As has been established in the preceding blogs in this series, YieldCos offer investors high yield low-risk investment opportunity, and provide developers access to cheap capital to rapidly develop more renewable energy assets. Like the MLPs they are modeled on, YieldCos provide investors with steady stream of dividends. However, they go one step further by promising high dividend growth at the same time. This is evident from the fact that while the best performing MLPs provide 5-7% distribution growth [1], the best YieldCos targeted growth rates are of around 12-15%, as shown in the figure below. (Image Source : [1] )
In this blog post, we’ll look at how YieldCos manage their dividend payouts and answer the following questions:
- What strategies can YieldCos use to increase dividends year-on-year?
- Are YieldCos projected dividend growth rates unsustainable for long term growth?
- What steady dividend growth rates would be acceptable for the investors, and achievable by the YieldCo managers?
So let’s get to it!
How can the YieldCo increase dividends?
A typical company can increase its dividend per share by utilizing many techniques [2][3]. In this section we’ll evaluate how those techniques hold up for YieldCos, and if any combination of those techniques can result in a 12-15% dividend growth rate.
1. Normal increases in income from existing business
In the case of YieldCos, increase in income from existing businesses come from inflation escalation in the Power Purchase Agreements (PPA). However, these are typically 2-3% and therefore offer very little scope for increasing dividends year-on-year.
2. Reinvesting money generated by the business
Aside from the natural increase in cash flow from escalators in existing PPAs, a YieldCo can raise its cash flow available for distribution (CAFD) per share by increasing invested capital per share. This increases future dividends at the expense of current yield. However, since most YieldCos distribute nearly 80-90% of their available cash flow, this is not a significant contributor to dividend growth.
3. Buy assets at lower prices
The YieldCos can boost growth by getting continual access to good projects at lower enterprise values i.e. they can get higher rate of return on these projects. YieldCos build their pipeline majorly through ‘dropdown’ projects [4] – projects they get through Right of First Offer or Call Rights Agreement with their controlling sponsor (parent company, for eg. NRG Energy for the YieldCo NRG Yield), giving them early access to high NPV projects developed by their sponsor. However, in the past there has been notable examples of YieldCos (SunEdison and TerraForm) acquiring overpriced assets from their sponsor, jeopardizing long-term dividend growth. More transparency in asset selection process and robust methods can prevent this conflict of interest [5]. Undeniably, all successful YieldCos are successful because of their powerful and reliable sponsors. In summary, having a strong sponsor can help in getting continual access to good projects at lower enterprise values with certain precautions and oversight in project selection.
4. Issue debt instead of equity to fund their growth
Issuance of debt was a well exploited option in 2015, when the interest rates were low, and it helped achieve rapid scaling of YieldCos then. Today, rising interest rates make this option less attractive.
Issuance of debt was a well exploited option in 2015, when the interest rates were low, and it helped achieve rapid scaling of YieldCos then. Today, rising interest rates make this option less attractive.
5. Increase shares at constantly increasing valuations
YieldCos typically issue new shares to create capital for new acquisitions. Historically, this provided the YieldCos the ability to keep increasing their dividends even without retained earnings or great returns on investments. This weird trick is best summarized in this excerpt by Tim Konrad [1]
NRG Yield raised $11 per split adjusted share in its July 2013 IPO. In its July 2014 secondary offering, it sold shares at a split-adjusted $27 per share. Every dollar invested in the Energy Systems Company acquisition in 2013 produces 6.7¢ of annual cash flow. At $11 per share, that is 73¢ cash flow per share. In contrast, NRG Yield's 2015 investment in the second group of Right of First Offer (ROFO) assets from its parent, NRG, produces a very similar 7.3¢ per dollar invested. But the shares it sold in July produce $1.97 of cash flow per share when invested in the ROFO assets.
This trick would have led to an ever higher increase in dividends (the 12-15% rate) as long as the YieldCos share prices kept increasing. But if stock prices increase continuously it’s a bubble, and is unsustainable. YieldCos share prices have seen a roller coaster ride since 2015. In the good early days, YieldCos saw a rapid increase in their share price immediately after their IPO, providing them with lot of cheap capital to fuel their growth and fulfill their promise of increasing dividends every year. However, soon after, a drop in their share prices caused by a) aggressive capital raised by YieldCos and b) growing distrust in YieldCos due to SunEdison’s bankruptcy, put a question mark in their growth prospects.
This analysis shows that in the current market, with the stock prices still below their IPO levels and rising interest rates, there is not a lot of scope for the YieldCos to provide high dividend growth rates.
