In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool analyst Jason Hall dive into the incredibly profitable world of yieldcos. Tune in to find out what yieldcos are, how the business model works, how they're able to pay out so much in dividends, what to know about the tax implications, and a basket of picks you might want to add to your watch list for some low-risk, high-reward renewables exposure.
Learn more about the pros and cons of Brookfield Renewable (BEP 4.19%), TerraForm Power (TERP), NextEra Energy Partners (NEP 6.28%), and Pattern Energy (PEGI), and which one looks most attractive right now. Plus, the hosts talk about the future of Boeing (BA 1.17%) as an investment, and what effect the 737 tragedies will have on the company's long-term picture.
A full transcript follows the video.
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This video was recorded on March 14, 2019.
Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, March 14, and we're talking energy and industrials. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Jason Hall via Skype. How are you doing, Jason?
Jason Hall: I am fantastic! It's good to be back on! It's been a little while, I think this is the longest gap in shows that I've had in a little while. It's good to hear your voice!
Sciple: Yeah, Jason, we haven't chatted since around the new year. It's good to catch up with you. We've got a lot of news this week. We're going to give our listeners a preview on how to handle their taxes as we approach the dreaded tax day, April 15. And we're going to talk about some of our favorite yieldcos. These are companies we've talked about a lot on the show and some of our listeners had asked us to talk about some of our favorites, so we're going to do that.
But first, Boeing is in the news this week. There was a second tragic crash of the 737 Max aircraft on Sunday that occurred in Ethiopia shortly after takeoff, tragically killing all the passengers on board. The pilot had cited issues with the plane's controls leading up to the crash. In the ensuing aftermath, the 737 Max has now been grounded by Boeing following a large number of groundings from countries as diverse as the U.S., China, and India. Shares of Boeing are down nearly 12% this week on the news.
Jason, how should investors be approaching this uncertainty around Boeing and this latest tragedy from this airplane?
Hall: First, obviously, this is tragic, what's happened. You think about these kinds of things, two planes crashing on the other side of the world. We actually have a colleague who had a friend who was killed on this latest crash. It kind of comes home a little bit when that kind of thing happens.
Looking at it just as dispassionately as possible, frankly, I don't see this as a catalyst for investors that are value-hunting to try to look at this as a great opportunity to buy Boeing. If you think about this from a pure valuation perspective, Boeing shares were pretty much at their all-time high in late February. So, not too long before all this happened, this stock was at its all-time high. If you go back to Christmas Eve, the low point for stocks over the past decade, really, shares are still up 27%. We're talking less than three months, Boeing shares are up 27% still. That's after losing what 15% from the high.
I don't think we're talking about a stock that I would necessarily be running out to buy on this, like it's really cheap right now. If you think about it from a pure earnings valuation perspective, right now, shares trade for almost exactly 21 times trailing earnings. I'd say that's probably fair value for Boeing, with no overhang like the 737 Max potentially represents. It was trading for 25 times earnings three weeks ago. If you look at it in the aerospace industry, look at it for defense contractors -- usually, that's the two areas where it makes a living -- it's an expensive stock, and it generally always is because it executes so well.
Now, thinking about it from the longer-term perspective, if this is a stock that you bought six months ago, three months ago, five weeks ago, I can't say that I think this is really a catalyst to necessarily sell. One of our colleagues, Adam Levine-Weinberg, who writes a lot about airlines and the aerospace industry, pointed out really well just a couple of days ago that the 737 Max, airlines don't really have any other alternatives. The Airbus A320 is the other similar narrow-body aircraft that airlines are buying, that's similar to the 737 Max. They have a backlog that's like five years at their maximum output capacity, which is like 750 planes a year. They can't build anymore. It's not like airlines that are lined up for the 737 Max have somewhere else they can go to buy jets that they need for their operations.
The other thing, too, you go back not too long ago, four or five years ago, the 787 Dreamliner. I don't know if you remember, Nick, the lithium ion battery problems they had. The fleet was grounded. These lithium ion batteries were catching on fire on the planes. Obviously, I don't want to compare that situation to two jets that have crashed and killed hundreds of people, but it was a severe concern that planes would spontaneously catch on fire in the air. It was quickly corrected. That 787 has been a very successful plane.
