In this week's episode of Industry Focus: Energy, Fool analysts Nick Sciple and Jason Hall dig into the Brookfield (BEP +2.00%)-TerraForm (TERP +0.00%) deal. Learn what shareholders should know about holding the combined company in their accounts, some general rules about investing in partnerships and yieldcos, why Brookfield is acquiring TerraForm now, how this merger will benefit both companies involved, and more.
Also, in light of all the great yieldcos that have been snatched from the public markets this year, the guys share some appealing yieldco names to add to your watchlist. And stay tuned to the end for some college football talk.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on Jan. 16, 2020.
Nick Sciple: All right, it's Thursday. We've got another great episode of Industry Focus: Energy planned for you. Jason Hall is with us once again. Jason, how are you doing?
Jason Hall: I am doing fantastic. I'm doing quite good. But I'm kind of mad that all my favorite yieldcos keep merging and getting bought out and going private. How about we talk about that?
Sciple: Yeah, yeah. You mentioned, it's been a crazy year. Jason, you've been a big fan of TerraForm Power, which is a yieldco, as well as Pattern Energy, both of which have been acquired or gone private, in the case of Pattern Energy. And in the news we're going to talk about today, this week, TerraForm Power shares are up 11% on the announcement, Monday that Brookfield Renewable Partners is going to make a $4 billion all-stock offer to acquire the remaining 38.5% of the business that it doesn't already own. Jason, I mentioned you own both of these stocks, both Brookfield Renewable and TerraForm Power. What was your reaction to that news when you heard about it?
Hall: It was a little bit of just like, "OK, fine." Not any major big deal. So, you go back a couple years ago -- we'll talk about it more in the show -- and Brookfield Renewable through its sponsor, Brookfield Asset Management, and some other partners, already had a controlling stake in the business. It has for about three years now. So, I think to a certain extent, a lot of us have thought it was an inevitability that TerraForm was going to get rolled into Brookfield Renewable. Most of us were just waiting and hoping that it wouldn't happen for a while, because a lot of us that bought over the past couple years have done really well, capturing the better yield that TerraForm has. So, I was just hoping to milk what for me was about an 8.5% or 9% yield on my investment, my actual cost, for a little bit longer. But, oh well. Great companies get acquired by other great companies all the time.
Sciple: Sure. Yeah. You've mentioned that over time, it's kind of been expected. As we'll talk about it in the show with TerraForm Power, this relationship with Brookfield is a big part of thesis for the company, of why were so attracted to it. But it has been for a long time, as you said, a suspicion that sooner or later, these companies were going to come together. Why do you think now was the time these companies chose to combine?
Hall: I think probably the biggest one is something that Brookfield recently announced that it was going to do with Brookfield Renewable Partners. The timing made sense in terms of the corporate structure change we'll talk a little bit about, too, to go ahead and combine the whole entity into a single corporation, especially for current investors in TerraForm Power. The short version is, TerraForm Power is a corporation. Brookfield Renewable partners is a publicly traded partnership. There's some differences with the tax implications. There can be challenges between holding partnerships in tax-advantaged accounts like 401(k)s and Roth IRAs and traditional IRAs. So, I think it was just a more shareholder-friendly time to do it, versus, if Brookfield Renewable was going to remain a partnership, it wouldn't have been necessarily the most shareholder-friendly way to acquire TerraForm Power with a stock transaction.
Sciple: Sure. One of the things that I noticed when you look at this transaction that I suspect may have played a role as well. You look over the past several years, these stocks have traded together. The stocks have moved up and down together. You saw over the last three months or so, those diverged. Brookfield Renewable Partner's stock has continued up on their upward trend, while TerraForm flattened off. When you're doing an all-stock transaction, when you can exchange your higher-price stock for a lower-price stock that you think is undervalued, there's some attractiveness there as well.
Hall: A little arbitrage.
