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The Long Case For NextEra Energy Partners

Summary NEP is a first-in-class YieldCo with robust fundamentals and a strong sponsor. The upside is driven by long term contracts from diversified energy projects, with double digit distribution growth. NEP trades at a discount to intrinsic value with upside of 55%. By Cillian Huang and Ryan Ren Rating: Buy Market Cap: $732.9M Price Target: $ 37 . 01 Shares Outstanding: 29.67M Price(10/23/2015): $2 3 . 9 5 52 – week High/Low: $48.23/$19.34 Potential Upside: 55 % Dividend Yield: 3.8% Investment Thesis Nextera Energy Partners, LP (NYSE: NEP ) is a growth-oriented Yield Co that acquires and manages clean energy assets with contracted long term cash flows. Affected both by macro market volatility and by sector factors, NEP is currently trading at a discount to its intrinsic value, presenting an attractive buying opportunity with an upside of 55% . We see NEP as a premier Yield Co with strong fundamentals bolstered by a portfolio of existing assets operated by topnotch operators; and by a slate of upcoming assets supported by the development capabilities of North America’s largest clean energy developer NextEra Energy, Inc. (NYSE: NEE ). Why Does The Opportunity Exist? Solid renewable s pipeline : Supported by its sponsor NEE, NEP has been provided with Right-of-First-Offer (ROFO) on a portfolio of clean energy assets that are currently being developed by NEE. NEE is the leader in the clean energy space. It has developed over 12GW of renewables and is the largest clean energy developer with 17% of the current market share. NEE continues to grow its renewable development pipelines, creating a visible stream of projects to propel NEP toward its growth target of 12-15% until 2020. Extended growth runway : NEP recently acquired NET Midstream, which owns and develops seven gas pipelines that are strategically located in the Eagle Ford play. The transaction is immediately accretive to shareholders and contributes approximately $150M adjusted EBITDA and $115M CAFD in 2016. Adding gas pipelines to NEP’s existing renewable portfolio offsets its exposure to resource variability caused by wind and solar. The transaction furthermore provides the platform for NEP’s future expansion into the gas pipeline space, considering NEE is building its presence in the business by developing three pipeline projects that would be dropped down to NEP. Robust renewable s growth prospects : The renewables have presented a robust growth path during the past decade. The momentum will continue with the improving renewable economics, the increasing Renewable Portfolio Standards, the enactment of the Clean Power Plan, and bipartisan support for extension of the production tax credit and investment tax credit. Viable Yield Co model : Yield Co’s growth is dependent on their regular access to the debt and equity market to fund projects acquisitions. Present market conditions have been adverse to the entire Yield Co space, making it challenging for Yield Cos to raise funds by issuing equity that should fairly reflect fundamental values. However, we are confident in the validity of the Yield Co structure, as this model has worked successfully in the MLP space. With effectively managed cost of capital and solid project pipelines, we believe Yield Cos like NEP will continue to deliver stable cash flow in the long run despite a difficult short term trading environment. Proven management track record: The parent company NEE has provided NEP with a high quality management team with extensive experience in developing and financing clean energy projects. With prudent capital market discipline, the management team led by CEO James Robo has demonstrated a track record of success in delivering value to shareholders. Valuation NEP’s unit price has tumbled as a result of market concern over the Yield Co sector and negative market response to the NET acquisition. However, we still see NEP as a premier Yield Co with strong fundamentals. Ultimately, a Yield Co with high distribution growth, strong and stable cash flow, and efficient capital structure deserves high valuation. We reached the one year price target of $37.01 by blending two methodologies – distribution discount method and EV/EBITDA multiple method . Due to the recent financing need for the acquisition of NET Midstream and Jericho Wind Energy, the dilutive effect incurred by potential NEP’s equity issuance has been baked into our valuation models, increasing the total LP units from 93M to 96M. The DDM – Gordon Growth method reflects NEP’s robust distribution profile to satisfy investors’ appetite for income growth. Our view on NEP’s sustainable capacity to deliver growth is reinforced by NEP’s near-term execution on planned drop-down wind energy assets acquisitions and its long-term strategy to expand into the natural gas pipeline space. Supported by a deep assets pipeline developed by its sponsor NEE, NEP is on track to achieve 12.0% to 15.0% distribution per unit growth rate through 2020. In the DDM – Target Yield method, we applied the 2016 target yield to our 2016 estimated distributions per unit. We assumed NEP will maintain a 3.80% yield, which is in line with the pure play peers’ 2016 estimated average yield. Our EV/EBITDA Multiple starts with 2015 estimated adjusted EBITDA of $459.75 million that is driven by 2072MW renewables generation capacity with 19 years average PPA; and by the recently acquired 7 gas pipelines with aggregated capacity of 3 BCF/day binded to 16 years ship or pay contracts. Due to NEP’s stable long term cash flow and better growth prospects, we applied the median EV/EBITDA multiple of 15x derived from trading comps, reflecting a reasonable premium to NEP’s current trading multiple of 12x. Caveats Rising Interest Rates : Interest rates hike presents a downside risk by diverting yield-hungry investors to U.S treasury notes that offer competitive yield with lower risk. High interest rates further undermine NEP’s ability to maintain an efficient cost of capital due to the increasing financing costs. Unfavorable financial markets : The Yield Cos are vulnerable to volatile financial markets. Depressed share prices hinder the Yield Cos’s ability to accretively fund new acquisitions by issuing new shares. Conversely, a healthy financial market is advantageous to the Yield Co, making it easier to raise equity at a proper valuation. Unpredictable resource variability: Although all of NEP’s wind and solar assets are contracted with Power Purchase Agreements, the wind does not always blow and the sun does not always shine. Weak wind together with dimming sun diminishes cash flow estimates. Corporate governance : The sponsor NEE controls the major voting rights of NEP. Besides third party acquisitions, NEP’s growth is largely contingent on its ROFO rights to projects developed by NEE. This could present a risk to NEP’s shareholders when NEP is unable to negotiate favorable terms by catering to NEE’s interest. Conclusion We are confident NEP is the first-in-class Yield Co with robust fundamentals supported by its strong sponsor NEE. The upside is bolstered by contracted cash flow, double digit distribution growth, and experienced management. The downside is indicated by potential interest risk hike, unfavorable financial markets, and possible conflict of interests between NEE and NEP.

