The world needs to invest an estimated $10 trillion in the decades ahead to replace its current carbon-based power systems. The market opportunity is even larger when factoring in energy-demand growth and the electrification of transportation. That positions renewable power companies like Pattern Energy Group (PEGI +0.00%) for a massive upside in the coming years.
Pattern Energy has already grown its renewable generating capacity at a brisk pace since its formation in 2014. But all that growth has yet to create much value for its investors. While the company is working to change its approach, it still has some work to do. Because of that, investors should view it as a high risk/high reward opportunity.
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The bull case for Pattern Energy
Pattern Energy currently owns 2.9 gigawatts (GW) of wind and solar power assets in the U.S., Canada, and Japan. That's nearly triple the size of its portfolio when it went public in 2013. The company sells the bulk of the power it generates under long-term contracts, which supplies it with predictable cash flow. Because of that, Pattern Energy's rapidly growing generation capacity has enabled it to expand its cash flow by 135%, giving it the power to increase its dividend 35% over that time frame, and boosting its yield to its current 9.3%.
Pattern Energy still has plenty of growth ahead since the company has access to a 10 GW development pipeline. It has already identified more than 700 MW of opportunities, giving it clear line-of-sight on its near-term expansion potential. In Pattern Energy's estimation, it can grow its cash flow at a high-single-digit to double-digit annual pace in the coming years as long as it has access to the capital it needs to fund the acquisitions it has coming down the pipeline.
The bear case for Pattern Energy
While Pattern Energy has grown its cash flow and dividend at a brisk pace over the past few years, this expansion hasn't created much value for investors. Overall, shares are down nearly 22% since its IPO, though its total return is almost 10% after adding in the dividend, which has still vastly underperformed the S&P 500's more than 80% total return over that time frame.
One reason for this is that Pattern Energy has issued a boatload of new stock to finance its fast-paced growth, with its outstanding-share count ballooning 90% since its IPO. At the same time, it has borrowed nearly $2.3 billion, which has pushed its leverage ratio up from 0% to about 50% of its enterprise value. Meanwhile, it has increased its dividend at such a fast pace, that it's currently paying out close to 100% of its cash flow. While this business model enabled the company to rapidly increase the size of its portfolio, it has stretched the limits of its financial flexibility.
Pattern Energy is working to address this situation. The company stopped increasing its dividend at the end of last year, which will enable it to slowly improve its payout ratio from nearly 100% to a more comfortable long-term target of around 80%. In addition, the company sold its assets in Chile to bolster its liquidity. Those steps will help improve the company's financial flexibility and its ability to get funding over the long term.
The risk could be well worth the reward
Pattern Energy has grown at a brisk pace over the years by selling stock and issuing new debt to expand its portfolio and dividend. However, it has yet to create value for investors because its business model was focused instead on growing the size of the company. That should change going forward given that Pattern Energy has taken steps to improve dividend coverage as well as its balance sheet.
On the one hand, Pattern Energy is a riskier opportunity compared with other top renewable energy companies, which is why some investors might want to put it on their watchlists until it gets its financials on a firmer footing. On the other, its currently discounted valuation, high yield, and visible growth make an attractive option for risk-tolerant investors to buy for the long haul.
