This article is the first in a series of articles about TerraForm Power Inc. (NASDAQ:TERP) and NRG Yield (NYSE:NYLD), the Yieldco IPO spinoffs from SunEdison (SUNE) and NRG Energy (NYSE:NRG) respectively. In this article, we cover the basics of the Yieldco, and in subsequent articles, we will discuss the investment thesis of NRG Yield and Terraform Power. We will end the series with discussion of the impact of these yield vehicle spinoffs on the parent companies NRG Energy and SunEdison.
In the current low interest rate environment, there is an enormous investor appetite for high yield instruments. Investors are chasing yield to a point where highly speculative instruments are being snapped up at incredibly low interest rates. Much has been written about this topic, and it is disturbing that we have now gotten to a point where CCC bonds yield around 8%. This shows a complete disregard for long-term risks and makes it tough to argue that we are not in the middle of a debt bubble. If history is any indication, this debt bubble will not end well.
Yieldcos have risen in popularity in 2013-14 by catering to the needs of yield chasing investors. One of the perceived safe bets for yield chasers are investments in power generation, particularly renewables. At a time when demand for Greek debt exceeds supply, it is understandable why investors would chase the utility segment.
Unfortunately, it is in this negative macroeconomic context that we talk about Yieldcos. So, what is a Yieldco?
A Yieldco is an entity created to own and operate consistent cashflow generating assets providing predictable income to shareholders. In this regard they are similar to REITs and MLPs. REITs and MLPs are more tax efficient than Yieldcos but are deemed unsuitable for renewable energy generating assets due to tax/regulatory issues.
In theory, Yieldcos are particularly well suited to the energy industry because of the industry's historic track record of safe and predictable cash flows. In the context of solar projects, Yieldcos can take advantage of tax credits and accelerated depreciation to shelter earnings at the corporate level and help reduce or eliminate taxes on its distributions. This tax shield reduces or disappears as the tax benefits of the existing assets are exhausted.
To maintain the tax shield and to increase investor returns, a Yieldco company needs to constantly add new assets with tax credits and depreciation to its portfolio. Yieldcos also need new projects to replace revenue streams from atrophying or obsolete assets. Consequently, a key success factor for any Yieldco is its access to a steady pipeline of new projects available for purchase.
The need for initial assets as well as the need for ongoing "dropped in" assets means that Yieldcos can benefit from a reliable project development sponsor. NRG Energy and SunEdison, with their massive project ownerships and development pipelines, are two such capable sponsors.
At the inception of a Yieldco, the parent company sponsor sells some of its project assets to the Yieldco at a pre-negotiated price. To ensure a steady project flow, a Yieldco typically obtains the right to acquire additional projects from its sponsor parent, providing it the necessary deal flow to generate additional tax credits and accelerated depreciation, and to grow its dividend.
For a project developer like SunEdison, the risk of a solar project is bimodal. There can be substantial delays and cash flow impacts on a project during the process of developing, permitting, interconnection, financing and customer procurement. However, once the project is operational with a long-term PPA from a creditworthy customer, the project is considered low risk. This perceived risk profile makes these solar projects highly suited for a Yieldco.
The drop in needs of the Yieldco also provide the project developer a reliable source of low cost public financing for future projects. During the capital-intensive development stage, having a known built-in source of low cost financing can considerably reduce the cost of building solar projects and can help accelerate the project developer growth rate.
Prior to the arrival of Yieldcos, private buyers of solar projects valued solar projects by discounting the solar project cash flows by a high single digit or a low double digit number. Investors in a Yieldco such as NRG Yield, on the other hand, seem to be content with a yield below 2.7%. SunEdison hopes to exploit this yield expectation disparity by selling its projects at a much higher average selling price to TerraForm Power Yieldco than what would have been possible with private utility scale project investors.
Investors should note that the difference between the discount rates of a private investor versus a Yieldco investor tends to increase as the size of project decreases. In other words, a DG project developer is likely to gain substantially more by selling its projects to a Yieldco than a utility scale developer. SunEdison, with its large portfolio of DG assets, is likely to sell its much smaller DG projects to TerraForm Power at much more advantageous prices than what is possible in the private market.
These industry dynamics favor the project holders and project sellers immensely. With the arrival of Yieldcos and the increased project prices, private investors who in the past bought renewable projects from early stage developers are now in the market to sell their assets at the inflated prices offered by Yieldcos.
However, by far the biggest winners in the creation of Yieldcos are the parent project sponsors. The Yieldco effectively becomes a captive high price buyer for the sponsor's existing projects and projects under development. NRG Energy and SunEdison will not only be able to sell their projects to the captive Yieldcos but they can also buy third party projects at a low cost and resell them to the Yieldco at a good markup - a nice arbitrage opportunity!
This dynamic brings us to a key risk of the Yieldco. There is a clear conflict of interest in this model between the Yieldco and the sponsor. In an ideal environment, the Yieldco should purchase its assets at as low a cost as possible. The sponsor, on the other hand, needs to sell its projects at as high a value as is possible. Given the Yieldco is an IPO from the sponsor and is dependent on the sponsor for many business needs, we have little doubt that the sponsor companies are likely to be the ultimate beneficiaries at the expense of the Yieldco investor. We believe that credit agencies like Moody's are misinformed in viewing the Yieldcos as credit negative for the sponsor.
Call us skeptical, but we view the current Yieldco exercises as efforts by sponsor companies to maximize their near- and mid-term profits and socialize the losses through Yieldcos. The risks of these Yieldcos will not come to the forefront until many years down the road, by which time the sponsors' share of the Yieldco would have dropped substantially and the risks will be borne by the Yieldco public shareholders. This is a pure and simple case of sponsor companies taking yield-chasing investors for a ride.
An increase in interest rates is the other big risk to the Yieldco investors. The Yieldco model is built on the premise of low long-term interest rates and when that premise is broken, the entire business model may fall apart, leading to disastrous results for long-term investors.
The constant flow of 'drop-in' assets from the sponsor or third parties holds the promise of increasing dividends and stock appreciation for the Yieldco investors. Having bought into these growth expectations, investors buying the Yieldcos are willing to accept a lower dividend yield in return for stock price appreciation. As a proof that investors are buying this line of thinking hook line and sinker, the yield on NYLD is currently at 2.7% - well below that of many utilities. We are not sold on this premise especially in context of the risks faced by the Yieldco investors.
In light of the current debt bubble, we hope that we have dissuaded the long-term investor from considering any Yieldcos including TerraForm Power and NRG Yield. For an investor still interested in these Yieldcos, we will discuss the details of specific industry risks and other risks of these companies in future articles.
Our Sentiment on NYLD: Avoid
Our Sentiment on TERP: Avoid
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.