There is nothing worse as an investor than seeing one of your companies deliver a disastrous quarterly earnings report. The immediate response for some investors is often an anger- or panic-driven decision to immediately sell the stock. Other investors ignore the problem altogether and hope it goes away. Neither of these responses is optimal. In this post, I will present a more rational approach for dealing with a disastrous quarterly earnings report. I will use the recent example of Algonquin Power’s 2022 Q3 earnings report to make the discussion more concrete.
Define the Current Situation
I took an initial position in Algonquin Power at $17.82 CDN per share back in October 2021. The position represented less than 2% of my entire investment portfolio. I viewed Algonquin’s “green energy” projects as a nice complement to my core holdings in two conventional regulated utilities, Fortis and Emera. Part of my justification for adding a third electric utility to my portfolio was my belief that electric utilities would likely do well over the next decade as electric vehicles become more prevalent in the marketplace.
Algonquin Power had very recently announced a deal to purchase Kentucky Power for ~$2.8B USD, as well as a concurrent equity financing deal for $646M USD to fund a portion of the purchase. The deal promised to be accretive to earnings in the first year following the acquisition.
The annual stock dividend of $0.6824 USD at the time of purchase provided a yield of 4.73%. The company had delivered a solid 9.7% CAGR over the past decade. Thus, the company had an attractive initial dividend yield and a solid dividend growth history. However, I should have noted more closely that Algonquin did cut their monthly dividend by almost 75% back in late 2008.
The share price of Algonquin Power floated for several months after my purchase. The company raised their dividend in May 2022 to $0.7232 per share, representing a 6% dividend increase. This provided me with some reassurance that the company was still on track.
On August 30, Mr. Arthur Kacprzak stepped down as CFO and was replaced by Darren Myers, who was previously at Loblaw. I should have paid more attention to this announcement as the stock price subsequently went into a freefall in September and early October. The price rebounded slightly in October and then plummeted down to ~$10 CDN following the release of their disastrous Q3 2022 earnings report.
The drastic price decline should be setting off alarm bells in every Algonquin Power shareholder. The magnitude of decline in the share price of what is supposed to be a stodgy utility stock tells you that something is wrong. The rational approach for an intelligent investor is to carefully review the recent quarterly and annual reports to understand the nature of the problem. Based on the facts, an investor can then make a conscious decision to buy more of the stock (rebalance), hold on to your existing position or sell the stock at an appropriate price. Impatient investors are known to panic sell when bad news is released, which sometimes presents a buying opportunity for more patient investors. Other times, the bad news keeps coming, leading to larger and larger permanent losses of capital. So, let’s look into the 2022 Q3 earnings release to figure out what happened.
Determine the Root Cause of the Problem
Algonquin Power has two operating Groups: Regulated Services and Renewable Energy. In 2021, the Regulated Services and Renewable Energy Groups generated revenues of $1,944.2M and $268.0M USD, respectively. Thus, 87.8% of their revenue comes from regulated services. The company should generate consistent earnings operating in a largely regulated environment.
On November 11th, Algonquin Power released their Q3 2022 earnings report. Although the company reported a 26% increase in revenue on a year-over-year basis to $666.7B USD, the adjusted net earnings were down by 25% to $73.5M USD. The Company also reduced the adjusted net earnings guidance for the year to $0.66-$0.69 from $0.72-0.77 USD per share. This represents a downward earnings revision of 10% for a largely regulated utility. Something clearly went horribly wrong!
The Bank of Canada dramatically changed their low interest rate monetary policy immediately following Algonquin Power’s 6% dividend increase in May 2022. The overnight interest rate charged to banks was rapidly increased from 1.0% to 4.0% over a six-month period. This was problematic for Algonquin Power due to having $7.2B USD in long term debt and expecting to add further debt to complete the acquisition of Kentucky Power. Moreover, the percentage of their debt that was subject to floating interest rates increased from 12% to 22% between Q1 and Q3, 2022. This increased the interest expense from $57.9M to $75.0M USD over the same time period.
The company’s financial situation will worsen going forward unless the Bank of Canada reverses their interest rate policy as Algonquin Power will be adding $1.221B USD in floating rate debt in Q1 2023 to pay for their Kentucky Power acquisition. Algonquin Power management was clearly unprepared for a rapidly rising interest rate environment. Their major mistake was to trust Bank of Canada Governor Tiff Macklem when he assured households and businesses in October 2020 that interest rates would remain low until 2023.
Algonquin Power announced an agreement to sell a couple of its renewable assets in early October 2022. This will reduce their debt load slightly and, more importantly, decrease the amount of debt that is subject to floating interest rates. Algonquin Power will continue to operate these assets, which will be a source of service fees.
Algonquin Power is a company with too much debt subject to floating interest rates. In addition, the company has funded too much of its growth by issuing shares, which has led to shareholder dilution. The best possible scenario for the company would be a rapid reversal in the Bank of Canada’s monetary policy in the first half of 2023, which would allow them to restructure their debt at acceptable interest rates. The company needs to successfully complete the Kentucky Power integration and reduce costs to increase profitability. A further sell off of assets will help to reduce its debt level. Algonquin Power currently pays out $361M in dividends annually. Cutting the dividend would enable the company to reduce their debt level faster.