Sciple: Exactly. Bruce Flatt and the folks at Brookfield are great at finding those opportunities to buy assets that are undervalued, or maybe when the market doesn't recognize the true worth that they have. But you mentioned this changeover in the structure of Brookfield Renewable. That's raised some questions among investors. We did get a question from our listener Rod in Albuquerque who says, "I currently own TerraForm Power in a Roth IRA. With the upcoming merger with Brookfield Renewable," will he now have an MLP in his Roth, or only the new corporation? As you mentioned, there's moves to transition Brookfield Renewable into a corporation. For investors that own both of these companies in a tax-advantaged account, how should they be thinking about this merger and how it will affect those holdings in tax-advantaged accounts?
Hall: A couple of things. First of all, to explain for everybody that's listening, this is really good information to have as you're investing. In general, if you have a Roth IRA, a traditional IRA, or a 401(k) that you can buy stocks in, one of the biggest benefits is being able to take advantage of deferring, or in the case of a Roth, avoiding any taxes whatsoever on your investments. The catch with MLPs, master limited partnerships, or publicly traded partnerships, is that many of them generate a type of income that's called unrelated business taxable income, or UBTI. The thing with UBTI is, through the dividends that you're paid, if you earn more than $1,000 in UBTI in any one year -- and not just in each IRA. Let's say you've got a Roth IRA, and then you've got a rollover IRA from a prior employer, and then you've got another 401(k) that you're able to own stocks in. Across all of those accounts, if you generate more than $1,000 in UBTI, you actually have to pay tax. For younger investors, it's not necessarily that big of a concern, but as you get older, as your wealth increases, the potential of creating a tax event inside of a tax-advantaged account is why in general, it's recommended that you avoid owning these partnerships inside of your retirement accounts.
Now, with that said, the general outlay of owning partnerships, the Brookfield partnerships -- Brookfield Renewable, Brookfield Infrastructure Partners -- they don't generate UBTI through their investments. They're structured in a way so that's not a concern. But some brokerages still won't let you buy any company that's a partnership inside of your retirement accounts. So, even though they say it's OK, sometimes some brokerages still won't even let you buy it. So, that's a limitation. So, that's Rod's concern, is if he gets these BEP shares, what's it going to do for him? Since it's Brookfield, it wouldn't create any tax event for you. But, again, the bigger idea is, Brookfield wants to go ahead and make that a non-issue.
The other part of it, too -- and honestly, this might be a bigger one -- as its partnerships have gotten larger, more valuable, and as the opportunity to grow in these renewable spaces and as global infrastructure spending grows, these entities are going to get much, much bigger over the next decade. And they're really limited in terms of showing up in major stock indices being structured as partnerships. So, I think there's the potential, especially as indexing and index funds have become a bigger way most people invest, it's going to create a larger potential pool of investors. And that means more capital for these growth-focused entities. Does that make sense? Did I explain that well?
Sciple: Yeah. So, Brookfield is making these moves to convert their existing partnerships into corporations. We're seeing that occur with Brookfield Renewable Partners. They're creating Brookfield Renewable Corporation. They're doing the same with Brookfield Infrastructure Corporation, where you'll be able to own in a corporate form the economic equivalent of owning Brookfield Infrastructure Partners. Brookfield is obviously making it a big priority of giving investors the opportunity to own these previously partnerships in a corporation form that the investor would like. Unrelated to the TerraForm Power merger, as Brookfield opens up these continued opportunities to own Brookfield Infrastructure, Brookfield Renewable in a corporate form, if you're an investor that only owns the partnerships today, as the opportunity to own the corporation rises, what are the pros and cons of an investor switching over to owning that corporate forum versus just continuing to hold the partnership that they already own today?
Hall: The key thing here is that when you think about a corporation versus a partnership, you get different tax documents, you get your schedule K-1 for your partnerships, and most of your taxes, the distribution that you earn is probably going to be taxed at your marginal income tax rate, versus a qualified dividend, which is what most corporations are able to pay, that is taxed at the 15% for most earners, taxed at 15% long-term gains tax rate. Again, we haven't seen what the deal is going to be. The corporate entity will pay corporate income taxes. The partnership is what they call a pass-through, it's designed to pass more cash through without paying taxes internally. So, the needle needs to move on some certain things to understand what you're buying to say for sure. But in general, a corporation, you pay lower taxes on your dividends, and you get a 1099 so it's a little bit cleaner when it comes time to actually do or file your taxes at the end of the year.
