Fortis Inc. Stock Report

Fortis Inc.

 

Adjusted earnings per share (the purple line) have grown steadily over the years and the growth has increased in recent years due to an even faster pace of acquisitions. Revenues per share have been relatively flat but this is largely driven by energy prices that are largely passed through to customers without much impact on profit. Book value per share (the green line) has increased rapidly. Note that the spike in book value in 2016 is higher than it should be because I use average shares (correct for earnings) which in the case of a rapid increase in the share count (as in 2016) distorts my book value calculation. The final figure in Q3 is the correct figure.

Fortis Inc. (FTS, Toronto)
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’16 Y.E. + Q3 ’17
Last updated: 28-Dec-17
Share Price At Date of Last Update:  $                             46.18
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (higher) Buy at $46.18
SUMMARY AND RATING:  The graph of revenues per share (red line)  has been relatively flat since 2008 but that was likely caused by lower natural gas and wholesale electricity prices and does not affect earnings. The adjusted earnings per share growth has been relatively steady at a compounded average of 7.5% per year.  The book value per share has grown at a compounded average of 10.9% per year. Book value per share grew faster than earnings per share, despite paying out much of the earnings as dividends, due to issuing shares at prices well above book value. The Value ratios in isolation would indicate a (higher) Buy rating . Management quality appears strong . The insider trading signal is moderately positive. Executive compensation is not a concern given the size of the company.  There is a risk of a price decline as interest rates rise even though earnings will likely be unaffected. A higher Canadian dollar would hurt results while a lower Canadian dollar would be beneficial. It should be assumed that benefits from lower U.S. income taxes will largely be passed onto customers. Overall we rate this a (higher) Buy.
DESCRIPTION OF BUSINESS: Fortis Inc. is a parent or holding company that owns a number of regulated electric and gas utilities with geographic diversification across Canada and the United States. Fortis Inc. is the parent company of ITC, UNS Energy, and Central Hudson Gas and Electric in the United States. In Canada, Fortis owns utilities in Alberta, British Columbia, Ontario, PEI and Newfoundland. The company also owns a utility in the Caribbean. Non-regulated entities include generation assets in B.C. and Belize, as well as a natural gas storage facility in B.C. Assets are $48 billion and there are over 8000 employees.
ECONOMICS OF THE BUSINESS: The economics of regulated utilities are largely driven by the regulator. This appears to be a low risk business with an acceptable ROE. The recent approximate 8.5% adjusted ROE may rise slightly over time as purchased goodwill (which does not earn a return) declines as a percentage of regulated assets.
RISKS: Overall this appears to be a lower risk investment. Risks would include lower ROE awards from regulators and any unfavorable regulatory decisions including non-allowance of portions capital spending. In terms of the stock price (but not the earnings) higher interest rates are a risk.
INSIDER TRADING / INSIDER HOLDING: Based on December 1, 2016 to December 28, 2017. Many insiders are buying under a plan. This provides only a weak signal as it tends to be done without regard to the share price. Still, the amounts are substantial in many cases and it does show confidence. Several insiders sold substantial shares after exercising options but still held tens of thousands of shares or even over 100,000 in a couple of cases. The CEO exercised options and kept all the acquired shares. One insider sold 1280 shares at $45 but still held 8684 shares. Overall the insider trading signal is moderately positive. In terms of insider ownership there are many insiders listed and many of them own over 10,000 shares and some own over 100,000. This is a positive signal.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (pass due to relatively simple regulated operations), has favorable long-term economics due to cost advantages or superior brand power (pass due to monopoly position), apparently able and trustworthy management (pass due to past record of successful growth), a sensible price – below its intrinsic value (pass), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (not really relevant as capital spending is directly rewarded in this case)
MOST RECENT EARNINGS AND SALES TREND: Adjusted earnings per share in the past four quarters, starting with the most recent, Q3, 2017 was 15%, 34%, 5%, and 57%. In 2016, the earnings per growth for the year was 11%. In the same four previous quarters the revenue per share growth was minus 14%, minus 8%, minus 9%, and positive 8%. For fiscal 2016 RPS growth was minus 8%.  Overall, the recent trend in adjusted earnings per share is quite strong. The revenue per share trend has been negative but due to the manner of regulation has little impact on earnings.
