by Robert Muir
Given the determined investor quest for yield as the Federal Reserve maintains the benchmark Federal Funds rate at zero, and the resurgence of attention being paid to alternative energy generation, mainly solar, and to a lesser extent wind and hydro, it’s no wonder Yield Co’s have gained so much investor interest lately. In the near to mid-term, the enthusiasm may be justified. Supported by Power Purchase Agreements, energy infrastructure financing and leasing contracts, and electricity transmission and distribution concessions, all with credit-worthy counter-parties, Yield Co’s are designed specifically to pay out a large portion of their EBITDA to shareholders in the form of dividends. By virtue of their steady cash flow and above market yields, these companies are often viewed by investors as relatively safe and stable, similar to high yielding traditional utilities, and their shares tend to trade with low volatility and beta.
Structured as they are to generate and pay out cash flow to investors these firms are to a large extent valued on both current yields and their anticipated ability to maintain and increase future dividends. Therefore vigorous deal flow and a robust acquisition pipeline are key. I’m most in favor of Yield Co’s that are direct spin offs and by contract have Right of First Offer (ROFO) on any projects developed by the parent. The other very important factor I consider is financing. I like to see structured debt financing at attractive rates that is properly engineered into the financial metrics of the acquisition. I tend to avoid Yield Co’s that finance development projects and acquisitions with the issuance of new equity.
Green Alpha Advisors holds Yield Co’s in some of our portfolios. One I particularly like is Pattern Energy Group (PEGI). PEGI has the ability to expand it MW production capacity, and therefore grow its revenues and cash available for distribution, through a solid pipeline for identified projects from Pattern Development on which it has ROFO, while also being able to consider beneficial third party project acquisitions. It will benefit through 2016 from the Federal Renewable Electricity Production Tax Credit. PEGI currently holds only wind capacity generation in its portfolio but management is open to adding solar as well. The company has a stated goal of increasing its cash available for distribution by 10-12% annually and increasing its dividend by 12% annually over next 3 years. With a current yield of 4.10%, and an annual dividend of $1.31, PEGI is currently fairly priced at around $32.00. Its forward performance estimates are trending nicely, with estimated full year revenue growth of 25.5% in 2014 and 35% in 2015 and estimated full year EPS growth of 32.8% in 2014 and a whopping 133% for 2015. Both its Price to Book and Price to Cash Flow are estimated to trend lower in 2014 and 2015. Its EV/EBITDA valuation ratio is high, but not relative to its superior EBITDA, and its EV/EBITDA vs. EBITDA ratio is markedly more attractive than many of its competitors. PEGI seeks to pay out 80% of EBITDA, and if the company performs as estimated it should be able to meet both that benchmark and its dividend growth targets. If the company does meet those growth targets its annual dividend in 2017 will be $1.67. All things being equal, if the yield were to remain at 4.1% that would potentially make for a 2017 price of $40 a share. Inversely, if the price were to stay close to $32.00, the 2017 yield will have ballooned to 5.2%.
While acknowledging many positives, I do see some risk in owning shares in these firms. Firstly, Yield Co’s stock valuations, like traditional dividend paying utilities, often considered bond proxy’s, or any high yield investment instrument for that matter, have negative exposure to a rising interest rate environment. A seven, six, or even five percent yield might seem extremely attractive when the Ten Year U.S. Treasury Note is yielding just 2.52%, but if or when benchmark interest rates return to more historical norms income investors may not be willing to pay today’s prices for shares with those same yields. To offer some context, in 1995 the Fed Funds rate was 5.5%. In the minutes from the most recent Federal Reserve meeting, released on July 9th, FOMC members anticipated the fund rate will be at 1% in 2015, 2.5% in 2016, and 3.75% in the longer term. To preserve share prices in a rising interest rate environment Yield Co’s will need to be able to increase their dividends commensurately.
Also, as the number of publicly listed renewable energy Yield Co’s has risen, the demand from these firms to secure renewable electricity generation projects has also spiked, leading to less attractive pricing and revenue metrics on third party, competitive bid acquisitions.
Another potential risk that Yield Co’s face, albeit in the longer term, is the threat to the traditional “Hub and Spoke” electricity generation and distribution model. This is far and away the model of the majority of the holdings in Yield Co portfolios. As the generation and storage technologies that will bring about distributed and eventually autonomous energy production advance this utility model will become increasingly less economically viable. I know of only a handful of Yield Co’s at this time, NRG Yield Inc. (NYLD), Hannon Armstrong Sustainable Infrastructure Capital, Inc. (HASI), and TerraForm Power, Inc. (TERP), that have distributed solar assets in their current portfolio of holdings. This is clearly a longer term concern and doesn’t affect my near term analysis of the space or any individual companies. However, it is something I will continue to monitor.
In my view Yield Co’s clearly have a role to play in any diversified equity investment model, particularly one designed to generate dividend income.
Disclosure and Sources:
Green Alpha Advisors is long PEGI and HASI, and has no position in NYLD or TERP. Data on PEGI is sourced from Thomson Reuters as of 08/05/2014. This information is for information purposes only and should not be construed as legal, tax, investment or other advice. This information does not constitute an offer to sell or the solicitation of any offer to buy any security. Some of the information contained herein constitutes “forward-looking information” which is based on numerous assumptions and is speculative in nature and may vary significantly from actual results. Green Alpha is a registered trademark of Green Alpha Advisors, LLC.
About The Author
Robert Muir is a Partner and Senior Vice President at Green Alpha Advisors, LLC. He is a member of the Shelton Green Alpha Fund (NEXTX) Investment Committee. An earlier version of this article wa
s first published on Green Alpha’s Next Economy blog.