I think over the long term, Boeing is going to address this, they're going to get it taken care of. The business should be fine. I just don't see this as a catalyst to necessarily jump in and buy, or even to sell, as far as that goes.
Sciple: Yeah, Jason, I agree with you completely there. It's kind of a wait-and-see position here. The 737 Max, the numbers that I've seen are that that aircraft represented nearly a third of Boeing's profits. Boeing had been expecting the 737 Max to make up maybe 90% of its deliveries in 2019. So, of course, in the near term, that's a really significant cloud over the stock, as we see how Boeing can resolve the safety issues with the plane. If course, if this ends up being something they can fix over the air with the software update, it could be just a little bit of a speed bump for the company. But if this is something mechanical, and you have to do a full redesign, that can really weigh on earnings for a long period of time.
But really, when you look at the company over the long term, as you mentioned, Jason, when we look at these large passenger aircrafts, it's really a global duopoly between Boeing and Airbus. That dynamic is not going to change based on this recent news. As you said, we'll have to see how the 737 Max safety concern gets shaken out over the next weeks and months. That's going to be definitely a near-term cloud over the stock. But the global environment for aircraft is still bullish over the long term, and the competitive environment hasn't been changed significantly by this. Any thoughts before we move on, Jason?
Hall: No, I agree. I agree 100%.
Sciple: Awesome! Well, Jason, now I want to talk a little bit about, before we get into our discussion on yieldcos, we've gotten a couple of listener questions about schedule K-1 taxes. We've spent a decent amount of time on this show in the past six months talking about MLP companies and companies that might pay this type of income that can complicate your taxes when you own an MLP business. Jason, first off, for listeners who aren't familiar, can you talk about what schedule K-1 is and when it might apply to you as an investor?
Hall: The best way to describe it is a pain-in-the-butt, complex tax form that has lots of individual lines that you have to input if you do your taxes yourself and you itemize your deductions. You have to input each of these individual fields into your tax software to properly calculate what your tax obligation is. MLPs, master limited partnerships, are commonly called a pass-through entity. They don't pay corporate income taxes because they're not a corporation. It's a partnership. You, as a unitholder, which is MLP-speak for shareholder, are a partner in it. That means that you get a share of the earnings that it passes through.
Here's where it can get tricky: if you have multiple MLPs that you own, and here's the key thing. These are dividend stocks. These are stocks that you buy because they're cash flow efficient because they don't have the tax impact. They can pass through an outsized amount of cash flows. They typically pay pretty high yields, generally 5% and above, and in some cases well above 5%. That's what makes them attractive as an investor. You're generally going to end up paying a little bit of a higher tax rate. Sometimes your tax rate on the distributions that you get is regular earnings, so they don't always qualify for that long-term capital gains tax rate that's 15% for most people, it's 20% for some people. You may pay a higher effective tax rate on the income you get from them than you do from regular C-Corps and real estate investment trusts. So, that's one of the things. It's more complex to fill out the taxes and file, and you can end up paying a higher tax rate.
Now, here's the other part of it, too. This is really, really important. If you're investing inside a retirement vehicle, so, if you can buy individual stocks in a 401(k), if you have a Roth IRA or traditional IRA that you're buying shares in, if you own MLPs inside those accounts, you could end up having to pay taxes on the dividends that you get because of a rule, something called UBTI. It's unrelated business taxable income. Some of the distributions paid by a lot of master limited partnerships qualify for UBTI. The threshold's pretty high. You have to earn more than $1,000 in a year from all of the MLPs that you own in all your accounts. So, let's say you have a Roth IRA and a traditional IRA, and you have some MLPs in both. You have to add it all together, and if you exceed $1,000 in UBTI in a year earned inside those retirement accounts, then you may have to pay taxes on it.
That's an additional complexity that it adds. That's why, in a lot of cases, for most investors, sometimes it's better to just avoid owning a limited partnership. Now, I will say this, this is something really interesting. The Brookfield family of limited partnerships, they explicitly say in their frequently asked questions on the taxes section that their MLPs are generally fine for American investors and Canadian investors to own in their retirement accounts because they don't pay UBTI. The caveat with a couple of them is that they do have some revolving credit instruments that they have available to be able to use, that are kind of a last resort credit instrument they have. If they tap those, it could generate UBTI. But in general, they don't. I personally own two of the Brookfield MLPs inside my 401(k), so I feel pretty confident that there's not going to be any tax implications from those companies.
