Income investors often turn to utilities when searching for safe, high, and slowly growing yields. In a recent article, I outlined why I believed that Atlantic Power (AT) was one utility that investors should avoid, as I felt it was an example of "reaching for yield". My argument against Atlantic Power was two-fold.

First, I was concerned that its heavy use of natural gas power plants, in an age of steadily rising natural gas prices, would increase costs and make the power it attempts to sell to regulated utilities less competitive, thus hurting its ability to earn profitable, long-term contracts.

Second, I was concerned about its liquidity and access to debt markets, having just undergone a harsh refinancing that required a 66% dividend cut. With its market cap down to under $400 million and a yield of over 11%, I pointed out that issuing equity to raise capital would threaten the security of the dividend and prevent dividend growth going forward. 

With first quarter earnings now released I decided to reexamine the investment case for Atlantic Power, to see if there is a strong enough case to warrant a position and whether or not it can compete with a much better, equally unknown utility, Hawaiian Electric Industries (HE -0.64%). 

Atlantic power: some improvement, but is it enough?
The company has started to address my two chief concerns by increasing its liquidity at very favorable terms: $415 million refinanced at 1% lower interest rate, and no new financing required until 2017. In addition the company was able to negotiate a new credit revolver and increase its liquidity by 33% this quarter. It also has plans to further pay down $86 million in debt by the end of the year. 

The company has also made strides to diversify away from gas generation. In 2013 renewable energy (wind, solar, hydro, biomass) made up about 40% of its adjusted EBITDA. Indeed, on the back of strong wind and biomass generation the company was able to increase total generating capacity 11% this quarter. 

However, that is the extent of any good news. In the bad news column:

  • Adjusted EBITDA fell 8%.
  • Cash flows from operating activity fell 133% (from $89.7 million to -$28.7 million).
  • Free cash flow down 157% ($82 million to -$46.3 million). 
Further bad news comes in the form of two major contracts expiring this year, Selkirk and Tunis. Both are expected to be renewed at much lower rates (estimated $12 million loss of adjusted EBITDA).
 
What investors most want to know about is the dividend and here there is both good and bad news. The good is that the current dividend costs about $44 million/year.
Management is guiding for cash flows from operations of $70 million-$95 million, which covers this easily. However, bad news comes in two forms. First, in addition to the common stock dividend is the preferred dividend, which costs $3 million/quarter.
 
In addition, distributions to non-controlling interests cost another $2.1 million which means that the actual annual payout is $64.4 million. While still covered by the guidance, there is not much room for error and certainly no room for growth at this time. 
 
Hawaiian Electric, a better alternative
Providing 95% of Hawaii's electricity, this regulated utility monopoly is not only an ultra-low volatility, high-income stock, but also a regional banking and renewable energy play. Composed of two primary units: electric utility and American Savings Bank (third largest bank in the state), this company can be considered a pure play on the economic prosperity of the state. The investment thesis consists of three parts.
 
First, the company is moving away from inefficient oil-based electricity generation and is investing in improving efficiencies through a combination of renewable energy, smart grid technology, and switching to gas-fired power plants (fueled through LNG imports). 
 
Second, the Hawaiian economy, which has grown at an average 1% annually over the last 20 years, is projected to grow at a much stronger 2.6% through 2017. This will help increase both demand for the company's power and banking services.
 
Finally, the company's generous 5.2% dividend is projected to grow at 3.84% CAGR over the next decade, according to analysts at S&P Capital IQ. 
 
Foolish takeaway
Atlantic Power's fundamentals show clear signs of improvement. In the face of ongoing contract roll-offs and a lack of major new diversification projects, the company's dividend remains safe, albeit tentatively so. However, with Hawaiian Electric's generous yield, low volatility, and strong growth prospects cemented in the state's future prosperity, income investors would do better to stay away from Atlantic Power for now and choose the safer and higher quality alternative.