Yieldco: A New Way To Get Bigger Yields

It's not an imaginative name for 'new company,' but it serves as a temporary placeholder for legal purposes until a better name can be found. These days, many companies are shifting to a new business model called 'Yieldco.' Carving out a slice of a business to deliver a steady and growing dividend yield is suddenly becoming very popular.

In just the past year, Yieldcos such as NRG Yield (NYSE: NYLD), and Pattern Energy (Nasdaq: PEGI), have begun trading, and the early gains have been impressive.

NRG Yield is up 50% since its July launch, and Pattern Energy is up 30% since its debut last September. Their yields have been pushed down 3% to 4% as the share prices have risen, but they were fairly robust when these Yieldcos started trading.

So what exactly is a Yieldco?

To understand that question, it helps to examine NRG Energy Co. (NYSE: NRG), which spawned NYLD. NRG is a $14 billion (in revenue) independent power producer that owns nearly 90 fossil fuel and nuclear power plants, along with a growing portfolio of clean-energy power plants, such as wind and solar. Pricing for the companies is mostly (but not always) set by regulators, and $2.2 billion in earnings before interest, taxes, depreciation and amortization (EBITDA) for NRG Energy last year shows that it's a profitable business.

NRG's executives felt that investors were undervaluing many of the company's long-term energy supply contracts, and decided to bundle them into a separate corporate entity. An independent board was established to ensure that the parent company, which still retains a majority interest in those bundled contracts, was fulfilling its obligation of delivering agreed-upon dividend distributions.

The goal for NRG -- and others expected to follow -- is to drop down 70% to 90% of distributable cash flow to the YieldCo, while also aiming for 10% to 15% annual dividend growth.

If this sounds similar to oil and gas pipeline master limited partnerships (MLPs), it is. MLPs obviously offer better tax treatment as they are not taxed at the corporate level. Another key difference: These Yieldcos will likely be heavily focused on the new wave of long-term energy supply agreements signed by wind and solar power operators, along with companies that act as third-party energy providers in various markets.

You could argue that the MLP trend has matured as the pace of new oil and gas pipeline construction begins to slow. Yet these Yieldcos are only at the start of their long-term growth wave.

'With the onset of Yieldcos, we believe solar companies could increasingly transition to owning and operating solar assets -- and selling energy -- an evolution that is still in its early stage and that we view favorably,' note analysts at Goldman Sachs.

Why would companies consider a Yieldco? For the 'ability to lower the cost of capital as well as smooth cyclicality via recurring and contracted cash flows,' add Goldman's analysts.

Thus far, the Yieldcos have squarely focused on the renewable portfolios of these independent power producers. NYLD, for example, gets the bulk of the cash flow from NRG's solar, thermal, wind and natural gas plants. PEGI was formed in 2012 to secure the rights to roughly a dozen wind farms, all of which have long-term supply agreements (averaging 17 years) at fixed prices with local utilities.

Goldman Sachs, which recently took an extensive look at this burgeoning asset class, cites four characteristics to look for when you are considering purchasing a Yieldco:

• Strong and sustainable dividend growth
• Long-term low-risk supply contracts in place
• An independent board of directors
• Limited construction risk

Let's pivot back to NYLD as an example of how to value such stocks. This stock has been so popular that its yield has been pushed down to just 3.1%. Yet according to NRG's long-term goal, NYLD's dividend may be able to grow at a 15% annual pace. You can buy utility stocks with higher dividend yields, but not that kind of dividend growth. (If you have access to Canadian stocks, TransAlta Renewables (TSX: RNW) is a Yieldco that sports a more impressive 6.8% current yield.)

Risks to Consider: As with any yield-producing investment, shares could drop in value if interest rates rise and fixed-income investments attract more investor assets.

Action to Take --> Yieldcos have thus far been limited to clean energy suppliers, though the category will likely broaden to any firm that wishes to monetize its long-term contracted cash flows. Thanks to the initial popularity of these first wave of Yieldcos, look for more of them to come. If you own shares of traditional electric utilities, or any other firm that has sustained long-term cash flows, you may be offered a chance to buy shares in a newly created Yieldco. You should take them up on the offer.