YieldCos: The Pseudo-MLP
The Master Limited Partnerships Parity Act (MLPPA) seeking to extend the MLP tax break to renewable energy technologies continues to gather dust in committee with long odds of passage.
But commerce hates roadblocks, and suppliers of renewable energy have found another way to attract yield-oriented investors.
Enter the financial instrument known as a YieldCo. As the name suggests, YieldCos are investment vehicles spun off with income-generating assets to provide a predictable tax-deferred yield in exchange for cheap equity capital. They differ from MLPs in that they are not automatically exempted from the corporate income tax, but accelerated depreciation provisions of the tax code and other tax breaks offered to renewable power producers mean that they are able to report net losses for five years at least, while paying out positive cash flow to investors via dividends that will be classified as a return of capital.
With YieldCos, distributions are treated as dividends under US tax law to the extent they are paid out of current or accumulated earnings. If dividends are paid out in excess of current and accumulated earnings for a taxable year, the excess cash payments would be treated as a return of capital for US federal income tax purposes. This would reduce the adjusted tax basis of the shares, and any balance in excess of adjusted basis would be treated as a gain for US federal income tax purposes.
Internal Revenue Code Section 7704 states that at least 90 percent of an MLP’s income must come from qualified sources, such as real estate or natural resources. Section 613 of the tax code requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. But since YieldCos are not MLPs they are not subject to these limitations.
Early returns suggest this proposition is generating plenty of enthusiasm. When NRG Energy (NYSE: NRGY) became the first company to spin off a YieldCo subsidiary holding solar generating assets last July, the offering price for NRG Yield (NYSE: NYLD) provided for a 5.5 percent yield at the promised dividend rate. The IPO was more than 10 times oversubscribed — an indication of pent up investor demand for such offerings. Less than 11 months later, NYLD’s share price has more than doubled, so even though it has already raised its dividend the yield is down to 2.7 percent.
Two YieldCos stuffed with wind and hydropower projects debuted in NYLD’s wake last year. TransAlta Renewables (TSE: RNW) listed on the Toronto Stock Exchange in August at an initial price of $10 Canadian a share and a projected dividend yield of 7.5 percent. The company owns 16 wind facilities and 12 hydroelectric facilities. The share price has since risen to $11.39 and the yield has fallen to 6.8 percent.
Pattern Energy Group (NASDAQ: PEGI, TSE: PEG) listed simultaneously on the NASDAQ and Toronto Stock Exchange last September with a projected dividend yield of 6.25 percent. The company owns interests in eight wind power projects located in the United States, Canada and Chile. The share price has since risen by 33 percent, and the yield has dropped to 4.2 percent.
Now comes a second YieldCo to include solar assets, from Spain’s Abengoa (NASDAQ: ABGB). Abengoa Yield (NASDAQ: ABY) owns two newly constructed concentrating solar power plants in the US (in California and Arizona), as well as two smaller ones in Spain. Other assets include a wind farm in Uruguay, a fossil fuel cogeneration plant in Mexico and electric transmission lines in Peru and Chile, along with an equity investment in a transmission venture in Brazil.
Abengoa Yield opened for the first time last Friday at $29 and closed up 27.6 percent on the day. It pegs its initial dividend rate at an annualized $1.04, for a 2.8 percent yield based on Friday’s close.
There are risks for YieldCos. The starting yields are low, and therefore subject to losing much of their current appeal should interest rates meaningfully rise, as they ultimately will. And while energy MLPs have a full and indefinite shield against the corporate income tax, YieldCos can only shield income to the extent they can carry forward net operating losses, which will largely depend on their ability to keep growing so that new projects provide additional depreciation.
This matters because solar is a relatively new, dynamic and technology-dependent industry, and as such is subject to dramatic changes in the economic and competitive landscape. It’s also sensitive to changes in public policy, notably in relation to the looming expiration in 2016 of the production and investment tax credits for renewable projects. So while it’s true that fixed-rate 20-years solar power purchase agreements provide excellent revenue protection, only continued growth will maintain the tax shield on the distributions.
Williams Buys the Pot
There’s nothing like buying your way out of problems and immediately getting the purchase price tacked on to the value of your equity.
That’s the neat trick Williams (NYSE: WMB) pulled off today in converting its equity investment in Access Midstream Partners (NYSE: ACMP) into full control that will allow it to use ACMP’s surplus cash flow to offset the deficit at its fully sponsored Williams Partners (NYSE: WPZ) MLP, which is to be folded into Access. Williams shareholders get stepped up dividend growth and strategic control of valuable assets.
With the stock recently up nearly 19 percent on the deal news, subscribers who acted on our Oct. 12 buy recommendation promptly have now seen a total return of 60 percent. And at least two analysts following Williams have opined in the deal’s wake that there’s room for more, since the stock continues to offer a yield above that of other MLP general partners.
As part of the deal announcement, the company said it would increase its third-quarter dividend to 56 cents a share, up 32 percent from a year ago and good for an annualized yield of 4 percent at the recent share price of $56. From there the dividend would increase another 10 percent next year, and an additional 15 percent a year in 2016-17. Limited partners have been promised annual distribution growth of 10 to 12 percent through 2017, starting with a 25 percent increase per unit next year over what Access was forecasting on a standalone basis.
How will Williams afford this everyone-wins bonanza? Well, the restart of its Geismar, Louisiana olefins petrochemical plant following a deadly blast almost exactly a year ago will surely help. Production there is expected to resume in August, a month behind the previous schedule, and the additional costs associated with the delay were “primarily” to blame, the company said, for the 10 percent cut it made to the Williams Partners distributable cash flow forecast for 2014. That would have left Williams with a distributable cash flow deficit of 11 percent relative to the forecast Williams Partners distributions.
And that deficit could have grown, and still may, with insurers “recently rais(ing) questions” over Williams’ Geismar claim and withholding the bulk of the $200 million sought by the company in its most recent claim. (They did pay out $50 million, boosting Williams’ receipts on its claims to $225 million out of the $500 million in forecast insurance proceeds.)
But Access also has a crucial role to play in covering the distribution gap, most immediately because Williams will be able to reduce its rich 1.38x distribution coverage ratio. Over the longer-term, Access is expected to enjoy rapid growth in demand for its gathering and processing services in the Marcellus, Utica and Eagle Ford, among other shale basins, complementing Williams’ gathering assets and its extensive distribution system spanning the Eastern seaboard and the Gulf coast.
Williams said equity sales would finance half of the $6 billion purchase price, which also covers enough Access limited partner units to give Williams a 50 percent stake and ensure approval for its planned MLP merger. The remaining half would come from long-term debt, revolving credit line and some $1 billion of cash on hand. Williams plans to subsequently drop down more of its directly owned assets to the MLP to repay some of the borrowing on the revolver.
Not typically mentioned in those comparisons of Williams to other GP stocks is that few are already as heavily leveraged, with the company’s nearly $13 billion in debt working out to more than 5 times its trailing annual EBITDA.
We’re every bit as excited about growth opportunities at Williams as we were when we called it our #5 Best Buy with an increased buying limit in March. But today’s action certainly limits the scope of future appreciation. Given the magnitude of the gain, a drop from these levels below our prior buy limit of $46 would no longer constitute an immediate buying opportunity. As such, we’re downgrading WMB to a Hold. But we wouldn’t be in any rush to sell it.
— Igor Greenwald