1 Risky Utility to Avoid and 1 Safer Alternative

Income investors like utilities for high and secure yields. This article points out a dangerous utility with a sky-high, but stagnant yield and one alternative that's likely to crush the market in the long run.

May 1, 2014 at 9:55AM

Income investors naturally gravitate to the utility sector because of its high and secure yields. The growth in dividends might be slow, but it's consistent, and investors aren't likely to lose their shirts owning low volatility shares. However, those traits describe regulated utilities, and there is another, more speculative kind -- one that offers tantalizingly high yields but for good reason. The risks inherent with these kinds of utilities are so high that most investors should avoid them. This article is designed to warn investors of one such dangerous company and point out a far better alternative.

Sky-high yields: for good reason
Atlantic Power Corp (NYSE:AT) yields 11.8% but for good reason. The company is struggling due to problems intrinsic to its business model and had to slash its dividends in 2013 (by 66%). The resulting stock drop was devastating to investor capital.

Atlantic Power Chart

Source: Ycharts

What are the problems with Atlantic Power? And can they be fixed enough to make this company a worthy long-term investment? 

Atlantic Power's business model is that of a wholesale electricity producer who owns power plants and sells electricity to utilities. Long-term contracts can provide stability but in 2012 contracts in Florida expired and were not renewed. The company sold three Florida power plants in the face of New York and Ontario contract expirations (which, if renewed would be for much lower rates). 

Further asset sales included its California Path 15 transmission line stake and 17.1% stake in the Gregory Cogeneration power plant. After the asset sales and dividend cut the company now has sufficient cash flow to cover the dividend but any hopes of dividend growth face enormous headwinds -- particularly two key challenges. 

First, the company, though diversifying into wind and biomass, is still tied heavily to natural gas (58% of generating capacity).

Natural gas prices have been increasing since 2012 from a low of $1.95/Mbtu to $6/Mbtu and the Energy Information Administration predicts a gradual, long-term uptrend to $7.65/Mbtu through 2040.

This will place immense pressure on the company's margins and limit dividend growth, unless the company can invest in new growth projects, such as renewable energy. This leads to the second major problem -- financing.

Small utilities such as Atlantic Power have two options to finance investment: debt and issuing equity. Atlantic Power, at a $392 million market cap, would face immense dilutionary pressure if it attempted to sell equity. Each share sold would be a commitment that permanently raises the dividend cost (think of an equity offering as a permanent 11.8% bond). The other option is debt, but the company's recent debt restructuring (which included new 9% and 11% notes)and future rising interest rates will put pressure on future margins (future investment returns will need to overcome much higher interest costs). This will make dividend growth a challenge.

A better choice
Brookfield Infrastructure Partners (NYSE:BIP) is a small but highly diversified utility with world class assets on four continents.

  • 3,400 km of toll roads in Brazil and Chile
  • 98% of power transmission lines in Chile
  • 15,500 km of natural gas pipelines in North America
  • Railroad monopoly in western Australia
  • World's largest coal export terminal
  • 2.1 million gas connections in the UK
  • 28 European Ports
  • 2 container ports in California
Unlike Atlantic Power, the cash flows at Brookfield are rock solid with 90% of revenue either regulated or on long-term fixed contract (70% is indexed to inflation and 60% is non-volume dependent). 
 
The distribution (Brookfield is structured as an MLP so pays distributions instead of dividends) yields 5% but has grown at 10.4% CAGR over the last seven years. Management is guiding for 10% long-term growth of FFO/unit (funds from operations, which pays the distribution). This should easily allow the utility to achieve its goals of 5%-9% distribution growth, as it usually outperforms guidance. The high yield in combination with strong distribution growth should allow this utility to continue returning market-smashing total returns (17% CAGR since 2008 compared to market's 7%).

Bottom line
In the investing world it's often true that "the safest dividend is the one that's just been raised." It's for this reason that income investors should steer clear of Atlantic Power and instead opt for Brookfield Infrastructure Partners. Brookfield may not offer the seemingly spectacular yield but its 10% distribution growth rate and rock solid diversification into international assets mean that calamities such as what befell Atlantic Power are almost an impossibility. As Warren Buffett says, "the first rule of making money is not losing it.

The second rule is "remember rule one." Brookfield has an excellent track record of outperforming both other utilities and the market at large while Atlantic Power has the opposite record, of destroying investor capital. Given the immense headwinds Atlantic Power is likely to face, I don't believe the high yield compensates investors for its risks and opportunity costs (of investing in better companies). 

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Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Brookfield Infrastructure Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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