Are YieldCos a Smart Choice for Dividend Investors?

NRG Energy is using a novel approach to raise cash for growth and reward investors with a growing distribution—but is the market too excited about the concept right now?

Aug 12, 2014 at 10:17AM

NRG Energy (NYSE:NRG) is taking a page from the limited partnership space with NRG Yield (NYSE:NYLD). While that may seem great, you have to step back and ask if this "new" yield-focused type of utility investment is better than owning an old stalwart like Southern Company (NYSE:SO).

A pioneer
NRG Energy is one the country's largest independent power producers, and at the cutting edge of the industry. That includes its effort to build renewable power and more aggressive steps like retrofitting carbon capture technology to one of its coal power plants -- something that will help move the needle on a key technology that has applications for all carbon-based fuels, like natural gas.

Looking even further out on the energy horizon, NRG Energy is partnered with Segway creator Dean Kamen on a device that can create electricity from natural gas within a customer's home. This device would be leased to customers, creating a recurring revenue stream, and when paired with rooftop solar, allow customers to completely sever ties with the local power company.

(Thomas R Machnitzki, via Wikimedia Commons)

And now NRG has created NRG Yield, a move to raise cash for NRG's growth efforts similar to oil drillers separating off their pipeline assets into a limited partnership (LP).

Dropping the assets
The assets going into NRG Yield generally have long-term contracts, so the revenues from the assets sold to NRG Yield (essentially akin to drop downs in the LP space) can support a distribution-focused entity. And, even more enticing, NRG is increasingly looking to drop down environmentally friendly assets like solar installations. Note that NRG Yield is just one of the so-called YieldCos that have been created recently.

Although you have to pay particular attention to what is in each YieldCo, NRG Yield looks like it will be heavy on the renewable end of the spectrum, at least over time. Of the 3.4 gigawatts of power NRG Yield owns or that is slated for purchase from NRG Energy in the near term, 1.4 gigawatts is described as conventional, thermal accounts for 1.35 gigawatts, and renewable is only 0.454 gigawatts. Although it will likely look different in the future, today it looks more like a traditional utility.

Price versus yield
However, the future is, in the end, the main reason to buy NRG Yield and the other YieldCos. The more assets that get dropped down, the more dividends get increased. But NRG Yield is up roughly 90% from its initial public offering, a quick ascent since it only came public in July 2013.

NYLD Chart

NYLD data by YCharts

The most recent quarterly share dividend was $0.35. At the $22 listed IPO price that would have annualized to a yield of roughly 6%, high in the utility space. However, at the recent price of around $52 a share, the yield is only around 2.7% -- not quite as appealing.

Dividend growth, however, is expected to be in the 10% to 15% range. That's impressive and may be worth paying up for. However, assuming 12.5% distribution growth (the middle point of this range) for five years, the annual dividend would increase to roughly $2.50 a share for a yield of around 4.9% at the current stock price.

Southern Company, for comparison, yields around 5% today and has over a decade of dividend increases under its belt. Moreover, Southern Company is also working on carbon capture tech and renewables, just in a regulated business model. That's similar to the long-term contracts that NRG Yield's assets have.

NRG and the other YieldCos are taking a novel approach in the utility space to raise capital and reward shareholders. And there's a green angle to it, too. However, at current prices you need to take a step back and ask if the current yield and potential dividend growth justify recent valuations. If dividends are your focus, you might find you're better off buying a traditional utility.

That said, investors tend to take things to extremes, and clearly there's optimism in the air right now. Any price weakness might present a good opportunity to acquire green assets and a decent yield via NRG Yield or a similar YieldCo.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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