The Greatest Gift a Parent Can Give
When we last checked in on NextEra Energy Partners LP (NYSE: NEP), the YieldCo subsidiary of utility super-giant NextEra Energy Inc. (NYSE: NEE), the once high-flying stock was heading back toward its all-time low.
Soon thereafter, however, NEP began a sharp reversal and is currently up 31% off of its trailing-year low, which it hit just two months ago.
Although we’ve long been skeptical of YieldCos, we added NEP to Utility Forecaster’s Wish List as it was approaching bottom. But we couldn’t quite bring ourselves to pull the trigger.
We’re kicking ourselves a bit for not taking advantage of the stock’s swoon. But even with the backing of one of our favorite utilities, NEP still has a lot to prove.
Better, But Is It Good Enough?
One of our misgivings was that the company was fresh off a string of earnings misses, falling short of analyst estimates by an average of 55.1% over the six consecutive quarters from the beginning of 2015 through the middle of last year.
It’s not unusual for newer entities—NEP made its market debut in June 2014—to have volatile earnings. In addition to operational snags, analysts are still wrapping their heads around a company’s earnings power, while executives are learning how to manage expectations.
But with so many earnings misses, we had to take Wall Street’s expectations of strong future earnings growth for NEP with an entire shaker of salt.
Since then, however, NEP has managed to beat earnings estimates by a wide margin, exceeding forecasts by 23.5% and 89.8%, respectively, during the third and fourth quarters. That’s not yet enough of a track record on which to base an investment, but the trend is finally heading in the right direction.
Another concern is that NEP has considerable leverage. Net debt to EBITDA (earnings before interest, taxation, depreciation, and amortization) stood at around 7.0 times at the end of the fourth quarter, while its debt-to-equity ratio is a similarly high 158.2%.
Our expectation is that an asset-dropdown vehicle like NEP should eventually see leverage decline as cash flows ramp up from new projects. We’re seeing some evidence of that, as both leverage metrics, though still elevated, have steadily declined over the past four quarters. Again, the trend is heading in the right direction.
There’s an additional nuance to NEP’s debt burden. The vast majority of the debt on the balance sheet is actually at the project level, not the holding company level, and much of it is limited recourse.
Furthermore, project-level financings are typically structured to align expected cash flows with interest payments. That gives us some comfort that NEP’s balance sheet is less heavily levered than it appears at first glance, especially given that most projects are under long-term contracts.
Given the prospect of a rising-rate environment, however, we’re less comfortable with the fact that so much of NEP’s debt is variable rate, which means interest payments on existing debt will head higher as rates rise.
Despite all these worries, NEP just became a much more compelling income investment.
NEE recently gave NEP’s investors a big gift, one that should boost cash available for distributions, thus powering long-term distribution growth.
Here’s how it works:
To incentivize NEE to make accretive drop downs, NEP pays incentive fees that are leveraged to the growth of its quarterly distribution.
Under the old regime, NEP had already hit what’s known as the high splits: 50% of all distributable cash above the quarterly distribution threshold of $0.28125 per unit was being kicked up to NEE.
But with NEP’s units no longer commanding a premium valuation, NEE would have difficulty using its subsidiary as a vehicle to monetize existing assets. And that’s much more important to NEE than incentive fees.
Dropdown vehicles typically fund the purchase of a parent’s assets with a roughly equal mix of debt and equity, so when unit prices hit the skids that makes it much more difficult to finance such acquisitions on attractive terms.
Consequently, NEE needed to do something dramatic to help give NEP’s units a boost.
To that end, NEE decided to modify its incentive distribution structure, so that NEP is only kicking up 25% of cash available for distribution above the quarterly distribution threshold of $0.3525. Not coincidentally, that threshold happens to be the level of NEP’s current distribution.
In other words, NEP’s value proposition just got a whole lot better for income investors. Not only will more cash be available to NEP’s unitholders, but the runway toward future distribution growth has been extended, while the need for dilutive equity issuances has been reduced.
NEP is now promising unitholders distribution growth of 12% to 15% annually through the end of 2022. The units already have a forward yield of 4.6%, so it’s easy to imagine how that distribution growth will compound the income received from this YieldCo over time.
We just need to see one more quarter of improvement—or perhaps one more sharp selloff—before we’re willing to make our move.
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