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Considering the recent downfall in TerraForm Power stock levels we look at if it is worth investing in this security. We review various risk factors and our assessment on required yield based on the risk factors. Currently we view the valuation range of $17.50 to $20 subject to downward revision if Vivint Acquisition goes through. Over the last year, we have been consistently negative on YieldCo valuations and did not see a reason to invest in any of the YieldCos in the market. We were of the opinion that the market was mispricing risk in the long term assets held by these YieldCos. However, the yield bubble that we were in for much of the last year has caused many of the YieldCos to be priced at incredibly high valuations and consequently drove project developers like SunEdison (NYSE: SUNE ) go on an unsustainable growth path. One of the risks of this yield mispricing is that project developers counting on low yields tend to develop projects at unacceptably low margins. When yields rise, as they did recently, these developers find themselves cash strapped and with limited options on exiting from the projects under development. That is the quagmire that SunEdison finds itself in today. Companies affected by this same malady but to a much lesser extent, in an approximate order of declining risk, include SolarCity (NASDAQ: SCTY ), Vivint Solar (NYSE: VSLR ), SunRun (NASDAQ: RUN ) in the residential sector and Canadian Solar (NASDAQ: CSIQ ), SunPower (NASDAQ: SPWR ), Fist Solar (NASDAQ: FSLR ), Trina Solar (NYSE: TSL ) and JinkoSolar (NYSE: JKS ) in the large scale project sector. Of the above group, we are skeptical about the survival chances of the residential solar installers as their risks are far in excess of what the markets currently comprehend. Of the latter group, we believe the risk factors are more manageable given the manufacturing component of the companies, the much smaller project component, cost/margin advantage due to the use of in-house panels, and the location and returns of the assets under development. Of the solar asset holding companies, only SunEdison, First Solar and SunPower have their own YieldCos. When it comes to these companies many investors have tended to tie the performance of these sponsor companies with their YieldCos. As misguided as that line of thinking was, the markets and the Wall Street analyst community played a role in reinforcing that sentiment. However, we believe the time has now come to decisively cut the cord between sponsors and YieldCos and look at these companies separately and objectively. With this mindset, we now review the prospects for TerraForm Power (NASDAQ: TERP ). It should be noted that TerraForm Power has fallen from a peak of about $42 in April of this year to about $22 today – almost a 50% correction for a so called stable yield vehicle. At the current price, TerraForm Power yields about 6% on a TTM dividend basis and about 8% on forecasted 2016 dividend basis. Is the current stock price a reasonable approximation of the Company value? Or, conversely, is the yield level appropriate for this class of assets? To evaluate this, we believe one has to consider the risk factors of the asset base of the YieldCo and assess an appropriate risk/yield level. Our view of the required yields and risk factors are as follows: – To begin with, when it comes to energy assets, investors should note that not all solar asset classes have the same risk. We are of the opinion that, all else being equal, US utility assets deserve a discount rate of about 8%, US high grade commercial assets about 10%, and US residential assets about 12%+. – While TerraForm Power management prides in saying the YieldCo consists mainly of OECD assets and thus low risk, we believe investors should keep close tabs on the source of the assets. Not all OECD countries have similar currency and country risk profiles and some countries have a vastly higher set of risks than others. Several of the currencies have depreciated significantly vis-à-vis dollar and there is not much of a compelling story on why the trends should reverse. In general, assets from any country with likely future depreciation against dollar should cause the yield to increase. – Remaining life of the PPA is also a significant risk factor. With the rapidity of the changes in the solar industry, it is likely that some of the solar PPAs will not even be renewed. To the extant they are renewed, it is likely that they will be renewed at prices far lower than the existing PPA levels. – It is also likely that many of the assets would require significant upgrades for them to be renewed. For example, the utility or commercial customer may demand certain amount of dispatchability or a shaping of the energy. The capital costs required at renewal for any such changes and upgrades should be rolled into the IRR and yield calculations. – The rate of the PPA compared to the current market should also be a consideration. The larger the disparity between market and PPA rates, the higher the motivation for the customer to renegotiate and a chance that the asset may become distressed. – The potential for curtailment for each of the assets should be evaluated and discounted. – Wind resources, on the other hand, have a different risk profile than solar. Wind has an energy profile that complements the solar production and may end up holding up better in terms of PPA prices in the future. Wind resources may also likely need smaller battery support to make the power plant resources “pseudo dispatchable”. In other words, the wind assets may have a lower risk factor at renewal time than solar assets. – Investors should note that this is only a partial list of risks and any other risks specific to an asset or asset class should also be considered and impact evaluated While having a checklist can be useful, there are multiple challenges in evaluating the risks and costs we present above starting with disclosures. Even if the risks and costs can be reasonably identified, weighing of the factors is, at best, an informed estimate. When dealing with such unknowns, a reasonable safety margin is mandatory. Without using much scientific rigor in analysis, our estimate is that the current portfolio of assets in TerraForm Power need to yield at least 10% to provide a satisfactory risk adjusted return to investors. This, in turn, would imply that the valuation of TERP is likely around $17.50 a share based on forward guidance. Note that this valuation does not give any premium for growth. One question to ponder in this context is how much growth is possible at the new and increased cost of equity. To understand the Company’s growth potential, one has to estimate the future cost of capital for TerraForm Power. Firstly, while it is true that the cost of equity has gone up substantially for TERP, we believe that there is a reasonable chance that TerraForm Power can obtain debt capital at attractive rates. Secondly, markets have consistently demonstrated that unsophisticated investors are likely to buy debt and equity at surprisingly high valuations. If TerraForm Power can attain a WACC in the 8 to 10% range, we believe that growth, though hard to come by, is possible. Discounting for possible growth, and assuming a fairly benign yield environment, we can see TerraForm Power’s intrinsic value reaching about $20 by the end of 2016. This, of course, assumes that asset quality remains reasonable. As we wrap up this discussion, investors should consider another key factor when acquiring a YieldCo stock. While the current yield bubble has burst, it is neither the first one not will it be the last one. With Wall Street’s penchant for newfangled metrics, and with no shortage of investors subscribing to yet another non-standard valuation methodology, managements will always be faced with bubbles in the stock price and yields and will be issuing new equity or debt to take advantage of it. When the prices of these instruments correct from bubble levels, the preexisting stockholders who acquired the equity at a lower level will be beneficiaries of the largesse of the new stockholders. To benefit from this effect, it is very important for yield oriented investors to accumulate the YieldCo stock when the asset class is out of favor and shun purchases when the asset class is trading at rich valuation levels. All things considered, for yield oriented investors, we see TerraForm Power as a buy in the $17.50 to $20 range. While the stock has not gotten to this trading range, alert investors may be able to enter the position when there is a market weakness. Alternately, given the limited downside from the stated levels, the position can also be entered through selling puts at the $17.50 or $20 levels. The key risk factor at this point for this YieldCo is the acquisition of Vivint Solar . While this deal makes increasingly less sense, management has continued to stick with it to date. Vivint asset purchase and the aggressive addition of residential assets ahead of ITC step down could push up the risk adjusted yield requirements of the portfolio to north of 11%. In such an event, the entry point to TerraForm Power should be adjusted accordingly. Given the emerging nature of the energy landscape, we believe there may be several unanticipated risk factors for this equity and from that view, TerraForm Power can be considered overvalued. Summary Of Our View: Enter through selling put contracts in the $17.50 to $20 range. Disclosure: I am/we are long FSLR, SUNE, JKS, TSL, CSIQ. (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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