But in general, the schedule K-1 is just kind of a pain-in-the-butt document because it adds complexity, especially if you do your taxes yourself. It's going to add probably a half an hour of time, plugging these individual lines in. Maybe an hour if you own three or four of them, plugging all that into your tax form every year. If you pay somebody to do it, they might want a little more money if you're giving them K-1s. But, in short, that's pretty much it.
Sciple: Right. Basically, because a partnership is a pass-through entity and you're the owner of the partnership, and the income of the partnership's getting passed through to you, it has to be accounted for through the schedule K-1 in the same way your income, say, from dividends might be in a 1099. It's a special form to cover that. It adds extra complexity. It's also one of those forms that's notoriously one of the last to come in, so if you're a person who likes to get your taxes done early, it's something to be aware of. Make sure you have all those forms in.
It's not to say that you shouldn't invest into a company that's going to give you a schedule K-1. Just, know what you're getting into, particularly when it comes to tax season. It's going to be a little bit extra effort.
Jason, let's move on to our main topic today. We're going to talk about some of our favorite yieldcos. The inspiration for this came from a question from our listener, Cam Kane on Twitter. He asked us to do a show diving into the American yieldcos -- TerraForm Power, Pattern Energy, NextEra Energy, and Brookfield Renewable Partners.
Before we dive into those businesses, Jason, for our listeners who may not be familiar with what a yieldco is, can you talk about what exactly a yieldco is, and how it fits into the tapestry of the global energy market?
Hall: In short, yieldco is a little bit of a catch-all term. Traditionally, what a yieldco is, it's really a vehicle to fund these large utility-scale energy projects, primarily renewables, think about solar and wind projects, to be able to develop these big projects and then to monetize the production of the power that they sell and make money on the cash flows. Generally, the way it works is, a yieldco would be sponsored by either a project developer -- for example, Pattern Energy came to be because of Pattern Development, which is a privately held renewable energy, primarily wind energy, project developer for a number of years. They actually share the same CEO. It was a vehicle to use the capital markets to develop and monetize these big projects. Then you have NextEra Energy Partners, which is sponsored by NextEra Energy, which is one the biggest utilities in the United States and the biggest renewable energy utility in the U.S. You've got Brookfield Renewable and its almost-subsidiary, TerraForm Power. Brookfield Renewable owns almost 70% of it. They're sponsored by Brookfield Asset Management, which is one of the world's biggest infrastructure real estate asset developers in the world.
So, when somebody says yieldco, it's an energy producer that is sponsored by some big asset developer or utility company. The thesis for investors is yield. It's right there in the name. You're going to make money from the dividends or distributions that they pay out. They typically take on a lot of debt to build out these projects, but the debt is typically at fixed terms over very long periods of time. Then they sell the power from their wind or solar assets, or, NextEra Energy, for example, owns a lot of natural gas distribution resource assets. Then they sell those things on these really long-term contracts, like 20, 25 years. They make money on the difference between their operating and their debt costs and the cash. So, you can get these really good, predictable, long-term dividends. That's the thesis and that's what makes them really interesting to investors.
Sciple: As we were prepping for the show, you had mentioned some macro trends as we see energy shift over toward more renewables and the cost of each individual unit of new electricity company regresses more toward zero over time. The role yieldcos play as the middleman between these power companies puts them in an attractive position. Do you want to talk a little bit about that thesis for our listeners and how that fits in?
Hall: It's interesting. You think about, you're a big utility, Southern Company or Duke Energy or one of these big guys. Why would you want to go to a middleman to buy power? It seems like it doesn't make sense to do that. The reality is, if you're a utility and you need more power than you're able to produce from your existing assets, especially if you're a regulated monopoly, a power producer, you don't just go contract a builder to build you a coal or natural gas or a wind plant. It's not that easy. Typically, you have to get approval from your regulator, which is often the state because you have to pay for that, which means you're going to have to take on debt, which is going to mean incremental expense, which means that you're going to have to go to ratepayers to sometimes increase your rates. There's all these steps that you have to go through.
