A Hydro One sign is seen on the wall of a building at 483 Bay St. in downtown Toronto, on July 10, 2017.Fred Lum/The Globe and Mail
Hydro One Ltd. is in a slump and even enthusiastic analysts are cutting their target prices on the stock – a double whammy of bad news if you're a shareholder, and I am.
But the utility is doing everything it should, from cutting costs to boosting dividends to expanding its footprint, which is why the stock looks to be a wonderful bargain right now.
After the province of Ontario privatized Hydro One through an initial public offering in 2015, investors were initially keen: The share price rose 30 per cent within eight months. Since then, the shares have retreated about 20 per cent, dipping below the IPO price of $20.50 last week.
What explains this rough ride?
Bond yields have surged over the past two months, weighing on the valuations of dividend-generating stocks in general, and regulated utilities in particular. As well, the Ontario government has continued to reduce its significant stake in the company, flooding the market with additional shares in 2016 and 2017.
And in the run-up to the Ontario provincial election later this year, Hydro One has become a political football. The NDP wants to return it to government ownership, and has thoughts on everything from bill design to usage rates. Even the Conservative party wants to rein in corporate salaries.
No wonder many investors have been turned off.
But there are three compelling reasons why Hydro One is a solid, long-term bet – especially after the sell-off.
First, elections bring out all sorts of politically motivated noise that goes quiet soon after votes are counted.
It's hard to believe that a new government would nationalize Hydro One so soon after its privatization, whipsawing investors, surrendering billions of dollars in gains and casting a pall over the province's commitment to business. (Hydro One's IPO prospectus didn't even mention a government takeover as a potential risk, so perhaps it isn't.) After the election, expected in June, the political overhang will likely disappear.
Second, Hydro One shares have been hit by rising bond yields, but the downturn looks overdone.
As the share price has declined over the past 12 months, the dividend yield has risen to 4.3 per cent from 3.5 per cent. That's a hefty yield, and it's well beyond anything you can get from a government bond. Even after a sharp increase, the yield on the 10-year Government of Canada bond is still below 2.4 per cent.
And keep in mind that Hydro One has been boosting its quarterly dividend. Okay, the increases have been a humble penny a year so far (a hike of less than 5 per cent), but the payouts should accelerate as financial results improve. After all, the utility expects to pay out 70 per cent to 80 per cent of its annual profit in dividends.
Which leads us to the third reason for buying this stock: Financial results are promising.
In its fourth-quarter report, Hydro One said its profit was 26 cents a share, up 18 per cent from the same period last year. After some adjustments, profit was 29 cents a share and above most analysts' estimates.
Its plan to expand into the United States with a US$3.4-billion deal for Avista Corp. is expected to boost profit if it clears regulatory approval in the second half of this year. Lower valuations for utilities could make further expansion cheaper.
Hydro One is also showing it can cut costs and improve efficiency as it adjusts to life outside of government control, adding another engine to profit growth. In 2017, these savings rose to $89.5-million, up from $24.9-million in 2016.
"We see productivity enhancements and cost savings as a way to generate near-term earnings while in the long term allowing for capital investment into the system," Robert Kwan, an analyst at RBC Dominion Securities, said in a note.
Mr. Kwan trimmed his target price on Hydro One to $26 from $28, partly reflecting the impact of U.S. tax reform on Avista's expected profit contribution. Analysts at Raymond James lowered their target price to $25 from $26, acknowledging the impact of rising bond yields on stock valuations.
But both shops still recommend buying Hydro One shares: Their lower target prices imply double-digit returns from the current share price, while the high dividend yield provides steady income while you wait for next rally to arrive. And it will.
David Berman