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  Keeping a light on for Algonquin

BENJ GALLANDER and BEN STADELMANN

Friday, October 8, 2010

It's fascinating to review the history of Algonquin Power since its inception as a business trust in December 1997. This is easy to do, as Algonquin has a comprehensive website. What started out as a modest foray into the utility business with an IPO of 8 million units at $10 was quickly built into a significant player in the renewable energy segment.

The company's peak year was arguably 2003, when net earnings tallied $45.4 million, or 66 cents a share. At that point in the story, the motto in the glossy annual report — "Experience — Stability — Opportunity" — seemed apt. So, what happened to propel Algonquin on a trajectory to ruination? It's an important question, as the management restructuring features a number of the same old faces responsible for those critical decisions.

In the period 1998–2003, management complained that hydro production missed targets due to hydrological conditions that were below what they should have been, based on long-term averages. This deficit was as wide as 18 percent in 2002. Clearly, Mother Nature was too fickle, so the company diversified into other areas that supposedly would provide a more stable and reliable revenue stream.

At first, this meant buying into biomass and natural gas cogeneration plants, then into a wider concept of infrastructure, including water distribution, reclamation, and waste disposal. This strategy expanded revenues robustly from $147.6 million in 2003 to $213.8 million in 2008, but despite that growth, the unglamorous loss was $19 million at the end of that period.

The bottom line is that Algonquin traded the minor vagaries of river flow rates for the far greater risks of investing heavily in the U.S. and in areas outside of their core competence. In an effort to hedge against future changes in foreign exchange rates, the company got into derivative instruments whose mark-to-market accounting causes far greater volatility in earnings than hydrology fluctuations ever do.

The good news is that because of the distribution cut, there is now plenty of cash to work with. In 2009, cash provided by operating activities totalled $50 million, with just $19.3 million needed to pay dividends. This is a completely different scenario from 2007, when $40.4 million of cash was generated and $69.9 million went out the door in distributions. For the first half of 2010, the ratio has continued to be favourable, $21.9 million in cash generated compared to dividends of $11.3 million.

With the internalization of management, an expensive exercise that richly rewarded the head honchos with gobs of shares, the top executives should be far more accountable to the board, and their top priority ought to be to place the company on a more stable footing. To do so, expansion into the U.S. should be curtailed and the hedging program simplified. Revenues from resources that are performing at a level above 95 percent of long-term averages should be diverted into an equalization fund. This fund would be accessed in years when the rain dribbles and winds are light.

As for capital expenditures and acquisitions, the company should be more conservative. That seems to be the case with the Red Lily Wind Project in Saskatchewan, where partners are putting up $50 million of the financing. More dubious is the Tinker Hydroelectric acquisition, which cost $40.7 million, added to the debt load and incurred extra risk as electricity production is insufficient to service customers, so power has to be purchased on the spot market. One would hope that, in the future, purchasing Algonquin's own convertible debentures, which pay 7.5 percent interest, would be considered as a home for extra cash, as that represents a nice, guaranteed, risk-free return.

Algonquin was added to the Vice-President's Portfolio last January at $4.32, with the expectation of it being a steady income generator with the potential for modest capital gains. If managed prudently and efficiently, it ought to be able to do just that for many years to come.


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