Description

Idea Overview

Algonquin Power and Utilities (APUC) is a dual-listed, Canadian-headquartered but primarily US-based utility. 80% of APUC’s business mix is derived from a portfolio of regulated utilities. The other 20% of APUC’s earnings are from its renewable generation portfolio.  

Like most North American regulated utilities, APUC is a good, predictable business. The profitability of APUC’s regulated portfolio is not subject to customer usage, production or pricing, as the utilities operate under a rate-base construct. The renewable generation portfolio, while unregulated, has a similar visibility to the regulated business as nearly all electrical output is sold pursuant to long-term contractual arrangements (~11 years in duration).

APUC is a capital-intensive business that has always been managed with a growth orientation. Unfortunately, capital intensity and growth is not a great concoction heading into a rapidly rising rate environment. APUC has learned this the hard way as its consolidated earnings are forecasted to decline ~20% versus expectations only eight months ago! The primary culprit for this decline in earnings is higher interest expense due to rising rates.

APUC’s interest costs are expected to be further punctuated by the largely debt financed $2.4bn acquisition of Kentucky Power. The acquisition has yet to close, but here lies my primary variant view: I strongly believe the Kentucky Power transaction is unlikely to close. If the deal does not close, APUC will be up ~40% and trade towards ~US$11 / share. Without Kentucky Power, I see APUC earnings of $0.60 / share in 2023, and I believe APUC will trade towards the average current utility earnings multiple of 18x.

The Kentucky Power merger agreement has an outside termination date of April 26, 2023 (i.e. less than six weeks away). The Federal Energy Regulatory Commission (FERC) has already denied the transaction as it has concerns about how ratepayers in Western Kentucky will be impacted by the transaction. I see it being very unlikely that the FERC will change its stance over the 38 days. In turn, I believe APUC can walk from the transaction for an immaterial break fee. Most notably, two days ago (March 17, 2023), on APUC's Q4-22 conference call, APUC's CEO essentially confirmed that it would walk from this transaction at the outside date. In a response to a question from a BofA analyst, the CEO said "..we are as always have been using reasonable best efforts, and we continue to use reasonable best efforts right up to the outside date".  

If the regulator does a one-eighty and comes to a different view on the transaction by the end of April, then I still see APUC shares representing value. APUC laid out a very credible plan on a January 12^th, 2023 investor update call. The plan protects shareholders’ earnings power with no external equity capital and see’s APUC deleveraging its balance sheet with asset sales. APUC has proven an ability to monetize assets in the current higher interest rate environment and I believe the asset sales will lead to minimal earnings dilution. I’m cognizant that it will take some time for the market to get comfortable with the earnings power of the business and come to a similar view that asset sales will not be dilutive, but ultimately, I see normalized APUC earnings with Kentucky Power of >$0.60 / share. The average utility trades at 15x 2025 earnings, and given the overall quality, leverage profile and growth outlook of APUC, I expect a similar multiple. As such, under a Kentucky Power deal scenario, I see APUC being worth ~$9 / share TODAY and we will receive a ~6% dividend while we wait. This is still a favourable return considering APUC is trading for <$8 today. 

Bringing this all together, I see the bookends in an APUC investment as follows: either the Kentucky Power deal does not close and we do more than OK, quickly! Or the Kentucky Power deal does close, and we do OK.

Background

To better understand why the APUC opportunity exists today, it is important to understand APUC’s history. APUC has primarily been built through acquisitions which were largely externally financed. Aggressive M&A has really been core to APUC since its inception as a public company in the late 1990s. Shortly after going public with a handful of power generating assets the company expanded its focus beyond power and into utilities through the purchase of a regulated water and wastewater treatment facility in Arizona. Soon after, the utility expanded its footprint, buying water assets in Texas, Missouri and Illinois. While the company was experiencing success, APUC’s funding structure did not make much sense. APUC was acquiring regulated utilities, embarking on a power generation development program all while paying out nearly 100% of its internally generated income in dividends in order to meet the needs of its primarily Canadian retail investor base. Moreover, the power business, which represented the majority of the company’s earnings power had a merchant component. Declining power prices coupled with a nonsensical capital allocation strategy all came home to roost during the financial crisis. The board decided to hit reset at the worst possible time, in October of 2008, where it cut the dividend ~75% as its operating earnings went on to decline by 50%.

