One year after its IPO, the honeymoon may be over for Hydro One

A year after its IPO, the Ontario electric utility has been a star performer in a hot sector. Here’s what needs to happen for it to keep powering ahead

Technicians working on high-tension power lines

(Education Images/Getty)

It’s not every day that the main power utility in Canada’s largest province sells shares to the public, so when Hydro One did so last year, investors got a little giddy. The offering on Nov. 8, 2015, took in $5 billion, far more than the $1.6 billion expected. Since then, the stock has climbed by 22.5%, and that doesn’t include its 3.2% yield. It’s been a great 12 months for shareholders. But with Hydro One now trading at a premium to its peers, is it still a good buy?

This former Crown corporation has a near monopoly on electricity transmission in Ontario, and its 30% of the province’s distribution market makes it the largest player in that space. It’s also operating in a benign regulatory environment, says Vijay Viswanathan, a portfolio manager at Mawer Investment Management. The provincial government, which still owns 70% of the company’s equity (though that should eventually fall to 40% through more share offerings), has approved infrastructure improvements and rate hikes. It also has a strong management team. “It’s a high-quality operation,” says Viswanathan.

None of this has changed over the year, but how investors perceive utilities has. The lower interest rates go—and today a third of global government debt pays (“charges” may be a better word) a negative yield—the more investors eschew bonds in favour of rock-solid stocks that at least return a few percentage points of income to their holders every year. That’s increased the demand for utility stocks, and their valuations.

Since 2009 the sector’s price-to-earnings ratio has climbed from about 10 times to around 17. At the same time, the threat of rising interest rates has made utility stock prices more volatile. While the Canadian utilities sector is up about 16% year-to-date, it actually fell nearly 18% between April 2015 and January of this year, as chatter around a U.S. Federal Reserve rate hike increased. These companies, with their regulated returns, are vulnerable to rate hikes because they’re seen as bond proxies. When bond rates rise, income investors pile back into bonds, with their greater assurance of capital preservation. If a rate hike does occur—and many expect the Federal Reserve to institute one before the end of the year—the sector’s shares, including Hydro One, will fall. “You will see investors pull some money out of the sector if we see rising rates,” says Jeremy Rosenfield, an equity analyst at Industrial Alliance.

There are still reasons to add Hydro One to a portfolio. It is a safer play than other utilities, says Rosenfield, because it doesn’t actually generate electricity and thus has no exposure to volatile commodities such as natural gas or coal. Plus it’s in a province with a solid economy. Ontario’s population is projected to increase by 30% over the next 25 years, notes Massimo Bonansinga, a portfolio manager at CI’s Signature Global Asset Management. Since being privatized, it’s also found ways to operate more efficiently. For most investors, though, Hydro One should be considered a Hold. Like the bonds it so resembles, it’ll be hard pressed to deliver a capital gain.