Tag Archives: industry

High-Yield Utility That Has Fallen Off Everyone’s Radar

Summary Brookfield Renewable Energy yields 6.6%, over 1.6% higher than the typical utility that yields under 5%. The company is riding on the mega-trend train of a global growing demand in renewable energy, and the business has the expertise to bank on acquisition opportunities. The business forecasts dividend growth of 5-9% per year through 2020 and a long-term shareholder return of 12-15%. I’m primarily a dividend growth investor. So, current income and growth of that income is important to me. Utilities are typically known for their high yields. So, buying utilities, I expect a good part of returns to come from their dividends. The lower the price goes, the higher the yield climbs. That’s the case with Brookfield Renewable Energy Partners LP (NYSE: BEP ), as it has fallen over 18% from a year ago. (click to enlarge) Compared to most other popular utilities, Brookfield Renewable has performed quite poorly price-wise in the past year. Particularly, I’ve put it in a chart with Consolidated Edison, Inc. (NYSE: ED ), Duke Energy Corp (NYSE: DUK ), WEC Energy Group Inc (NYSE: WEC ), and Southern Co (NYSE: SO ). Source: Google Finance The utility group typically yields in the 4-5% range, and Brookfield Renewable stands out by yielding 6.6%. But, perhaps, that’s because it is viewed as higher risk with an S&P credit rating of BBB, while the others all have a rating of A-. BEP Dividend Yield (TTM) data by YCharts To consider it as a potential utility holding, the question you want answered is probably: “Is Brookfield Renewable Energy’s distribution sustainable?” First, let’s find out if it’s the kind of business you want to own. Business and Assets Brookfield Renewable has started investing in hydropower facilities 20 years ago. Today, it has become one of the biggest public pure-play renewable businesses with global assets. It focuses on accumulating long-life and low-cost assets that will continue generating cash flows. Since it requires deep operational knowledge and marketing expertise to enter the space, there’re significant barriers to entry. Brookfield Renewable has $19B worth of power assets, including around 250 power generating facilities across 14 markets in 7 countries. 81% of its 7,300 MW capacity is generated by hydroelectric facilities with about 18% generated by wind power. Currently, 50% of its assets are in the U.S., 25% are in Canada, 20% are in Brazil, and 5% are in Europe. Not Just an Income Play, But Also a Growth Play Demand for renewable energy has been growing. New investments in renewables around the globe have grown from $45B in 2004 to $270B in 2014, a CAGR of 19.6%. More recently, from 2013 to 2014, they grew at a rate of 16.4%, which is still admirable growth. Specifically, hydro power capacity grew at a CAGR of 4% over the decade, and 3.6% from 2013 to 2014. Although its growth only keeps pace with inflation, hydro power generation is low cost, and is more reliable than wind power generation. On the other hand, wind power capacity grew at a CAGR of 22.7%, and 16% from 2013 to 2014. In the last four years, Brookfield Renewable acquired and developed about 3000 MW, which is a CAGR of about 14%. How Does Brookfield Renewable Grow? Over the next 5 years, Brookfield Renewable plans to deploy over $3 billion of equity, expecting 15% returns. The focus will continue to be on hydro power generation, and acquiring global renewable assets at attractive prices. For example, in 2004, Brookfield Renewable acquired a 600MW capacity pumped storage asset with its 50% joint partner during a period of low power prices for $99M. It then entered into a 15-year contract that creates a predictable cash flow stream. At the same time, it’s not shy from selling for good profit as well. For example, in 2009, Brookfield Renewable acquired an early-stage wind power development project for $90 million. It finished constructing it and optimized operations by leveraging its wind expertise to maximize value. In July 2015, it sold the asset by attracting global bidders and generated an internal rate of return of about 30%. Like it did in North America and Brazil starting in 2011, Brookfield Renewable can continue its value creation process and repeat it in Europe, Latin America, and other new markets. A Safely Growing Dividend As Brookfield Renewable grows, it doesn’t forget to reward shareholders. From the distribution that commenced in 2011, it has grown from a quarterly distribution of 33.75 cents per share to 41.5 cents per share this year, a CAGR of 5.3%. About 90% of Brookfield Renewable’s cash flows have a 17-year average contract term with inflation-linked escalation, so its cash flows remain stable to support its distributions. Further, it targets an FFO payout ratio of 70%. With FFO expected to increase by $220-$280M a year, Brookfield Renewable forecasts distribution growth of 5-9% per year through 2020. Valuation Brookfield Renewable believes it’s intrinsically worth $34 a share even when excluding potential for rising prices, and existing project pipelines. At $25, it is discounted by over 26%. Adding in organic growth, the business believes it’s easily worth over $40 in the future, implying a significant discount of over 37%. (click to enlarge) Source: Brookfield Renewable October Investor Meeting – Slide 35 What Should Be Your Returns Expectation? Other than forecasting distribution growth of 5-9% per year through 2020, the business’s objective is to deliver long-term total returns of 12-15% to shareholders annually. With a current yield of 6.6% and the distribution estimated to grow at least 5%, that implies a rate of return of at least 11.6%, which is close to the low-end of that objective. Conclusion I just added to my position in Brookfield Renewable last week. How about you? Did you buy any utilities recently? Share in the comments below! If you like what you’ve just read, follow me! Simply click on the “Follow” link at the top of the page to receive an email notification when I publish a new article. Resources and References Brookfield Renewable October Investor Meeting ( pdf ) Brookfield Renewable November Presentation ( pdf ) Ren21 Renewables 2015 Report ( pdf )