What am I going to do? I'm probably not going to do anything, again, until I see what the numbers look like. And it could be an opportunity, kind of like what Nick mentioned earlier with how TerraForm's stock has diverged over the past three months or so from Brookfield Renewable's stock. Honestly, I might just play arbitrage and buy one or the other as I'm adding over time based on if it looks like one is a better valuation for some strange reason. Which, sometimes you see that with dual-share stocks. Sometimes, every once in a while, the market gets screwy, and one is just cheaper for some reason.
Sciple: Sure, yeah. You already can see that in some instances. I don't know how big the difference is, but there already exist Brookfield Property REIT in addition to Brookfield Property Partners. So, we're seeing a similar framework play out with the changes that the company is making to Brookfield Infrastructure Partners and Brookfield Renewable Partners. We'll have to see as the details come down from the company. I'm sure we'll talk about that on this show.
Going back to the TerraForm power merger with Brookfield Renewable, when you look at the assets, bringing together the TerraForm assets with Brookfield Renewable, what does this create for the business going forward? And do you feel this business is stronger together than they were separately?
Hall: There's definitely some benefits to combining it. Just right off the top, it's going to be more cost efficient, just because corporate structure costs should go down. I think you're going to see the retention of the best management from both. The management that was running TerraForm Power are all people with the Brookfield background anyway. So I don't know that it necessarily strengthens management. I think there should be -- I hate this term, but you should see cost efficiencies, you really should, because Brookfield already knows everything about TerraForm. How its run, where it can find cost opportunities.
I think the biggest thing is that Brookfield Renewable pre-merger is still, I don't know, almost three-quarters of its cash flows come from hydroelectric. That's where its legacy business is. After this merger, more than 40% of its cash flows are going to come from wind and solar. So, it's really moving the entire business toward where the market is and where the real opportunity is. And that's corresponding to the costs of wind and solar production. Now, with energy storage costs falling so much, they're really on parity with just about any other source of electricity on a global basis. So, I think the timing is right to simplify how Brookfield invests. If you look back at TerraForm Power's biggest needle-moving transaction since the acquisition, it acquired Saeta, a Spanish wind and solar producer. That was funded by equity investments that Brookfield made into TerraForm Power. So now, instead of Brookfield giving money to TerraForm Power and then TerraForm Power going and spending that money on the asset, it's just one business. And one business makes a business decision what assets to buy, what assets to sell what, assets to improve, however it works. So, I think it really does make a lot of sense in the long term to leverage the best growth as a business unit.
Sciple: Sure, yeah. When we've talked about, in the past, Brookfield Renewable, the fact they were overweight to hydroelectric versus having that exposure to wind and solar, it's really exciting to get that exposure now in Brookfield Renewable. Last question on this merger. We saw the shares pop up 11% when the merger news was announced. If I'm not mistaken, the premium that Brookfield Renewable is offering, coincidentally, is 11% above where the shares were trading at that time. We see this transaction is very likely to close, given the relationship between Brookfield Renewable and TerraForm Power. As someone who owns TerraForm Power, how are you going to handle your shares in this period between now and the closing of this transaction?
Hall: It's business as usual for me. I own significant shares of both, looking at them for high yield and for the long-term dividend growth. That's not changing. I've also kept them in the same bucket in terms of exposure risk, because so much about TerraForm Power is tied to Brookfield. It's a related party already. So, in a way, I've already considered them one unit in terms of that risk. So, I'm not making any changes. I'm not selling TerraForm because of this. I'm not going to make any changes to my portfolio. I'm just expanding some of the other entities that I'm looking for in terms of where I'm going to invest new money. That's probably the only thing that I'm doing different.
Sciple: OK, Jason, we talked about on the first half of the show how this year has really been brutal for some of our favorite yieldcos. TerraForm Power merging with Brookfield Renewable, Pattern Energy being taken private by a Canadian pension fund. Since those companies are no longer on the market, it's time to start looking for new renewable yieldcos to add to our watch list. Jason, do you have a couple companies you want to share with us?
Hall: Yeah, I do. I've got a couple that are on my list. If you want, we can start talking about Atlantica Yield, ticker AY. How does that sound?
