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Summary Attractive sustainable current dividend yield of over 8 percent; expected to increase by 31 percent next year. YieldCo sponsored by global engineering giant with a substantial pipeline of attractive acquisition opportunities. Solid diversified asset portfolio with stable cash flow and global exposure. Last week we brought readers an interesting opportunity with a renewable energy focused YieldCo in NextEra Energy Partners (NYSE: NEP ). With this article, we’re focusing on another YieldCo with substantial upside potential, along with a strong sustainable high yield dividend. This time, however, the company is more nuanced and has, in our view, a different risk profile than NextEra Energy Partners. However, we believe the potential upside with this company is significant and offers a great source of low cost diversification to an income focused portfolio. Abengoa Yield PLC (NASDAQ: ABY ) is a United Kingdom registered company that trades primarily on the NASDAQ. Abengoa Yield follows the typical YieldCo model for project developers: its sponsor, Abengoa SA (NASDAQ: ABGB ), wins contracts, develops projects and then the Yieldco has the opportunity to be the first bidder on these projects as they’re sold. The sponsor benefits by freeing up capital to pursue more development opportunities and investors in the Yieldco benefit by holding onto long-term stable cash flow generating assets that can be levered to produce a high dividend yield. The sponsor, Abengoa SA, is a global engineering company based in Spain whose expertise is primarily in the development of power projects. Its market capitalization is approximately $1 billion, with 2014 revenues of over €7 billion. As of the second quarter of 2015, the sponsor held a 51.1 percent interest in Abengoa Yield, though the company is targeting this to be reduced over time to a 40 percent interest. Unfortunately for Abengoa Yield, there are conflicting views on the financial health of the sponsor, with a recent upgrade by Standard & Poor’s in July offset by the news that Moody’s has put the company on credit watch in early August. Abengoa Yield PLC does enjoy a higher credit rating from Moody’s than the sponsor, indicating limited concern about the impact of a default or bankruptcy of Abengoa SA on the YieldCo’s immediate financial situation. However, there is no doubt that a default of the sponsor would have a considerable impact on the future project pipeline that the YieldCo has access to, and we believe that this risk is captured in Abengoa Yield’s lower valuation and higher yield. With the YieldCo business model, questions around governance are common. In the case of Abengoa Yield, we believe there are adequate governance controls in place to protect the interests of its shareholders. First, a majority of its Board of Directors are independent directors, independent of both management and of the sponsor company. The board must vote on any acquisition of assets from the sponsor and determine that the terms are set “no less favorable than terms generally available to an unaffiliated third-party under the same or similar circumstances.” These terms would be determined based on a market analysis of what similar projects would be priced at in the market. While the risk remains that the board could be swayed by influence of the sponsor, it would be at great legal risk to the independent directors and so we believe that this level of control is adequate. Further, there is an inherent control in the business model as the sustained ability for the YieldCo to raise equity in the market is based upon its ability to generate attractive cash flow returns. A poorly priced deal could hamper the YieldCo’s ability to attract equity financing in the future, harming the very purpose of the fund for the sponsor. Finally, in the case of Abengoa Yield, the sponsor does plan to dilute its interest over time to only 40 percent of the outstanding shares, handing majority shareholder ownership over to the public. In terms of its asset portfolio, Abengoa Yield is a highly diversified YieldCo, with assets ranging beyond just renewable energy on long-term contracts. In addition to solar and wind generation assets, the company also owns a conventional 300 megawatt gas plant, 1,100 miles of electric transmission lines and two water treatment facilities, along with a financial interest in a Brazilian electricity transmission project. The diversified nature of its assets is attractive, with many other YieldCo type models more focused on generation specific projects. All of these assets are backed by long-term contracts, most with investment grade counterparties, allowing Abengoa Yield to apply a significant degree of leverage through project financing. The average remaining contract life for the assets is 23 years. (click to enlarge) Source: Abengoa Yield PLC’s June 2015 Investor Presentation Along with the