This is our seventh article in a series of articles about Yieldcos - specifically TerraForm Power (Pending:TERP) and NRG Yield (NYSE:NYLD). For an introduction to Yieldcos and our view of the energy industry, please refer to the previous articles here, here, here, here, here, and here.
In the last article, we started looking at the S-1 of TerraForm Power - an IPO spin-off of SunEdison (NYSE:SUNE). In this article, we continue the review of the TerraForm Power S-1 and offer our view on the valuation and the risk factors.
One of the fascinating observations we have about the TerraForm Power IPO is the sheer number of "Risk Factors" - the S-1 has 40 pages of these risk factors. While some of these are boilerplate and some are related to the organizational complexity, there are several risk factors that we believe are worth investor consideration. A comprehensive review of the risk factors is outside of the scope of this article due to its sheer size, but we share our view of some of the more significant items below:
1. "Counterparties to our PPAs may not fulfill their obligations, which could result in a material adverse impact on our business, financial condition, results of operations and cash flows."
As we discussed earlier, counterparties not fulfilling their obligations is not a risk but an eventuality. The real question in this regard is what percentage of the assets is likely to be impaired. We would have much rather preferred the management to model a default rate and share the consequences than simply showing this as a risk.
2. "A portion of the revenues under the PPAs for the U.K. projects included in our initial portfolio are subject to price adjustments after a period of time. If the market price of electricity decreases and we are otherwise unable to negotiate more favorable pricing terms, our business, financial condition, results of operations and cash flows may be materially and adversely affected."
The UK portfolio constitutes about 14% of the total TerraForm Power MWs. While the extent of risk here is unclear, it is interesting that UK customers have written electricity price decrease clauses into the contract. This clearly runs counter to TerraForm Power's statement, "We expect retail electricity prices to continue to rise due to increasing fossil fuel commodity prices, required investments in generation plants and transmission and distribution infrastructure and increasing regulatory costs." Here, customers' contracts are showing that customers see possibilities diametrically opposite to TERP's claims.
3. "Certain of the PPAs for power generation projects in our initial portfolio and that we may acquire in the future contain or will contain provisions that allow the offtake purchaser to terminate or buy out a portion of the project upon the occurrence of certain events. If these provisions are exercised and we are unable to enter into a PPA on similar terms, in the case of PPA termination, or find suitable replacement projects to invest in, in the case of a buyout, our cash available for distribution could materially decline."
Per the S-1, this particular clause is related to contracts with CAP, a 10% customer, and several US DG customers. If the current yield-chasing trend continues, this risk is real. The customers in these cases may exploit the inflated Yieldco project pricing by exercising the purchase option and reselling their shares of the projects to TerraForm Power or a different Yieldco.
4. "Most of our PPAs do not include inflation-based price increases."
This risk factor is actually a positive, as the PPA pricing will correlate better with falling energy prices and reduce the risk of default. An inflation-based PPA would have a higher chance of default. However, the lack of inflation-based price inflation can be detrimental to the shareholder interests at times of high inflation or hyperinflation.
5. "A material drop in the retail price of utility-generated electricity or electricity from other sources could increase competition for new PPAs."
While this risk is stated in the context of competition for new PPAs, the much bigger unstated risk is the potential renegotiations and defaults of current PPAs.
6. "Our ability to grow and make acquisitions with cash on hand may be limited by our cash dividend policy."
This is not a risk factor as much as a statement of economics. In this regard, any money paid out to the sponsor as IDRs is money not available for the Yieldco or the common stockholders.
7. "If our subsidiaries default on their obligations under their project-level indebtedness, this may constitute an event of default under our Term Loan and Revolver, and we may be required to make payments to lenders to avoid such default or to prevent foreclosure on the collateral securing the project-level debt. If we are unable to or decide not to make such payments, we would lose certain of our solar energy projects upon foreclosure."
Investors who may have assumed all project debt is non-recourse should note that TerraForm Power uses non-recourse, limited recourse, and recourse debts for projects. To the extent that debt is not non-recourse, defaults of large customers could generate significant losses to the shareholders.
8. "Our ability to generate revenue from certain utility solar energy projects depends on having interconnection arrangements and services."
9. "For some of our projects, we rely on electric interconnection and transmission facilities that we do not own or control and that are subject to transmission constraints within a number of our regions. If these facilities fail to provide us with adequate transmission capacity, we may be restricted in our ability to deliver electric power to our customers and we may incur additional costs or forego revenues."
Under normal conditions, interconnection aspects should not be a significant risk. However, as the penetration of alternative energy rises, the owners of the interconnection and transmission equipment may strategically choose to not invest in the interconnections or use the interconnections as a point of leverage. We expect this risk to increase as utilities business models become threatened and as utilities look for ways to maximize their cash flows from their distribution/interconnection infrastructure.