This leads to the question - can the YieldCos bounce back and deliver the combination of high yield and high growth they initially anticipated? In my opinion, the answer is no. Recent history has shown us that the YieldCo business model cannot support both high yield and high dividend growth rates, at least not at the 15% rates the YieldCos envisioned. We have already seen how the virtuous growth cycle fueled by higher and higher share prices [1] caused the YieldCos stock prices to fall on their faces. Since then most of the YieldCos are on the path to recovery, but it would be safe to assume that the investors wouldn’t fall for the ‘high share price driven dividend growth projections’ again. This would mean the share prices wouldn’t reach their previous highs.
Industry expert Tom Konrad [3] posits - “Toronto-listed YieldCo TransAlta Renewables has also returned to the capital markets by selling CAN $172 million of new equity in December (2016). Unlike American YieldCos, it never promised double-digit dividend growth, did not see its stock price spike during the bubble, and did not suffer a severe decline when the bubble burst.”
I understand that such simplistic generalization isn’t robust, but there’s definitely merit in this line of thought.
So then what dividend growth rate would be sustainable?
Despite their tumultuous history, YieldCos still have merit. They offer low risk long term cash flow investment opportunity to the investors. Konrad [5] believes that the investors “don’t want a stock price that fluctuates too much too quickly, they don't want a dividend getting raised really quickly because the YieldCos are selling lots of stock.” He posits “Both investors and management just need to stop focusing on dividend growth. A more rational growth rate for dividends would be 2% to 5%.”
What are the potential pitfalls of scaling back the dividend growth projections in the current market?
Historically, low rates have drawn income investors into alternative asset classes like YieldCos. However, could higher rates turn them back to the safety of CDs at US banks (with current rates around 2%) [3]? Would MLPs or other similar investment structures become more attractive at low dividend growth projections? I would like to open the conversation to all the readers!
References
[1] Tom Konrad, C. (2017). My Yieldco Raised Its Dividend With This Weird Trick. Seeking Alpha. Retrieved 17 April 2017, from https://seekingalpha.com/article/3216746-my-yieldco-raised-its-dividend-with-this-weird-trick
[2] Feeding the beast: are US yieldcos sustainable? :: Environmental Finance. (2017). Environmental-finance.com. Retrieved 16 April 2017, from https://www.environmental-finance.com/content/analysis/feeding-the-beast-are-us-yieldcos-sustainable.html
[3] How Much Can Clean Energy YieldCo Dividends Grow?. (2017). Greentechmedia.com. Retrieved 16 April 2017, from https://www.greentechmedia.com/articles/read/how-much-can-yieldco-dividends-grow
[4] M. Urdanick, "A Deeper Look into YieldCo Structuring," (2014) Retrieved 16 April 2017, from Available: https://financere.nrel.gov/finance/content/deeperlookyieldcostructuring.
[5] S. Kraemer, "US YieldCos Will Survive," (2015) Retrieved 16 April 2017, http://www.altenergystocks.com/archives/2015/10/us_yieldcos_will_survive.html.
YieldCos can't sustain a double digit growth rate in the long-term and at the same time constantly give big dividends to shareholders. Sustainable growth of an electricity generation company implies the reinvestment of cash flow in new projects, and the refurbishing and expanding of existing projects. The main reason for this is that the service life of existing electricity generation assets is limited, even if they last for 20 or more years.
ReplyDeleteSolar PV power panels are usually guaranteed for 25 years at most, with a progressive curve of degradation in performance [1]. Therefore, if a YieldCo that owns a solar PV power plant wants to keep growing, it must keep increasing the capacity of its generation assets, because the revenue stream will be affected by the lower electricity generation output year after year. And this is without considering the other big problem that a solar PV power plant might confront: lower (or even zero [2]) spot electricity prices without a PPA.
Maybe buying assets, like already commissioned power plants or turnkey projects, could be a feasible way of fostering the growth of the company. But to be actually useful for the YieldCo in the long run, they must be carefully evaluated and examined under the YieldCo´s strategy (not the parent's strategy). They can't be a burden for current operations, or compromise the existence of the YielCo per se.
I personally think that YieldCos are a useful vehicle for already established companies to carry on with riskier investments, as renewable energies can be. They allow consolidated companies to promote technology innovation by investing in new ventures. But in order to succeed in the long-term, YieldCos must not be squeezed to provide high returns to the parent company or high dividends to shareholders. Landing expectations of dividends and returns should be an important issue in the communications' strategy of the YieldCo. This would allow the YielCo to allocate part of their cash flow into new investments that nurture its long-term growth.