Furthermore, there's been some utilities that have really had some serious debacles over the past few years, with these big projects that they've tried to develop and just haven't panned out. Ratepayers are on the hook for something that has failed. So, if you're a utility and you need to add a little bit of incremental power, being able to tap a TerraForm Power to buy a certain amount of electricity is a great way to be able to do it because you can meet that incremental need without having to add capital expense, add leverage which means adding additional risk for your shareholders, and not have to go through the process of getting approval from your regulator to do all those things. So, it's really a great situation for these independent producers, these yieldcos, to be able to fill a need that really, really supports the utility's ability to provide low-cost, especially renewable energy to the ratepayers.
Now, one thing that you brought up that's really important, you want to talk about the accelerated depreciation? That's another big issue for the utilities. I think that's another thing that's really important.
Sciple: Sure. As the cost of renewables have come down over time, it makes these existing assets like coal and things like that, the value of those assets are reduced over time. When you install these new renewables, once they're physically in place, they're going to continue producing energy at a marginal cost that's much lower than each incremental bit of energy you have to produce via coal plants. As that happens over time, and those plants become less economical, those have to be written down by utilities over time, which creates additional pressure on the business from the ability to put more cash to work, to expand and transition their power assets. Jason, I'm kind of rambling here a little bit. [laughs]
Hall: No, no. It does. I think the key part of it is the incremental cost. Think about especially wind, and solar is coming down quickly, too, but especially wind. It's cheaper for a utility, in many cases, to buy wind from a Pattern Energy than it is to continue to fire a 40-year-old coal plant, in terms of per-unit energy production costs. They have this old asset that's too expensive -- it costs them more to maintain and use that asset than it might be to buy incremental power from one of the yieldcos. And, they have to write off the value of that old asset. It has a negative impact on their books if they try to replace it by accelerating the depreciation of it.
It's another way that renewables and these yieldcos are really disrupting the utility industry. But at the same time, they're providing the utilities with what they need to address the disruption that's happening.
Sciple: Right. They operate in this nice little space where they're not subject to the regulation that existing utilities have to deal with when you talk about having to negotiate increases in rates, as well as, they're not limited by these existing assets that put pressure on the ability for these yieldcos to allocate their capital in the best way they could.
Let's talk about some of these yieldcos that we think investors should be paying attention to. The first one I want to talk about is Brookfield Renewable Partners. Matt Dilallo and I spoke about this company at some length on a recent episode. When you look at Brookfield Renewable, most of their assets are hydroelectric assets. They've been moving more recently into wind and solar. What do you like about Brookfield Renewable Partners as a yieldco for investors to take a look at?
Hall: One thing that jumps out at me, and stock has bounced back, but over the past year, the stock price continued to fell pretty steeply, and it really pushed the yield up because of the way that the folks at Brookfield tend to run their businesses. They really have a long-term focus. They think about these assets, and what can they generate over a five-year period, over a 10-year period, and longer. They don't get caught up in managing to the quarter-to-quarter Wall Street mentality. One thing that Brookfield Renewable has done a lot over the past year, year and a half, is they've done a lot of what they call asset rotation, asset recycling. They take assets that they don't really project that asset's ability to grow cash flows at the rate that they want to generate the kind of returns that they want. If they can yield a good premium by selling that asset, they'll sell it. Then they take the capital, the proceeds, and then they're going to hunt, and they're going to find the next opportunity to redeploy that capital into assets. They're going to generate higher returns than what they just sold.
The short-term impact of that is, it might be a quarter, it might be multiple quarters, when they don't redeploy that capital, and you see a short-term impact on cash flows. But in the long term, it absolutely always pays off because these guys are so good at being disciplined and then finding the next thing to buy. They sell something that might generate 2%, 3%, year on year cash flow growth, and they buy something that's going to generate upper-single-digits, maybe even lower-double-digit year on year cash flow growth. They're really good at that. And often, when they sell an asset, they can get a really good multiple on the cash flow yield of that asset. Then, when they buy, they often pay a lower multiple than what they realized to generate that cash. They're just really, really good at capital allocation.
