Yieldcos are one of the more unusual asset classes, but they can offer huge returns and, as the name implies, massive yields. In this episode of Industry Focus: Energy, host Sarah Priestley and Fool.com contributor Jason Hall give listeners some background on how yieldcos work, what their different corporate governance structures mean, what risks to be aware of, and a few of the most promising players in the space today.

Tune in and get the scoop on four different companies across the renewable yieldco subsector, what the heck an MLP is, what tax considerations you should know before buying in, how trends in energy and policy have been affecting the space, and more.

A full transcript follows the video.

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This video was recorded on July 12, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 12th of July, and we're going to be talking about renewable yieldcos and their corporate structures. I'm your host, Sarah Priestley. Joining me on Skype is Motley Fool contributor, Jason Hall. Jason, how are you doing?

Jason Hall: I'm good, Sarah. How about you? Are you doing well?

Priestley: I'm good. I'm enjoying the brief respite from the 90-something degree heat we're going to get next weekend.

Hall: The July 4th holiday, it's supposed to be unbearably hot.

Priestley: Yes. I should let people know that this is a pre-recorded episode. We're talking about July 4th, this was recorded just before July 4th, in case anybody's wondering. 

Jason, this conversation for the show today evolved from me asking you if you kept up with the 8point3 acquisition. 8point3 was owned jointly by First Solar and SunPower, but they have sold their stakes to capital manager Capital Dynamics for a total enterprise value of $1.7 billion. They announced that deal just closed on the 19th of June. Then, you started talking to me about renewable energy, yieldcos, and the different corporate structures. We had a question recently about MLPs, so we wanted to address that in a little bit more detail and give listeners a bit of a rundown on some renewable stocks.

Hall: It's a really compelling and a really interesting space for investors to look at right now. The potential growth with renewables, this is a multi-decade thing, but it's also a capital-intensive industry, these are more comparative to utilities in a lot of ways. But I think it's a really, really interesting sector, and it's worth taking 20-35 minutes and talking about the companies, and the corporate structures, and how that affects investors. I'm really excited about doing this show.

Priestley: It's a lot of companies that you're pretty passionate about, and that people will have probably heard the both of us talking about on the show before. The first one is Pattern Energy Group (PEGI), their ticker is PEGI. Jason, as I said, you've talked about Pattern before. Can you give us a bit of a background on what their business is?

Hall: It's a private independent power company. Historically, their business has been taking stakes in wind farms all over the world -- the U.S., Canada, South America, Japan -- and playing a role in the operations of these wind farms. It generates cash flows from selling the electricity on long-term contracts. When I say long-term, I mean measured in decades, like 20-25 year contracts. They basically make their money on those long-term contracts and the spread between what it can sell the electricity for and its cost to operate those facilities, and its costs for debt and all of the various little things. 

It's had to slow its growth a little bit here recently because of some changes in U.S. tax laws. It's one of the downsides of the new tax law, with the lower tax rates that were put in place to start this year. It affected some of the access to capital for some of these alternative resources. But, because it's a diversified global company, I think it's a temporary little slowdown that's happening.

Priestley: You've mentioned independent. What do you mean by independent in this sense?

Hall: If you think about your utility bill that you get for your power in the mail, it has a name on it. Southern California Edison, or Southern Company, or Duke Energy, one of these big companies. They don't always produce 100% of the power that they provide to you and that they provide to the businesses and the manufacturers in your area that use their electricity. Sometimes, they contract out with third parties to provide them with power. Generally, what Pattern does is it sells electricity to utilities, and also sells it to large consumers, to industrial consumers, as well. It's a producer of the power, and it doesn't sell it always directly to the end user like a traditional utility does.

Priestley: People really love these stocks, generally, because of their yield. Pattern is no different. It has a 9.2% yield at the minute. As you mentioned, there's a bit of bearish sentiment toward Pattern at the moment. I think there are quite a lot of short holdings. Shorts have increased more than double over the past seven months. That's people betting that the stock is going to decline. I think a lot of this, as you hinted at, was this betting that the company's ability to generate growth in the near-term, or cash flow in the near-term, might be jeopardized, might put the dividend in jeopardy. I would argue, and I'm sure you would argue, too, that their method of these sales to acquire companies with a better financial position for them is actually quite wise.

