- Regulated utilities have long been a staple of high income portfolios.
- Southern Company is one of the largest and most popular high-yield utilities, thanks to its safe business model and slow but steady dividend growth.
- However, there are plenty of other great utilities, including NextEra Energy Partners.
- Learn why this best in breed renewable energy utility is set up to crush not just most other utilities but the market as well in the coming years and decades.
- But also what risks investors need to keep an eye on.
That being said, the downside to this industry is that the biggest and most popular names, such as Southern Company (NYSE:SO), have relatively slow growth prospects.
Combined with declining yields in the past few years, courtesy of record low interest rates, this means that future total return potential from this industry is generally sub par.
Of course, that doesn't mean there aren't some much faster growing, exceptional high-yield, dividend growth opportunities.
Let's take a look at why income investors considering Southern Company might want to consider NextEra Energy Partners (NYSE:NEP), the gold standard of renewable energy yieldcos instead.
Southern Company: Solid Investment But...
Southern Company has become known for its slow but steady dividend growth, which has helped it to generate strong, peer and market-beating total returns over the long term.
Of course, in the last few years, shares have lagged both its utility peers and the S&P 500. However, management has a plan for turning things around.
The key to Southern's long-term strategy is to diversify into faster growing businesses but only those backed by long-term, fixed contracts.
Midstream Base Rate Growth
For example, as you can see, Southern Company expects to receive regulatory approval for 2.6% annual growth in its electric base rate.
However, thanks to the company's aggressive push into the midstream gas segment (pipelines), it can tap into a much faster growing market, one powered by America's fracking revolution and the continuing boom in natural gas production.
Combined with the company's planned $22 billion in growth investment through 2021, Southern Company believes it can achieve much stronger than average EPS growth, which bodes well for its dividend growth prospects.
While Southern Company's long-term prospects make it a safe long-term income growth investment, the fact remains that NextEra Energy Partners potentially offers high-yield investors an even better utility option.
That's because NextEra Energy Partners is the gold standard of yieldcos, which are essentially renewable energy utilities.
The way it works is that a yieldcos sponsor, general partner, and manager, in this case, NextEra Energy Inc. (NEE), America's largest clean energy provider, builds solar and wind projects, which it then contracts under very long (20-25 year) power purchase agreements or PPAs with other major utilities.
These long-term PPAs ensure a steady and long-term stream of cash flow from which NEP pays a generous and fast-growing distribution.
That in turn attracts income investors, who help the yieldco raise external debt and equity capital to keep buying NextEra Inc.'s portfolio of contracted solar and wind projects.
Meanwhile, thanks to NextEra Energy Inc. owning the 65% of NEP's units and 100% of its incentive distribution rights, NEE is able to recoup the cost of constructing its renewable energy projects while still benefiting from an exponentially growing stream of cash flow.
In other words, NEP and NEE have a symbiotic relationship that helps them both achieve industry leading growth, which results in excellent market beating total returns.
Better yet? Because NextEra Energy is the single largest renewable energy provider in the world, it has an enormous asset base which it can drop down to grow NEP's cash flow and payout.
And, thanks to NEE's agreement to lower its top IDR level to 25% from 50%, a move that will result in much higher profitability and faster growth for the yieldco in the future, NextEra Energy Partners now expects to grow its distribution by 12% to 15% for at least the next five years.
Strong Balance Sheet Helps Secure The Payout
|Utility||Debt/EBITDA||EBITDA/Interest||Debt/Capital||Current Ratio||S&P Credit Rating|
|NextEra Energy Partners||4.07||7.40||62%||1.83||BB|
Sources: Morningstar, GuruFocus, Simply Safe Dividends
Strong long-term growth potential is meaningless if a company has an overleveraged balance sheet that can result in a dangerous dividend or lack of liquidity.
Fortunately, while both Southern Company and NextEra Energy Partners have high debt loads, their strong recurring cash flow are more than enough to service their debts and short-term obligations.
That's why despite above industry average levels of debt, Southern Company continues to enjoy a strong investment grade credit rating and nearly $5 billion in current liquidity with which to invest in its ambitious growth efforts.
Meanwhile, while true that NextEra Energy Partners doesn't have an investment grade credit rating, it does boast the strongest balance sheet of any yieldco, including the lowest leverage ratio, strongest current ratio, and a very strong interest coverage ratio.
