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posted on 28 October 2015

Fear And Loathing In YieldCo Town

by Investing Daily, Investing Daily

Investing Daily Article of the Week

-- this post authored by Richard Stavros

The name itself conjures up a vision of a fee-hungry investment banker's ingenious pitch to wary utility executives: YieldCo.

After all, with interest rates at historic lows, how could income investors possibly resist an asset class whose very name promises to deliver exactly what they want? And if that's the case, why wouldn't utilities and investment bankers give it to them (while making a lot of money in the process)?

That may sound like a win-win situation, but count us among the skeptics. We continue to advise income investors to steer clear of YieldCos. And the recent rout in the YieldCo space confirms the prudence of our position.

During this month's Utility Forecaster Live Web Chat, a subscriber asked whether the collapse in YieldCos - one index that tracks the asset class is down more than 26% from its year-to-date high - represents a buying opportunity.

Our assessment now remains the same as it was when we last wrote about YieldCos: Many of these new firms are too small to compete for assets and offer questionable tax benefits.

In creating this new asset class, energy utilities (and the investment bankers who advise them) were likely hoping to replicate the massive success of master limited partnerships (MLPs).

Utilities would bundle together operating assets that generate steady, low-risk cash flows, particularly from renewables, and then spin off the entity via a public offering as a YieldCo.

From the utility's standpoint, a YieldCo offers an opportunity to unlock new value from assets that are precluded by current law from being dropped down into an MLP. And if the asset class were to catch on in the same way as MLPs, then utilities would have a convenient and affordable way to raise new capital.

Of course, from an investor's standpoint, it's all about the income. But while YieldCos do offer attractive yields and rising payouts, they don't have the same tax-deferral benefits as MLPs since their payouts are generally taxed as dividends.

Furthermore, while MLPs enjoy minimal taxation at the corporate level, YieldCos will only be shielded from taxation at the company level for the initial five- to 10-year period during which their net operating loss carryforwards can be used to offset taxable income.

That's a key distinction because favorable tax treatment at the corporate level helps support a sizable payout.

The Dawn of a New Era ... Or More of the Same?

Beyond these shortcomings, it's hard to give the utility sector the benefit of the doubt when it comes to a new asset class because it has a long history of failure in such ventures.

Since the late-'90s era of electric deregulation, every few years a group of would-be financial capitalists comes along to pitch the industry on a new spinoff strategy. So we've been through this before.

But rather than dismiss the space entirely, we're willing to wait and see whether the strongest names prove they have staying power.

And we should note that there are huge qualitative differences among the YieldCos that have been created over the past two years.

Nevertheless, the protracted downturn in the YieldCo space has shown that the market no longer cares about such distinctions. And some of the bigger players are beginning to publicly lament being painted with the same broad brush.

James Robo, CEO of Utility Forecaster favorite NextEra Energy Inc. (NYSE: NEE), which launched the YieldCo Next Era Energy Partners LP (NYSE: NEP), is clearly frustrated that the market is no longer rewarding higher-quality YieldCos relative to their lesser peers.

Robo argued:

"I think one of the things that has troubled us is there is an enormous differentiation in quality between the various YieldCos in the sector. And NEP is, in our view, a premier YieldCo because of the visibility we've had into the long-term drop-downs into the vehicle."

Robo makes the case that because NextEra is NEP's sponsor, the YieldCo stands to benefit from the thousands of megawatts of assets that are available for drop-down.

And Mark McGettrick, CFO at Utility Forecaster stalwart Dominion Resources Inc. (NYSE: D), which launched the MLP Dominion Midstream Partners LP (NYSE: DM), recently offered a similar take. Although his commentary is about MLPs as opposed to YieldCos, it's instructive nonetheless.

McGettrick observed:

"The differentiation in the MLP sector actually was pretty good for a while between commodity and non-commodity sensitive entities. But now they're kind of getting squeezed together. And as you look at it, the angst in the sector is something that's driven by a number of activities."

In the case of Dominion Midstream, McGettrick notes that the market is currently indifferent to the fact that the MLP does not have commodity risk and has a stronger sponsor than its competitors. But he believes his company will be vindicated in the end.

McGettrick said:

"Ultimately, we think that the companies that have the highest distribution growth rates, that have very stable long-term cash flows from non-commodity sensitive assets, will be rewarded. But right now, it's just kind of a swarm where everybody's caught up in it a little bit."

It must sound strange to industry insiders to hear top executives at two of the country's premier utilities sound so disheartened. But it's rare for utilities to take on entrepreneurial risk and suffer the deep skepticism from investors that such bets often entail.

We empathize. But the cold, hard reality in a world of startups like these is that no corporate parent, sponsor, or affiliation will ever be enough to assuage sour sentiment. The only thing that is going to appease investors is performance.

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