Jan. 16, 2017
Apprehensions about the renewable industry do not affect yieldcos.
Rising interest rates do not mean end of growth, but yieldcos need to be attentive.
Some yieldcos seem better than others - my view.
Yieldco market, today, has some apprehensions. The most important one is a risk of rising interest rates to which I dedicated most of this article. Others evolve around the federal energy policy, which does not support renewable energy. Another apprehension has to do with the market's experience with TerraForm companies, Power (NASDAQ:TERP) and Global (NASDAQ:GLBL). Finally, solar overcapacity seems like it matters but truly does not.
Outside of interest rate, all other anxieties are just the noise. The easy one to dispute, like a projected turmoil upon arrival of new energy policy, has no bearing on business at all. My article on Pattern Energy Group Inc. (NASDAQ:PEGI) discussed political impacts, and for almost all yieldcos, the forecast for their current operations has the same boring prediction of business as usual.
The concerns about transparency and conflict of interest not only muddied affairs of bankrupt SunEdison (OTCPK:SUNEQ) and its yieldcos but managed to sour the mood toward investing in them. Still, both are, certainly to industry, value worth the pursuit. While the bidding process is about making money, an end game is about unlocking assets with a proper sponsor. As soon as this is done, industry will find relief.
There seems to be a mild case of apprehension how sponsors of 8Point3 Energy Partners (NASDAQ:CAFD) will treat it when margins remain shrank for next two years, but solar overcapacity has nothing to do with yieldcos except cheaper modules lower cost of the new asset acquisition.
The tougher one to rebut is the concern about rising interest rates. So what happens when they do?
Prevailing fixed income instruments trade below par value to match the yield offered by the new debt as soon as interest rates rise. The market does the same to dividend stocks, but historically, in the relatively short term, they recover. The recovery, in my opinion, is linked to dividend growth as companies can grow and increase dividends. In comparison, the bond has fixed coupon and locked face value. Thus, no growth is possible. Although there is volatility, in the case of equities, growth, at least in theory, is unlimited.
Of course, not all dividend stocks recover. Investors sell them the moment they see the expectation of low earnings. Dividends are paid from retained earnings, so if earnings shrink, the anticipation is that dividends will follow. So-called dividend traps are born when stocks sell off due to shrinking earnings, but they resort to keep the same level of dividend just to drop it unexpectedly in the future.
Yieldcos are dividend growth-oriented entities. To this point, the market has treated them as a risky dividend stock. Their revenue comes from renewable energy production contracted under power purchase agreements or PPAs. Apart from seasonality impacting capacity factors and potential fluctuation in maintenance expenses, yieldcos offer a high visibility and predictability of cash flow. This condition produces support for the dividend and allows for high level of distribution, so reduction of the dividend is not the source of the anxiety, the ability to grow it is.
Yieldcos grow dividends through the acquisition of renewable assets. Each asset is expected to have an internal rate of return, or IRR, greater than the cost of capital. Otherwise, it would not generate cash available for distribution. Most of the acquisitions, at least initially, are financed by equity sold via share or a corporate bond issuance. In the execution of a dropdown, as the transaction is called, along invested equity, yieldcos will assume, replace or renew debt obligation carried by the asset.
It is important to note that rise in interest rates would impact the cost of the existing debt with variable rates, but the crux of the problem is not the current state, but how the cost of capital could limit or even prohibit acquisitions.
The cost of capital consists of cost of debt and equity weighted in an average calculation called WACC, unique to each yieldco. My presentation uses a simple format that does not reflect the complexity of the subject. Along with deep financial knowledge, specific information about inner workings of individual yieldcos and details about individual projects are required to make those determinations. I use this simple format to illustrate concepts, but those examples should not be considered as complete, and therefore, serve a sole purpose in the investment decision.
The cost of debt starts with the average interest rate that company borrows to invest. Since borrowing is an expense, the cost of debt should be calculated using the tax rate. For example, a 6% average interest rate multiplied by an adjustment for the tax rate of 30% is 4.3%.
The cost of equity is where the trouble starts. For example, some consider yield of the dividend as the cost of capital using modified dividend capitalization model. The DCM is more of the determination tool for investors looking to understand returns on equity. For example, NextEra Energy Partners (NYSEMKT:NEP) paying 6% yield and having 10% dividend growth would offer 16% DCM. Buying project with 8% IRR would not make a lot of sense if this were the cost of capital. Opportunely, the yield is not the cost of capital or even equity.
The accepted cost of equity calculation is Capital Asset Pricing Model (CAPM) shown below:
Cost of equity = risk-free rate + beta (market rate - risk-free rate)
PEGI's CAPM, using 2.63% yield of risk-free 10-Year Treasury combined with 8% stock market return, and a beta of 0.97 provided by Yahoo Finance, is 7.84%.
