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Algonquin Power (AQN) Stock | NYSE: AQN | TSX: AQN.TO

The Future is Green

Algonquin Power & Utilities Corp. (“AQN”) owns and operates generation, distribution and transmission utility assets. Operating mainly in the United States, with operations in Canada, Bermuda, and Chile, the company seeks to provide high-quality utilities to residents in the area, as well as lead the world into a greener future with its renewable energy generation business.

Although the company is found mainly in dividend portfolios, there are ample growth opportunities for investors with many styles to include AQN in their accounts. AQN is a serial acquirer, prudently managing capital with years of experience to drive value, grow its customer base, and ultimately capitalize on these expansion efforts. It also faces secular tailwinds in its renewables business, partnering with some of today’s most important companies to decarbonize the planet.

Growth

72

Valuation

87

Quality

48
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Where Are We Now

Updated on: 11/7/2021

Conviction Score

5

Algonquin Power is an operator of regulated utility and renewable energy assets in North America and some South American regions. We like this utility company for its reliable revenues derived from long-term contracts and its growing operations in “green” renewables. However, it is certainly not on our priority list as long-term oriented investors.

  • Algonquin should grow as it rolls out its 5-year $9.4 billion capital program. These regular utility and renewable energy investments will help Algonquin score long-term contracts and expand its footprint in North America and elsewhere.

  • We remain confused about Algonquin’s current financing strategy. Despite being in a world of low interest rates today, the company recently issued $900 million of expensive equity units (i.e., shares) that dilutes shareholders.

Investment Thesis

  1. AQN operates mainly in the rate-regulated utilities distribution business, fostering a reliable and stable revenue source for the company that is effectively recession-proof. Almost all of its revenues are derived from this business segment, while less than a quarter of its revenues come from higher-growth renewable energy generation.

  2. AQN enjoys characteristics of a moat, including long-term contracts in its renewables business, a large and expanding global footprint of utilities assets across Canada, USA, Bermuda, and Chile, and a capital-intensive – and profitable – business model that acts as a deterrent to new entrants.

  3. The company faces risks in terms of regulation, rate reviews, power prices, and its reliance on acquisitions to keep the growth machine moving. Additionally, the company engages in equity issuances to fund some of its growth, potentially introducing substantive dilution risks to current shareholders if any of these projects are not as profitable as expected.

  4. AQN has ample room to grow – it recently announced a $9.4 billion capital spending program through 2025, indicating that management sees many accretive (i.e., profit-expansive) opportunities for the business to grow. On top of this program, the renewable group is expanding with various partnerships and a promising development pipeline that is seeking to capitalize on the decarbonization of the world.

  5. AQN’s dividend appears to be set to grow at a rate similar with the 10% CAGR throughout recent history and in line with management’s expected profit growth of 8 – 10%.

The Basics

Formed in 1988, AQN began as a business venture as an Independent Power Producer that developed hydroelectric projects, the first of which was developed in Hastings County, Ontario.

In 2001, the company entered the utility business by purchasing a rate-regulated water and wastewater facilities in Arizona. Shortly thereafter, infrastructure was obtained in Texas, Missouri, and Illinois. From this, Algonquin continued to grow and began to dip its toes into wind generation in 2004, electric utilities in 2009, solar power in 2014, and more renewable energy infrastructure with partnerships and acquisitions from then on.

Today Algonquin Power & Utilities Corp., as the name signifies, operates across a variety of power and utilities services. AQN is divided into two main groups of subsidiaries, which also represent the two major business segments of AQN:

  1. Regulated Services Group

  2. Renewable Energy Group

The Business StructureSource: Algonquin 2020 Annual Report

The Regulated Services Group (“RSG”) owns various electric, natural gas, water distribution, and wastewater collection systems and transmission operations across the United States, Canada, Chile, and Bermuda. Revenues in this group are capped due to rate regulations imposed by governments in the mentioned operating regions. RSG is also known as the Distribution segment.

Algonquin Power's Customer Connections by Utility System Type (Q3 2021)

Source: Algonquin Power Investor Relations

The Renewable Energy Group (“REG”) is the unregulated unit of AQN, operating in the realm of renewable and thermal electricity generation across North America and some international regions. AQN’s hydroelectric, wind, solar, and thermal assets generate clean and renewable energy, which are primarily sold under long-term contractual agreements. RSG is also known as the Generation segment.