Sciple: Before we get into Atlantica Yield, Jason, when you're just looking across the sector at yieldcos, what are you looking for in these companies? What are the boxes you like to check off that say this is a company that's attractive to you?
Hall: There's probably three things that I focus on. No. 1 is trying to find a good margin of safety. What I mean by margin of safety? In typical terms, you think of margin of safety, you think, it's a company that's got a ton of cash sitting on their balance sheet, a company that doesn't have very much debt. But the reality is that you look at any of these yieldcos, and generally they don't carry very much cash on their balance sheet, and they all have a lot of debt. So, how can they have margin of safety? The way they have margin of safety is, they have strong contracted cash flows. Just like any other utility, they invest in these wind and solar farms, natural gas plants in a few cases. Atlantica Yield's case, water systems. Then they have these long-term contracts to sell the output. Or, they have some units that are regulated utilities. These kind of businesses, they generate steady cash flows, no matter the economic environment. So, you want to look and find the ones that have the contracts in place for large cash flows, that support their dividend, and don't put them at risk of the big interest expenses that they're not going to be able to meet that are going to force them to then cut their dividend and leave investors high and dry. So, that's the first thing I look for.
The next thing I look for is, typically with these yieldcos, they have a sponsor, they have another company in the background that's either publicly traded, like Brookfield Asset Management is for the Brookfield family of entities, or in Atlantica Yield's case, it's privately held, Global Infrastructure Partners. You want to have a strong financial backer, typically that has some experience in that specific arena of assets, and a history of being a good, responsible investor and a long-term focused investor. So, those are the two things that I look for.
No. 3, I usually try to find -- this is a second part of the margin of safety, but specific to the yield -- I like to find one that is generating 20% more distributable cash flows than they actually need to support their dividend. That's usually a pretty good margin of safety for this kind of business.
Sciple: OK, Jason, taking that framework, let's now move on and talk about Atlantica Yield. When you take a look at their assets, you mentioned the water assets that they have. What stands out to you about the business?
Hall: You hit on a couple things. It does have a strong yield. 18 years weighted average contract life is quite good. Again, that's the source of those predictable cash flows. So, those are things that I definitely like. I also like the fact that it's actually relatively small. 25 assets and about 1.5 gigawatts of energy generation capacity. It's certainly on the smaller side. So, you just draw that out on paper, and it says this should be one that has an opportunity for outsized growth, because it can participate in smaller deals that can give it meaningful gains and results. So, those are things that I definitely like a lot about it. Geographically, it's got some interesting diversity. It's got some assets in Europe, it's got assets in North America, it's got assets in South America. Those are things that I definitely like about it.
Now, let's talk about why I haven't bought it yet; why it's just been on my on my watch list for a few months. I think the short version is, if you look at its corporate history, I'm not completely confident in its corporate backing at this point. It was founded by Abengoa, a Spanish company. A couple of years ago, it sold off most of its stake to Algonquin Power Utilities, which is a Canadian utility company that actually has a lot of operations in the U.S. I think Algonquin owns about 45% of the company now. Here's where I'm concerned. No. 1, it's had a fairly recent transition in its sponsorship, which in and of itself isn't necessarily a bad thing. But the difference here, you think, you've got a Canadian utility company that's getting involved, that sounds like Brookfield, right? The difference is that Algonquin doesn't have the same history of developing assets outside of the regulated utility space. I want to give the story time to play out a little bit more. Algonquin and Abengoa have a joint venture that they've created to develop primarily renewable assets. Atlantica has a first right of refusal, which is the typical way these deals are structured when there's a sponsor in a yieldco. In other words, it has the right to pick and choose from this list of developed assets, and buy the ones that it's the most interested in. So, that's kind of good. But, again, it's typical, it looks good, but I want to give it time to play out, and see, does it generate meaningfully positive results? Is Algonquin really committed to this venture? Or is it going to get to a point where it's not able to focus on its regulated utilities business and it's not able to dedicate the resources to this joint venture and to Atlantica? So, that's my concern. That's why I'm not ready to pull the trigger just yet.