Following this blunder during the financial crisis, Algonquin vowed to de-risk the business. This was largely achieved by ensuring that all power assets were under contract with PPAs and M&A would be centered on regulated utilities.

In 2010, APUC made its first electric utility purchase with the acquisition of California Pacific Electric Company, the first electric distribution utility, located in Lake Tahoe. Then from 2011-2012, the company expanded into natural gas utilities in New Hampshire, Missouri, Iowa, Arkansas, Georgia, Massachusetts, and Illinois. While the company continued to organically develop power projects, with a focus on renewables, the core of APUC’s growth strategy centered on utility acquisitions. This growth strategy was furthered in 2017 with the US$2.4 billion acquisition of Empire District Electric Company, which owned and operated various utilities through the US Midwest (Missouri, Kansas, Oklahoma, and Arkansas). Later, the externally financed aggressive growth strategy continued with five more regulated utility acquisitions totaling over US$1.5 billion.

Over the past decade, APUC was successful in derisking the operating profile of its business. However, its aggressive, externally financed growth strategy has remained constant. During the ZIRP era, this strategy served APUC incredibly well, with its share price more than doubling during its acquisition spree, all while paying out a mid-single digit dividend. Unfortunately, APUC’s growth strategy is coming home to roost once again, like it did during the financial crisis.

In 2021, APUC announced its intention to acquire Kentucky Power from large-cap utility AEP for US$2.4 billion. The plan for the small carve-out utility was logical: acquire an under earning utility, file for rate increases to bring the ROE of the rate base to its allowable rate and drive rate-base growth over time with the investment in renewable sources. There was really no push back on the acquisition, but shortly after the deal announcement, interest rates began their aggressive rise. While APUC did raise some equity for the transaction, its debt financing was largely floating. This is in addition to the floating exposure that APUC already had! As a result, APUC’s earnings power started facing pressure and the company trimmed guidance on its Q3-22 earnings call. On November 12, 2022, the company guided to $0.68 (midpoint) of earnings from $0.75 (midpoint), representing a decline of nearly 10%. In the utility world not only is this a big revision, but it was a red herring that the sacred $0.72 annual dividend would be cut.

After the November 12, 2022 results, APUC’s shares entered a free-fall. Management and the board tried to ease concerns by stepping in and buying shares. From November 14-16, four separate insiders purchased >200k shares at an average price of ~US$8 / share. The market shrugged this vote of confidence and the stock continued its downward trajectory.

On January 12, 2023, the company hosted an update call. Investors were bracing for a bad scenario but were further surprised to the downside. Specifically, on the update the call, the company announced:

1. A 15% cut to 2023 guidance versus 2022. The street was forecasting flat earnings year-over-year but embedded in management’s 2022 guidance from November was a one-time $0.08 /share gain on sale. In addition, in APUC’s earnings walk, the company highlighted that it would likely close the Kentucky Power acquisition in Q2-23 and that it would be dilutive to earnings in year one. Many were expecting the deal to be accretive.
2. A 40% cut to the dividend. The dividend is now $0.40 / share. Dividend cuts are never well received by retail oriented investors.
3. Targeting to divest $1 billion in asset sales. This created further uncertainty on the earnings power of the business as forced asset sales could be dilutive. 

This update soured sentiment further, and the shares closed the week following the announcement towards a 52-week low of $6.66 / share, despite broader indices seeing a sharp bounce. In addition, after the investor update, S&P issued a press release maintaining its negative outlook on Algonquin’s BBB credit rating, suggesting that the utility will be downgraded in the next 12-months if it does not sell $1 billion in assets to delever and if its leverage ratio does not improve towards 14% FFO / debt.

No deal scenario should be the base case

So far, this should all read incredibly bearish. However, there is one key assumption that investors, the rating agencies and the sell-side community is making as a result of management’s outlook spoon feed: the Kentucky Power transaction closes in 2023. Based on the current fact pattern, I do not believe this to be the base case and I expect the Kentucky Power transaction to fall through. Specifically, on December 15, 2022, the Federal Energy Regulatory Commission (FERC) denied the approval of the Kentucky Power transaction. In the FERC’s 29-page docket, the commission was explicit that they had major concerns on how the Kentucky Power transaction will affect ratepayers: “..applicants [Algonquin Power] having failed to show that the Proposed Transaction will not have adverse effect on rates.”

