Oftentimes, when we talk about renewable energy and utilities, we're talking about large projects like solar and wind farms that can power thousands of households per year. But looking on a smaller scale -- a much smaller scale -- is just as important.
No, you don't need to break out your microscope. Microgrids are large enough to see without any viewing aids. Connected to the main power grid but able to operate independently, microgrids are small energy grids, which can maintain operations even if the main grid were to fail because of a storm or other event. According to the Department of Energy: "A microgrid can be powered by distributed generators, batteries, and/or renewable resources like solar panels. Depending on how it's fueled and how its requirements are managed, a microgrid might run indefinitely." GTM Research believes that the U.S. microgrid market will surpass $3.5 billion by 2020. Until then, you may want to hold on to these dividend payers that could profit in a big way from the microgrid market.
The starting five
One company well positioned to benefit from the development of the microgrid market is Honeywell International (NYSE:HON), and it has already demonstrated its qualifications. The Department of Defense selected Honeywell to develop a microgrid for use at Fort Bragg in North Carolina. Whereas the army base had previously used generators to provide power during outages, this still left some buildings in the dark. According to Honeywell, its solution will provide power to all buildings, thus "helping main power for vital operations."
As Eaton Corporation (NYSE:ETN) waits for the U.S. microgrid market to develop, it has turned its attention to Africa. On a small island off the coast of West Africa, Eaton is developing a 5 MW microgrid -- a system that, when completed, will be the largest self-sufficient solar microgrid project in Africa. Eaton Corp. is qualified to provide project development and site engineering services for microgrid projects -- a segment of the market that Greentech Media estimates to be worth about $353 million.
Arguably, the company best suited to profit from the developing market is General Electric (NYSE:GE). Capable of assisting in microgrid control and energy management, project development and site engineering, energy storage solutions, and micro-generation, GE offers developers a substantial variety of services.
For example, project developers already have the option of using GE's Grid IQ Microgrid Control System. According to GE, the solution "enables distribution grid operators to integrate and optimize energy assets with an objective to reduce the overall energy cost for a local distribution grid, also known as a "microgrid."
A fourth company that has the ability to offer its services to the burgeoning microgrid market is Raytheon (NYSE:RTN). Like Honeywell and GE, it is qualified to provide services related to microgrid control and energy management. And, like Honeywell, Raytheon is a major defense contractor. Just as Honeywell helped to develop the microgrid project at Fort Bragg, Raytheon also has demonstrated its effectiveness. In March, Raytheon announced that its partnership with Primus Power, Advanced Energy, and the National Renewable Energy Laboratory had sucessfully built a microgrid system that relies solely on solar power -- no conventional fuels needed. According to Paul Ferraro, Raytheon's vice president of Integrated Defense Systems' Advanced Technologies Programs, the energy management solution "enhances energy security and efficiency, which are essential components required to meet current and future DoD energy objectives."
The development of this market is going to require some financing, and one company for which microgrids are in its wheelhouse is Hannon Armstrong Sustainable Infrastructure Capital (NYSE:HASI). This REIT provides debt and equity financing to the energy-efficiency and renewable-energy markets. Unlike some REITs that are not very diversified in their holdings, Hannon Armstrong has a $1.1 billion portfolio that consists of three main segments. Energy efficiency investments accounted for $331 million; solar and wind transactions accounted for $735 million; and other sustainable infrastructure investments accounted for $50 million.
Yeah, but how 'bout those dividends?
First, we're looking at holding on to these stocks for several years while the microgrid market develops. In that time, it'd be nice to be reasonably confident that the company will be successful over the long term, and what better way to show that than be a consistent dividend payer. For all of the companies -- except Hannon Armstrong, which has only been public for a little over two years -- dividend growth has been a staple for each company.
Evaluating the sustainability of a company's dividend can take different forms, but, one of the simpler (and just as effective) metrics is payout ratio. By taking the annual dividends paid per share and dividing by the annual earnings per share, or EPS, we get a sense of how much of the company's earnings are being returned to shareholders in the form of a dividend. Because REITs are required to pay out at least 90% of their taxable earnings in the form of dividends to shareholders, using the payout ratio can be unreliable. We'll hold off on looking at Hannon Armstrong again for the moment.
A payout ratio that's too high suggests that a company may not be making the best use of its earnings -- sacrificing a more prudent use of its cash to distribute a dividend to shareholders. Honeywell, Eaton, and Raytheon all sport healthy ratios. Although Eaton's ratio is borderline high at nearly 45%, the company has maintained that level for years and raises no red flags. GE is the outlier here, but we must remember that it's selling off most of GE Capital, and while this unfolds, its financials may be a little deceiving. For example, in the second quarter it booked a one-time charge of $4.3 billion against earnings.
Because the use of payout ratios as a metric to evaluate a REITs dividend can be misleading, many times investors prefer to use Funds From Operations, or FFO, which adds the depreciation and amortization charges back to the net income and subtracts any gains from the sale of property. In the chart below, we see that Hannon Armstrong has, more or less, been growing its FFO; however, it should be readily apparent that there isn't a lot of history upon which we can look back -- the company has only been a publicly traded company since April of 2013. So, one must recognize that there is a higher degree of risk with an investment in Hannon Armstrong than with one of the companies discussed above. .
Final Foolish thoughts
The microgrid landscape is just beginning to take shape, and there are bound to be plenty of winners and losers. Think one of the companies discussed here has what it takes to profit from this soon-to-be booming segment of the energy industry? Make sure you dig deeper to see which stock is right for you.
Scott Levine has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.