long-term, stable cash flow contracts, Abengoa Yield has also locked down O&M costs for all of its assets. This has generally been done through long-term inflation linked O&M agreements, primarily with Abengoa SA as the contractor. This provides cost certainty not only on the revenue side but also on the cost side, offloading operating and maintenance risks to the O&M services provider. This is a common practice in the YieldCo space, and Abengoa SA certainly has the skills and global reputation to be a strong operator of these assets. Abengoa Yield is still exposed to capital maintenance expenditures for its assets, however, and increasing capital maintenance costs could pose a risk down the line. In the medium term, however, we review this risk as small as most of the assets are fairly new in vintage and won’t be facing substantial overhauls for decades. In many cases, much of the return on and return of capital for a project is captured in its initial contract term, making maintenance and renewal of future contracts an option that the company can decide, or not, to exploit down the road depending on market conditions. Beyond the diversification in the types of assets of the company, the firm is also significantly geographically diversified. Its solar projects are split between the United States, Spain and South Africa, while its wind generation is located in Uruguay, its gas generation is in Mexico and its transmission assets are in Peru and Chile. Finally, the firm’s water treatment projects are in Algeria. Some of these jurisdictions certainly add risk to the company’s profile, but we also find the diversification to be encouraging in an industry where political and regulatory risk threaten companies with over-concentrated positions. We would expect further diversification of the company’s assets geographically due to the nature of potential push down projects from the parent, which truly operates in every corner of the globe. The firm’s assets are generally supported by long-term contracted cash flow arrangements. This enables the company to pay both a high dividend and maintain a significant amount of leverage. The firm’s cash flows are based 61 percent on availability, rather than production, and 93 percent of the cash flows are in US dollars, or hedged to US dollars through a swap arrangement with the sponsor. Further, less than 4 percent of contracted cash flow is from counterparties that have less than an investment grade rating. The combination of these factors provides a very stable cash flow base from which the company can support its high payout ratio dividend. In terms of future projections, the company has published some attractive but well supported numbers, with a projected 2016 exit dividend of $2.10-2.15 per share annualized. This would be a significant increase from the $1.60 per share paid today. The company then projects ongoing growth at 12-15 percent per year based primarily upon further acquisitions of Abengoa SA projects, potential third-party acquisitions and efficiencies. We think the long-term trend might be on the aggressive side of attainable and we reflect that in our valuation analysis further on this report. Source: Abengoa Yield PLC’s June 2015 Investor Presentation The YieldCo’s primary source of expansion projects is completed projects with contracted cash flows purchased from the sponsor. The firm has a Right of First Offer on all projects that Abengoa SA offers for sale, giving it the opportunity to participate in any potential acquisition from Abengoa’s substantial project list. The sponsor had a backlog of €8.8 billion, according to its first half 2015 presentation, with significant power and infrastructure projects under development that would be ideal assets for inclusion in Abengoa Yield PLC’s portfolio down the road. Previous asset sales occurred at a 15 percent IRR, which is a significant discount to Abengoa Yield PLC’s current return on equity as calculated in our valuation, offering the potential for accretive acquisitions at its current price. Positives Diversified Geographical Exposure: The variety of geographical locations represented in Abengoa Yield’s holdings is an attractive feature for a company of this nature. Having a variety of jurisdictional exposure limits the impact of any one country’s political or regulatory changes, which can have a significant impact on these types of assets. Despite the geographic diversification, the contracted cash flows for the company are primarily in US dollars or are hedged to US dollars and therefore the firm has limited foreign exchange exposure risk. Diversified Portfolio of Asset Types: The variety of assets held by Abengoa Yield is attractive for investors. We believe that the lower risk conventional gas generation and electric transmission assets act to reduce required equity returns for the firm overall and underpin the company’s stable cash flow profile. The renewable assets are