10. "A significant deterioration in the financial performance of the retail industry could materially adversely affect our distributed generation business."
As we discussed in our last article, retail customers constitute a high risk over a 20-year span. As is common practice with commercial leases, defaults and renegotiations are virtually guaranteed in this segment (more so if the leases are above-market). We would have preferred to see this risk being modeled and assigned a reserve, instead of simply being stated as a risk.
11. "International operations subject us to political and economic uncertainties."
The international risks of solar projects are substantial. However, much of the solar opportunity is likely to be international, and it would make sense for a Yieldco to invest in international assets. To the extent that a Yieldco has international assets, investors must comprehend the risk and seek an appropriate return.
12. "We are exposed to foreign currency exchange risks because certain of our solar energy projects are located in foreign countries."
The risk of currency rate movements is real, and TerraForm Power intends to enter into hedging contracts to reduce the risk. However, any hedging is likely to be short term and any secular weakening of a foreign currency against the US dollar could depress long-term results. In this context, we observe that the UK pound, though relatively stable in the recent past, has been in a secular decline against the dollar for several decades.
13. "We may not be able to replace expiring PPAs with contracts on similar terms. If we are unable to replace an expired distributed generation PPA with an acceptable new contract, we may be required to remove the solar energy assets from the site or, alternatively, we may sell the assets to the site host."
Along with the declining cost of energy, there is a large obsolescence risk in the solar installations that companies like SunEdison have deployed to-date. Given the ongoing efficiency increases and cost reductions of solar technologies, it is extremely likely that the assets in the field today will have values close to scrap values by the time the current PPAs expire. In this regard, it would be appropriate for TerraForm to work with such an operating assumption, instead of showing it merely as a risk. This is likely to be one of the reasons why TerraForm Power will underperform in the later years.
14. "Our Sponsor will be our controlling stockholder and will exercise substantial influence over TerraForm Power, and we are highly dependent on our Sponsor."
15. And, "Our organizational and ownership structure may create significant conflicts of interest that may be resolved in a manner that is not in our best interests or the best interests of holders of our Class A common stock and that may have a material adverse effect on our business, financial condition, results of operations and cash flows."
At the time of the IPO, SunEdison will have a combined voting power of 94.9% in TerraForm Power. Given the inherent conflict of interest in the pricing and procurement of projects, we see this level of voting power as a negative to TerraForm Power shareholder interests.
16. "Market interest rates may have an effect on the value of our Class A common stock."
This is one of the biggest risks for not just TerraForm Power but any Yieldco shareholder. Given the current historically low yields, the common stockholders are taking considerable risk in terms of potential higher interest rates in the future. Higher interest rates not only depress the stock price but also affect the operational aspects of the Yieldco.
One could argue that the Japanese market has demonstrated that it is possible to have extended periods of low interest rates. While there is merit to this argument, this data point is isolated and the risks to investors at the current interest rates are substantial.
17. "If you purchase shares of Class A common stock sold in this offering, you will incur immediate and substantial dilution."
Per the S-1, the as adjusted net tangible book value of Class A common stock prior to the IPO is $7.45 per share. A $20 per share offering in this case dilutes the stockholders at IPO. The solar industry, while somewhat specialized, has low barriers to entry. Based on the industry data, we would argue that solar projects would be fairly valued at about a 30% premium to the book value. This level of premium puts the value of the IPO at about $10. We note that this valuation correlates with our yield-based valuation in the last article.
It should be clear to readers that we are highly skeptical of the TerraForm Power and the Yieldco model - especially in light of the low yields that the current Yieldco vehicles offer. The Yieldco model is rigged to the benefit of the sponsor and to the detriment of yield-chasing investors. To be an attractive investment, a Yieldco in the solar industry should have the following characteristics:
- A yield reflective of the asset risk - high-single digits for large utility-scale plants with solid customers, low-double digits for DG-scale plants with credit worthy customers, and a few hundred basis point premium for international assets.
- The Yieldco should also be independent from its sponsor, and not simply an avenue for the sponsor to get rid of its projects at high valuations.
- The Yieldco should preferably not have any IDRs
TerraForm Power has none of these characteristics. Given the risk of the asset base of TerraForm Power, and using two different valuation approaches, we see value in this IPO in the $10 to $11 range. Anything beyond that would likely yield subpar returns for a long-term investor.
However, the markets are irrational in the short term and, assuming the TerraForm Power IPO goes as planned, speculators may push the already high IPO valuation to a bubble level. Given the current market dynamics, shorting this IPO could be hazardous to the short-term financial health of investors.
We would strongly urge investors shun these Yieldcos, including TerraForm Power, and to consider other avenues for yield.
Our Sentiment: Avoid (at the stated IPO price)
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.