RSX Bear Thesis: What Worked And What Did Not Work

Summary RSX is down 10% since by initial bear thesis article was published in June. I can’t call it a success and I surely expected more downside. I discuss the reasons for this underperformance and the outlook for RSX. Back at the end of June, I published an article titled RSX: The Bear Thesis , where I outlined my thoughts about the direction of the Market Vectors Russia ETF (NYSE: RSX ). My main points were the weakness of the ruble, the poor state of the economy and bearishness on oil prices. I mentioned cheap valuations of Russian companies as the main factor for the bullish thesis, but stated that these valuations were chronic and that I did not expect them to provide significant support for RSX. How the thesis played out so far On June 26, when the initial article was published, RSX closed at $18.28. On October 27, RSX closed at $16.47, declining 10% from the day when the initial thesis was published. During this period, RSX was volatile: it touched lows of $14.00 and then rebounded to $17.81 before sliding to current levels. At the same time, USD/RUB, which closed at 54.78 on June 26, increased to 64.90 on October 27. Brent oil declined from $63.05 to $47.03. Thus, oil declined 25.5%, the ruble declined 18.5% and RSX declined only 10%. I can’t call it a bad idea but I’m a little bit disappointed because I expected more downside. I think it is time to revisit the thesis and see why it did not play out as well as I expected and whether there is still more downside possible. Why RSX gained more support than I expected I strongly believe that the lack of interest rate adjustment in the U.S. together with the monetary policy in the EU provided support for RSX. Tired of ultra-low (and sometimes negative) interest rates, investors decided to shop elsewhere. Also, Russia finally had its first capital inflow in 5 years, as money was most likely repatriated in fear of further sanctions. I’ve seen different opinions on why exactly Russia suddenly had a capital inflow despite no positive changes in economy, investment climate, etc., and I stick to my own view of repatriation of the capital. I must admit that you won’t get a firm data on this topic, so any conclusions imply some sort of speculation. The next thing is that the Russian government was willing to accept a lower ruble-denominated oil price. The ruble-denominated price is critical for the Russian budget, which is seriously dependent on oil income. However, the USD/RUB quote is followed by the majority of population during spikes. An increasing ruble is perceived as a sign of strength of the country, and the declining ruble is a sign of weakness. Therefore, everyone gets nervous when ruble devalues further. So, there is a kind of political “stop” to the rate of ruble’s devaluation even if it hurts the budget and the economy to some extent. When I was writing my initial article on RSX, the ruble-denominated price of oil was 3453 per barrel. Now, it is just 3052 per barrel. This is an 11% decline and I expect that the ruble-denominated price of oil will normalize closer to at least 3200 level. Ultimately, it is a bet on oil price direction Here are RSX top 15 holdings . Stock Weight Sector Surgutneftegaz ( OTCPK:SGTPY ) 8.69% Oil & Gas Sberbank ( OTCPK:SBRCY ) 8.22% Financial Gazprom ( OTCQX:GZPFY ) 8.04% Oil & Gas Magnit 7.97% Services LUKOIL ( OTC:LUKFY ) 7.89% Oil & Gas Novatek 5.83% Oil & Gas Tatneft ( OTCPK:OAOFY ) 5.47% Oil & Gas VTB Bank 4.93% Financial Rosneft ( OTC:RNFTF ) 4.83% Oil & Gas Transneft 4.00% Oil & Gas Mobile Tele Systems 3.94% Technology Uralkali 2.25% Basic Materials Yandex (NASDAQ: YNDX ) 2.21% Technology Polyus Gold ( OTCPK:OPYGY ) 2.20% Basic Materials Polymetal ( OTCPK:AUCOY ) 2.19% Basic Materials As you can see, most companies directly depend on oil and gas prices. The devaluation of the ruble gave them cost advantage, but at the same time they remain vulnerable to additional oil price downside. Financial and services companies will continue to feel pressure from the slowing economy. In my view, the more oil stays around $50, the worse the Russian economy will get. The head of VTB Mr. Kostin even made a remark ( Google translate link ) during the forum “Russia calling” that it made no sense to lend to small and medium businesses in the country. Of course he got bad media for this call, but truth is truth no matter how ugly it is – new businesses need growth prospects in order to survive, and these prospects are muted in the current environment. I believe that pressure on all non-energy and materials sectors will mount if oil prices stay where they are. RSX is mostly a bet on the energy sector, but the performance of other companies does matter as well. GDP continues to shrink along with domestic demand. Reserves has been stable in recent months, but the budget deficit will start eating the country’s reserves unless there is an increase in the price of oil. At the end, it looks like everything will mostly depend on the price of oil. If you believe in the oil price upside, you should buy RSX. If you, like me, think that there will be additional downside in the price of oil, then RSX is a short candidate. I think that currently neither investors nor economy is ready for Brent prices of about $40 per barrel. If we see this, RSX will likely retest its last-year lows.

