Hydro One Ltd. (H-T) has a problem: It’s performing too well.
The share price has rallied 43 per cent over the past three years, not including dividends.
That’s a big move for a regulated utility, especially over a period when interest rates soared, dampening the appeal of many rate-sensitive dividend-paying equities.
The stock has easily outperformed peers such as Fortis Inc. (FTS-T) and Emera Inc. (EMA-T).
So where’s the problem? The recent gains have raised Hydro One’s valuation well beyond what’s typical for a utility, imposing a significant hurdle to future gains.
The stock trades at about 25 times trailing earnings, which is well above the valuations of its biggest peers, which trade at about 20 times trailing earnings.
What’s more, the rising share price has pushed Hydro One’s dividend yield – a major reason to invest in a utility – to just 2.6 per cent.
That’s below the yield from the S&P/TSX 60 blue chip index. And it is far lower than the yields from both Emera and Fortis, which are 4.7 per cent and 3.7 per cent, respectively.
There’s no real mystery behind Hydro One’s strong performance: Investors have latched onto a stock that can withstand an economic downturn, but also generate decent growth.
“The market is rewarding high-quality, defensive companies with visible growth, such as Hydro One, with higher valuations,” Robert Hope, an analyst at Bank of Nova Scotia, said in a note this week.
In its first quarter, Hydro One’s revenues increased by 11.2 per cent year over year. Its earnings increased to 60 cents a share, up 22.4 per cent over the same period and beating analysts’ expectations.
The utility expects it can generate earnings growth of 6 to 8 per cent annually through 2027 – not bad given all the dark clouds moving in.
Indeed, the utility’s winning combination of growth and safety looks especially attractive right now amid tariffs and trade uncertainty.
Even though the stock market has roared back to health after a sharp sell-off in February and March, concerns linger.
Nathan Sheets, global chief economist at Citigroup, says that the muted impact from tariffs so far is because businesses and consumers are front-running tariffs by spending early.
The full effect is coming, though, as real purchasing power declines and those front-loaded purchases come to an end as prices rise.
“As such, we view the current period as still ‘the calm before the storm,’ and we expect growth in the second half of the year to weaken,” Mr. Sheets said in a note.
Hydro One, with operations in Ontario, isn’t exactly immune to the impact of tariffs given that the utility relies upon U.S. suppliers for much of its equipment.
In a call with analysts earlier this month, chief executive officer David Lebeter said the situation was creating a lot of uncertainty.
But the utility has options. It is diversifying its supplier base and exploring the possibility of reducing costs by consolidating its purchasing power with other Canadian utilities.
There’s even upside potential here: Smaller utilities have less flexibility in how they respond to the indirect impact of tariffs, which could push them toward either consolidating with one another or jumping into the arms of a bigger, well-capitalized player like Hydro One.
“We’re certainly hoping it turns into sales,” Mr. Lebeter said in a call with analysts earlier this month.
But, returning to Hydro One’s problem, some analysts believe that the utility’s many advantages are reflected in its share price already.
Theo Genzebu, an analyst at Raymond James, can’t say enough about how great the utility is. But the stock’s steep valuation relative to peers holds him back from recommending the stock as a buying opportunity.
Emera is considerably cheaper, has a bigger dividend yield and has embarked upon a plan to strengthen its financial profile through asset sales and expansion into higher growth areas. This makes it something of a turnaround story.
Fortis is hardly a steal, but it’s cheaper than Hydro One. It also offers greater geographic diversification with large operations in the United States, all while delivering solid earnings growth.
Admittedly, the valuation argument against Hydro One isn’t having any impact. The share price has gained 14 per cent over the past three months alone, which is more than double the gain of Emera and Fortis over the same period.
Investors who have ignored the risks associated with buying an expensive stock are doing just fine. But those risks aren’t going away.