The second thing that they're really good at is, once they own these infrastructure assets -- in this case, we're talking about power assets -- they're really good at standardizing and making sure that they wring all the costs out that they can to maximize the cash flows and maximize the output of these things. For example, one of Brookfield Renewable's great sources of cash flow is from TerraForm Power. I think it owns like 69% of TerraForm Power. They helped provide a large cash injection that allowed TerraForm to buy this big Spanish renewable energy producer that increased TerraForm's cash flow something like 40% year on year. They also helped push this initiative for TerraForm Power to sign a deal with GE to take over maintaining their North American wind fleet. That's going to reduce the cost of maintaining their wind turbines in North America by like 10%. These things flow right to the bottom line. If you're looking for a steady, solid, buy-it-and-forget-about-it, high-yield stock... I mean, I love Brookfield Renewable for that.
Then, you think about its ability to grow. Brookfield Renewable forecasts between 5% and 9% year on year long-term growth of the dividend payout. The ability to grow that dividend regularly by growing cash flows over the long term makes this a great buy-and-hold, reinvest-those-dividends stock. I'm just a huge, huge fan of most of the Brookfield entities, Brookfield Renewable especially right now.
Sciple: Right. Brookfield Renewable, if you look over its history, it's delivered a 15% total annual return. Obviously, that takes into account that dividend. But if you can compound your wealth at 15%, particularly as we look at the way the trends have to move when it comes to renewables over time, there's going to be real opportunities for them.
You talked about their asset recycling. 2018 was really a period in which Brookfield Renewable was going through that in a really significant way. They've opened up a lot of liquidity on their balance sheet to allow them to start redeploying capital to drive new investments and continue to drive returns. They have over $2 billion in liquidity on their balance sheet. They've been able to have their debt structured in such a way that they don't have any maturities for the next four or five years, so they can really start deploying their liquidity to grow the business. As you mentioned, the track record of management, to continue to allocate capital in a prudent way and drive returns for shareholders in a really attractive way to get exposure to renewables.
I will say, a lot of folks will see that they have a large portion of their assets in hydroelectric power, and maybe it's not as exciting as wind and solar. But those assets can give you a really dependable return over time. We've talked in the past, Jason and I, about the issues that you can have with matching supply and demand from an energy point of view with solar and wind. You avoid those issues with hydroelectric power.
I really like the way they've allocated their assets. I like their track record. I like that they have a strong history of prior returns. It's a really great business to look at and put in your portfolio and be able to sleep at night pretty well.
Jason, you mentioned TerraForm Power. That's the second yieldco I'd like for us to talk about. You mentioned Brookfield Renewable and Brookfield Asset Management together. The Brookfield family took a majority interest in TerraForm Power back in 2017, bought it away from SunEdison when they were in bankruptcy. This is another instance, as we mentioned, of Brookfield being able to buy assets at attractive valuations, talk about an asset you can buy out of bankruptcy. Rarely do you see better valuations than that. They've really been able to, as you mentioned, pump cash into the business to allow it to continue to grow.
When you look at TerraForm Power, ticker TERP, as an opportunity separate and apart from Brookfield Renewable, what advantages does TerraForm Power have vs. Brookfield Renewable when it comes to an investment to differentiate between the two? And which do you find more attractive today?
Hall: One thing is, going back to the whole schedule K-1 thing, Brookfield Renewable Partners is a limited partnership. You get the K-1. I address the fact that the Brookfield partnerships tell you that you can own them in a retirement account. I personally do, so I don't have any concern about it. But if you do have any issues -- and, there's a lot of cases where you're buying in a taxable account. Again, you may have to pay the higher tax rate. There's more complication, especially if you're dealing with a larger portfolio and you may own a multitude.
TerraForm Power is not a limited partnership, it's just a regular old corporation. It pays out qualified dividends. You get your 1099. It's a lot cleaner, it's a lot easier. That's just a nice thing to know.
In terms of the thesis, it's a wind and solar play. It really is. That's where their assets are. The dividend yield's a little bit lower, I think it yields around 6% or so. Right now, Brookfield Renewable yields something like 6.4%. So, there's around a 7% premium yield you get from Brookfield Renewable today. That can change pretty quickly over a few trading days. But in general, Brookfield Renewable has paid a higher yield. That's part of the exchange for the higher taxes, lower taxes go into TerraForm Power.
