Give YieldCos Another Chance?
When it comes to so-called YieldCos, you can’t help but admire Wall Street’s cynicism in coining a name for an asset class that promises the very thing income investors crave.
At Investing Daily’s Utility Forecaster, we’ve been skeptical of YieldCos since the first wave of these securities debuted on the market a few years ago.
At the time, utilities and other companies involved in generating renewable energy were looking at master limited partnerships’ (MLPs) tremendous success and wanted to get in on the action too.
The MLP structure allows companies to monetize stable, income-producing energy infrastructure assets, such as midstream oil and gas pipelines, by selling them to a subsidiary limited partnership. The parent company can then redeploy the proceeds from each sale toward new growth projects.
In this way, MLPs can essentially become a cash machine for their sponsors.
They’re not only a convenient way to raise capital, but the ownership structure, which typically includes control of the MLP’s general partner as well as a significant equity stake in the limited partner, means that sponsors stand to continue earning an outsize take of the cash flows these assets generate. That’s like having your cake and eating it too.
Of course, MLPs only become a high-value currency for their sponsors when they deliver on their main promise to income investors, which is a high and rising payout. When payout growth stalls or an MLP’s operations prove riskier than expected, it becomes much more difficult for them to tap the capital markets.
But over the long term, most midstream MLPs have achieved their sponsors’ aims.
Although most electric utilities would have loved to replicate the success of this business model, the problem is that the types of assets they own generally aren’t eligible for an MLP structure.
So senior utility executives put their heads together with their favorite investment bankers and tax attorneys and created an alternative investment vehicle whose very name does most of its own marketing: Enter the YieldCo.
The big problem for risk-averse income investors, which are YieldCos’ primary demographic, is that these securities have a very short track record, generally no more than three years. During that time, investor demand saw shares of some YieldCos generate phenomenal returns in terms of price appreciation, only to crash and burn amid the broader MLP meltdown.
Beyond that, it’s too much to extrapolate MLPs’ long-term success to YieldCos. That’s because there are key differences between these two structures.
A crucial distinction is that key sources of a YieldCos’ payout have been contingent on policies that face potentially greater peril than the one that gives MLPs their tax-advantaged status.
Gray Sells Green
One of our concerns had been the fact that tax credits for renewable energy production from wind and solar were set to expire. In fact, these credits have been a perennial issue for renewables, since they were previously extended on an ad-hoc basis.
But late last year, legislation was signed into law that significantly extended these tax credits.
The 30% credit for large commercial solar projects now runs through 2018, and then declines incrementally to 10% by 2022, where it will remain thereafter.
The wind power tax credit—2.3 cents per kilowatt hour of production—is good through this year, and then gradually declines until expiring in 2020.
Unless these credits are subsequently rescinded, renewables now have a longer runway of tax-credit fueled growth, affording time for their economics to make them more competitive with fossil fuels.
The Taxman Cometh
Our other concern is that a significant portion of a YieldCo’s payout is based on net operating losses (NOLs) derived from the huge initial investment (and subsequent depreciation) it takes to get a renewable project up and running. NOLs can be carried forward to future years to shield cash flows from taxation.
Unfortunately, this tax-avoidance strategy has a limited lifespan, generally around five to 10 years per project. Since YieldCos are so new, it remains to be seen how they and their sponsors will navigate through this future headwind.
For long-term investors, that’s no small consideration since it could weigh on future distribution growth, at the very least, or possibly lead to distribution cuts.
One possibility is that YieldCos simply continue acquiring new projects with associated NOLs. That requires a sponsor that has a long pipeline of assets available for future dropdowns.
The Next Era?
The one other problem with YieldCos had been that their unit prices raced ahead of their distribution growth, thereby resulting in puny yields. But the subsequent sector crash eliminated that issue.
A quick scan of the relatively small YieldCo space shows that most of these securities now sport enticing yields, though we’re less certain about whether their payouts are sustainable.
Let’s take a look at one name whose deep-pocketed utility sponsor means that it’s more likely than most to endure.
Utility giant NextEra Energy Inc. (NYSE: NEE) launched its YieldCo NextEra Energy Partners LP (NYSE: NEP) a little more than two years ago.
The nearly $60 billion utility is one of the most forward-thinking operators in the utility space. It uses the steady cash flows generated by its regulated Florida power utility to invest in renewables via its competitive-generation business.
With net property plant and equipment valued at more than $30 billion after depreciation, NextEra’s renewables segment isn’t just some token effort toward generating cleaner energy. The unit has become one of the largest wind-power generators in the world and now accounts for more than a third of NextEra’s operating income.
With an asset footprint encompassing 110 wind farms across 19 states and Canada providing nameplate generating capacity of more than 12,400 net megawatts, NextEra has no shortage of assets it can drop down to its YieldCo subsidiary for years to come.
For its part, NEP currently has 20 solar and wind farms with nameplate generating capacity of 2,656 megawatts, along with 542 miles of natural gas pipelines with 4.05 billion cubic feet per day of capacity. These assets are contracted to sell power under long-term agreements, with an average remaining contract term of 19 years (based on a weighted contribution to earnings).
Upon its initial public offering in mid-2014, NEP reported that it had sufficient net operating losses and carryforwards to offset taxable income for the next 15 years, which largely eliminates that aforementioned concern.
Looking for Safety in Numbers
Nevertheless, our skepticism about YieldCos in general along with NEP’s low Safety Rating and a sector-wide shake-out has kept us on the sidelines.
NEP currently trades just 7.5% above its initial public offering price, evidence of the carnage the sector has suffered.
Meanwhile, the YieldCo’s quarterly distribution has nearly doubled since its first payout two years ago, for a distribution of $0.34125 per quarter, or $1.365 annualized.
At current prices, that translates into an attractive yield of 5.1%, with the promise of more to come. The partnership is targeting distribution growth of 12% to 15% annually through 2020.
One of the metrics that has given us major pause, however, is NEP’s low Safety Rating. Our proprietary Safety Ratings are intended to gauge the sustainability of a company’s payout, but they also function as an instant credit check.
When assigning Buy/Hold/Sell ratings to our wider coverage universe of stocks, we lean heavily on our Safety Ratings since they incorporate eight fundamental criteria.
One shortcoming of this system is that because it necessarily relies upon reported financial data, Safety Ratings are ultimately backward-looking metrics. Therefore, newer companies that have yet to establish track records of three years or longer will be penalized.
Furthermore, NEP’s cash flows are still ramping up, which makes its leverage ratios appear downright alarming at first glance. For instance, the YieldCo’s net debt to EBITDA (earnings before interest, taxation, depreciation and amortization) ratio is around 7.2x. And total debt is more than 2.5x NEP’s market cap.
But the consensus forecast is for NEP to grow next year’s EBITDA by 30%, to $854.2 million, which would bring net debt to EBITDA down to a more manageable 4.3x.
The caveat is that, so far at least, NEP has done a pretty dismal job of meeting analyst estimates for revenue, adjusted earnings per share and EBITDA.
The YieldCo has fallen short of forecasts by high double-digit margins in many recent quarters for sales and EPS, and has also failed to meet expectations for more forgiving metrics such as EBITDA.
Nevertheless, the numbers appear to be rapidly improving. And the fact that NEP has a sponsor like NextEra does instill greater confidence that this might be one utility financial experiment that doesn’t leave investors holding the bag.
At current prices, NEP may be a worthwhile play for aggressive investors. But as risk-averse income investors, we’d like to see a bit more improvement in the numbers before we’re ready to come off the sidelines.