Transmission lines, especially those carrying cleanly generated electricity, are now thought to be the sexiest assets.Tim Fraser/The Globe and Mail
For a sector that nearly everyone mocks for being so boring, Canadian utilities sure are shocking the market. In the past six months, they've delivered the biggest Canadian privatization in decades by way of an initial public offering (IPO) and three multibillion-dollar acquisitions in the United States. How do you like them apples?
Several forces are at play, so it's tricky to group them all together. Ontario's Hydro One $1.8-billion privatization never would have launched if the province weren't broke and desperate for cash. Recent purchases in the United States, by the likes of Fortis Inc. and Algonquin Power & Utilities Corp., wouldn't be necessary if Canada wasn't so small, limiting the options to buy at home.
But there's also something more fundamental behind the rise of utilities: The way investors view the supposedly dull, dry utility market has evolved. In a world where resources are way too volatile, dependable companies with steady cash flows look that much more lucrative. That's especially true in Canada, where we absolutely love our dividends.
Still, there's a hierarchy within the sector. Lately, transmission companies – such as Hydro One, as well as ITC Holdings Corp., which Fortis bought Tuesday for $6.9-billion (U.S.) – are thought to be the sexiest assets. They're effectively pipelines that carry electricity instead of oil, and their businesses aren't too volatile, because North Americans almost always need electricity during hot summers and cold winters. These companies also typically have investment grade counterparts – the governments or private power generators that produce what they carry.
Even better, they often sign decades-long contracts to transport power from these partners, so their earnings are rather easy to forecast. Now you can appreciate why Warren Buffett paid $3.2-billion (Canadian) to buy Alberta electricity transmission company AltaLink in 2014.
It wasn't always this way. When ITC went public in 2005, transmission lines weren't nearly as sought after. That was a good thing for the company, because it allowed management to acquire new assets for prices that are now considered incredibly cheap. During the decade since the IPO, rival utilities eventually caught on and started holding on to their transmission lines – making it much harder for ITC to grow. "Our success has actually caused a lot of companies that would have sold transmission [assets] to now realize that transmission is really a growth engine," ITC chief executive officer Joseph Welch said on a conference call Tuesday.
That's affected the valuation. Broadly speaking, U.S. investors aren't as in love as Canadian investors are with stable, dividend-paying companies – relative to growth-oriented stocks – so ITC's valuation multiple isn't what it once it was. The share price tumbled before announcing a strategic review late last year, allowing Fortis to swoop in.
Because transmission assets are now so coveted, Fortis seems keen on rebranding its image. Mr. Perry asserted that his company is now "a wires business with a large gas distribution business, and very little generation exposure whatsoever." Power generation, you see, has become second-class within the utilities world. Just look at what's happened to share prices at companies such as Capital Power Corp. and at TransAlta, which have coal-fired plants that don't jibe with new environmental standards.
Yet, there's a key distinction to make. Cleaner power generation, such as natural gas, is still in vogue – especially if it comes with long-term power-purchase agreements attached. Even Fortis loves its Waneta project in British Columbia, which has a 40-year PPA.
This respect is driving deals such as Algonquin's purchase of Empire District Electric Co. for $1.49-billion (U.S.) – as well as Emera Inc.'s September purchase of Teco Energy for $6.5-billion. Even though Empire still has a decent number of coal-fired plants, it has been converting more and more to cleaner energy. In 2000, 44 per cent of its power came from coal, and 26 per cent from natural gas; by 2014, 62 per cent of its power came from gas and 31 per cent from coal.
Despite this overarching logic, investors aren't always sold. Since Fortis announced its deal, the stock has fallen roughly 10 per cent, while Algonquin's shares have dropped 8 per cent.
Editor's Note: Editor's Note: The online version of this article has been corrected to say Hydro One had the biggest Canadian privatization in decades by way of an initial public offering. An earlier version said the company had the biggest Canadian IPO in decades.