Activist Starboard lays groundwork to reduce leverage at Algonquin Power

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Company: Algonquin Power & Utilities (AQN)

Business: Algonquin Power is a renewable energy and utility company that provides energy and water solutions and services in North America and internationally. The Company operates through two segments – (i) the regulated utilities group, which provides a portfolio of rate-regulated water, electricity and gas utilities, and (ii) the renewable energy group, which generates and sells the electricity generated by its portfolio devices.

Stock Value: ~$5.7 billion ($7.87 per share)

Activist: Starboard Value

Ownership percentage: 7.5%

Average price: $8.38

Comment from the activist: Starboard is a highly successful activist investor and has extensive experience helping companies focus on operational efficiency and margin improvement. Starboard filed 111 pre-13D filings with an average yield of 12.10% vs. 27.52%. S&P 500 during the same period. This is Starboard’s first 13D filing in the utilities sector.

What is happening?

On June 30, Starboard reported a 7.5% stake in Algonquin Power. The firm said in a July 6 letter to the company that the sale of Algonquin Power’s renewable energy business could help it reduce leverage and provide a “safer dividend.”

Behind the scenes

Algonquin Power is a Canadian-based utility company with most of its assets in the United States. The regulated services segment accounts for 87% of the company’s revenues and its business consists of: 60% electricity, 20% gas and 20% water. 65 percent of the electricity provided by the company is produced by gas, and 35 percent by renewable sources. The core utility business is operating efficiently with an underlying growth rate of 8% versus 6% to 7% for its peers. Nevertheless, Algonquin currently trades at 13 to 14 times price earnings, with a 5% dividend yield, compared to a P/E of 17.5 times and a dividend yield of 3.5% for its peers. Plus, the water business is better than electric and gas, and Algonquin Power has more exposure to water than its peers, so it should trade at a higher P/E ratio.

Arun Banskota was appointed CEO of Algonquin Power in 2020 and prioritized strategic operations over operations. Accordingly, the company announced an agreement to acquire Kentucky Power in October 2021 for approximately $3 billion. In December 2022, the Federal Energy Regulatory Commission denied approval of the transaction. In April 2023, the company canceled its agreement to buy Kentucky Power. Amid these developments, Algonquin Power’s stock fell from $15 a share to about $6.52 as shareholders lost confidence in management. And for good reason: A major acquisition was the last thing the company needed. Investors were looking for a stable, predictable company with a strong balance sheet and a good dividend yield—things you’d generally expect from utilities. Instead, the acquisition would have added to an already overstretched balance sheet, putting Algonquin Power in an even less stable financial position.

The activist campaign here is relatively simple: sell the renewable energy business and focus on the core, stable regulated utility business. The sale of the renewable energy business will not only provide the company with a large influx of capital to stabilize its balance sheet and support its dividend, but also provide the type of investors who love the utility business with more certainty, predictability and stability. In other words, it would do the exact opposite of what Kentucky Power accomplished. Although the renewable energy business only has about $300 million in revenue and about $200 million in earnings before interest, taxes, depreciation and amortization, there is more value in the business than meets the eye for several reasons. This includes the fact that Algonquin Power has several joint ventures that have yet to start generating revenue, plus significant tax benefits that are not included in EBITDA. On a per-megawatt basis of compositions, a renewable energy business can generate more than $5 billion in sales to one or more large companies.

Plus, it’s like pushing an open door. In May, the company announced it had retained JPMorgan to conduct a strategic review of its renewable energy business. So, unlike many activist campaigns, convincing management is no longer an obstacle: Now it’s just a matter of execution. We have no doubt that Starboard will be watching the company closely to see how it executes on this strategic vision. If the firm feels the company needs some guidance in the process, we expect it will seek board representation given Starboard’s history. Ultimately, if this happens, it will likely lead to a more operationally focused CEO as opposed to a strategic visionary.

There is also an Activist ESG (AESG) thesis here. Algonquin Power’s power generation is currently split into natural gas and renewables. However, since the equipment and facilities are obsolete, they can no longer be included in the rate base and the company cannot charge for them. So companies like Algonquin Power will close facilities and retire equipment, build new facilities and buy new equipment that can be added back into the rate base. The trend in the industry is towards more environmentally friendly assets. So, while the company is currently about 65% natural gas and 35% renewables, there is an opportunity to increase the percentage of renewables in the future.

Ken Squire is the founder and president of 13D Monitor, an institutional shareholder activism research service, and he is the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Algonquin Power is the fund’s holding company. Squire is also the creator of the AESG™ investment category, an activist investment style focused on improving the ESG practices of portfolio companies.

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