The docket then goes on to address several other deficiencies of the AEP/APUC proposed transaction terms including how the cost of service for transmission, which is still owned by AEP, will be transfer priced / serviced. This also includes the operating and maintenance of the transmission assets.

The ultimate takeaway from the docket is that APUC has failed to show how ratepayers in Western Kentucky will be impacted by the transaction and that before approving any transaction, they want to see what their intentions are with the utility. A FERC Commissioner, James Danley, was somewhat apologetic in that it took nearly a year for the commission to respond and that the FERC could have acted in a much more timely manner. The FERC is aware of the potential “adverse” consequences by dragging its heels with this decision, including the fact that the transaction may now be in jeopardy and cause APUC to be “liable for a $65 million termination fee because of us”.

What’s obvious from this original docket is that the FERC has no idea that by either denying this transaction outright or even just taking their time with the process is literally the best outcome for APUC shareholders. The $65 million termination fee would be a gift and I estimate could create ~$2.0 billion in APUC shareholder value!

On February 13, 2023, AEP and AQN announced that they had refiled their 203 application with the FERC. Details can be found here:  https://www.aep.com/news/releases/read/8831/AEP-and-Liberty-File-New-FERC-203-Application-for-Approval--of-Kentucky-Sale

The most important takeaway from the filing is that AEP asked for an expedited timeline to close the transaction by April 26th, the merger agreement's outside date. In the original docket rejecting the transaction, FERC Commissioner Danley stated that it can take up to one year from refiling to come to a decision. Moreover, AEP asked the FERC to shorten the comment period from 60-days to 30-days. The FERC denied this request and said they would keep the comment period open (basically allows the public to intervene on the transaction) for 45-days. This means the public has until March 31, 2023 to comment on the transaction. Based on my read, no one wants this transaction to happen other than AEP. By having AEP ask the FERC to shorten the comment period and expedite the process, they are trying to turn their problem into the FERC’s problem! If APUC just amended the end termination date, there would be no need for an expedited process. 

Regardless of what the refiled application states, APUC's merger rationale is very clear from their October 26, 2021 merger presentation. The ultimate thesis in acquiring Kentucky Power is that the utility is looking for improved regulatory outcomes, ultimately resulting in higher ratepayers' prices. Specifically, APUC’s plan for Kentucky Power are as follows:

• Improve the ROE through proper rate setting: Kentucky Power had an average earned ROE of 6.6% from 2016-2020 as compared to an authorized ROE of 9.3%, and an average time of 33 months between electric utility rate cases filed in the last seven years
• Grow the rate base by adding rate-regulated renewables: Anticipated transfer of or retirement (for rate-marking purposes) of Kentucky Power’s 50% ownership interest (representing 780 MW) in the Mitchell coal plant in 2028 allows opportunity for rate-regulated renewables to be added to Kentucky Power's rate base
• Improve rate setting mechanism: Opportunity to switch to prospective test year from current historical regime
• Increase the equity proportion of the rate base: Kentucky Power’s current equity thickness is lower than peers’

All of these anticipated improvements will cost ratepayers more money! 

I also think it's worth noting that AEP will likely not push further in trying to get this deal through, and I find it highly unlikely they will get litigious: 

• The divestment of Kentucky Power is immaterial to AEP. Sale proceeds represent less than 3% of AEP’s market capitalization.
• AEP's CEO at the recent Morgan Stanley utility conference made it clear that the proceeds from this transaction are not required for AEP's capital investment plan
• AEP-FERC relations are extremely important. The FERC directly regulates ~25% of AEP's rate base

Most important to the investment thesis, if there is no transaction, all of APUC’s problems go away:

• APUC’s leverage ratio be >14% FFO / debt and in turn, be comfortably BBB stable from S&P
• Their will be a positive earnings revision as the transaction is dilutive on 2023 numbers and the financial outlook will be for earnings growth from 2023 onward
• From my conversation with APUC’s CFO, under a no deal scenario, the company will only look towards highly accretive asset sales and use the excess proceeds to buy back stock (driving further EPS growth)
• Street analysts will turn positive on the stock. There are 14 analysts that cover APUC and only four are buy rated. This is a consensus hold / sell

Historically APUC was a consensus-recommended list name at the retail brokerages. Since the Q3-22 earnings results, when it became obvious to the entire street that the dividend would be cut, all the analysts have pulled this from their recommended list. If the Kentucky Power deal does not close, I expect APUC to be put back on the recommended list and retail will chase the name higher. All the brokers have been pulling this idea from the recommended list at the time they should be adding it to the list!

