Description

If you’re bearish and short, it can be hard to find anything to be long as a pair. From this perspective I believe Fortis, the largest publicly traded regulated utility in Canada, is a relative buy. A few reasons why:

• They thought they were going to get upgraded from S&P recently from A-, so they have more bullets than most others against likely downgrades that will sweep across the world.
• With treasury yield and corporate bond yields decoupling, Fortis’ equity is a proxy for IG type exposure through an equity. I’d put it in a bucket that I’d think is first order / derivative for stability in pricing if recent downward trend & volatility finds some footing.
• Corporate bad news will be good, in that a reduction to their 5-year capital plans (especially in Alberta) would be met with praise from shareholders.
• CADUSD currency move is near-term positive for earnings given >60% assets earn in USD but stock is CDN.
• ROE’s will come under pressure, however they’re geographically diversified so it will be gradual, the reductions will be ‘sticky’ in that we’ve already moved away from more detrimental methodologies on utility returns (e.g. Opinion No. 531) and the reason for the decline (i.e. treasury yields) has counter argument for the equity built-in (i.e. lower int. rates while an ROE headwind have been positive for equities since 2009).

Overview

Fortis is diversified regulated electric and gas utility with ~$53 billion of total assets. 99% of its assets are regulated utilities, of which 82% is electric and 17% is gas. 93% are related to transmission and distribution. 63% of total assets are in the US, 34% is in Canada and 3% is in the Caribbean. Fortis partially hedges its USD exposure, estimating a five-cent increase in the US dollar relative to the Canadian dollar from US$1.00=CAD$1.33 ($1.40 today) would increase EPS by $0.06.

Credit

Reducing the probability of potential downgrade in a recession scenario, following Q4 2019 reporting management were optimistic on the probability of S&P (A-) returning its “Negative Outlook” to “Stable” (given their 11% FFO-to-debt target for a stable rating vs. 2019 at 12%) and possibility of Moody’s (Baa3) moving up to Baa2 (although holdco debt likely too high in the near-term).

Capital Plans

Fortis’ 2020-2024 stated capital plan for $19 billion, funded by operating cash flow, utility debt and their DRIP, is expected to increase rate base from $28 billion in 2019 to >$38 billion by 2024 (6.5% CAGR). 20% of these plans are considered major projects, debt issuance is part of the funding plan & some of this growth was for Alberta and FortisBC Energy.

Earnings

Treasury yields are obviously lower so there will be further pressure on ROEs. It will take time given Fortis is geographically diversified, but earnings still will face a headwind on this. I generally agree with the math that others have shown where for every 50bps change in ROE about ~$0.17 or 6% change in EPS (>40% of which from ITC (FERC)). Also, since 2009 declining rates despite the ROE pressure that comes with it have been net positive for utilities (i.e. reduction in ROEs have been stickier than decline in treasury yields).

EPS estimates (prior to recent turmoil) for 2020 are ~$2.65 while last DPS annualized is ~$1.91.

Value

Using a simple GGM with $1.91 DPS with 2-4% long-term growth rate (vs. 6.5% rate-base 4-year guidance) implies 6.0-8.0% cost of equity for shareholders purchasing Fortis at $47.91/share. Assuming EPS of $2.65 with 2-4% long-term growth rate implies 7.5-9.5% cost of equity for shareholders purchasing Fortis at $49/share (in a world where treasury rates are less than 1).

Catalyst

- Future earnings releases showing positive impact from currency change.

- Growing understanding that even in a zero interest rate world regulated utility ROEs will not drastically change overnight.

- Reduced vol in A and Baa credit markets.