Wednesday, December 18, 2013

The YieldCo: Return of the Utility Spin-off

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Major utilities and various renewable companies are planning to create spin-offs structured as yield companies (YieldCo) or master limited partnerships (MLP) that promise to pay higher yields by offering direct exposure to stable, cash-generating assets.

The launch of these investment vehicles has been a source of excitement in the power industry, particularly with NRG Energy Inc’s (NYSE: NRG) successful initial public offering (IPO) of NRG Yield Inc (NYSE: NYLD), the firm’s YieldCo. That’s prompted a number of utilities to announce similar plans. The question is whether these new securities offer enduring value, similar to what’s happened in the traditional MLP space, or whether they’re just another way for firms to raise cash by making a cynical play for yield-starved income investors.

From a taxation standpoint, dividends paid by YieldCos are generally taxable as ordinary income, though dividends may be qualified under certain conditions. Some YieldCos are shielded from corporate-level taxes from net operating losses (NOL) generated by wind and solar assets. By contrast, the majority of an MLP’s distribution is typically treated as a return of capital, which serves to lower an investor’s cost basis and, therefore, shields income from taxation until the units are sold.

But even as we share the industry’s enthusiasm for these new investment vehicles and the potential for superior high-yield opportunities, there is much investors need to know about the history and potential risk implications of these transactions, to the utility company and its new subsidiary. This is particularly important, as past spin-off efforts have met with mixed success.

Innovation and Risk

These new investment vehicles do offer some innovations. For the first time, investors will be able to have a direct stake in electric utility-owned natural gas subsidiaries through MLPs. Meanwhile, Congress is working on legislation that would allow renewable assets to enjoy the same tax treatment as natural gas assets, which means they could also be included in these MLPs.

And the YieldCo is a new variation on previous utility spin-off strategies of the early 2000s. Rather than offer exposure to high-risk, high-growth assets, which is what investors sought during the early part of the last decade, this new structure will offer investors exposure to low-risk, high-yield assets, as well as the aforementioned favorable tax treatment.

Clearly, these attributes are an improvement from previous initiatives. But in considering such an investment, there still are risks that must be scrutinized.

For example, a company’s choice to spin off a set of high-quality, income-producing assets raises the question of whether it will be weakened from a credit and earnings standpoint, thus undermining its value as an investment.

According to a Moody’s Investors Service report, “YieldCos permanently transfer a portion of the parent’s most reliable cash-flow-producing assets to another entity resulting in residual cash flow that is materially less to support the parent’s credit profile. In the best case scenario, this form of financial engineering could be considered credit neutral if all or a substantial portion of the IPO cash proceeds are used for parent company debt reduction …”

But given NRG’s example, Moody’s suspects that companies will use the proceeds from such offerings for ends other than debt reduction. The rating agency concludes, “YieldCos are growth vehicles, and we suspect that, in most cases, net proceeds will not be used in this manner. Rather, they will be used for higher return, higher risk investments or used by the parent company for share repurchases.”

Beyond our concerns about the effect on the legacy companies, the proposed size of some of these subsidiaries would be miniscule compared to behemoth MLPs such as Kinder Morgan Energy Partners LP (NYSE: KMP), and thus possibly more risky. These entities would have capitalizations in the small- to mid-cap range, which means they would lose the economies of scale they previously enjoyed from being part of a larger integrated company.

And given their relatively high yields and the resulting demands these payouts place on cash flow, these smaller YieldCos and MLPs may not be able to weather an unforeseen economic or market shock, especially if they have to compete for new projects against much larger firms. One approach that might increase the possibility of success for these new structures would be for several utilities to work together to create a single vehicle comprised of asset drop-downs from each participant. This would help the new entity achieve greater economies of scale and make it more competitive in the marketplace.

In fact, the most successful spin-offs in the utilities industry have typically been very, very large, such as transmission systems that have themselves achieved better economies of scale by integrating with larger regional transmission organizations. That’s a marked contrast to what happened in the last decade to some small- and mid-size companies that were spun off from the merchant power divisions of utilities and subsequently wound up in bankruptcy when market dynamics suddenly changed.

Furthermore, non-arms-length transactions can be a recipe for disaster, given examples from the recent past where parent companies negotiated advantageous agreements at the expense of subsidiaries. In some cases, the parent company even dumped non-performing assets into a subsidiary or off-balance sheet partnership to improve the optics of the legacy company’s financials. The question here is how to know whether the YieldCo is getting good assets for its money, when the controlling parent is on the other side of the deal.