Under a no-deal scenario, I see $0.60 in 2023 EPS, which should grow at a normalized mid-to-high single-digit level. The balance sheet will be comfortably BBB stable and in-line with the broader utility universe. Under this no-deal scenario, I expect the company to quickly re-rate and trade towards the broader utility sector average implying that AQN should be a $11 stock, representing ~40% upside from current levels.

An even simpler way to see just how jarring the discount APUC is trading at relative to the broader utility space is to look at the following chart. This chart highlights the historical normalized P/E (2-years forward) over the last 10-years. What we see is that in general, APUC has traded flat or a premium to the broader utility space, but today, is at a 50% discount! Again, I expect this discount to close in very short order should the Kentucky Power transaction fall through.

I also believe there is a potential big idea embedded within APUC, levered to the renewable power business. The IRA was officially enacted on January 1, 2023, but given the noise around the Kentucky Power transaction, the company has yet to receive any credit for the breakthrough agreement. The IRA is a real game changer for APUC and peers levered to the Act trade at a premium.

Before IRA, APUC qualified for two federal incentives, wind production tax credits and solar investment tax credits. However, APUC always had the challenge of planning the business with those federal incentives expected to phase down and expire in a few months or years. Some years, they were extended. Others, they were not. The uncertainty changed customer behavior and it changed APUC’s behavior.

Today, under the IRA, the incentives are clear. They support a broader range of renewable technologies. They are in place into the next decade. Therefore, the IRA provides growth visibility for a broad range of low-cost, clean energy solutions in a predictable way and for a long time. This is worth something and is not discounted at APUC’s current price. Peers that have renewable development capabilities (e.g. NextEra) trade at large premiums driven by investors willing to credit future developments.

What if the Kentucky Power Transaction goes through?

As discussed, on January 12, 2023, APUC hosted a detailed investor update call providing an overview of the company’s financial outlook. The outlook assumes that Kentucky Power closes in Q2-23.  Management provided 2023 EPS guidance of $0.58 (midpoint, see slide below). Management also effectively guided to flat growth for 2024 as the company will face a headwind from dilution associated with the mandatory converts, lost earnings from asset sales, and a higher effective tax rate; offset by renewable assets coming on line in 2023, uplift from a New York American Water rate case, accretion from the Kentucky Power acquisition (full year results plus rate case) and some deleveraging.

The main concern surrounds what the balance sheet looks like if the Kentucky Power transaction closes. Based on the 2023 outlook management communicated, I see FFO / debt of 11%. This is well below the 14% target management would like to achieve in order to ensure they can maintain their BBB rating at S&P.

However, in speaking with the CFO on Wednesday, January 18^th, it’s clear that S&P is onside with their plan and that there is a path towards 14% FFO / debt. Based on my calculations, I can bridge to ~14% FFO / debt by 2025:

• Nearly 100 bps improvement would come from the $1bn in asset sales
• Underlying FFO growth would provide another 100 bps improvement over two years. FFO is forecasted to grow faster than EPS as FFO is not impacted by the convert dilution
• 50 bps improvement from a ~$350 million securitization at Kentucky Power

It’s also worth mentioning that S&P has a higher tolerance for leverage for businesses that have a greater proportion of regulated businesses. Pro forma the Kentucky Power transaction, 85% of APUC’s earnings power will be from its regulated utility business. Therefore, even with a Kentucky Power scenario, the base case is APUC’s BBB credit rating is maintained. Worst case, the company is downgraded to BBB- because it can’t sustainably get to >14% FFO / debt, but most importantly, I do not see a scenario where Algonquin’s investment grade ratings are in jeopardy.

What are some potential asset sales?

APUC has assets on both the regulated and renewable side which should command a value far higher than APUC’s consolidated multiple. Moreover, given that the use of proceeds from asset sales will be used to reduce higher interest cost debt (~6% area), I expect divestitures to be hardly dilutive.

