After Gaining +30%, is Canadian Utilities Running Out of Gas?

Our investment in Canadian Utilities (“CU”), which delivers gas and electricity, in November 2023 was based on a straightforward premise: its attractive 5.7% dividend yield positioned it as a prime beneficiary of anticipated interest rate cuts. We believed falling rates would naturally enhance the appeal of high-yielding dividend stocks like CU for income investors seeking alternatives to less compelling fixed income options. We initiated positions for suitable clients at $31.44 per share, or 13x earnings, which was near the lower end of its historical valuation range of 12-19x.

Our expectations regarding interest rates proved accurate, with the Bank of Canada initiating a rate-cutting cycle that brought rates down from 5.00% in June 2024 to 2.75% currently. This decline fostered a favorable environment for CU, leading to a notable expansion in its valuation. The market’s willingness to pay a higher price-to-earnings multiple for CU’s profits increased as lower interest rates made its dividend yield more attractive. Now valued at roughly 16x earnings, CU has seen a substantial appreciation from our entry point. Factoring in dividends, our clients have achieved approximately a 30% return since November 2023.

Now that our initial thesis has largely played out, what’s next for Canadian Utilities?

CU now appears less suited as a long-term core holding and more as a potential source of cash for new opportunities. While we acknowledge the strategic value of the planned $2.8 billion Yellowhead natural gas transmission pipeline, slated for service by late 2027, the near-term earnings growth outlook remains modest, projected at only around 5% for the next couple of years. At a 16x earnings multiple and a 4.8% dividend yield, that’s an expensive price to pay for such modest growth.

Despite the current valuation concerns, CU benefits from several positive tailwinds. Alberta, where CU has a strong foothold, is enjoying robust growth, fueled by strong housing development, a favorable regulatory climate, a dynamic young workforce, low taxes, and high household incomes. Greater clarity from Ottawa regarding energy generation policies could spur the construction of much-needed AI data centers, offering a considerable boost to utility providers.

However, these tailwinds are tempered by notable headwinds that complicate the rationale for a higher valuation. Despite its impressive 53-year streak of dividend increases – a truly remarkable achievement – the pace of those increases has slowed significantly since the pandemic, with a mere 1% annual raise since 2020.

From a technical perspective, CU faces strong resistance around the $40 per share mark. Its current price of $38.30 puts it near this level, and historically, every time it has approached this price, we’ve seen it sell off. This isn’t just a technical anomaly; it speaks to the psychology of the market. Many investors likely bought at or near this $40 price and are looking to exit once they break even.

For CU to truly push beyond its $40 historical ceiling, we’d need a combination of clear, supportive energy policy from Ottawa and further interest rate cuts to make its current 4.8% dividend yield even more enticing. As new opportunities emerge, we’re actively assessing whether the capital currently tied up in CU could be deployed more effectively elsewhere, continuously seeking the best opportunities available for our clients.

-written by Jeff Pollock