Of the numerous strategies espoused by investors, one of the simplest and most effective is keeping a watchlist, a tool to help investors remain focused on potential additions to their portfolios. For some time now, Pattern Energy (NASDAQ:PEGI) has been a presence on my own watchlist. With the stock trading at 8.6 times operating cash flow, below its five-year average of 15.9 according to Morningstar, I recently decided that it was time to move it from the watchlist and into my portfolio.
An independent power producer, Pattern Energy maintains a portfolio of wind and solar projects located in the United States, Canada, Japan, and Chile, totaling 2,942 MW. Once generated, the power is sold to utilities under long-term, fixed-price power sale agreements, otherwise knows as PSAs, providing the company with long-term, stable cash flows.
A powerfully compelling proposition
One of the features of the stock which initially caught my attention is its mouth-watering dividend. Several years ago, when Pattern Energy first appeared on my radar, the stock offered investors a dividend yield of approximately 5%. Currently, however, the stock provides shareholders with an even more enticing yield of 8.9%. With a dividend like this, Pattern Energy represented an ideal fit for the tax-free income benefit which my Roth IRA provides.
Since the stock's IPO in 2013, Pattern Energy has raised its dividend 15 times; moreover, the current annualized payout of $1.688 per share represents a 35% increase over the company's first distribution. Of course, there's no guarantee that it will continue climbing in the future, but management's history of returning capital to shareholders in the form of a dividend -- and the company's future growth plans -- suggests to me that there's a strong probability that future raises are in store.
Understandably, some investors may recognize the high dividend yield as a cause for concern. Pattern's management, however, asserted in a 2017 investor presentation that it aspires to achieve a long-term 80% payout ratio of its cash available for distribution (CAFD) run rate, suggesting to me that it's not willing to jeopardize the company's financial well-being in order to hike the dividend. Although the payout ratio is currently over 90%, management has endeavored to lower the ratio by leaving the dividend unchanged for the past three quarters, at the same time it forecasts 2018 CAFD will grow 14% over that which it reported in 2017 if the company achieves the midpoint of its CAFD guidance: $166 million.
Forecasting strong wind, sun, and growth
Management's eye on the future represents another reason why Pattern Energy migrated from my watchlist to my portfolio. Over the past five years, the company's portfolio has more than doubled, growing from 1,041 MW of owned or managed capacity to the current amount of 2,942 MW. And, presumably, further growth is on the horizon; Pattern Energy aspires to grow its portfolio to 5,000 MW by 2020. Looking farther out on the horizon, we find there's reason to believe that the company's portfolio will continue to grow in 2021 and beyond, for the company has 10,000 MW in its development pipeline. Besides the projects which the company currently owns or operates in the U.S., Canada, Japan, and Chile, Pattern Energy anticipates gaining a foothold in Mexico.
Uninterested in raising equity, management intends to fund the future growth by using cash on hand and accessing its revolving credit. And once management reduces its payout ratio to 80%, it intends to use the remaining 20% of cash flow to fund future projects.
Pattern's counterparties defaulting on contracts represents one of the existential risks for Pattern Energy. To mitigate this risk, management is committed to only partnering with companies which have high credit ratings. For example, management recognized in its investor presentation that the average credit rating (from Standard and Poor's and Moody's) of its off-takers is an A. Providing further reassurance to investors, management has asserted that it will continue to seek counterparties with investment grade credit ratings.
Checking in with a quick checkup
Management's targeted payout ratio of 80% assuages some of the concerns associated with a high dividend, but I'm maintaining the candidates for my Roth IRA to a high standard with the intention of holding them for the long term. Therefore, I needed further evidence that the company is in sound financial health and well-suited to sustain its dividend. And I found it. Pattern Energy has achieved strong operating cash flow growth over the past three years -- growth which is even more notable when comparing the company to its peers: Brookfield Renewable Partners (NYSE:BEP) and NRG Yield (NYSE:NYLD-A) (NYSE:NYLD).
Delving deeper into the financials, we find that the company, which has a net debt-to-EBITDA ratio over 9, relies heavily on leverage. Moving forward, I'll be monitoring this closely. Although I'm bullish on the company's future, I'm also cognizant of the fact that the company's debt represents a fair amount of risk. Should the company's net debt-to-EBITDA ratio creep higher, it will certainly motivate me to reevaluate the company's position.
Charged up about this electric addition
Although the holdings in my retirement account lean predominantly lean toward the conservative end of the spectrum, I feel comfortable carving out a niche for a more aggressive choice -- in this case, Pattern Energy. And investors looking to diversify their holdings with a renewable energy leader -- albeit a more aggressive one -- may also want to give Patter Energy some consideration.
Even if the stock recognizes little capital appreciation over the next few years, I'd be more than happy to keep a position provided the company remains committed to both rewarding shareholders with a hearty dividend and maintaining a sound financial position.