A 5.2% Yielding Utility Offering 10% Dividend Growth And Over 300% Return Potential Over The Next Decade

Posted On August 13, 2018 10:55 am

Dividend Profile: Industry Leading Yield, Dividend Growth And Total Return Potential

The most important part of any income investment, and what ultimately drives total returns, is the dividend profile. This consists of three parts: yield, dividend safety, and long-term growth potential.

Stock Yield Payout Ratio Expected 5 Year Dividend Growth Expected Total Return Valuation Adjusted Total Return
Algonquin 5.2% 36% 10% 15.2% 17.3%
S&P 500 1.8% 38% 6.2% 8.0% 0% to 5%


Sources: Morningstar, earnings releases, management guidance, Gurufocus, FastGraphs, Vanguard, Blackrock, Yardeni Research, Gordon Dividend Growth Model, Simply Safe Dividends

Algonquin’s current yield is not just impressive compared to that S&P’s paltry payout, but it’s also much higher than the industry norm of 3.3%. More importantly that high-yield is well covered by the company’s highly stable and recurring cash flow. In fact Algonquin is currently retaining 64% of its adjusted funds from operation to invest in its ambitious growth plans.

But of course in a capital intensive industry such as this a strong balance sheet is the other half of the safe dividend equation. And with Algonquin’s penchant for aggressive M&A and $6.4 billion in growth projects planned, this becomes even more important.

  • Debt/Adjusted EBITDA: 3.9 (industry average 4.9)
  • Interest Coverage Ratio: 4.6 (industry average 3.3)
  • S&P Credit Rating: BBB
  • Average Interest Rate: 5.5%

Fortunately the utility’s balance sheet is strong, with below average leverage, and a strong interest coverage ratio. That provides Algonquin with a stable and strong investment grade credit rating that allows it to borrow at profitable rates to funds it growth.

Ultimately that growth is the driving factor behind this stock’s investment thesis. Management’s current guidance of 10% EPS and AFFO/share growth through 2022 would mean that AQN could safely raise its dividend at the same rate. That would mean a 2022 yield on cost of 7.5%. For context the S&P 500 has historically returned 9.2% per year so by 2022 you would be nearly matching the market’s historical returns on dividends alone. Better yet if analysts are right that AQN can keep up that growth rate through 2028 then it would mean this high-yielding utility should be able to generate about 15% total returns over the next 10 years. And when we adjust for the stock’s current low valuation (more on this in a moment) that annual  total return potential rises to about 17%. Not just is that a fantastic potential return for any stock, but it would put most utilities to shame. It would also be about three times higher than what the S&P 500 is likely to generate from current valuations according to Morningstar, BlackRock and Vanguard.

Valuation: A Good Time To Buy A Great Company

Three things ultimately determine a dividend stock’s total return: yield, long-term dividend growth (share price usually tracks) and valuation changes. Thus the reason that I focus so strongly on undervalued high-yield (but low/medium risk) fast growing dividend stocks.

How undervalued is Algonquin right now? Well there are numerous ways to value a stock, dozens in fact. For a stable business like this there are two in particular I think are most useful. The first is to look at the stock’s forward PE ratio.

  • Forward PE ratio: 15.8 (historical average 25.0)
  • EPS growth baked into share price: 3.7%

At 15.8 AQN’s forward PE is not just is it below the market average (16.6) but it’s far below the stock’s historical norm of 25.0. And by using a formula developed by Benjamin Graham, Buffett’s mentor and the father of modern value investing, we can estimate how much growth is currently baked into the stock price. That implied growth rate is just 3.7% or nearly three times below management’s long-term guidance. That implies that AQN is set for major multiple expansion. How much?

To answer that we can use the fact that stable businesses like regulated utilities usually have mean reverting yields over time. That means that over the long-term yields cycle around a relatively fixed point that approximates fair value.

  • Current Yield: 5.2%
  • 5 Year average yield: 4.7%
  • 13 year median yield: 4.6%
  • Discount to fair value ($10.80): 12%

Note that the five year average yield and 13 year median yield are nearly identical validating out assumption that a fair value yield on AQN is about 4.65%. With the yield currently 5.2% that implies a fair value of $10.80 or 12% above today’s levels.

While that’s not a fire sale price, it’s more than enough to recommend this high-quality utility especially given its: strong growth prospects, safe yield, and above average balance sheet. That being said, potential investors in AQN still need to be aware of potential risks facing the utility.

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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