ITOT: A Solid Core Holding For Building An Efficient Portfolio

Summary This ETF has a low expense ratio and looks like a solid option for a core position. As a total market ETF there is very little opportunity to modify exposures. Due to the sector allocations I believe the fund is best utilized when combining it with a small position in more specialized ETFs to tailor the sector allocations. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio for ITOT is only .07%. I tend to be very frugal with my expense ratios, so I like to see those low levels. There are a couple lower expense ratio ETFs in the categories of broad or total market, but .07% is still pretty good. Depending on where an investor does their brokerage, they may have incentives to use different ETFs to mitigate trading fees. Largest Holdings The following chart shows the largest holdings for the fund: These shouldn’t be a surprise since this is a total market ETF. The holdings across most total market ETFs will be very similar which gives investors a good reason to watch for high expense ratios, bid-ask spreads, and trading commissions to determine their long term costs. These allocations are subject to change, but I wouldn’t expect much in the way of change. Given the presence of such strong dividend champions at the top of the chart, investors might expect a strong dividend yield. Instead, they’ll find the yield is only around 2%. That’s no problem for most investors that would just reinvest their dividends anyway, but it may be less than optimal for investors in retirement seeking stronger yields to provide income without selling shares. Sectors The following chart breaks down the allocation by sector: The only sector I’ve been generally opposed to over the last several months has been telecommunications due to the aggressive price wars being waged. In this case the telecommunications allocation is just over 2.14%. In my view, that is a positive factor because 2.14% is a fairly low allocation for telecommunications among domestic equity ETFs. Using the holdings chart above, we can also determine that AT&T (NYSE: T ) and Verizon (NYSE: VZ ) combined to be about 1.92% of the portfolio, so most of the telecommunications allocation is right there. Energy Energy can be a fairly tricky sector because it can be referring to established champions like Exxon Mobil (NYSE: XOM ) or it can be referring to massively more aggressive plays such as off shore oil drilling. I like the fundamental premise of owning enormous producers of oil. If oil ever becomes irrelevant, it would be a very bullish sign for the rest of the economy pointing towards very low cost transportation and more capital available for spending on other goods and services. In order to hedge that risk, I want to see some of the established oil companies in the ETFs I use in my personal portfolios. I really wouldn’t mind seeing a higher allocation here so long as it was those established champions. They don’t have anywhere near as much upside as buying those drilling operations, but I am happy to sacrifice the upside to have dramatically reduced downside. Information Technology I know this is a growing part of our economy and it may continue to grow dramatically because information technology firms will generally have access to great economies of scale. I want some exposure to this part of the economy, but I wouldn’t mind seeing a slightly lower allocation because with great economies of scale comes the opportunity for earnings to get punished by a large drawdown in the economy or a black swan event. By definition, we won’t be able to predict black swans. However, I do believe we can estimate which industries have more exposure to those events. One Other Note There are 1509 holdings in this fund and it tracks the S&P Composite 1500 index. In my opinion a fund holding 1500 individual securities and tracking an index of 1500 securities is a broad market ETF, not a total market ETF. In my view any domestic ETF with fewer than 2000 holdings looks more like a broad market ETF than a total market ETF. Conclusion Overall this looks like a fairly good ETF. Since the ETF is going for a very low expense ratio and a passive style, there is not much to be done about adjusting the allocations. My preferred way to use an ETF like this would be to combine it with another more specialized ETF that placed a very high emphasis on my preferred sectors. When the investor combines the iShares Core S&P Total U.S. Stock Market ETF with another domestic equity fund they can look at the weighted average of the sector allocations which would be nice for building a very efficient portfolio.