Hall: We have a couple other companies that we'll talk about, and we'll get into the importance of really good management, in terms of allocating capital in this space. I think, because there's a lot of leverage involved, a lot of debt, some financial mechanisms that are important to understand. 

It's really important for these companies to have the right leadership in place. Mike Garland, who's the CEO at Pattern, is somebody that I really like in the space. Before Pattern Energy, the public entity, was launched a couple years back, this guy has been in this industry for about 30 years. I think it was '87 or '88, he was involved in developing and selling the first wind farm that he was personally involved in. He's been doing this for a very long time. 

They recently announced they sold off an investment they had in a wind farm in Chile. They sold it for a higher cash flow rate than they paid to buy it. That's a way that they're able to free up capital now, that they can reinvest to gain higher returns. Having somebody that can navigate these changes in the landscape is really important. That's one of the things I really like about Pattern -- their long term history, having good leadership in place.

Priestley: The metric to look at with the two companies that we're going to be talking about in the first section of the show is cash available for distribution. You mentioned that the Chile sale, they essentially sold the property for 10X the value of its cash available for distribution. The plan was that they would then buy a cheaper asset that they can grow and evolve to add to their income.

Hall: Right, absolutely. That's important. Because of the dynamic nature of this industry as it grows, and where the demand is, and where the opportunities to make the best cash returns are, having the ability to be flexible and to be savvy, to move out of one operation and take that cash and move it into something else, is really important.

Priestley: The next company we want to talk about is TerraForm Power (TERP), ticker TERP. Jason, can you give us a little bit of background on TerraForm?

Hall: One of our colleagues, Tyler Crowe, actually just wrote a really interesting article about TerraForm Power. He named it as a high-yield stock that he's adding to his personal retirement investment. 

TerraForm Power had been part of SunEdison. SunEdison bankrupted. That was terrible, and it's been very well-covered. TerraForm Power has this really great base of assets. It was a separate publicly traded company, so it wasn't directly affected by SunEdison's bankruptcy.

But Brookfield Asset Management (BN -1.14%) swooped in, took over, made a substantial investment to become the sponsor. They're basically putting in the Brookfield way of allocating capital to take those great wind and solar assets that generate good cash flows, and creating an entity that will operate more like, say, Brookfield Infrastructure Partners, which is one that you and I have talked about on the show before, that has these assets that produce great cash flows. And instead of just throwing them all back to shareholders, they retain some of that cash to reinvest to grow, and to really be effective with that capital management. 

I think, with Brookfield Asset Management behind the scenes now stabilizing the financial situation, it makes TerraForm Power and its 6.5% yield a really stable business. I really like the way that Brookfield's entities have grown steadily and really delivered strong shareholder returns. I really, really like TerraForm Power a lot right now.

Priestley: The way that these structures work with these parent companies -- jump in and correct me at any point, Jason -- is that they will have a company ... I think it's Brookfield Renewable?

Hall: Yeah, Brookfield Renewable fits in this niche of what we're talking about. Brookfield Renewable Partners. TerraForm Power is a traditional C Corp. Then you have the MLPs, master limited partnerships, which we'll talk about. Brookfield Renewable Partners, they own hydroelectric, wind, solar assets, as well. 

With TerraForm Power, Brookfield owns an equity stake, just like any other investor would. It owns an equity stake, the value of the equity that it holds on its books. Then, just like the rest of us, it gets its dividend that it collects. We'll talk about the MLPs in a minute. There's a little bit of a different structure with additional ways that the sponsor can make money.

Priestley: I completely agree with you. I only recently started to look at TerraForm, but it seems like they're very clearly focused on their growth initiatives, both internally to improve their margins and improve the power generation in their existing assets by doing things like bringing in bigger, essentially, turbines. Then, their organic growth initiatives, in partnership with Brookfield, with their right of first offer on Brookfield's own portfolio. Then, repowering existing wind farms, buying out minority investors, all those kinds of things seem like they have a really clear strategy of how they want to achieve growth. And it looks like they're set to keep expanding dividend payout.

Hall: I think so. If you look at the renewables space, one thing that's happened, because these are very much technology-driven, with the wind turbines and with the solar panels, and now with energy storage, there's cost to the technology. As time goes by, the technology improves, it's a little more efficient, and the cost per unit of power production -- or power storage, in the case of storage -- falls. 