COMPARABLE STORE SALES: Not applicable
Earnings Growth Scenario and Justifiable P/E: The current P/E of about 17 can be justified with growth of about 3% combined with the 3.7% dividend yield.
VALUE RATIOS: Analysed at $46.18. The price to book value ratio is not excessive for a regulated utility at 1.43 but the price to tangible book ratio is unattractively high for a regulated utility at 10.1.  (In acquisitions, Canadian regulated utilities trade at about twice tangible book value). On an enterprise basis the company is trading at about 1.17 times which is not at all excessive. The dividend yield is attractive at 3.7% and is based on a payout ratio of 69% of trailing adjusted earnings. The P/E ratio based on adjusted earnings is neutral in attractiveness at 17.4. The adjusted ROE is good but not exceptional at about 8.5%. Adjusted earnings per share growth in the past five calendar years is strong at 7.8% compounded. The revenue per share growth in the past five years is modest at 2.1%. Intrinsic value is calculated at $45.27 if the per share growth for the next five years is 5% and the P/E after five years declines to 15. Or $60.14 if the per share growth for the next five years averages 8% annually and the P/E after five years is 18. Overall, in isolation, these value ratios would support only a (higher) Buy rating.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: FTS, Toronto
Currency: $ Canadian
Contact: investorrelations@fortisinc.com
Web-site: www.fortisinc.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $8,243.0
Latest four quarters annual earnings $ millions: $1,018.0
P/E ratio based on latest four quarters earnings: 17.7
Latest four quarters annual earnings, adjusted, $ millions: $1,034.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: As reported by management
Quality of Earnings Measurement and Persistence: Earnings quality is high and persistence is high.
P/E ratio based on latest four quarters earnings, adjusted 17.4
Latest fiscal year annual earnings: $585.0
P/E ratio based on latest fiscal year earnings: 30.7
Fiscal earnings adjusted: $721.0
P/E ratio for fiscal earnings adjusted: 24.9
Latest four quarters profit as percent of sales 12.5%
Dividend Yield: 3.7%
Price / Sales Ratio 2.18
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         1.43
Balance Sheet: (last updated for Q1, 2017) Assets are constituted as follows: 61% is utility capital assets (upon which it would normally earn a regulated return), 26% is goodwill, a large portion of which is related to the ITC acquisition, (which for regulated utilities typically earns nothing but is paid for to acquire regulated assets in transactions), 5% is current assets (12% of which is cash and which would earn a regulated return after deducting current liabilities), 6% is regulatory assets (these are basically longer term deferred receivable which normally earn a regulated return), 2% is intangible assets such as software and land rights (which would normally earn a regulated return) and 1% is other assets. In total about 74% of the assets would normally earn a regulated return and the remaining 26% is goodwill which does not earn a return but which was paid to acquire some of the regulated assets.  On the other side of the balance sheet, these assets are supported as follows: 46% debt, 23% common equity, 3% preferred shares, 8% current liabilities, 7% deferred income taxes, 4% regulatory liabilities, 3% other liabilities, and 1% capital leases.
Quality of Net Assets (Book Equity Value) Measurement: The concern here would be the large amount of goodwill which lowers the quality and reliability of the book value per share figure.
Number of Diluted common shares in millions:                                 419.3
Controlling Shareholder: Fortis reports that no individual or entity owns more than 10% of the shares. In effect, senior management and the directors appear to control the company.
Market Equity Capitalization (Value) $ millions: $19,363.3
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 28.8%
Interest-bearing debt as a percentage of common equity 157%
Current assets / current liabilities: 0.5
Liquidity and capital structure: The liquidity and capital structure is strong. Fortis’ debt to equity ratio is 157%, which is not excessive for a regulated utility company. The credit rating for Fortis’ unsecured debt is BBB+, BBB (high), Baa3 from S&P, DBRS, and Moody’s, respectively. S&P puts the corporate rating at A minus while DBRD puts it at BBB (high)
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 9.6%
Latest fiscal year adjusted (if applicable) net income return on average equity: 6.9%
Adjusted (if applicable) latest four quarters return on market capitalization: 5.3%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 2.1%
Volatility of sales growth per share:  Revenue per share has been relatively flat and not volatile.
