Renewable energy has been scorching hot over the past few years. Fueled by climate change fears and falling costs, developers are building wind farms and putting up solar panels as fast as they can. Solar panel installations in the U.S., for example, have grown at a 68% annual clip over the past decade, while global wind capacity has risen about 90% in the last five years.
This rapid growth has allowed companies like TerraForm Power (NASDAQ:TERP) to expand their portfolio of operating renewable power plants at a brisk pace. Though in TerraForm's case, it grew a bit too quickly and had to scale back after its former parent went bankrupt. That said, renown value creator Brookfield Asset Management (NYSE:BAM) recently took over as its parent and has helped TerraForm slowly get back on a firm financial foundation while also outlining a new strategy designed to grow shareholder value instead of just the size of the company. That shareholder-focused growth plan makes TerraForm a top renewable energy stock to buy right now.
Creating value from what's already there
Brookfield officially took control of TerraForm Power last October when it closed its deal to buy a 51% stake in the company. The companies got to work quickly in putting together a strategic plan to grow the value of the business, unveiling it in November.
The first step is to maximize the cash flow coming from TerraForm's high-quality fleet of wind and solar assets. The company currently owns 2,600 megawatts (MW) of renewable generating capacity primarily in the U.S., though it does hold some assets in Canada, the U.K., and Chile. It secured long-term contracts for 95% of the expected power production from these facilities, which will supply it with a very predictable revenue stream.
That said, Brookfield believes TerraForm can generate more cash from its existing asset base in the next few years by making a few changes to enhance margins. In 2018, for example, the company believes it can produce an additional $10 million in cash flow by streamlining processes and optimizing the operating structure. Meanwhile, in the next two-to-three years the companies believe TerraForm can save another $15 million by replacing high-cost legacy operating and maintenance contracts on its wind fleet through either in-sourcing those functions or signing lower-priced agreements. Those margin improvements alone should enable TerraForm to grow its cash flow by around 6% per year through 2020.
One of the primary uses of that cash flow will be to return value to investors in the form of dividends. TerraForm used to offer investors a high-yield payout but suspended it in 2015 to reduce debt. However, with its balance sheet much stronger, the company expects to reinstate the dividend this year, with plans to pay out $0.72 per share, which works out to about a 6.3% yield at the current stock price. While that's down from an annualized $1.40 per share in 2015, it's an affordable level of between 80% to 85% of anticipated cash flow. Meanwhile, the margin improvements alone position the company to increase that payout around 6% annually to an estimated $0.80 per share by 2020.
Leveraging the platform to grow the right way
Brookfield, however, isn't just content to milk the lucrative cash flows from TerraForm's existing portfolio. Its goal is to increase the value of the company over the long-term. One way it plans on doing that is by reinvesting the 15% to 20% of cash flow it retains to grow the renewable generating capacity of its existing portfolio. Future projects could include expanding existing sites, adding energy storage capabilities, or asset repowering, which means upgrading legacy equipment to generate more power. The company plans to target projects that would earn at least a 10% cash flow yield on the investment. That high return growth positions the company to generate enough cash to add another $0.06 per share to the dividend over the next five years.
In addition to that, Brookfield sees a significant opportunity to build out TerraForm's platform via acquisitions. However, it would only make deals that meet that same 10% cash flow yield, which is a much higher hurdle rate than it had for acquisitions under its former parent. That said, at that rate of return, it wouldn't take much to move the needle. In Brookfield's view, acquisitions funded with $100 million of new equity could generate another $0.04 per share in dividend growth. That puts the company on pace to increase its payout at a 6% annual rate through 2022 when it could pay out at least $0.90 per share, or an 8% yield at the current price.
This forecast, however, is just scratching the surface of TerraForm's potential upside from acquisition-fueled growth. That's because Brookfield has already offered it the right-of-first-refusal to buy up to 3,500 MW of wind and solar generating facilities currently operating or under development and set it up with a $500 million credit facility to make acquisitions. Meanwhile, TerraForm also has access to 500 MW of capacity currently owned by third parties. With the company's existing 2,600 MW asset base worth around $6 billion, this pipeline could drive high-powered growth for years to come. Though, it's only the beginning since Brookfield expects to be an active acquirer of renewable power assets in the coming years, which would only increase TerraForm's opportunity set.
A proven strategy to generate market-beating returns
Brookfield's plan to create value for TerraForm investors shares many similarities to the one guiding its hydropower company Brookfield Renewable Partners (NYSE:BEP). That strategy would see Brookfield Renewable increase its 5.6%-yielding distribution to investors by 5% to 9% per year through a combination of margin expansion, organically developed growth projects, and acquisitions. It has worked well in the past, with Brookfield Renewable delivering 15% total annualized returns since 2000, which has obliterated the market's 6% average annual total return over that timeframe.
Brookfield is looking to replicate that success with TerraForm Power. It believes that the combination of a 6%-yielding dividend that grows at a 5% to 8% annual rate can power total annual returns of around 12% over the long-term. With that value-creating turnaround starting to unfold, TerraForm is one of the most attractive renewable energy stocks to buy right now.
Matthew DiLallo owns shares of Brookfield Asset Management, Brookfield Renewable Energy Partners, and TerraForm Power. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.