What happens is that, over time, as these costs continue to fall, we're quickly approaching the point where we're going to consistently see renewables be able to generate electricity at a lower cost than cost of fuels. It's still several years away before it's a consistent thing. But, when renewables become the low-cost leader, I think that's when we're going to really see massive global investments toward renewables. 

By the way, renewables for I think five or six years now on a global basis, incremental investment in the energy space, more incremental dollars have been invested in renewables than in oil and gas. That's where the big investments are already going.

Priestley: Yeah, which isn't good for the oil and gas industry, but is definitely good for the renewable industry. Both of these, Pattern and TerraForm, are C Corps. Jason, the corporate structure is definitely not my forte. Can you talk a little bit about C Corps?

Hall: I'll just make it really simple. It's the same as a utility stock that you might buy for the dividend, or General Mills, or one of these other traditional corporations. It pays a corporate income tax, it pays you a dividend, and there are different ways that it can give dividends to you. Qualify a dividend, and that's what qualifies for the low capital gains tax, which you might pay on your dividends at the end of the year. 

Some of these -- actually, I think TerraForm Power and Pattern Energy both right now, this is a good snippet for people to know, both right now have been historically paying their dividends as a return of capital. That generally means that it's actually a tax-free dividend that you're getting. It's actually not even considered a dividend, it's considered a return on capital that was invested in the company. So, just a little interesting thing to know. It's more important to understand in relation to the MLPs. We're going to talk about that in just a second.

Priestley: We've already touched on this company briefly. The next company we want to talk about is Brookfield Renewable Partners. We've already talked about Brookfield Asset Management. They're one of the biggest renewable energy owners in the world because of the companies they control, one of which being Brookfield Renewable partners. They own hydro, electric, wind, solar, and energy storage assets. They generated $2.74 billion in revenue over the past year, which is crazy. 

They have a unique structure compared with other yieldcos because they don't necessarily pay out 100% of their funds from operations. They pay about 70%, and then they use the rest to acquire projects to grow the business. They aim to grow the business about 5-9% organically annually, which would obviously improve their yield. The dividend yield isn't bad, though, it's 6.5%. What are your thoughts on BEP?

Hall: I think it gets back to the Brookfield way of operating. To segue into something that we saw about two and a half years ago, a lot of the midstream companies in the oil and gas space, the big master limited partnership midstream companies, when oil prices plummeted, there were a lot of those midstreams that were actually over-exposed to oil prices. A lot of them had to cut their dividends sharply because they were paying out basically all of their cash flows in dividends and counting on the debt and selling stock to raise cash for their growth. 

That's not how Brookfield operates. It pays out a reasonable dividend. 6.5% is more than double the 30-year Treasury note. That's a very substantial yield. That allows the company to retain cash to invest back in the business, instead of relying on the whims of the market -- which, as we've seen in other spaces, can really be devastating to their ability to support the dividend, which is the underlying thing that brings so many investors in. 

Even a few years ago, there were concerns with Brookfield Renewable being able to sustain its dividend. But because of the way that Brookfield tends to operate through all of its ventures, obviously, it played out very well.

Priestley: I personally appreciate the conservative approach that they're taking to their distribution. This isn't an MLP, but if you take a well-known example, you can look at what's happened to GE recently. Their stock was sold as such an income stock that, when they did cut their dividend, it had broad implications for the value of those shares. I think that this strategy, as you said, to shield themselves from the cost of borrowing, or the cost of issuing new shares, is actually very sensible.

Hall: Yeah. It's the leverage that creates such a risk. You mentioned GE. I just have to throw this in. Jamal Carnette, one of our other colleagues, and I, were chatting about GE just a few days ago. Do you realize, going back to 2003 -- this was the post-.com bust. 2003, the bottom for GE. Did you know that it has lost a net 12%, including the dividends paid, over the past 15 years? Isn't that stunning?

Priestley: Yeah. It's scary, [laughs] is what it is. As a GE shareholder, it's scary.

Hall: There you go. I think it's a matter of the risk of that leverage and that over-exposure to debt. GE's was through a bunch of other mechanisms. But the point is, it can be very dangerous. 

