A Unique Security With One Goal In Mind: More Money In Your Pocket

I spent some of the most productive workday hours last week staring at the walls during a power outage. It’s a helpless and frustrating feeling — but a great reminder that consumers and businesses can’t function for long without electricity. 

Nobody would ever consider electricity to be a discretionary purchase — it’s a constant “must-have.” 

You can’t say that about too many other products or services. And that’s exactly why I consider regulated power providers to be good “forever stocks” that can be held for years with minimal oversight. But I’m not writing today about ordinary regulated utilities like American Electric Power (NYSE: AEP) or Duke Energy (NYSE: DUK). 

Nothing against those stocks, but I believe there’s another angle for income investors. I’m talking about a special class of securities that bundles the steady demand of a power utility with the contractual cash flows of a master limited partnership (MLP). 

These stocks get little attention from the financial media — but taking a few minutes to get acquainted can be well worth your time. 

One of the largest chalked up a total return of 34% last year. Another climbed 40%. And still another has posted a 95% gain over the past three years. That’s doubly impressive when you consider these unique businesses were created specifically for income, not growth. 

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An Insatiable Appetite For Electricity
Let’s go back to power consumption for a moment because that’s where the heart of this story lies. 

According to the U.S. Energy Information Administration, the nation’s power plants were asked to supply 4.18 trillion kilowatt hours of electricity. As you probably know, natural gas has displaced coal as the primary source of energy. It now accounts for approximately 35% of the nation’s electricity. But renewable sources such as wind, solar and hydro have been catching up as well and handle 17% of the workload (about half as much as natural gas). In other words, they power roughly one in every six homes and businesses across the country.

Over the past decade, renewable power generating capacity has doubled in the United States and Europe. But that’s nothing compared with China, which has seen growth of 255% over the same period. China now produces half of the world’s wind turbines and 60% of its photovoltaic solar cells. According to the International Renewable Energy Agency, China’s solar power installations now produce 130 gigawatts of electricity — 1,156 times the level from 2008. That’s enough to power the entire United Kingdom. 

china solar farm‚Äč 
Solar panels and wind-power farm in Golmud, China

Beijing has pledged to invest another 2.5 trillion yuan ($370 billion) in renewable power generation projects by 2020. And while China is leading the way, it is by no means the only country making a big commitment to green-energy development (Ireland, Germany and Italy are a few other examples). 

Over the last five years, $1.5 trillion has been invested in renewable energy, adding one million megawatts to global power grids. Renewable sources currently account for one-quarter of the world’s electricity, and that percentage is headed ever higher as costs fall and environmental standards tighten. Favorable tax credits and subsidies are also hastening the transition. As it stands, 176 countries currently have renewable energy targets in place. The Center for Climate and Energy Solutions is forecasting that wind, solar and other renewable power installations will generate nearly one-third of the world’s electricity within the next two decades.

Meet The YieldCos 
Given the massive amounts of capital being thrown into the renewable energy space, it’s not surprising that some of the brightest financial minds have engineered a novel ownership vehicle to reduce funding costs. 

It started back in 2012 when Brookfield Asset Management (NYSE: BAM) launched a separate tracking company created for the sole purpose of operating its various green energy assets. That subsidiary was called Brookfield Renewable Energy Partners (NYSE: BEP), which hit the market with a bang and has been expanding ever since. 

Today, BEP owns 100 wind farms, 250 hydroelectric facilities, and 500 solar plants representing 17,000 megawatts of generating capacity from Brazil to China. 

In much the same way that midstream energy companies sell pipeline space to oil and gas shippers, BEP sells its electricity output to utilities and other buyers under long-term power purchase agreements (PPAs). These offtake agreements are often in force for 20 years or more, providing steady, recurring income.

More than 90% of BEP’s cash flows come from these PPA contracts with dependable counterparties. And unlike plants fueled by coal or natural gas, the income from these renewable power contracts is generally tied to volume rather than wholesale electricity prices (just as MLP fee-based contracts are largely insensitive to fluctuating oil prices). 