When I apply the rate of 1% as a risk-free rate with all other factors being the same, CAPM is 7.79% (PEGI WACC fig.). It makes sense that interest rates have little to do with equity as the biggest impact on CAPM comes from beta and the overall market return.
PEGI's average borrowing rate in the third quarter came at 4.3%. If the interest rates rose by 1%, the cost of debt after the tax rate would be 3.71%
Pattern Energy's ratio of debt to equity, based on Q3 2016 balance sheet was 0.94. Therefore, the weighted average cost of capital for PEGI forecasting 1% rise in interest rates would be 5.78%.
If I substitute CAPM with a current yield of 8.35%, WACC would increase to 6.03%. Last equity offering with shares sold at $23.80 paying $1.63 dividend would yield 6.85% return, reaching WACC of 5.28%, a 14% lower.
I can see how high yield paints a negative picture; I disagree with it even though common sense tells me that equity sold at the highest price has the best effect on the cost of capital. I explain this by the ability of yieldco, as anyone's on the market, to sell shares at a profit, or better than the average cost of own equity.
Further, when the weighted average has more debt, the cost of capital improves. For example, NEP and NRG Yield (NYSE:NYLD) have D/E ratio of 2.4. If PEGI started buying projects using a similar weighted average, its WACC would drop from 5.78% to 4.95%. Finally, the cost of equity, at 7.84%, could be replaced by a convertible bond with a significantly lower rate. Interestingly, buying PEGI shares when yield is greater than 7.84% seems opportunistic for investors.
To summarize, in current market conditions, debt content can improve capital cost even when interest rates rise. The yield increase due to the selling of the shares is a distortion, and with stable dividends, selloff is an opportunity. A 1% increase in interest rates does not have a significant impact on the cost of capital and should cover, expected in 2017, interest rate increases. Yieldcos seem to be able to add assets this year, and with it, grow dividends.
Until now, I focused on WACC, but the growth of IRR can equally improve investment thesis. Here are some of the ways this could happen as yieldcos need to be vigilant during project acquisitions to protect own interests.
The price of the project can be lower due to cheaper engineering, procurement or construction. The cost of land can also be reduced.
To date, technical development has enabled wind generation almost anywhere, and material cost decreases concurrently produced greater efficiency. Module prices experienced similar depreciation over the years. Technology is expected to continue to evolve and to reduce costs further.
Lastly, long-term presence of higher interest rates can force an increase in electricity prices, and future PPAs could reflect that. I need to mention tax incentives, like ITC and PTC, that improve project returns.
Out of the choices of yieldcos, both, NEP and NYLD buy projects from sponsors who are not developers. Utilities, which own them, are immune to renewable industry weaknesses and are large enough to have the buying power. on the other end, sponsors look for the margins when they drop assets. In essence, NEP and NYLD could be paying for two companies' margins.
In the case of PEGI, the sponsor is the developer, to add, a private one. I like to think that corporate obligation to achieve profitability expected from the public company could have a different tenet in this case. I expect a private developer to seek returns to satisfy own investors, but depending on the market, they can be moderated with options not available to public sponsors.
PEGI and NYLD do not pay incentive distribution rates or IDRs. Those are paid to the sponsor when the level of dividend reaches a certain objective. Not having IDR keeps the growth of dividend and in times of growth constraint, IDR reduces cash available for distribution. TERP and GLBL do not pay dividends so until their sponsorship situation is cleared, they are not meeting the definition.
The likable factors for NEP and NYLD are the lower distribution versus available cash. Reaching profitability, despite yieldco structure, is a plus for both, and also an attractive feature for investors who feel strongly about generally accepted accounting principles and expect traditional earnings. However, both companies give a dominant feeling of being only the financial vehicle for own sponsors. In contrast, PEGI is organized as a corporation, and its sponsor operates behind the veil of privacy, which, for some, is a minus.
PEGI has room to leverage borrowing, has accretive acquisitions already aligned and will be able to increase the dividend based on them. PEGI also planned to include 2GW of future projects under full PTC, which ended in December 2016. PEGI can access borrowing in countries with low or lower interest rates like Japan and Canada. Yieldcos which operate on international arena can gain but also lose on currency exchange.
In closing, I suspect the market will not see new yieldco IPOs for some time. In turn, this could improve the status of those being around. I can imagine that someone who is not watching yieldcos today, in five years from now, could be surprised by their maturity and attraction. While the perspective of interest rates rising is a concerning proposition today, yieldcos can and will operate in such an environment because the armor of protection forged with sponsor's ability to build cheaper, profitable projects will secure their success.
Disclosure: I am/we are long PEGI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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