgrading CU to a Buy.

Current Setup

CU’s Q3-2023 numbers were a small miss versus consensus estimates, for the full year, CU is expected to deliver $2.21 in earnings per share. There was some noise around the Alberta regulatory environment in the last 6 months, but most of the developments have been positive on the regulatory front. The return on equity clarity and the equity thickness stability should allow CU to continue to do well.

In fact, we have seen a small trend up in consensus earnings estimates for 2024 and 2025 over the past few months.

The driving factor is also the rather massive population growth in Alberta as one of the few places with reasonably priced housing.

Outlook

Overall, we think CU can deliver 3% earnings growth despite the rather higher interest rate environment. While 3% is not much to get excited about, it does get it into an 8%-10% total return range, when we factor in the 6% dividend. One key reason we like it, is the fact that CU has one of the best debt maturity profiles amongst its Canadian peers. Near term maturities are virtually non-existent for this one.

Refinancing will be quite pleasant and the rating agencies continue to give CU high marks.

Valuation

There are three aspects for valuation here, and the first is just relative to its peer group. This includes Fortis Inc. (FTS), (FTS:CA), Algonquin Power & Utilities Corp. (AQN:CA), (AQN), Emera Incorporated (EMA:CA) and Hydro One Limited (H:CA).

EMA, FTS, and Hydro One trade well above CU’s multiples. AQN trades under, but that is a very different situation with far higher levels of leverage and a lot of non-regulated earnings. So CU wins here by a big margin.

The second thing to note here is that CU wins, despite the lowest leverage in this group. Often a low P/E ratio is just a symptom of higher leverage. Here, it is not. EMA, for example, carries way more debt with a 6.7X net debt to EBITDA on 2023 numbers. CU is at 5.2X. CU gives you that and a very solid yield relative to the peer group.

The second aspect is the P/E ratio relative to its own history. CU has historically traded near 17X over the last decade. Sure, the higher rate environment deserves a modicum of discount for utilities, but at near 12.5X, we are going just too far for an A rated utility. We believe a 14X multiple on 2025 earnings would push CU to $33 per share. Even assuming it happens by the end of 2025, we are looking at about 11% annual returns from here.

The third aspect once again comes back to whether we want to own ATCO or own CU. ATCO owns 52% of CU, so that 52% still exceeds the value of CU’s current market capitalization.

You continue to get the modular structures and Neltume Ports for free. The latter is a mission-critical piece and really adds value to the ATCO story.

ATCO has a 40 per cent interest in Neltume Ports. Neltume Ports is a port operator and developer with a diversified portfolio of multipurpose, bulk cargo and container terminals located primarily in Chile with additional operations in Uruguay, Argentina, Brazil, and the U.S. Neltume Ports employs approximately 7,400 people and operates 17 port facilities and 6 port operation services businesses. In 2022, Neltume Ports handled 43 million tonnes of product, including copper, forestry products, consumer goods and agricultural products.

Through Neltume Ports’ exposure to global trade and transportation, the business is able to capitalize on increasing demand for resources; particularly copper, agriculture and forestry products, as well as on other global trends.

Source: ATCO

But, we understand that investors do favor the higher dividend yield and CU does give you that (6.06% vs 5.38%). CU is fundamentally undervalued enough that it is difficult not to put a buy rating on it. There is also the chance that ATCO may consolidate CU into its fold and if it did that, it likely would pay a premium over the current price. Finally, the ratio of the two market capitalizations, (CU to ATCO) has moved enough in ATCO’s favor since our last update.

Verdict

Canadian companies have taken on more balance sheet risk than their US counterparts. We see this primarily in REITs, but even in utilities, we are seeing some high leverage risks. CU has none of that. Those debt maturities are about as perfectly placed as they can get, and the overall leverage levels are fantastic. We own a large position in ATCO, but now are open to adding CU as well and upgrading it to a buy. One side note we want to add here is that we do own a piece of CU, via CU Inc. Cumulative Redeemable Preferred Shares Series 1 (CIU.PR.A:CA). The ticker is not present on Seeking Alpha currently, but hopefully will be added down the line.

The fixed rate preferreds yield 6.65%, and they seem to get a bump up from the ratings assigned to the “Canadian Utilities” preferred shares.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.