Dynegy: Too Early To Buy

Summary Dynegy shares have been cut in half in 2015 as investors run for the exits. While metrics are improving, the company still doesn’t generate significant operational cash flow. Additionally, I have concerns over whether cash flow problems have impacted the company’s ability to properly maintain its assets. It’s still to early to buy. If you really want a piece of this company, buy the preferred shares instead. Dynegy (NYSE: DYN ) is a holding company that owns a large portfolio of power generation assets throughout the United States, with a heavy concentration of these assets located in the Northeast and Midwest. The company operates regulated utility operations while also competing in the wholesale electric business, where it provides electricity to utilities, power marketers, and industrial customers. Unlike traditional regulated utilities that are the sole source of power for their customers, the wholesale market pits many players against each other in the name of driving down costs. Dynegy operates approximately 26GW of generation assets, with the vast majority of production evenly split between modern combined cycle natural gas plants and legacy coal plants. In acquiring and developing these assets, the company has had both an interesting and volatile past. Dynegy emerged from bankruptcy in 2012 with a little help from the renowned Carl Icahn , only to make a $6.25B acquisition (12.4GW) of coal and gas-fired assets from Duke Energy (NYSE: DUK ) and Energy Capital Partners just a few short years later in 2014. While the debt load may appear large given the company’s size and recent bankruptcy, the acquisition was viewed favorably by most ratings agencies in regards to improving earnings by acquiring some retail regulated business. However, this debt didn’t come cheap – weighted average interest rate of the debt was 7.18%, quite high given our current position in the interest rate cycle. Operating Results (click to enlarge) As one of the largest merchant energy providers using natural gas, you might expect operating results to have been a little bit more favorable than this post-bankruptcy. There are some sparks of improvement for investors to grab on to, such as improving gross margins. The retail Duke Energy/Energy Capital Partner assets have improved the company’s margin profile, and spark spread improvements due to collapsing natural gas prices have also boosted margins. SG&A expenses have also grown quite slowly, indicative of the scale that is present in many utilities. Bigger is generally better in this sector. Like the income statement, cash flow generation hasn’t been much better. Dynegy generated negative operational cash flow in 2013 and 2012, and was only generated marginal cash flow in 2014. 2015 is set to be a better year, but the company still struggles to generate enough cash to sustain itself. Through this point in 2015, the company has barely spent any money at all on capital expenditures ($500M over three and a half years). Even after taking into account the change in the business from the acquisition, this still seems woefully low. Great Plains Energy (NYSE: GXP ), another company with heavy coal exposure and nearly identical enterprise value, has averaged $600-800M in annual capital expenditures. I’m not sure I buy into just $130M in capex to support the company’s 16 power plants in 2014. This company is a long way away from supporting itself from a cash flow perspective, never mind instituting a dividend that can be healthily supported. I do like the company’s natural gas operations. Citing industry trends, management itself notes that it expects ~50GW of coal power plants to be phased out of markets that Dynegy competes in due to a variety of factors, such as falling natural gas prices, increased capital expenditure requirements, and burdensome regulatory costs. However, I can’t help but feel this leads to a negative in and of itself as well. This bullishness on natural gas generation seems to run contrary to the assets picked up from the Duke Energy deal, as a sizeable (roughly 40%) portion of those assets were coal-fired. Duke Energy has been reluctant and slow to shift generation away from coal, and while these were non-core assets for Duke Energy (the company has decided to focus on its East Coast operations), Duke Energy management wouldn’t have taken a poor deal just to dispose of these assets. Conclusion Dynegy is too early in the turnaround stage for me to recommend it, and it is too early to go bottom fishing, despite the stock getting halved in price in 2015. While I’m not going to call it a short (I would have six months ago), the company is still years away from being what investors want in a utility: consistent cash flows, a healthy dividend, and a fair valuation. The preferred issue is probably the better play here if you’re deeply interested in the company. The preferred currently yields 8.49%, and is convertible into 2.58 shares of Dynegy if you choose to later on. At $59.22/preferred share at this point, if this thing ever does recover, you’ll be sitting pretty and will have been paid a healthy dividend to boot while you wait.