Priestley: Yeah. The next company we want to talk about, we have spoken about before, is NextEra Energy Partners (NEP -2.04%). The ticker is NEP. They own wind and solar power-generating facilities in North America. Actually, something else I'm very bullish on is natural gas infrastructure, which they own in Texas. Their dividend yield, lower, 3.7%. But their total returns, when you look at share price appreciation, are pretty impressive.

Again, they operate similarly. They sell electricity and also their gas line capacity and long-term contracts. Set up similarly to the companies that we're talking about, but just in a different product line.

Hall: I think NextEra Energy Partners' connection to NextEra Energy, which has huge exposure to Florida and Texas and a few other places that are really growing, puts it in a really interesting position to generate really strong growth of its capital value, in addition to growing the dividend. Some of these other more independents may have to work a little bit harder. That's one of the things that I like. You have a lower yield, but I think there's some really interesting growth by being tied in to NextEra Energy that I really like.

Priestley: They're aiming to grow their payout between 12-15% through now to 2023. You can see why people are interested in the stock. You can't read any article about renewable yieldcos without seeing NextEra or its parent company. It's definitely a hot stock right now, and you can see why. It's well-diversified and it gives people a little bit of everything that they might want.

Both of these companies are MLPs. We've had questions about MLPs before. I am not qualified to do the ins and outs, and I'm aware of that. Jason, can you talk us through the MLP structure?

Hall: Master limited partnerships. These are businesses that are not corporations, they don't pay any corporate income taxes at all. It's kind of a pass-through entity, is the way that they're often described. To be able to be structured as an MLP, it has to derive the majority of its cash flows from energy-related business operations, which obviously is the case for these kinds of companies. 

The upside is, the corporate answer is, these are more efficient at passing through cash flows to the owners, whether it's the equity investors like you and me, or it's the sponsor, the limited partner, the general partner that generally controls these. 

The downside is, if you're looking to invest in a retirement account, your IRA or 401(k) or Roth IRA, over time, too much exposure to master limited partnerships can actually lead you to end up getting a tax bill for something you own in a retirement account. Once income of dividends is above $1,000 in all of your retirement accounts in a given year, once you cross that threshold, you can be subject to UBTI. Just look up that acronym, it's unrelated business taxable income. That's the risk of owning master limited partnerships inside of a retirement account. Five, ten, 20 years down the road, you might cross that threshold and not even realize it, and now you're paying taxes on an account you shouldn't be paying taxes on. 

If that's where you're generally saving or investing, those C Corps -- Pattern Energy, TerraForm Power -- you don't have any exposure to those kinds of tax consequences with those kinds of equity investments. That's the basic difference. If that's not your case, if you're putting it in a taxable account, then invest in master limited partnerships all you want. You will have a little more complication because you're going to get a K-9 tax form. It takes a little bit more work to process than the usual 1099 that you'll get for your dividends. But generally, it's minimal enough that, if the company fits your thesis and it makes sense for you to invest in, then getting the K-9 and having to fill out more complicated taxes shouldn't matter.

Priestley: Excellent. That was much better than I would have done, [laughs] which would have probably been reading one of your articles about MLPs.

Hall: [laughs] Fair enough. It's something I've personally dealt with. I don't want anybody to have to go through it.

Priestley: Anything that you would like to add before we end the show?

Hall: The last thing, I think one of the things that precipitated this was, we had some listeners that brought up 8point3. One of the things that I really like that's happened over the past several years is, you've seen a shift away from some of these more focused on a certain thing. 8point3 was solar because SunPower and First Solar wanted somebody to buy the solar farms from them. Pattern Energy has been historically wind energy. Now, you're seeing Pattern Energy expanding into solar and energy storage. That optionality, I think that's really important. 

When you're looking at these different companies to pick the ones that you want to invest in, think about their optionality. Do they have a history of investing in more than just one way to produce energy or not? As time goes by, as they operate in different areas, there may be advantages of investing in a solar project versus a wind farm or vice versa. You want companies that are able to be more flexible as this really, really dynamic growth space plays out in the years to come.

Priestley: That's it from us today. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for mixing the show. He's had his work cut out today from me. For Jason, I'm Sarah Priestley, thanks for listening and Fool on!