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From: Rebecca Van Nichols <rvan@tnag.net>
Date: Thursday, July 31, 2014
Subject: Fifteen Clean Energy Yield Cos: Where's The Yield?
To: mbannerman@arcstarenergy.com
Fifteen Clean Energy Yield Cos: Where's The Yield?
Tom Konrad, Contributor
July 29, 2014 | 2 Comments
PrintIn the first article of this survey of yield cos, I noted that many of the recent yield co IPOs have risen so far as to "lend the very term "yield co" a hint of irony" because rising stock prices are accompanied by falling annual dividend yields.
Find the first article in this series here and the second here.
Yield Co Worries
Because yield cos invest in clean energy infrastructure such as wind farms and solar facilities, conservative income investors may worry about the durability of the technology. Will solar panels still be producing power twenty years from now? Others have brought up the credit quality of utility counter parties, and the untested nature of residential solar leases.
All of these concerns are real. Some solar panels will fail sooner than expected, and possibly many at a single solar farm. Utilities in Europe are already struggling financially, in part due to regulatory policies which were designed to promote renewable power. The residential solar lease model is only a few years old. Many solar leases contain inflation escalators which cause the price of solar power to rise by a few percent a year.
If electricity prices fall with the cost of power generated from wind and solar, what will homeowners do if they find they are suddenly paying more for electricity from their solar panels than they would for grid electricity? Might populist politicians pass laws declaring solar leases invalid because the lessees feel like they've gotten a raw deal?
While all of these risks are real, most can be dealt with by diversification. Falling prices of solar panels will make it cheaper to replace ones that fail prematurely. Both electricity prices and politics are local, meaning that geographic diversification can do much to manage these risks. Technological risks can be dealt with by diversifying between technologies. See the second article in this series for details on the types of power generation owned by each yield co.
The Biggest Risk
While all these risks are real, they are fairly standard investment risks, and can be dealt with through portfolio diversification: Don't own just one yield co (especially the smaller ones that own only a few facilities), and don't focus all your holdings on wind or solar.
The biggest risk, and the one that can't be diversified away is the risk of paying too much. For yield cos, which are designed to pay healthy dividends, not paying too much means getting a decent yield, now or in the near future. For me, "decent" means at least 2% more than long term government bonds. Even 2% is a fairly thin margin to compensate for the risks discussed above. The ten year US Treasury note currently pays 2.5%, and the 30-year bond pays 3.3%, so anything below a 4-5% dividend yield is too little to be taken seriously, unless we are very confident that dividend growth can continue at a rapid pace for many years to come.
High Expectations For Growth
Most US-listed yield cos have outlined aggressive plans for dividend growth. NRG Yield (NYLD) is the most ambitious, and expects to grow its dividend by 15% to 18% for five years. In order of decreasing ambition, Terraform Power (TERP) aims for 15% growth for 3 years, NextEra Energy Partners (NEP) expects 12% to 15% growth for three years, Hannon Armstrong Sustainable Infrastructure (HASI) expects 13% to 15% growth for two years, Pattern Energy Group (PEGI) aims for 10% to 12% for three years, and Abengoa Yield is aiming for relatively modest 6.5% growth over the next 12 months. Canadian yield cos, like TransAlta Renewables (TRSWF or RNW.TO) and Brookfield Renewable Energy Partners (BEP, BEP-UN.TO) have not laid out specific dividend growth targets, but do have reasonably aggressive growth plans which are likely to boost distributable cash flow and dividends over time.
The three London-listed yield cos, The Renewables Infrastructure Group (TRIG.L), Greencoat Wind (UKW.L), and Bluefield Solar Income Fund (BSIF.L) are less aggressive, and aim simply to increase distributions in line with inflation.
Sources Of Growth
Investing Cash Flow
Since yield cos return most of their investable cash to shareholders, most expected future dividend growth cannot come from re-investing earnings, as we would expect from traditional growth companies. Hence, dividend growth will have to come either from issuing debt and using that to buy assets, or from buying assets (with debt or new equity) at low prices which make those assets significantly accretive to cash flow per share.
Debt
If debt is used to buy new assets, this will generally increase the dividend, but it will also increase overall risk to shareholders. There is also a natural limit to debt, because there will come a point where lenders will become unwilling to provide additional funds. Because of the increased risk inherent in using debt to buy assets and boost the dividend, I do not ascribe much value to dividend increases arising from increasing debt.
Developing Assets In-house
In contrast, the ability of a company to obtain clean energy assets such as wind and solar farms at low prices has real value. With the exception of TransAlta Renewables, the Canadian yield cos including Brookfield Renewable Energy, Primary Energy Recycling (PENGF, PRI.TO), Innergex Renewable Energy (INGXF, INE.TO), and Capstone Infrastructure (MCQPF, CSE.TO) have a tradition of developing projects in house as well as purchasing them from other developers when such projects are available at attractive prices.