On the renewable power side, I see any divestitures done north of 12x EBITDA to be neutral to EPS assuming proceeds are used to pay 6% debt. Street sum-of-the-part (SOTP) valuations assume contracted renewable assets are worth >13x EBITDA. For greater context, in October 2022, Algonquin sold $350 million of renewable assets to Sun Life’s infrastructure arm for an estimated ~14x EBITDA.

In a recent meeting I had with the CFO, he also made it clear that we shouldn’t assume renewable assets are the only assets that will be divested. This makes sense as regulated assets command extremely high multiples. For example, non-California regulated US rate base assets transact for 1.7x-2.0x rate base. A divestiture at the lower end of that range would be accretive to earnings only assuming debt paydown. In fact, valuing APUC at the low end of the range would nearly cover the entire enterprise value of APUC, suggesting we are getting the renewable segment for free! At 12x EBITDA, the implied value to the renewable business is over $3.50 / share, equivalent to 50% of APUC’s market capitalization. 

To be more specific, if the Kentucky Power deal were to close and APUC were forced to pursue asset sales in order to repair the balance sheet, I think management will look to sell the New Hamsphire Gas asset. This asset should command nearly a 2x rate base valuation (>30x earnings) and would require approval from only one regulatory body. Fortunately, given the diversified nature of APUC and it’s nearly two decades of acquisitions of disparate assets, there are plenty of of potential divestment opportunities.

What’s APUC worth if the Kentucky Power deal closes?

Post Kentucky Power and planned divestitures, APUC will have similar operating risks, similar growth prospects and similar leverage to its North American utility peers. The regulated utility index currently trades at 15x 2025 earnings. If we assume two years of no-growth from the current $0.60 in earnings (which I believe is on the conservative end), at 15x, we get to US$9.00 in fair value TODAY. This represents >10% upside, plus we get a ~6% dividend yield while we wait. This scenario is obviously not going to go in the investment hall of fame, but sufficient hurdles at a double-digit IRR from here. I expect the market to pull this return once there is some greater certainty with the outcome of Kentucky Power, evidence that the deal can be accretive in out years and evidence that asset sales will not be dilutive to earnings.

I'd also note that this $0.60 EPS forecast for 2025 will likely prove conservative and will prove to be higher even if Kentucky Power closes. You can see this by doing a simple rate-based approach. APUC's 2022 rate base with Kentucky Power is $9bn. This is expected to grow ~5% / year through 2025 and implies a rate base of $10.4bn in 2025e. Let's use the current authorized ROE of 9.4% and authorized equity to cap of 50%. $10.4bn x 9.4% x 50% = $490mm in earnings. $490 / 760mm shares outstanding gets us to ~$0.64 / share in EPS JUST AT THE UTILITY. The renewable segment should more than offset corporate costs and corporate interest expense.  Therefore, there is upside to my out year numbers. I believe on the January 12, 2023 update, management hit reset and they hit it hard. This sets them up to beat, raise, and get the momentum back in their favor. 

Lastly, even with Kentucky Power, if you take a SOTP approach to value APUC, you can get the stock to US$11 / share. I think to realize this share price, Renewables will need to be sold outright, corporate costs need to be slimmed down and proceeds from a renewable sale will be used to pay off all corporate debt. We would be left with a 100% rate-regulated utility with a conservatively levered balance sheet (depends on proceeds from Renewables but I can see a scenario where this is a strong BBB+ and even weak A-) that can manufacture earnings and dividend growth forever. Should management pursue this strategy, you could see >18x multiple on the >$0.60 of utility earnings with Kentucky Power. Let's save this analysis for another post, as the near-term trade is hoping that the Kentucky Power transaction fails to materialize. I do want to put this out there though as this can still work over the next 18 months for a respectable return, even with Kentucky Power. Therefore, I see the bookends in an APUC investment as follows: either the Kentucky Power deal does not close and we do more than OK, quickly! Or the Kentucky Power deal does close, and we do OK.

Catalyst

- Kentucky Power transaction fails to go through

- Street upgrades (particularly from Canadian brokerages that heavily influence the retail advisor network)

- Accretive asset sales 

- Outright sale of renewable