RSG (Distribution) makes up most of AQN's revenue balance and has recently grown bigger with the acquisitions of Empresa de Sanitarios de Los Lagos S.A. (“ESSAL”) and Bermuda Electric Light Company Limited (“BELCO”). Without acquisitions or inorganic growth, AQN grows revenue organically at low- to mid-single digits. Although organic revenue growth is rather muted, those revenues are highly predictable and mostly recurring like clockwork.

AQN’s management places great emphasis on maintaining strong customer and regulatory relationships, expanding customer connections, and accretive business acquisitions to drive growth in its distribution business. In other words, AQN relies heavily on business acquisitions to expand its potential customer base after which new customers can be captured.

Algonquin Power Revenue by Segment ($M) (Q3 2021)

Source: Algonquin Power Investor Relations

Most of RSG’s Net Utility Sales are generated in the US while Canada and International regions share the remaining. Distribution services are provided in 13 US states, New Brunswick in Canada, and Bermuda and Chile as the international locations.

Algonquin Power Net Utility Sales by Geography (Q3 2021)

Source: Algonquin Power Investor Relations

Competitive Advantages

Long-Term Contracts

AQN’s high-growth and arguably most important segment, renewable energy generation, has over 80% of output contracted under long-term agreements.

The weighted-average remaining contract life is approximately 13 years. This provides two main advantages for AQN as the world moves towards cleaner and greener forms of energy:

  1. Customers face high switching costs to exit the contract

  2. AQN can almost guarantee revenue generation from its current customer base over the next decade.

Large Footprint

AQN’s rate-regulated distribution business surpassed 1 million customer connections with the help of the ESSAL and BELCO acquisitions in 2020, which added 239,000 and 36,000 customer connections, respectively.

Algonquin Power Customer Connections (Thousands) (Q3 2021)

Source: Algonquin Power Investor Relation

AQN’s North and South American distribution utilities assets are scattered across 16 jurisdictions, diversifying revenue sources and operations to a nontrivial extent.

Management is committed to expanding customer connections through organic growth and acquisitions. A strong, widespread, and steadily rising base of customer connections should further widen the company’s moat.

Infrared Map of LocationsSource: Algonquin 2021 AGM Investor Deck

Capital Intensity

The capital intensity of an industry like utilities is a competitor deterrent, especially if well-established incumbents continue to scale their operations across many regions.

Capital expenditures have recently been in the zone of 30 - 50% of revenues in each year. AQN operates in such a capital-intensive industry where emerging players would not choose to commence operations alongside players like AQN. The upfront costs are also so high it would take years before any of the initial investments bear fruit and render the company profitable.

The industry is characterized by natural monopolies over various regions.

Massive Capital Program

AQN mobilized lots of money over the past few years on new capital and expansive investments. However, there is plenty more where that came from. AQN recently initiated a five-year capital program worth $9.4 billion between 2021 and 2025.

These investments will include organic investments and business acquisitions that make up a significant fresh pipeline of regulated utilities and renewable energy assets.

Capital Program GraphicSource: Algonquin 2021 AGM Investor Deck

These investments are also diversified on the risk spectrum – some are in their early stage of development and more "speculative" with higher upside, while others are in the process of constructions with near certainty of closing. Few of these projects would be classified as something in between the "boring" regulated investments and the developing renewables assets.

For a utility company with limited growth otherwise, AQN appears to be executing its merger and acquisition ("M&A") strategy well. We believe dividend-focused investors should be impressed with AQN’s ability to make sound acquisitions that provide ample growth opportunities.

Over the 2021 – 2025 program period, management is guiding for an 8 -10% adjusted net earnings CAGR and a rate base CAGR of over 11%.

The Future is Green

AQN is uniquely positioned to lead and benefit from the drive towards renewable energy utilization over traditional forms. The company already generates 10-20% of its revenues from such initiatives and will continue to invest in this realm as the world continues to strive towards a greener future.

AQN is making big moves in this space –AQN is partnering with Altantica Sustainable Infrastructure to purchase a 20-megawatt solar plant with a 15-year power purchase agreement (“PPA”) in Colombia for a combined $20 million once operational in mid-2021. This would be the first such investment in the country from either company, expanding their reach in renewables beyond North America and potentially opening the door for growing its asset base in South America.

AQN has also been partnering with customers to achieve their own emissions goals.

Governments, Facebook, Starbucks, Amazon, and General Mills are among some of the companies that work with AQN to drive this revolution.