I think in terms of pure growth from here, TerraForm Power is a little smaller, so there's a little bit more potential to grow its asset base. I think Brookfield Renewable has prioritized giving it the tools to be able to grow its per-share cash flows. You have to remember, Brookfield Renewable, based on what it's paid to buy its stake in TerraForm, it gets a cash-on-cash yield of like 11% or 12% based on what it paid for its stake. It's getting a very high rate of return. As TerraForm Power is able to grow its dividend, there's a lot of incentive for Brookfield to grow TerraForm Power because of its ability to grow that cash-on-cash yield. As a shareholder, you're very aligned with the majority owner of TerraForm Power. I think that's a really, really powerful advantage that TerraForm Power has to be a market-beating dividend growth investment right now. I really, really like TerraForm Power a lot.
Sciple: Again, the Brookfield relationship really gives you reassurances that they're going to be managed in a prudent way. If they need capital, that relationship with Brookfield Asset Management gives them access to capital at attractive rates. Things like that. Definitely an interesting opportunity, particularly if you want the Brookfield relationship but more of a pure-play on wind and solar vs. Brookfield Renewable, which is going to get you more of that hydro exposure. I personally like that, but different investors may have different preferences.
Let's move on and talk about Pattern Energy Group. This is a another yieldco focusing primarily on wind and solar. This is a company that has been among one of the highest-yielding stocks on the stock market over the past year or so. They've had some issues continuing to finance their dividend. The number I saw is, they paid out 99% of their available cash flow last year as dividends. Really want to bring that number down.
As you look at Pattern Energy Group, what stands out to you? What should investors be paying attention to?
Hall: That's the big thing. It paid out basically all of its cash flows last year to cover its dividend. If you go back to the end of 2017, the company had increased its dividend every single quarter. Sequentially, every single quarter, it had been able to increase its dividend since going public. It had to halt that increase because of the fact that its cash flows stopped growing. Part of the federal tax legislation that was passed little over a year ago now, one of the things that changed was... I don't want to get into the weeds too much, but essentially, it affected the pool of debt that was available to develop these wind and solar projects, the ability to share in some losses that were beneficial for highly profitable organizations to invest in these projects, to be able to offset their earnings and reduce their tax exposure. Factor in that, and also, interest rates haven't gone up over the past year. It's just been harder to get a lot of these projects financed.
At the same time, Pattern's largest wind project is in Puerto Rico. It was a long time that those wind turbines just sat there, not producing any cash flow at all because they couldn't be connected to the grid, because the grid was basically down. So, that took a bite out of its cash flows for much of the year prior, and created this situation where the dividend had to be frozen where it was. It wasn't cut, it was just frozen where it was. But there was a lot of concern, and the stock was shorted pretty heavily, because of this expectation that the dividend was going to get cut.
Over the past year, Michael Garland is the CEO, he's also the CEO of Pattern Development, that's the privately held project developer that sponsored Pattern Energy. He followed the Brookfield model a little bit. They did some asset rotation. They sold off a couple of projects that they weren't necessarily getting the best cash-on-cash yields from. They were a little more expensive for them to operate because they geographically weren't located in the same area that they tended to operate in. They sold off those assets, and they've been steadily redeploying that. And it's starting to pay off. Their cash flows increased double-digits this year, which is good, because if they didn't increase, their dividend would have cost more than their cash flows. They were able to avoid having to cut the dividend by reallocating and rejiggering their portfolio of assets.
The company just did something that I think is really interesting with their most recent earnings. They actually outlay their guidance for the next two years and explained how they're going to be able to get to that targeted 80% payout ratio, meaning that it will take about 80% of their cash flows to cover their dividend, giving them a 20% buffer. That two-year guidance broke out, between asset rotations and their ability to tap some of the other liquidity tools, that they would be able to grow their cash flows 20% over the next two years. Mostly in 2020, some second half of 2019, but mostly in 2020. And, how they would be able to accomplish that without having to sell stock to fund any of those capital projects. That's important with the dividend yield still being close to 8%. It's hard to generate per-share cash flow growth when you're going to be essentially paying 8% to come up with the cash to do it.
