Yieldcos Offer Very Attractive Opportunity In The Current Market

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Includes: ABY, CAFD, GLBL, NYLD, TERP
by: Deepak Kumar

Summary

Yieldco prices have declined along with other energy companies in spite of the very different nature of their underlying assets.

Several of these yieldcos are trading at a significant discount to book value now.

TerraForm Power offers a compelling opportunity at the current prices due to concerns over the issues with its parent company.

TerraForm Power is offering assets with stable and predictable cash flows at half of its book value and potentially can generate a 100% return with very limited downside risk.

The stock charts of yieldcos over the last two years provide some of the best proof of how inefficient capital markets can be. Yieldcos are comprised of assets with long-term contracted cash flows. How can the value of such assets fluctuate so much within such a short period of time?

I have been watching this development from the sidelines for most of the last two years. But with the recent decline in the share prices of yieldcos, I became interested in them and opened some positions. At current levels, most of these yieldcos are trading close to their book values with dividend yields in the range of 5%-30%, and some seem like good investment opportunities. Share prices for yieldcos have declined over last year along with other energy companies, but they have very little in common. Most of the assets in yieldcos are in the US and other developed markets and have almost no exposure to China-related concerns. Limited downside risks make these companies quite compelling for any investor in the current market environment.

TERP Chart

TERP data by YCharts

Before I go into the valuation of different yieldcos, I have outlined few basic points on these for those, who might not have followed this market in the past. You might want to skip next few paragraphs if you are already familiar with yieldcos.

Yieldcos

Yieldcos became the hottest thing in the renewable industry over the past year, and every developer was trying to create one to benefit from this trend. In the past, developed renewable projects were mostly sold to institutional investors (e.g., pension funds, insurance companies, and infrastructure funds). As markets for renewable projects grew, developers sought to create publicly traded companies comprised of these operating assets. This had the potential to increase developers' margins, as a potentially lower cost of capital can increase the value of these assets. A yieldco can potentially lower the cost of capital, meaning investors can benefit from higher diversification (thus lowering the risk from individual project) and liquidity. Also in the long term, this can expand the market size as a lower cost of capital allows for lower energy prices. You can read more on this here.

Dividend story

Yieldcos initially traded based on their dividend yield and projected dividend growth rate. Most of the sell-side analysts use dividend yield to derive the target prices for these yieldcos. Though investors have only been looking at current dividend yield and dividend growth rate, it is important to understand how these yields are generated and whether they are sustainable. In the past, most of the yieldcos traded below a 5% dividend yield as long as they promised double-digit growth rates. But with the recent decline in yieldco prices, most are now providing significantly higher yields.

Valuation of yieldcos

Typically the market value of a company depends on its capability to generate excess returns over its costs of capital. A company with higher return on equity compared to its cost of capital typically trades at some multiple of book value. To determine the market value of a yieldco, one needs to know its cost of capital and return on these projects.

A yieldco acquires projects either from its sponsor parent company or from other developers. Typical solar or wind projects in the developed countries (e.g., UK, Germany, and the US) generate around 7%-9% return on equity. Traditionally, these projects have been acquired by institutional investors (e.g., pension funds, insurance companies, and infrastructure funds focusing on renewable assets). Since a yieldco competes with these investors to acquire the projects, its return on equity can not be higher than this unless there is some synergy in owning large numbers of these projects.

For our analysis, we can assume that yieldcos can achieve around 7%-9% equity returns on these projects. Therefore a yieldco can trade on a multiple of book value only if investors in public markets require lower return on equity compared to the typical equity returns on the projects. To answer this question, we need to know the cost of capital for the yieldco and whether it can acquire projects with return on equity higher than its cost of capital.

Of course, some yieldcos have claimed they can. TerraForm Power (NASDAQ:TERP) claimed in its Q2-2015 earning presentation that its cost of capital is 7.3%. To calculate the cost of capital, TerraForm used standard CAPM model. I don't want to get into the academic discussion on the cost of capital for yieldcos, but it is certain that yieldcos cannot generate return on equity higher than 7%-9%. Yieldcos were trading earlier at a significant premium to book value. With low return on equity and share price at premium to book value, I did not bother to look into these companies. But after the recent fall in their share prices, several of these yieldcos are now trading below book value, and I think this has created some interesting investment opportunities. Below I have outlined the key risks of these projects to differentiate the risk profiles of various yieldcos in the market.

Risks with yieldco projects

Assets within a yieldco have two main risks: operational risk and contract risk. Operational risk can be attributed to the following key factors: technology, weather conditions and other unknown factors. For contract risk, the most important thing is the credit risk of the offtaker. But I think contract risk is also related to the difference in the wholesale prices and contracted prices for these assets. For example, the contracted price for a new wind farm is quite similar to the wholesale electricity prices. In case of a default by an offtaker of a wind farm, the wind farm can easily find a new offtaker at similar or wholesale prices. But for an old CSP project, which typically has a contracted price that is almost double or more than the wholesale price, it might be difficult to find a new offtaker in case of a default by the existing offtaker.

