Recently, NRG Energy (NRG) spun off some of its properties as a separate entity called NRG Yield (NYLD) in what’s termed a “YieldCo.” These businesses are designed like the master limited partnerships in the oil and natural gas industry, aiming to deliver predictable, long-term income to investors.
The YieldCo structure is fairly new for the electricity sector. Essentially, NRG will be “dropping down” power assets into it. A company establishing a YieldCo would initially seed it with existing, operating power or transmission assets and then grow the YieldCo portfolio through either the purchase of assets from other companies or the "drop down" of assets it has developed into the YieldCo.
The most attractive attribute of this structure is that YieldCos have long-term power purchase agreements with utilities or other customers that ensure consistent cash flows for the company and its investors.
Attractively, NRG Yield hold primarily renewable energy assets, allowing it to avoid the commodity risks faced by generators that rely on fossil fuels. How does the business look long term, and should you be interested as an investor?
The business
NRG Yield owns a diversified portfolio of contracted renewable and conventional generation and thermal infrastructure assets in the U.S. Total power output is roughly 3,630MW.
Each asset sells almost all of its output in long-term agreements with creditworthy counterparties such as utilities. The average remaining contract duration of these agreements is approximately 17 years.
Growth opportunities
NRG Energy retains a 55% stake in the business, so interests are aligned long term. The key benefit to this relationship is a reduced cost of capital. NRG Yield can leverage its parent’s size and extensive operating history to gain a competitive cost of capital, expanding growth opportunities through acquisitions and development.
Already, NRG Energy has identified over 2GW of power projects that are available to be “dropped down” to NRG Yield. This provides a reliable pipeline of growth projects. The following projects are expected to be “dropped down” this year:
While the initial dividend yield is fairly low (roughly 3%), the strong pipeline of future projects has allowed management a 15-18% annual dividend growth target over the next five years.
Long-term risks
While the company looks to be set for the next few years, there are a couple factors outside the company’s control that could dent long-term earnings and dividend growth.
- Rising interest rates – Currently, NRG Yield can arbitrage its extremely low cost of capital to buy projects with 6-8% earnings yields, making the difference between the two. If interest rates rise, margins fall as the purchase agreements with utilities take longer to reset higher. This could force NRG Yield to limit growth projects or pay more for the same output.
- Project longevity uncertainty – While we have significant amounts of operating data on coal, oil, and gas generators, the life cycle of a wind farm or utility-scale solar plant is less known. This poses a risk; if the health of the infrastructure degrades quicker than expected, the company may have to replace equipment at an additional cost.
Valuation
Shares surprisingly don’t look that expensive compared to Wall Street earnings estimates. This year, earnings estimates are for $0.71 a share, with a 5-year EPS growth rate of 24.7%.
Using GuruFocus’ DCF Tool, shares would be approximately 30% undervalued if these estimates prove correct. Given the certainty of cash flows and the existing pipeline of growth projects, they stand a good chance of being right.
Conclusion
At today’s close, the dividend yield is approximately 3.2%. Not only does the company have ample opportunities to grow this rapidly, but the price you’re paying for this growth doesn’t seem unreasonable at all. If you’re looking for a reliable income stream that should expand over the years fairly steadily, NRG Yield is for you.
For more ideas like this one, check out GuruFocus’ Spin-Off List or the rest of R. Vanzo’s Articles.