So this is definitely higher on the risk-reward side. The potential reward is, you get a yield that's a good 20% higher than most of the other yieldcos, if you're willing to take on the risk that management can't pull off what they're saying they're going to be able to do, to build a little bit of a gap to make their cash flows a little bit more secure in terms of protecting the dividend. I think the worst-case scenario is, they make a really bad investment decision into something that they can't bring online, and their expenses go up while their cash flows don't grow, and they end up having to cut the dividend because something happened on the way to the Coliseum, as the show says.
It's just risk-reward. If you don't want to take on that risk, and you want to guarantee the predictable income, Pattern Energy is not the way for you to go. Look at Brookfield. Look at NextEra Energy Partners, which we'll talk about in a second. But if you want to play that risk-reward, Pattern's worth a look.
Sciple: Yeah. Jason, when you look at the issues that they're facing trying to get that payout ratio down, the plan that they've laid out, you follow this business closer than me, what kind of track record does this management have when it comes to handling these types of issues? When you look at the return opportunity here vs. the risk, would you be buying shares today? How do you feel about the business? Give a little context for that.
Hall: Of all of these yieldcos, my largest personal stake is in Pattern Energy. I've been a relatively aggressive buyer over the past year, year and a half. Primarily because I'm 42, I'm not looking for income to pay for my retirement today. This is not a source of income that I need today. I have a long-term thesis. If the worst case happens and they have to cut the dividend and it costs me in the next two or three years, it's not going to affect me personally. Even if that happens, I think a decade from now, it would still work out to be a profitable investment.
Again, it depends on your individual situation as an investor. If you're retired, close to retiring, or you're looking to buy this to count on income today, and you really couldn't afford it if they had to cut the dividend, that would be a big hit to you, then it probably wouldn't be the right stock to buy. But if you're thinking for the long term and you're still working today, and this is part of a retirement plan for 20 or more years from now, I absolutely could see somebody making a call.
So, the biggest reason why I feel that way is because I have a lot of faith in Michael Garland, the CEO, and the team that he has around him. He's been developing renewable projects for something like 30 years now. He has a long track record of success. He's familiar with the government side, the regulatory side. Again, he's very well-aligned as the CEO of Pattern Development, the development company, and the CEO of Pattern Energy, the yieldco. You have alignment in management there, and I think that's really important. Again, you look at what they did over the past year, selling off assets -- it's going to sound like exactly what we just said about Brookfield Renewable. They sold assets at a higher-yield multiple than what they paid when they redeployed that capital into new assets. When you have a management that has a clear record of being able to get a better premium when they sell something than they pay when they buy something, I think you can feel pretty confident that you have a management team that's really disciplined when it comes to managing capital.
Sciple: Definitely an interesting opportunity for investors to look at, particularly with this high yield and the near-term questions, the long-term opportunity is certainly there.
The last yieldco I want to talk about today is NextEra Energy Partners, ticker NEP. You mentioned earlier, NextEra Energy Partners is servicing the energy projects led by NextEra Energy, which is the world's largest publicly traded utility by market cap and has the country's largest renewable energy backlog. Obviously, a great relationship to have for NextEra Energy Partners. When you look at this yieldco investment, what stands out to you?
Hall: The partnership is great for NextEra Energy Partners, there's no doubt about that. You think about Florida, which is NextEra Energy's primary market, the population's booming. There's huge demand for renewable energy. It really has the partnership in a great position to be able to grow. I think that one of the more aggressive plans is to grow their dividend payout. They're projecting a double-digit dividend growth at 12% to 15% annual growth over the next four or five years. That's a much more aggressive growth rate for the dividend. Considering it only yields around 4%, you're not getting the bigger payout that you get, but its ability to grow that payout is pretty good. That makes it really attractive. Again, for investors looking for that long-term ability to be able to grow the payout, to grow your returns that way, it's really interesting.
Sciple: Right. When you see the way they've been acquiring their assets, really novel financing. They entered a convertible equity funding agreement with KKR, which is a large private equity firm. Through that, KKR paid $900 million for an equity interest in this portfolio of renewable assets that NextEra Energy Partners created after they bought some assets that dropped down from the NextEra Energy parent company. When you see this financing they're partnering up with a private equity company to monetize their existing assets, what advantages does this financing structure give to NextEra Energy Partners? With that liquidity, what might they use that for going forward?