Various credit-rating agencies have also identified this potential governance risk. For example, according to a report by Moody’s, “All the senior officers of [NRG Yield] hold a similar position at NRG, and four of the seven board members have a direct senior management position with NRG, with one of the three independent directors being a former NRG director.”

YieldCos: The Shape of Things to Come?

Source: Company presentation

The rating agency concludes, “The interrelationship between the parent sponsor and the YieldCo, while understandable, raises several levels of potential conflicts of interest from a corporate governance perspective.”

In the final analysis, whether an investor should consider a YieldCo or utility MLP comes down to the perennial question of whether value can best be achieved through a diversified conglomerate or a pure-play model.

The Anatomy of a Spin-off

While various studies on electric utility diversification strategies have found moderate diversification can be beneficial to creating shareholder value, the overall industry result has been mixed. The only consistent trend is that ventures financed with high levels of debt are prone to disaster, regardless of whether they’re related to the core utility business. Historically, firms that tried to grow too broadly, too fast, and with too much leverage seemed to suffer.

That’s the general risk of any type of financial engineering: These structures, which typically create new external financing options, sometimes tempt a parent company’s management to use the proceeds to pursue growth projects at a time when the balance sheet is already stretched to the limit. Indeed, utilities such as Dominion Resources Inc (NYSE: D and NextEra Energy Inc (NYSE: NEE), which already have debt-to-equity ratios in excess of 100 percent, are currently contemplating spinning off certain assets in the form of a YieldCo or MLP. We can only hope their respective management teams will do the right thing with the proceeds.

Top Growth Companies To Watch For 2014

As a result, investors will have to monitor how the parent company uses these funds, as it would also have implications for the value proposition of owning the YieldCo itself.

And while the yields on some of these spin-offs will be enticing, parent companies will still have to periodically add new assets to their subsidiaries in order for them to produce steady dividend growth over time. The rating agency says, “Incremental contractual investments need to be added or ‘dropped in’ on a regular basis. As such, YieldCos’ sponsors need to have an active development program or need to augment the potential YieldCo backlog with regular acquisitions.”

But securing incremental long-term contracts often depends on factors outside management’s control. “Recent events at Atlantic Power Corp (NYSE: AT) demonstrate the shortcoming of a YieldCo strategy, ” the report states, noting the now infamous dividend cut that the firm had to make because of the firm’s “inability to extend expiring contracts and to secure sufficient long-term replacement contracts.”

Nevertheless, Wall Street investment bankers have been pushing these types of deals for years. The pitch by bankers has always been the same: A spin-off can help the utility raise cheap capital, boost the valuation of a diversified company, or cover a failed merger. In the case of a YieldCo, the intent is to raise cheap capital by unlocking the value of a business that management feels is not being recognized by the market.

But some executives have been skeptical of these deals because they believe they can erode the benefits achieved by economies of scale or integration. Back in 2007, when your correspondent was executive editor of Public Utilities Fortnightly, the utilities industry’s journal of record, he spoke about this topic with Michael Morris, former CEO and presently non-executive chairman of American Electric Power Co Inc (NYSE: AEP).

As Mr. Morris succinctly put it, “We don’t see a need for that. If you are an integrated utility today, unless you have huge capital needs or a state law that causes you to break apart your asset base, I don’t see the logic behind it.” Back then, he predicted the industry would see few such transactions because the vertically integrated model made so much sense.

He also had strong words for the Wall Street bankers that kept proposing these deals. “I’m always intrigued by those of you in New York, particularly those of you involved in the investment-banking business. You talk all of us into merging and cross functionalization and how wise that was. Then you come back four years later and say the market can’t understand the stock and you have to break the company apart.” Apparently, this time around, the bankers waited almost seven years to return with the same pitch.

In sum, financial innovations, if implemented properly and with the right safeguards, can be a source of greater shareholder value, as we’ve seen in the traditional MLP space.

But given low power-demand growth fundamentals, technological disruption from renewables, and changing market fundamentals, power utilities might be better served by keeping their most stable, income-producing assets in house.

We recommend holding off on investing in electric utility industry YieldCos or MLPs until their management teams build a longer-term track record, at which time these investments can be properly evaluated.

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