well diversified themselves with a split between solar and wind projects of varying sizes. ROFO Agreement with Abengoa SA: The firm’s Right of First Offer arrangement with Abengoa SA is highly attractive on the basis that the sponsor has a significant pipeline of developed and in development projects that could be sold down to the YieldCo at an attractive price. We expect that Abengoa SA will overcome its liquidity crunch in the medium term and this project pipeline will be realized at its full value for the YieldCo. Conservative Leverage at Hold Co Level: The firm currently reports a net debt to cash flow available for distribution of 1.8x versus its target level of 3x. This offers some ability for the company to finance future acquisitions through additional debt, rather than the dilutive equity offerings which are too common in the YieldCo space. Risks Many Assets in Higher Risk Jurisdictions: Many of Abengoa Yield PLC’s assets are located in jurisdictions that pose higher business risks than assets in North America or Western Europe. While a concentration of assets in any one high-risk jurisdiction may pose a concern for us, having small exposures to numerous jurisdictions seems to offer a higher potential return, with minimal incremental risk on a portfolio basis. That said, if future acquisitions continue to build exposure in an existing asset location, or if the risk profile of future asset locations was significantly higher, this would materially impact our required equity return and valuation. Financial Health of the Sponsor: The conflicting views on the financial health of the sponsor, Abengoa SA, are certainly weighing on this stock. We believe that Abengoa SA has taken steps to address its financial situation but the outcome of this is uncertain. Further deterioration in the financial health of the sponsor may have a material impact on the availability of projects for Abengoa Yield to acquire through the ROFO agreement. Valuation One attractive aspect of a company that is primarily driven by its dividend and distributes nearly all available cash to shareholders is the ease in analyzing and comparing its relative value along with assessing its implied cost of equity capital. In the case of Abengoa Yield, our baseline assumptions are the lower end of 2016 dividend guidance of $2.10 per share, a 90 percent payout ratio and an 11 percent annual growth rate. Why do we reduce the expected growth rate below the guidance provided by the company? Our concerns about the sponsor’s financial health are not insignificant and any major liquidity crunches at the sponsor could impact the available project pipeline for future acquisitions by the YieldCo. We do believe that the higher growth rate could be obtainable, as demonstrated by the company’s ability to beat that growth rate in 2016, if the sponsor company can maintain an adequate pipeline of projects at a reasonable cost. Into the details of the valuation, based on the September 18 share price of $19.34, these dividend, payout ratio and growth assumptions produce an implied cost of equity of 23 percent on a free cash flow to equity basis, nearly on par with the equity cost of capital determined in our analysis of NextEra Energy Partners, but still significantly higher than Brookfield Renewable’s (NYSE: BEP ) 16 percent cost of equity. Importantly, this is also a significant discount to the typical sale price of these types of assets, with the recent purchases from the sponsor occurring at a 15 percent IRR. This is reflected in Abengoa Yield PLC’s current price to book of 0.88. Arguably, the lower risk transmission assets held by this YieldCo should reduce its cost of equity compared to a firm like NextEra Energy Partners, who has a more concentrated asset exposure. Over the longer term, we believe that these YieldCos will trend towards a more reasonable 15-18 percent return on equity. This is the basis of our base case scenario for Abengoa Yield PLC of $30.00 per share (at an 18 percent return on equity). This would represent an even 7 percent dividend yield in 2016, which is much more generous than the yield on the firm’s stock earlier in 2015, illustrating significant upside potential beyond our projection. Summary Overall, we believe that Abengoa Yield offers an attractive valuation and potential upside for a set of high quality power and infrastructure assets located in geographically diverse locations. Current drag from the financial situation of its sponsor has weighed on this price but we do believe that this simply offers an attractive entry point for long-term investors. We view Abengoa Yield as having a unique risk and return profile and offsetting highly attractive qualities that together make for a bargain priced addition to a diversified portfolio. Disclosure: I am/we are long ABY, NEP. (More…) 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. Scalper1 News
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