Hall: I got a message on LinkedIn from a reader about an unrelated company with a somewhat similar question. In his case, he's asking about share issuance for a particular company. I think the key thing about it is, this is no different from selling stock or raising debt or using internal cash flows. What it really boils down to is, what is your rate of return? This is just another tool that management has in its tool belt of capital to be able to use. The reality is, one of the reasons NextEra Energy Partners' dividend yield is low is, you pay a higher cash flow premium to buy NextEra Energy Partners because it has a really good track record of growing those cash flows and growing them on a per-share basis.
Management has a really good track record of getting very high rates of return. I think this is just another way to do that. I don't think it's necessarily fundamentally a great big deal. It's just another creative way to leverage the best rate of return that they can get on wherever they get their capital from.
Sciple: Sure. The other question mark floating around NextEra Energy Partners has been their relationship with PG&E. Management was really open with this on their last call. Almost a quarter of the partnerships cash flow available for distribution is exposed to PG&E in one way or another. Management has stuck by its guidance that even despite these near-term issues related to the PG&E bankruptcy, they still expect to achieve its 12% to 15% growth in distributions through 2023.
As we look at the complications that might be added by this PG&E bankruptcy to NextEra Energy Partners, is that anything that investors should be concerned about? Or, management has said they're going to still meet their targets, so stay the course?
Hall: I think you have to be cognizant of it to some extent. And this isn't the only yieldco with exposure to that. Pattern Energy very early in the year, mid-January, the CEO wrote a letter to shareholders addressing the same concern because they have a couple of wind farms that sell power on long-term contracts to PG&E, too. The reality is, you have to remember that with PG&E, its liabilities, because of all of the recent wildfires, are its biggest issue. It's going to continue to need to buy power. It's going to continue to need to produce power. Unless, somehow the terms of some of these deals are just onerous and a bankruptcy judge says, "This deal needs to get cut by 30%," and I don't think that's the case. I think these deals are probably pretty competitive and they're pretty reasonable.
I think the bigger risk is, if any of these deals to buy power are a sweetheart deal, and NextEra Energy Partners is getting way too much cash flow from them, that's one thing. I think it probably feels like a bigger concern than it really is. I think over the long term, it's not going to really cause any issues.
Sciple: Right. They're not going to turn the power off in California because PG&E went bankrupt. I sure hope they don't for you, Jason. I'd like the lights to stay on in the in the Hall household over there.
When you're looking at NextEra Energy Partners, like you said, that partnership with NextEra Energy, really powerful for them. A really good customer to have, opportunities for growth. Maybe some near-term concerns with PG&E, but still an attractive opportunity. The market recognizes that. That's why it only yields 4% vs. Pattern Energy, that's had some near-term concerns and its yield got bid up for that reason. Another interesting yieldco for folks to look at.
To wrap everything up, Jason, as you look at these opportunities in the yieldco space, is there any of these that specifically you think would be most attractive for investors today? Obviously, different portfolios have different needs. But for the general investor, if you only had to buy one, what would you be most excited about buying today?
Hall: If you could only buy one of these companies, no matter your situation, I would say TerraForm Power. That's the one I would suggest. You're going to get a solid yield. It reduces any potential risks of weirdness with your taxes, so it's nice and clean and easy. And I think it has a tremendous pathway to growth and to grow the dividend. You're getting a nice, strong yield right off the bat today. TerraForm Power would be the one I'd suggest across the board.
Sciple: Sure. Can't go wrong there, Jason. I think I would probably lean a little bit more toward the Brookfield Renewable. You get that exposure to TerraForm Power, but you also get those hydroelectric assets, which I think is really interesting.
Jason, thanks for coming on the show, sharing with our investors this really interesting space to get exposure to renewables in a way that you really can sleep at night and get some dependable cash flow. Definitely something for our listeners to pay attention to. Thanks for coming on, Jason!
Hall: Absolutely! I think five years from now, you and I both are going to be proven right for our recommendations.
Sciple: Fingers crossed! We'll circle back in five years.
Hall: [laughs] Perfect!
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Jason Hall, I'm Nick Sciple. Thanks for listening and Fool on!