Among different renewable technologies, PV is the most robust technology with least operational risks. Solar irradiation varies very little from one year to the next. PV plants require very little maintenance. For old PV plants, the contract price is significantly higher than the wholesale price, and hence I will consider contract risk for these much higher than the new plants. In the last few years, a few countries (e.g., Spain and Italy) have changed the feed in tariffs retroactively for PV plants, and this has had significant impact on the returns from these projects.

For wind technology, we need to differentiate between onshore and offshore wind projects due to significant differences between them. Onshore Wind has the largest installed capacity among renewable technologies as of now. Onshore wind technology is quite advanced and robust as well, but involves more moving parts compared to PV plants and hence has slightly higher operating risk. Also wind speeds can vary significantly from one year to the next, resulting in significant variation in power generation in different years. But due to much lower prices, I think onshore wind projects have lower contract risk compared to other renewable technologies. For offshore wind projects, technology is less advanced and more expansive, resulting into higher operational and contract risk compared to onshore wind.

For CSP, we need to differentiate among two of the most commonly used technologies. Trough-based technology is quite robust and has been around for a long time, while tower-based technology is new and has much higher technological risk. CSP projects have higher operational risk and require much more maintenance than PV and wind projects. Most of the existing CSP projects have contracted prices that are much higher than wholesale electricity prices. CSP technology is still more expensive than other renewable technologies, and hence even new projects need to have high prices to be economically viable.

Summary of a few yieldcos

I have looked into a few of these yieldcos, and below is a short summary:

Company

TerraForm Power

Abengoa Yield (NASDAQ:ABY)

NRG Yield (NYSE:NYLD)

8Point3 Energy (NASDAQ:CAFD)

TerraForm Global (NASDAQ:GLBL)

Current market cap ($ B)

1.31

1.76

2.4

1.17

0.68

Book Value ($ B)

2.49

2.4

2.2

0.68

1.43

P/B

0.53

0.73

1.1

1.6

0.48

Dividend yield (based on last quarterly dividend)

14.9%

10.3%

6.8%

5.2%

28.7%

Location of projects

USA, Canada, UK, Chile

USA, Spain, Latin America

USA

USA

Emerging markets (India, China, Brazil and others)

Technology of projects

PV, Wind

CSP, PV, WInd

PV, CSP, Wind, Natural Gas

PV

PV, Wind, Hydro

Click to enlarge

I find TerraForm Power most compelling among these. TerraForm Global and Abengoa Yield have too much emerging market exposure. NRG Yield is also quite attractive given its 100% exposure to US-based assets and diversified portfolio. I will certainly consider it if it trades below its book value. 8Point3 seems expensive at current price levels, though from a technology and market perspective, it probably has the best portfolio. Also, it has two strong sponsors. If its market price declines, it can be quite compelling.

The share prices of all yieldcos have declined in last six months, but TerraForm Power's share price has declined significantly more than other yieldcos due to issues with its parent company, SunEdison (SUNE). Given all the liquidity and profitability issues with SunEdison, it is not clear if the company can survive through this crisis. This has certainly weighed on TerraForm Power's share price, and has created quite an attractive opportunity. Yieldcos have strong relationships with their parent companies, but their fate is not linked to those parent companies. Abengoa Yield has been doing quite well, while its parent company filed for creditor protection few months ago. Yieldcos were created to offer risk-averse investors an opportunity to invest in assets with stable cash flows without taking the risks related to project developers. The current market situation is certainly testing this hypothesis, and at least for Abengoa Yield, so far it has worked. I believe that TerraForm will also survive through the crisis at SunEdison, even if SunEdison does not survive.

Most of the assets held by TerraForm have fixed long-term contracts backed by credible off-takers. Since most of these are PV and Wind projects, the technological risk is quite low. With a large share of wind assets, contract risks are also low, as I discussed above. TerraForm still has two main risks: 1) It is possible that TerraForm overpaid for its projects, and 2) SunEdison tries to use TerraForm assets to survive through its current crisis. Looking at the current cash flow yield on the projects, it does not seem like TerraForm acquired these assets at inflated values. Also with the current discount to book value, I think there is enough margin of safety for this.

The risk of SunEdison using TerraForm for its own survival is certainly there. SunEdison recently changed TerraForm's management, and I think this risk has even increased now with fewer independent directors on TerraForm's board. But there is some good news. David Tepper recently built large position in TerraForm Power. He is pushing its board to be more transparent in its dealings with SunEdison. This certainly gives me some comfort. He is pushing the TerraForm management to act in line with TerraForm Power shareholders, and this certainly reduces the risk of TerraForm transferring value to its parent company at the cost of its shareholders. With TerraForm Power's stock trading at half the book value, I think it offers an attractive risk-reward opportunity at this point of time. As soon the clouds clear from its future, it could easily double in value, and while investors wait for this, it is going to provide a substantial dividend in the meantime.

Disclosure: I am/we are long TERP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.