In addition, NEP has $445 million in current liquidity, meaning unrestricted cash and remaining borrowing capacity under its revolving credit facilities.
However, it's important to note that because of the yieldco business model, which is similar to MLPs in that most growth capex is funded with external capital, NextEra Energy Partners, also enjoys exceptionally strong access to cheap equity capital.
That's thanks to both its strong balance sheet, a general partner with the largest available credit facilities of any utility and its premium unit price; which has soared since the IDR was lowered to 25%.
|Source Of Capital||2017 Capital Weighting||Cost Of Capital|
|Retained Cash Flow||23.0%||0%|
|Weighted Average Cost Of Capital||100%||3.54%|
Specifically, that means that NEP's weighted average cost of capital or WACC is much lower than its return on invested capital or ROIC.
And, given the recent IDR decrease, NextEra Energy Partners' future ROIC is likely to rise to the 6% to 7% range, meaning that even though the unit count will rise over time, its cash available for distribution or CAFD (yieldco equivalent to free cash flow and what funds the payout) per unit should continue growing strongly.
That not only means a highly secure payout but also excellent long-term total return potential.
Payout Profile Reveals NextEra's Superior Total Return Potential
|Utility||Yield||Payout Ratio||10 Year Projected Payout Growth||10 Year Potential Annual Total Return|
|Southern Company||4.9%||84%||4% to 5%||8.9% to 9.9%|
|NextEra Energy Partners||4.0%||77%||12% to 15%||16% to 19%|
Both NEP and Southern Company offer very nice yields, compared to the broader market.
Of course, the long-term total returns aren't just based on current yield, but yield + dividend growth. That's why I'm so bullish on NEP, because while Southern offers a safe and steadily growing yield, NextEra Energy's overall payout profile is far superior.
Now, I realize that some readers will question my projection for Southern's dividend growth. After all, with management guiding for 8% to 10% annual net income growth over the next few years, shouldn't investors expect similar payout hikes?
Not necessarily. That's because in recent years, Southern's increased capex spending resulted in its payout ratio climbing substantially higher than the historic 70% to 80% range.
That means that even if EPS ends up rising very quickly over the next five years, management is likely to grow the dividend slower to allow the payout ratio to come down to safer levels.
Meanwhile, NEP, because of its payout ratio being lower and thanks to its 4 GW of dropdown candidates from NEE (which would grow its overall cash flow by 133%), offers some of best payout growth (and total return) potential of any utility you can find today.
Of course, in a rising rate environment, many utility investors are worried about valuation compression and what it could mean for short to medium-term share prices.
However, the good news is that when we look at the current valuation of NEP, despite the strong recent rally, units continue to look undervalued.
Valuation Remains Attractive
While Southern Company has underperformed most other utilities thus far in 2017, as well as the S&P 500, NextEra Energy Partners has been on fire.
That's due mostly to the IDR reduction and management's extending of its 12% to 15% distribution growth target to at least five years.
However, while many might consider such a strong rally a sign that NEP is overvalued, that isn't necessarily true.
|NextEra Energy Partners||4.0%||3.6%|
That's because, when we compare both Southern Company's and NEP's current yield to their historical norms, (as well as their industry peers) we can see that both appear to be trading at small but significant discounts.
|Utility||Forward Payout||Projected 10 Year Payout Growth||Fair Value Estimate||Growth Baked Into Current Price||Margin Of Safety|
|NextEra Energy Partners||$1.46||15%||$51.14||9.4%||28%|
Sources: GuruFocus, Management Guidance
And, when we take a longer, 20-year view, using a discounted dividend model, we can see that Southern Company is actually fairly valued, while NextEra Energy Partners is trading at a very large margin of safety.
That's because the current share price of Southern accurately prices in its likely future dividend growth. However, NEP's unit price is likely underestimating what the yieldco's enormous growth potential is capable of.
That means that Southern has essentially no margin of safety, making it only appropriate for those looking to open an initial position and then buy on dips.
On the other hand, despite a nearly 50% rally this year, NEP units remain attractive for both new and existing investors, though, obviously, adding on dips is a great idea as well.
Risks To Keep In Mind
While both Southern Company and NextEra Energy Partners will likely make excellent long-term income investments, there are several risks to keep in mind for both.