In July 2020, AQN and Chevron – a multinational energy exploration, refining and marketing, and production corporation – announced a four-year agreement to co-develop renewable power projects that will provide electricity across Chevron’s strategic asset base. The partnership plans to generate more than 500 megawatts of clean electricity and advances Chevron’s important goal of reducing its carbon footprint as oil companies face ever-growing scrutiny against their operations.

Again, these are just a few examples of the developments in which AQN is currently partaking – there is plenty more where that came from. Incremental to the $9.4 billion five-year capital program is a group of Greenfield developments, a pipeline with over 3,400 megawatts of greenfield opportunities. These investments include earlier, more speculative projects, as well as later-stage developments with more quantifiable benefits. AQN is exploring the entire risk spectrum in a prudent fashion to exercise growth opportunities now and in the future.

Greenfield Projects GraphicSource: Algonquin 2021 AGM Investor Deck

We believe AQN is ready to ride this early wave of green initiatives and the shift towards a greener world.

Hydro, wind, solar, and other renewable energy sources make up a relatively small proportion of the world’s electricity generation today, but renewable energy consumption and production is expected to be the fastest growing form of energy throughout the next few decades, taking over fossil fuels around the year 2050.

AQN is right on the forefront of this revolution, and its strong asset base, partnerships, customer relationships, and prudent acquisition strategies should result in the company being cited as one of the leaders of this shift.

Energy Outlook on a graph

Dividends

AQN is a classic example of a quality dividend paying company. The operations of the company are stable, resilient, and profitable. AQN’s dividend payout ratio as a percentage of its adjusted funds from operations has consistently remained below 50%.

Although the ratio has been rising over the past five fiscal years, we believe the ratio is still healthy and AQN has enough growth and reinvestment opportunities to ensure a steady growth rate over time.

Utility operators in the US are awarded an “allowed return on equity" (“ROE”), the amount of ROE an operator is allowed to or expected to generate on its assets at a particular set of rates for utility services provided.

These service rates and allowed ROE amounts are set by the Federal Energy Regulatory Commission (“FERC”) and are intended recoup a company’s investment outlays and other expenses within a reasonable time frame. This allowed ROE amount has generally floated around 10%, essentially guaranteeing investors an adequate return on equity and company growth.

For AQN investors, this likely means the dividend is safe and will continue to grow at high single-digit rates for the foreseeable future.

Algonquin Dividend Payout GrowthSource: Algonquin 2021 AGM Investor Deck

Risks

Acquisition Growth

AQN expands its operations mainly through acquisitions, particularly in the non-regulated segment of its business. The main risks include general execution risk and diluting current shareholders if financed with equity (i.e., issuing new stock). These risks can be further perpetuated if synergies are not realized, or accretion is subpar. Over the last few years, AQN also issued billions in equity. Management recently closed a mandatory convertible equity units finance offering of $1 billion to fund a portion of the front end-loaded $9.4 billion capital program in 2021.

Regulation

AQN’s base case of an 11.2% rate base CAGR through 2025 may not materialize due to regulatory uncertainty surrounding rate reviews or permits to construct new, promising infrastructure. If regulators do not recognize the value of some of AQN’s investments and the positive impact they pose to customers or deem certain investments ineligible for consideration in their rate reviews, AQN may be placed in a position where growth opportunities are denied and allowed ROEs could be too low to recoup capital outlays and other expenses within a reasonable time frame.

Power Pricing

Over 80% of AQN’s revenues come from rate-regulated jurisdictions for its distribution business. General economic hardships, new political parties, customer complaints, anti-monopoly regulations, and unfavourable rate reviews could all hinder AQN’s ability to earn a decent profit in any of the jurisdictions in which it operates.

Bottom Line

AQN is part of an important movement to shifting the world to a greener and more sustainable future. Although the company operates mainly in the non-regulated distribution business, it is exercising optionality in the renewables space. Around 10-20% of its revenues come from renewable energy generation, a business that will only become more crucial as companies, governments, and other organizations band together to meet climate goals and move away from sole dependence on fossil fuels.

AQN is a high-quality company operating in a secular growth environment. Its long-term renewables contracts, large and expanding multicontinental asset base, and capital-intensive business shields it from competition as demand for its services ramp up. AQN also pays a healthy dividend yield at a moderate and sustainable payout ratio.

Dividend investors, rejoice – the company is expected to grow at a stable pace, and it is likely not disappearing anytime soon, which should allow the dividend to continue increasing in line with earnings.

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