5 Years compounded growth in earnings/share 2.7%
5 years compounded growth in adjusted earnings per share 7.8%
Volatility of earnings growth:  Modest steady growth, with little recent volatility.
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 2.1%
More conservative estimate of compounded growth in earnings per share over the forecast period: 5.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 8.0%
OUTLOOK FOR BUSINESS: The company is projecting continued growth and expects to increase the dividend by 6% annually for the next four years. It should be assumed that benefits from lower U.S. income taxes will largely be passed onto customers although perhaps there would be a delay where some of the benefits would flow to the bottom line. A higher Canadian dollar would hurt results.
LONG TERM PREDICTABILITY: As a regulated utility, Fortis appears to be very predictable in the long term.
Estimated present value per share: We calculate  $45.27 if adjusted earnings per share grow for 5 years at the more conservative rate of 5% and the shares can then be sold at a P/E of 15 and $60.14 if adjusted earnings per share grow at the more optimistic rate of 8% for 5 years and the shares can then be sold at a P/E of 18. Both estimates use a 6.5% required rate of return.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (Pass, each of its regulated subsidiary utilities has a monopoly service territory but it does face competition in making acquisitions). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (pass. Overall this industry appears to be attractive to an incumbent however that also depends greatly on the returns awarded by its regulators. FortisBC’s allowed return in 2016 was 8.75%, and FortisAlberta’s was 8.3%).
COMPETITIVE ADVANTAGE: This does not seem applicable within each of its monopoly service territories. In acquiring additional utilities it has some advantage is in access to capital markets.
COMPETITIVE POSITION: This is not applicable as the company operates regulated monopoly utilities with protected service territories.
RECENT EVENTS: In October of 2016, Fortis acquired ITC Holdings, a large U.S. electric transmission company, for US$11.8 billion. This increased the size of the company substantially. In July, 2015, Fortis closed the sale of its Hotel properties at a minor loss. In June 2015, Fortis disposed of its commercial properties division at a substantial gain. On August 15, 2014, Fortis completed the acquisition of a large Arizona gas and electric utility called UNS Energy Corporation.
ACCOUNTING AND DISCLOSURE ISSUES: The management discussion was clear and well organized. There could be more discussion of the regulated return on equity for each company. Also the competitiveness of the electricity charges at each utility compared to neighbouring geographies could be discussed.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: Based on the track record, management quality appears to be high.
Capital Allocation Skills: Fortis appears to have done well in this regard despite paying significant goodwill premiums in its many acquisitions. It continues to pay out a portion of its earnings as a dividend, and plans to increase its dividend by 6% annually until 2022. In 2016, Fortis held a public offering in order to partly finance its recent acquisition of ITC. The return on the acquisitions appears to be good but not great at a recent approximate 8.5% ROE. The high dividend payout ratio likely supported a relatively high price which was then beneficial in issuing shares. The company has been successful by sticking almost exclusively to regulated acquisitions and has avoided the deregulated energy assets that have often proven volatile and problematic for certain other large Canadian utility operations.
EXECUTIVE COMPENSATION: The CEO and President of the company was directly compensated $7.15 million in 2016 and the CFO was directly compensated $2.48 million. The EVP of Business Development was directly paid $2.62 million, the EVP of Corporate Service and HR was directly paid $ 1.66 million and the EVP of Eastern Canadian and Caribbean Operations was directly paid $ 1.74 million. The total direct compensation for the above employees was approximately $15.65 million. Fortis stated that executive compensation was high in 2016 due to annual incentive pay resulting from 2016 results and the acquisition of ITC. Given the size of the company, this compensation is not a concern
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. The group of directors here appear to meet that criterion.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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