First and foremost with Southern Company is that management's capital allocation skills haven't always been the greatest.
One needs to only look at the Kemper fiasco or the $1.3 billion in cost overruns for its Vogtle 3 and 4 nuclear reactors to see that management's guidance isn't always that trustworthy.
As for the elephant in the room, rising interest rates, there's good and bad news on that front.
In fact, despite interest rates falling to their lowest levels in history, utilities have actually underperformed the S&P 500 quite badly in recent years.
Of course, correlation isn't necessarily causation, and so just because utilities as a sector last beat the market when rates were rising steadily doesn't necessarily mean that the same will happen this time, or for Southern Company in particular.
Source: Southern Company Investor Presentation
After all, Southern's above average debt load means that it will have to refinance $13.8 billion in debt in the coming five years which could result in substantially higher interest costs.
And, speaking of interest costs, we can't forget that there is the risk that the tax reform the White House is pushing could result in substantial harm to the regulated utility industry.
As you can see, an elimination of this deduction would result in a 6% reduction in Southern's EPS, representing about one year's worth of growth.
What about NEP? What risks should investors look out for there?
Well, there are three main ones to keep in mind.
First, be aware that as a yieldco, NEP's volatility is much higher than most regulated utilities, with a beta of 1.23 compared to Southern's 0.12.
That means that investors who can't hold through periodic strong downturns, such as retirees living off the 4% rule, might want to avoid the stock, lest you be forced to sell units at a much lower price to fund living expenses.
Next is the fact that, because yieldcos are passthrough entities, which like MLPs are forced to raise external capital to grow, there is a risk that NEP's future growth potential could become limited if its yield falls outside its "sweet spot" of 4% to 7%.
That is the range at which the current payout is generous enough to meet immediate income needs but still low enough that NEP's cost of equity is low enough to allow for accretive growth.
|Source Of Capital||2017 Capital Weighting||Current Cost Of Capital||Cost Of Capital With Interest Rates +2% and Yield 8%|
|Retained Cash Flow||23.0%||0%||0%|
Sources: GuruFocus, Management Guidance
For example, if the Federal Reserve is correct that interest rates will rise by 2% by the end of 2019, and NEP's yield were to decline to 8%, then its cost of capital would rise by 47%, potentially limiting its ability to grow fast enough to maintain its targeted payout growth.
That's not to say that this will necessarily happen. After all, with the IDR fee reduction, NEP's ROIC is likely to rise to 6% to 7% meaning that even in a rising rate environment, the yieldco could still grow.
However, the point is that a yieldco's ultimate growth rate, like MLPs and REITs, is dependent on volatile investor sentiment.
Finally, we can't forget that, while its PPAs are very long-term (average remaining length of 18 years), decades from now NEP will have to renegotiate its PPAs with third party utilities.
Given the rate at which solar and wind power prices have been falling in recent years (and are projected to keep declining), it's likely that future PPA prices will be much lower. That means that NEP will have to continue growing quickly in order to offset its future PPA resets.
Bottom Line: NextEra Energy Is The Best Way To Profit From The Green Energy Gold Rush And An Excellent Alternative To Traditional Utilities
Don't get me wrong, I'm not saying that Southern Company is a bad investment, or that if you own it, you need to run out and sell it all.
Rather my goal is to point out a high-quality alternative with a generous, secure, and fast growing payout, one that's likely to grow for many years or decades to come.
And, while NEP isn't necessarily suited for everyone, if you have a long-term investment horizon, or plan to live purely off dividends in retirement, then it likely represents one of the best high-yield utilities you can own.
This article was written by
Dividend Sensei (Adam Galas) is an Army veteran and stock analyst with 20+ years of market experience.He is a founding author of the investing group The Dividend Kings which focuses on helping investors safeguard and grow their money in all market conditions through the highest-quality dividend investments. Dividend Sensei and the team of analysts (Brad Thomas, Justin Law, Nicholas Ward, Chuck Carnevale, and Sebastian Wolf) help members invest more intelligently in dividend stocks. Features include: 13 model portfolios, buy ideas, company research reports, and a thriving chat community for readers looking to learn how to invest more intelligently in dividend stocks. Learn more.
Analyst’s Disclosure: I am/we are long NEP. 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.
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