As a pass-through entity, the lion’s share of the cash is immediately distributed to stockholders. BEP sports a healthy yield of 6.5%. And the dividend grows with each passing year. With annual rate hikes kicking in and new assets being acquired, funds from operation (FFO) are expected to rise 6% to 11% annually — supporting distribution growth of up to 9%. 

Management aims to deliver lofty annualized total returns of 12% to 15%. And it has met that objective, achieving annual gains of 15% since the IPO. That’s good enough to double your investment every five years.

How They Work
BEP was among the first “yieldcos.” 

Just like MLPs and real estate investment trusts (REITs), this is a special class of securities with unique perks. These businesses were built to own long-lived assets that generate high levels of tax-advantaged cash flow. But instead of pipelines or rental properties, they own renewable power plants. 

Yieldcos always have a larger parent (or sponsor) that maintains an equity ownership interest. The parent is also entitled to receive incentive distribution rights (IDRs), which generally range from 25% to 50% of distributable cash flow beyond a certain threshold. From our standpoint as investors, lower is better. But the IDRs do encourage the sponsor to keep building and “dropping down” renewable power assets to the yieldco in order to boost cash flows. 

#-ad_banner-#The sponsor often bears the expense (and permitting headaches) associated with the construction of these costly plants. But once they are up and running, variable operating expenses are minimal — the sun and wind do most of the work. And with electricity buyers already lined up, yieldcos haul in predictable, low-risk cash flows. 

You’ll typically see it referred to as cash available for distribution (CAFD), which is the pool of earnings available for dividends after the payment of principal and interest and maintenance expenses. Up to 90% of CAFD is disbursed through regular quarterly dividend payments. The benefits of this arrangement are two-fold. First, by separating out completed, de-risked facilities with PPAs in place, yieldcos attract outside capital from investors drawn to their pure-play business model. Furthermore, this structure provides lucrative tax advantages. 

Building a hydroelectric dam or offshore wind farm involves huge upfront expenditures, which are then depreciated over time. Because of those depreciation charges, the companies that operate these facilities typically report GAAP earnings losses. Those losses not only offset any taxable income in the early years, but they can also be carried forward to reduce future liabilities.

Some yieldcos won’t owe a penny in federal income taxes until well into the next decade. Without taxable profits, the dividend distributions are classified as a return of capital (not to be confused with the destructive ROC from some closed-end funds). As such, these dividends simply reduce your cost basis in the stock and aren’t taxable upon receipt. 

Because of this, some financial writers refer to yieldco dividends as tax-free, but they are really tax-deferred. However, even when the tax bill comes due at the time the shares are sold, you will pay the lower capital gains tax rate, rather than your ordinary income tax rate. 

Because Uncle Sam doesn’t take a cut, yieldcos can typically pay out fatter dividends than most other businesses. This also effectively eliminates the double taxation imposed on ordinary dividends (where profits are taxed first at the corporate level and then again on the individual stockholder). 

By issuing shares, yieldcos can raise low-cost capital (compared to typical capital markets or private equity) with which to purchase more assets from their parent. And the parent can use the proceeds to acquire or develop new plants. The cheaper financing makes it a win-win for both public shareholders and the sponsor.

6 YieldCos Paying Up To 7.6%
As you might imagine, a number of large, established energy companies have decided to spin off their renewable operations into a separate arm to take advantage of this funding mechanism. And investors have accommodated by pumping billions into this new asset class. 

And with the world rushing headlong into green energy development, growth opportunities abound. Here are some of the more notable players… 

HY YieldCo table

If you’re interested in the yieldcos at all, then I encourage you to research the names in this table further on your own. Each of these companies is distinct and has something unique to offer. That said, I do have a favorite that we added to the High-Yield Investing premium newsletter portfolio back in April.

The point is, yieldcos are yet another weapon in the arsenal to fight against low interest rates. And given the steady, reliable nature of their assets — not to mention the overwhelming forces of demand behind them, they should be an option to consider for any serious income investor.

Meanwhile, if you’re looking for another way to earn more income, my colleague Amber Hestla has a special report detailing how she and her subscribers are earning hundreds — even thousands — in extra income per week with something called “bonus dividends”. Best of all, it’s doesn’t involve any complex trading strategy — it’s safe, simple, and you can use it on the stocks you already own if you want. To check it out, go here.