Algonquin's Dividend Looks Unsustainable as Interest Rates Rise and Growth Fades

The Canadian-based Algonquin Power & Utilities has historically operated with an aggressive payout ratio that often exceeds the firm's target range of 80% to 90% (we consider a payout ratio below 75% healthy for a utility operator).

Unfavorable conditions, including rising interest rates and supply chain issues, have caused earnings to fall short of expectations this year, pushing the payout ratio to over 100%.

That means Algonquin fully depends on outside sources to finance the firm's ambitious and capital-intensive growth initiatives and ongoing developments.

Algonquin has been more aggressive than a typical utility firm in expanding coverage through acquisitions and investing in green energy production.

As such, deteriorating economic conditions are weighing more on the firm's operations, which are widely spread throughout the United States, Canada, and even into Bermuda and Chile.

While over 80% of Algonquin's revenue comes from a reliable source of regulated utilities, that stability offers little comfort to the dividend considering the company's strained financials.

Rising interest rates, which immediately affect over 20% of Algonquin's outstanding debt, have complicated the utility's financial flexibility adding an estimated $16 million in annual interest expense (around 4% of earnings). And there's little wiggle room on the balance sheet to improve the negative outlook on the firm's BBB credit rating.

To help finance growth, Algonquin has relied heavily on issuing shares through the years as an easy way to raise capital. But with the company's stock down around 50% in the last three months, this form of financing no longer appears economical.

As a self-described capital-intensive growth-oriented company, Algonquin may need to find ways to cut costs and retain more cash as traditional financing options have grown far more expensive. This will likely involve cutting the dividend, which is now yielding almost 10%.

Given Algonquin has seemingly backed itself into a corner with stretched financial resources, we are downgrading Algonquin's Dividend Safety Score from Borderline Safe to Unsafe.

We estimate the payout could be cut by as much as 30% to 50%, which would return the dividend yield closer to its long-term average near 5%. During the 2007-09 financial crisis, the firm cut the dividend by almost 75%.

Algonquin remains committed to growth and doesn't sound intent on slowing green energy projects and regulated utility expansion, despite the increasing costs.

Furthermore, management is committed to maintaining the firm's investment-grade credit rating, which suggests debt reduction could be prioritized over the dividend if push comes to shove.

Overall, the risks of a dividend cut have increased as financial markets are likely to remain turbulent and the competing priorities of growth funding, debt reduction, and the dividend battle for capital from a smaller pool.

In response to the shifting environment, Algonquin is reviewing its long-term plans and targets. Management intends to provide more details at the utility's Investor Day in early 2023, which could be a logical time to downsize Algonquin's dividend policy.

If we owned shares of Algonquin, we would consider selling and investing in more conservative multi-line utility firms with healthier dividend profiles like Public Service Enterprise Group (PEG) or DTE Energy (DTE).

We will continue to monitor Algonquin and provide updates as needed.