In contrast, the US listed yield cos rely on others to develop projects for them. Hannon Armstrong is fairly unique in this regard, because it is an investment bank which has relationships with a number of blue chip companies that develop energy efficiency and other sustainable infrastructure projects for which it obtains the financing. Before Hannon Armstrong's IPO, it financed these projects by bundling the debt and selling it to institutional investors like pension funds. Now, while it still creates packages of investments for pension funds, it also keeps some such projects on the books.
I expect that Hannon Armstrong's position as the leading investment bank for such projects as well as its existing relationships should continue to enable the company to invest at attractive prices and continue increasing its dividend.
ROFOs
The other yield cos (NRG Yield, NextEra Energy Partners, Terraform Power, Abengoa Yield, Pattern Energy Group, and TransAlta Renewables) are relying on "Right Of First Offer" or ROFO agreements with their parent companies to obtain projects at attractive prices. The parent companies are all experienced project developers, and those parents with large portfolios assets and concrete road maps for dropping them down to their yield co offspring have been rewarded with the highest yield co share prices and the lowest current yields
The highest yield among the US-listed ROFO yield co is Pattern Energy Group. Its parent, Pattern Development is a private company with only a handful of projects that it is currently developing. The other ROFO yield cos all have publicly listed parents which already own significant clean energy assets, and are developing new ones as well. They have low yields and high stock prices to match.
The one exception is TransAlta Renewables, which trades at a 6.5% yield, compared to the 2% to 4% yields available on US listed ROFO yield cos. Its low price and high yield are due in part to the fact that its parent, TransAlta Corp (TAC), has not explained precisely which assets it plans to sell to TransAlta Renewables, and at what prices. TransAlta Renewables' lack of a US listing is also likely to be part of the reason for its high yield, but even given these factors, I consider TransAlta Renewables to be massively undervalued compared to the other ROFO yield cos.
Finite Growth
The flood of new capital which current and expected future yield cos are bringing to the market is likely to have significant effects on the price clean energy projects sell for. Most such projects take years to develop, and so the short term supply is limited. A large source of new capital chasing a finite number of projects is likely to boost the value of those projects on the market.
As project prices rise and ROFO agreements expire, we can expect that they will be renewed only with prices which are less attractive to the yield cos. Yield cos which develop projects in house will also find that their costs rise as other developers enter the market in order to sell projects into a robust market fueled by cheap yield co money.
Hence, while yield cos many be able to hit their aggressive short term dividend growth targets, this growth must slow over the longer term. I personally am only willing to believe current projections one to three years into the future. To reflect that, I have put together the following chart of the 15 yield cos current yield and expected yield growth over the next two years.
The horizontal lines show current yield, the x-axis shows how much yield is expected to increase over the next two years, and the diagonal lines combine these two to show expected yield in two years.
The Best
Paying a high price for a yield co not only reduces its current yield, it also reduces the effect of even very aggressive dividend growth targets. The chart reflects NRG Yield's extremely aggressive dividend growth target (15% to 18%) with an assumed annual dividend growth of 16.5%. Because NRG Yield has such a high price, its current yield is only 2.8%, and two years of compounded 16.5% growth bring it up to only 3.8%. Pattern Energy Group may have a less impressive (but still proven) parent in Pattern Development, but it offers a 3.8% yield today. With that sort of head start, it will have no trouble staying ahead of its US-listed ROFO yield co brethren.
Looking at the upper right hand corner of the chart, we see Hannon Armstrong and TransAlta Renewables. These offer current yields of 6.1% and 6.5% respectively. NRG Yield would have to grow its dividend at 16.5% per year for five years just to get to where Hannon Armstrong is today. NextEra Energy Partners, TerraForm Power, and Abengoa Yield would require even longer to get there.
In short, a dividend today is worth more than years of potential dividend growth. Among the current crop of yield cos, I consider TransAlta Renewables, Hannon Armstrong, Capstone Infrastructure, Brookfield Renewable Energy Partners, Primary Energy Recycling, and Innergex Renewable the most attractive, in that order. The London listed yield cos are also attractive, especially for geographic diversification, but are extremely difficult to buy for US based investors. The only one I've been able to purchase is The Renewables Infrastructure Group (TRIG.L).
This ranking of yield cos is almost entirely based on current and future expected yield. Primary Energy gets a slight boost in the rankings because of the real possibility of a takeover offer in the near future. In the last article, I looked into how each of the yield cos were structured. There, I noted that some (especially Abengoa Yield, NextEra Energy Partners, and Terraform Power) have structures which don't completely align management incentives with the interests common shareholders. That said, the most of the yield cos with the highest yield also have the best alignment of management and shareholder interests. My analysis of yield co structure only served to re-enforce my preference for those yield cos with the highest current yields.
In the end, is there any fairer way to evaluate yield cos than on the basis of yield? Without yield, the term "yield co" is just PR.
Disclosure: Long HASI, BEP, PEGI, RNW, CSE, INE, PRI, TRIG. Short NYLD Calls.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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