Sciple: Yeah. Sounds like evaluating management, making sure that the assets that they now control are going to be managed in a way that is going to consistently produce returns for shareholders over time. Moving on to Clearway Energy, that's the second stock that you've added to your watch list. What really stands out to you about Clearway Energy?
Hall: Clearway Energy, ticker CWEN. I think it owns 7 gigawatts of power generation. Mostly wind and solar, and some natural gas. So, again, it's substantially bigger than Atlantica Yield. It's also a little more familiar name. In North America, it was formerly called NRG Yield. It was sponsored by NRG Energy, the utility. Global Infrastructure Partners, which is a privately held private equity infrastructure investment partnership, acquired it about 1.5 years ago and renamed it Clearway Energy.
The things that concern me about it. Really, it's not the things; it's the thing. It has pretty outsized exposure to Pacific Gas & Electric, PG&E, which most listeners should be familiar with. That's the large regulated California utility that's going through bankruptcy related to all the fires out here in California that it has some liability for. The thing is, a substantial amount of its cash flows are tied to selling power to PG&E.
Sciple: Yeah, 30%, Jason. A really significant customer for them.
Hall: Yeah. The risk there is, depending on what happens with its bankruptcy, the first risk is, there's a risk of those cash flows getting slashed if the bankruptcy courts require renegotiation of those rates. I'm not particularly concerned about that to be honest with you, because these aren't sweetheart deals. They seem to be pretty fair market-rate deals. So, that's in Clearway's favor. But, you go back to ... when did they cut the dividend? About a year or so ago, I guess. They slashed the dividend in half when the rumblings were coming of PG&E's bankruptcy. So, I guess the best way to put it is that right now, management's really focusing on deleveraging the balance sheet, cutting costs, putting it in a little bit better financial position to have a little bit bigger margin of safety. with the idea that going forward, No. 1, it's trying to reduce its exposure to single customers. No. 2, creating a situation where it won't have to slash its dividend in half if there is a major issue with one of its large customers going forward.
I think for me, I'm at a point now where I'm relatively confident with where the business is. The yield is sustainable where it is. Cash flows are going to grow, I don't know, probably 15% to 20% this year. Their target is 18%. So, it should produce a pretty substantial amount of cash available for distribution. And then, once the PG&E bankruptcy plays out a little bit more, there's a substantial amount of cash that it has that's sitting at one of its subsidiaries that it can't even touch. And the reins should come off of that, and then it should be able to redeploy that cash flow. Whether it uses it for a special dividend or to pay down debt, or to acquire new assets, remains to be seen. But the point is, I think the company's pretty strong right now. There's some line of sight to what's going on. And I've got faith in Global Infrastructure Partners. They're a big name. They're well-established. And they're really good at what they do. I think I'm ready, honestly. I think this is going to move from my watch list and it's going to get added to my portfolio probably in the next month.
Sciple: Jason, just to add to the things that you said. They had to cut the dividend last year, but before the PG&E issues materialized, they had been on track to increase their dividend 5% to 8%, which is a pretty healthy amount. PG&E is still paying those bills on those power purchase agreements as they come due. It's just because of the nature of the way bankruptcy proceedings are, those assets are put into escrow until all the proceedings can be decided. So, it's really difficult for Clearway right now, because they have this money that otherwise would be coming in they could redeploy, that's just sitting in cash. But it seems likely that PG&E will emerge from bankruptcy, and with these agreements more or less intact, that's still a question mark. But, as that cash becomes comes free again, it really opens up a lot of opportunities for the company. Maybe they can raise that dividend back up to where it had been previously. But at the very least, the way the cash flows are playing out, you should get pretty reliable increases in dividend payouts over time. And if you look at the way their debt is trading, you mentioned that 30% of Clearway's cash flow is related to PG&E. But if you look at the way their debt's trading, all their debt, at least that I looked at, is trading above par, so there's not a lot of concern in the credit markets that because they've lost access to this cash flow, they're going to have issues. Really strong balance sheet. There's some concerns hanging over the stock, but I think from my view, I agree with you, Jason. This seems to be an opportunity if you're looking for a yieldco, reliable payout over time.