[1] Aarre Maehlum, Mathias. "The Real Lifespan of Solar Panels"(May 7, 2014). Retrieved from: http://energyinformative.org/lifespan-solar-panels/
[2] Dezem, V., & Quiroga, J. (2016, June 1). Chile Has So Much Solar Energy It’s Giving It Away for Free. Bloomberg News. Retrieved from https://www.bloomberg.com/news/articles/2016-06-01/chile-has-so-much-solar-energy-it-s-giving-it-away-for-free
“YieldCos offer investors a high yield, low-risk investment opportunity”. If this is true where do I sign up because I want a piece of the action. As an investor, I am highly skeptical of an investment with low-risk cash flows and high growth rates. Does it not seem somewhat contradictory to basic financial concepts?
ReplyDeleteMy understanding is that YieldCos provide a highly levered company an opportunity to, for lack of a better term, spin-off stable operations in exchange for present cash. In exchange YieldCo investors are compensated via dividends generated from power purchase agreements that, as you state, often have inflation escalators. This seems like a pretty reasonable exchange assuming the YieldCo shares are appropriately priced.
However, I do have some concerns regarding the stability of these dividends given that power purchase agreements can vary in duration. If they are anything less than the life of the asset investors can be exposed to substantial risk given that the steady stream of dividends is highly dependent upon electricity demand and, according a March 14, 2016 EIA report, U.S. electricity sales have declined in five of the last eight years. What does that predict for the future of large scale generation demand? It seems to indicate to me that future dividend payments could be anything but steady.
More important is the concept that YieldCos can facilitate continued growth through acquisition. Similar to the comment Ross made on last week’s post, I struggle to believe that YieldCos can create growth through acquisition. Value creation through acquisition can come in a few forms (1) the selling company is in distress and willing to sell at a discount, (2) the selling company materially underestimates the value of the firm, and (3) the acquiring firm can generate synergies. The first is uncommon and not a legitimate growth plan. The second would require the acquiring company to know more about the selling company’s assets or their market which is unlikely. The third option often comes in the form of overhead reductions or procurement savings, neither of which would be substantial in this case.
For the reasons stated above, I do not believe YieldCos can or should be anything but an opportunity for investors to secure stable, low-growth future cash flows valued at a discount by the Selling firm in exchange for present cash.
This really is an excellent blog post. It clearly identifies the hypothesis (high dividend / high growth / low risk), considers several potential sources for dividend growth, and finally provides a clear opinion - high growth rates do not appear to be sustainable in the market. I was particularly impressed that you didn't stop here, but you considered follow-up questions (what level is sustainable / what consequences would scaling back this structure have).
ReplyDeleteReading through the other comments as well, we all appear on the same page with respect to the long-term sustainability of a single YieldCo (we all recognize it becomes difficult to grow at high rates indefinitely).
I would add that from a company's perspective is it not necessarily a reason to move away from the structure altogether. YieldCos work as a financing structure, to me the key appears to be anticipating when growth slows and roll the structure back into the C-Corp (this obviously assumes the C-Corp is able to digest the tax impact etc.)
Nicely done. You’ve got a lot of moving parts. Comments on some below. I take your bottom line point that growing DPS can’t go on forever via growing equity issueance. The growth narrative is unstable and, moreover, not really necessary. Good line of inquiry.
ReplyDeleteForgive me for always saying this … but high dividend *distributions* are not necessarily high dividend *yield.* The latter reflects risk. If the risk is low the price will be high and the yield will be low.
Buy assets at low prices, dropped down from the sponsor. Kind of defeats the purpose … although if the sponsor has lots of LP units maybe not. Conflict between Yieldco LPs and shareholders of sponsor.
The Konrad “trick?” Is it really a trick? If you take as given growth in DPS, then, naturally, PPS will increase. This doesn’t necessarily mean high expected return (depends on the level of PPS). But why should you take as given growth in DPS? Is this circular? I think that it just boils down to what you have been rightly emphasizing …. a continual pipeline of NPV>0 projects. This is where the rubber meets the road and it is where the “unsustainability” must come from, if these things are indeed not sustainable.
Honestly … I think that the whole “low interest rates are bad news for MLP/Yieldco” thing is a bit of a red herring. True, higher interest rates increases everyone’s cost of capital …. the hurdle rate gets higher. But most of what we’re talking about here … at least from the point of view of investors … is the expected return *premium* over the riskfree rate, not so much the level of expected returns. If the short rate goes up, all asset prices fall somewhat, and then we’re back to the same old question … does the expected return, above the riskfree rate, justify the risk. What these MLP/Yieldco things should really be worrying about is that the risk premium goes up, not the riskless rate. The evidence is that the risk premium goes DOWN, not up, as the short rate increases at the top of the cycle.
Grading Rubric (badly formatted because comments don’t allow formatting)
Possible “grades:” Excellent (E), Very Good (VG), Good (G), Could be Better(CBB)
Takes a clear position: VG
Substantiates the position: G
Informs the casual reader: VG
Clarity/quality of exposition: G