Why I Sold Pimco High Income Fund

Summary PHK has managed to attract a premium near its historical average before its dividend cut. Although another cut is unlikely in the near term, the current premium is overly generous. Historical price trends have created clear buy and sell signals which indicate PHK is too pricey at its current premium. However, if PHK can continue its recent and opaque increase to NAV, a new higher price target may be in order. Pimco High Income Fund (NYSE: PHK ) consistently paid out the same dividend for over a decade, until a 15% cut that management insisted was reflective of the secular stagnation argument for lower global growth that has come to quietly dominate many economists’ thinking. In management’s words: “Generally, the changes in distributions for PHK, PCI and PDI take into account many factors, including but not limited to, each such Fund’s current and expected earnings, the overall market environment and Pimco’s current economic and market outlook.” The market’s response was unsurprising – the fund reached a 52-week low of 6.87 and saw its premium to NAV – once the highest in the CEF universe – fall to zero. This was a tremendous buying opportunity and I heavily added to my position before encouraging investors to not worry about a dividend cut anytime soon . A dividend cut remains unlikely. Since October, the new payout has remained steady. In November, NII covered distributions by 92%, and NII has remained just a hair under 10 cents since April, when NII fell precipitously to about 7.2 cents per share, as it also was in March and January. 92% is still not full coverage, leaving some investors concerned about PHK’s future payouts. However, PHK is preparing for an interest rate hike and the ability to buy new issues at new, higher rates. Prepping for the Rate Hike The duration of PHK’s holdings has fallen to 4.7 years as of the end of September, down from over five years earlier in 2015. The fund has been cutting the duration of its holdings for a long time in anticipation of raising rates, which actually hurt performance in 2014, as management acknowledged in its semi-annual report from September 2014 – and which management attempted to rectify by buying swaps: “Despite the Fund’s short exposure to the long end part of the curve, which has hurt the performance, overall increased duration exposure with interest rate swaps contributed positively to performance as Treasury rates declined.” Now the fund seems to be doubling down on its expectation of an interest rate hike. If Yellen does raise rates in December or early 2016 and high yield issues offer higher yields as a result, PHK will be able to churn into higher yielding debts and fully cover dividends more easily. (For more on how higher rates can be good for PHK, please see my two earlier pieces on the subject: Part 1 and Part 2 ). A Safe Payout – So Why Sell? The market seems to have accepted that PHK’s new distribution is about as safe as the old one, and may last just as long before being cut again. Yet I sold the fund because the market has overpriced the value of PHK’s new payout. As of November 25th, the fund’s premium over NAV was 24.65%, almost at the average premium the fund enjoyed over its lifetime before the dividend cut: In other words, the market is roughly pricing the fund’s ability to fund future payouts at the same premium as it has priced that fund’s future payouts before the dividend cut. At best, the market is punishing PHK with a premium that is 5% below its historical average. Is that sufficient for a 15% dividend cut? The Technical Concern There also is a technical argument to be made against buying PHK now – but keeping it on a watch list in the future. Since 2010, when the fund’s premium to NAV remained sustainably high, PHK has followed a steady pattern of slow appreciation to a peak, followed by a decline, and then a steady appreciation again: (click to enlarge) This pattern held for most of 2014 until the high yield market began to see serious risk aversion and a tightening of credit spreads at the end of the year, partly due to the strong dollar, partly due to rising oil prices, partly due to fears of collapsing liquidity, and partly due to fears of higher defaults resulting in an increase in interest rates: (click to enlarge) While I believe short-term speculation on asset prices is almost always a losing game, in the case of PHK the return to form seems to be congealing, and since the dividend cut the slow appreciation followed by a steep drop-off seems to be coming back to the name: (click to enlarge) However, we are currently not seeing a steep sell off as we did in the middle of September and earlier in November. This trendline, its historical performance, and its new payouts have all given me clear price targets to buy, sell and hold this stock which are currently telling me to wait until returning to the name. A Silver Lining? There is hope for PHK, however, which may help it close the gap on its current premium. In the last few days the fund’s NAV has shot up to its highest point since its dividend cut and the first sign of an increase in NAV since the beginning of 2015: (click to enlarge) It’s unclear how the NAV for PHK shot up so quickly in such a short period of time. Because bonds, especially high-yield bonds, are particularly illiquid, this could be the result of a new mark-to-market for a holding that was temporarily mis-priced due to thin trading. Alternatively, it could be a result of a cumulative appreciation of the high yield market as the fears of earlier in the year briefly fade. A third option is that the fund made a new purchase that was particularly undervalued by the market. In any case, the fund’s NAV shot up after the spread between high yield and U.S. Treasuries widened, giving more opportunities for fund managers to find high-yielding assets to fund distributions: (click to enlarge) This could mean PHK will find more ways to increase its NAV and close that gap between its current premium and the premium that it deserves after a dividend cut. I will continue to watch PHK closely to see if its ability to increase NAV is sustainable, or if the market decides to under-price the fund again. Until then, I’m waiting on the sidelines.