Hall: Yeah, I think probably the best evidence to use to demonstrate what the credit market thinks, what bankers think about Clearway is, Clearway was able to refinance around $600 million in debt in December at a lower interest rate. Banks don't do that if they're concerned about your ability to generate cash flows and repay your debt.
Sciple: Right, yeah. It's not to say that these bankruptcy risks aren't real, aren't something to be concerned of as a shareholder and continue to monitor. But I wouldn't be as scared as you might be otherwise when you hear bankruptcy, when you hear 30% of cash flows.
Hall: Right, exactly, exactly. California is going to continue to need electricity. PG&E, whatever it looks like on the other side of bankruptcy, is going to need to continue purchasing power that it can't produce itself. And its problems are how it's managed its existing assets and its infrastructure of power lines and gas lines, not that it was overpaying for the power that it was buying from yieldcos like Clearway.
Sciple: Sure. Yeah. Hopefully, they'll keep the lights on there for you there in California, Jason. I know they've had those rolling blackouts.
Hall: I have solar panels now, and I'm planning on getting a storage system sometime in the next year so I won't have to worry about what my local utility, which is Southern California Edison -- [laughs] I'm also not exactly a big fan of them, either. But, I plan on removing that thing from my from my problems.
Sciple: Yeah, I don't blame you, Jason. Moving on from stock talk here. I'd like to talk with you about college football a little bit. We just had the national championship on Monday. As you look back over this past season, what were your biggest takeaways, what will you remember?
Hall: I will remember that Alabama lost much sooner in the season than anybody expected. Losing a home game. It's been a while since that's happened for Alabama. But at least you lost at home to the eventual national championships. My Georgia Bulldogs lost at home to an eventual 4-and-8 South Carolina team. [laughs] We also did win the Sugar Bowl.
Sciple: Very exciting. We can't be an SEC championship game every year, Jason. But one of these days, we'll get back there. One thing I want to ask about is, obviously, this year in college football, the biggest thing has been so many incredible quarterbacks. Joe Burrow won the Heisman, Tua's coming out this year. Trevor Lawrence had another great year. You look to the NFL, Tom Brady's toward the end of his career, Drew Brees starting to hit the twilight of his career. As you see these new quarterbacks rising up, how excited are you to watch these folks as they move onto the pros?
Hall: One of the things I'm really excited about is, you look at Joe Burrow, and he's somebody that in a lot of ways, he's the prototypical quarterback that we've seen in the NFL for 40 years. He's 6'6, he's got a cannon for an arm. He stands high in the pocket, he makes all the throws. But, oh, by the way, he can also outrun most of the other teams' linebackers and extend the play like crazy. I think it's so exciting right now that you're seeing this shift away from the pocket passer or the quote-unquote dual threat, which was always just code for the guy that runs. And you have these guys that are truly phenomenal athletes at every aspect. Tua's another great example of that. This is a guy who's got an absolute cannon. He can make every throw. He's got precision. But he's also super-fast. These are guys that you're starting to see more of. Guys like Brees and Rogers, those are guys that, 10 years ago, started showing how valuable that was, that ability to create separation, extend the plays, and then make the big throw, or, oh, by the way, they could also take off and run a little bit if they need to. But this is the next evolution, taking it to the next step. So, I'm really excited. I might start watching the NFL again.
Sciple: Yeah, hey, it's another year until college football. We'll get a little bit of football fix here with the playoffs. Excited to have you on, Jason, as always. Next college football season, I'm sure we'll chat some more.
Hall: Yeah, we will. I'll say this -- I'm pretty excited. We've got pitchers and catchers reporting in less than 30 days. I've got something to go through here in mid-February.
Austin Morgan: The Astros cheating scandal is exploding on Twitter right now.
Hall: [laughs] Can you remember the last time baseball get this much news in January?
Morgan: There's all these reports of Altuve and Bregman using buzzers in their jerseys, and there's a burner account that's claiming to be Beltran's niece. All kinds of stuff. It's crazy.
Sciple: Well, folks, we're going to have to let you go so me and Austin can hop on Twitter and follow this breaking news. Thank you for listening, as always. Remember, 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 his work behind the glass. For Jason Hall, I'm Nick Sciple. Thanks for listening, and Fool on!