Reflect and Learn from the Experience
I started this investing blog for two reasons. The first reason was to improve my investing skills by refining my investment process. The second reason was to share knowledge with fellow investors for our mutual benefit. Following are four lessons that I have learned from my investing experience with Algonquin Power.
The first lesson is to remain vigilant when analyzing story stocks like Algonquin Power. A good story does not always make it a good stock to own. Although the company delivered excellent dividend growth over the past ten years, the 75% dividend cut in late 2008 should have been a showstopper for a conservative investor like me. It is relatively easy for a company to deliver excellent dividend growth numbers in the years following a severe dividend cut.
Secondly, Algonquin Power has increased its long-term debt from $1B to $7.2B over the past ten years. The number of shares outstanding has more than tripled over the same period. This indicates an over-reliance on debt and share offerings to finance rapid growth. In the future, I will spend more time questioning whether or not a company’s growth strategy is sustainable over the long term. Focusing on companies with a long dividend growth record is one way to do this. Reviewing company performance during past recessions is a critical step in this process.
Thirdly, I will develop a comprehensive checklist to be completed before I invest in a new company. This will ensure that I follow a rigorous investing process. Over the past few years, I have learned the benefits of carefully following the companies I own because it enables me to understand their operations and differentiate between short term operating challenges and more persistent deficiencies. Nonetheless, I will also develop a shorter checklist for companies that I already own before adding to positions to ensure that the company is still investment worthy. This will prevent me from taking shortcuts while making investing decisions.
Lastly, investors tend to beat themselves up excessively after making a bad investment. I think it is equally important to point out the parts of the investment process that functioned properly. I am pleased that my strategy of gradually building up new positions limited the paper loss in my Algonquin Power holding. I am also grateful that I did not purchase additional shares in Algonquin Power in the quarters subsequent to my initial purchase. The main reason that I didn’t increase my position was that the company did not report any positive operating results that would encourage me to increase my holding. On the other hand, I did add to my long-term holding in Fortis when the price dropped this fall due to my confidence their management team.
Develop an Action Plan
Now that I have investigated Algonquin Power’s Q3 2022 earnings release in detail and reflected on lessons to be learned from this experience, I am still left with the decision of what to do with my shares. The decision would be easy if the shares were in a non-registered account, which would provide me with a capital loss. Unfortunately, the shares were purchased in my RRSP so I could use the company dividends, which are paid in U.S. dollars, to increase my U.S. stock holdings. I did this because there is no withholding tax on U.S. dividends in a Canadian RRSP. (Buying Algonquin Power in my RRSP doesn’t seem like a bright move right now. This is another lesson learned!)
My long-term goal is to own 20-25 high-quality stocks in my investment portfolio. My analysis of Algonquin Power has given me reason to question my initial decision to take a position in the company. Their aggressive growth strategy has been based on increasing share count and debt levels rather than generating internal growth from retained earnings. This strategy does not lend itself to sustainable growth. I will be selling my shares in the foreseeable future.
Implement Your Plan
Algonquin Power’s shares have dropped in price from $21 CDN in March 2022 to around $10 CDN recently. For the next few months, there will be a large investor turnover. Some investors believe that the share price drop was overdone and will add to their holdings, while other investors will be selling their shares. I plan to hold onto my shares for a little while as the stock is very oversold. I will watch the stock’s price movement closely over the next couple of months and sell at an appropriate time. I am committed to taking a loss on the sale but will try to minimize the damage.
Concluding Remarks
It has been rewarding to spend time reviewing Algonquin Power after its disastrous Q3 earnings report. I now have a much better understanding of the company, something that I should have done prior to making my initial purchase. I believe that Algonquin Power’s financial challenges were primarily due to the rapid increase in interest rates by the Bank of Canada. Algonquin Power ended up with too much floating interest rate debt and the increased debt payments are eating into their earnings. The problem will persist until they are able to eliminate the floating interest rate debt.
Algonquin Power attempted to grow too quickly in a low interest rate environment by levering up their balance sheet and using share offerings to finance their acquisitions. The rapid increase in interest rates this year has revealed the weakness in this strategy. I am more comfortable owning a more conservatively run utility like Fortis, which has an impressive 49-year track record of dividend growth.
I have learned a number of valuable lessons through this experience. Hopefully, I will not make a similar mistake in the future. My immediate thought is to carefully review the debt levels of my other stock holdings to see if I have been too tolerant of companies that have racked up debt during the bull market.
In closing, I will remind readers that investing is personal and that the decision that I have made to sell Algonquin Power may not be right for you. The real intent of this blog post is to show you the process that I followed to review Algonquin Power after a bad quarterly earnings report. Investors should always do their own research and make the right decision for their personal situation.
Additional Algonquin Power Material
I offer the following information sources for investors who are interested in delving further into Algonquin Power: