With the coronavirus pandemic rocking the world’s healthcare systems and economies, markets have switched to full-blown panic mode where indiscriminate selling creates opportunities and leads to prices having been deemed unthinkable just weeks ago.
While it is true that it is impossible to predict the duration of the pandemic as well as the overall economic impact, we can certainly make some reasonable assumptions as to which businesses are impacted more and which less.
Obviously, the hardest-hit sectors are airlines, travel, lodging and mostly the entire services sector as well as the oil and gas industry, but it is very reassuring that after a lot of hesitation in the beginning governments and central banks around the world have pledged to do whatever it takes to overcome the economic crisis.
However, with markets dropping thousands of points on a daily basis likely driven by aggressive HFT mechanisms, this also punished stocks with hardly any exposure to the crisis. One of these sectors is the utility sector since electricity and power will still be needed and paid for even if businesses temporarily shut down.
One of my favorite stocks in the sector since it is in my view the best play on renewables is Brookfield Renewable Partners (BEP). As of the time of writing the article, the stock dropped as low as $35 from its all-time high of $57, representing a substantial decline of almost 40%. While I can’t assess whether this was the bottom, even today’s closing price of just below $40 is a great price for a great business currently on sale.
What is going on at Brookfield Renewable Partners?
In early February when Brookfield reported its full-year 2019 earnings, the world was certainly a much different place. But given that electricity and power are basic needs, that earnings print keeps relevance in today’s environment. Thus, we will first review how its business is doing and then highlight how the COVID-19 pandemic may be impacting it.
Brookfield is all about renewables and the long-term opportunity of this market is estimated to be massive. And I am not saying this because I envision a soonish end of oil and gas because of climate change but rather because costs of renewable energies have been almost exponentially decreasing over the last decades. For instance, the price of photovoltaic cells per watt has decreased an enormous 99.6% between 1977 and 2015 and continues to trend towards its long-term threshold value of zero. That 99.5% number is certainly staggering but also heavily distorted because of the very high initial cost, yet it makes it very apparent that there have been dramatic increases in efficiency.
Markets are not climate scientists but they focus on fundamentals and profitability. The only way I can see renewables taking the lead in the energy mix is when this technology is simply more profitable than the traditional oil, gas and coal way of doing it since ultimately the money will flow where the highest returns are and if that is also a net benefit to the environment and society, it is surely a Win-Win situation.
The fact that wind and solar power are now cheaper than gas, coal and nuclear power and may even be available almost free of charge for the foreseeable future will lead to a complete conversion of global energy production to renewable energies in the coming decades.
I can’t model what these developments mean for traditional oil and gas companies like Royal Dutch Shell (NYSE:RDS.B) (NYSE:RDS.A), BP (BP), Exxon (XOM) or mid-stream companies like Energy Transfer (ET) or MPLX (MPLX), but it certainly will play into the hands of Brookfield with capacity and demand ramping up quickly and sustainably, domestically and globally.
Source: Brookfield Renewable Partners – Investor Day Presentation
Investment into these energy sources is predicted to accelerate strongly with even the lowest estimate shattering the already growing investment volumes over the most recent years.
Brookfield has the scale and capacity to invest strongly into major renewable technologies with storage potentially becoming the most important one over the next years and decades.
It is not clear how the COVID-19 pandemic could impact Brookfield’s business given that its business model is to generate renewable power from its various assets located around the world covering different sources of energy and then selling that to its customers often based on long-term contracts offering significant downside protection.
Source: Brookfield Renewable Partners – Investor Day Presentation
From a capital structure Brookfield is also in very good shape featuring a BBB+ investment grade rating, 80% non-recourse debt and 10-year average debt duration which is the lowest risk balance sheet in the sector and allows the business to deliver strong results through economic cycles. Brookfield’s financial strength will allow the company to operate in today’s uncertain environment and continue to invest in further growth projects to enhance its portfolio and generate shareholder returns.
TerraForm Power Deal and BEPC
The biggest of these projects, actually it is a deal, is the acquisition of TerraForm Power (TERP) which will bring Brookfield’s stake from a current 62% to 100% full ownership in an all-stock deal. The conditions are that Brookfield will pay 0.381 shares of each BEP share for one share of TERP. This will create one of the largest publicly-traded renewable power platforms with $50B in assets and around $1B in annual FFO.
TERP shareholders can opt to exchange their shares for BEP or for a newly to be created publicly listed entity Brookfield Renewable Corporation (BEPC). This gives shareholders the option to invest into the renewable energy business either through a partnership or through a C corp which has different tax treatment but will be economically equivalent. And potentially more importantly, it will allow BEPC to be eligible for broader index inclusion, e.g. Russell, MSCI indices and other ETFs, and thus expand Brookfield’s investor base which should increase liquidity and ultimately also the stock price due to higher demand.
How about Brookfield’s distribution?
Brookfield Renewable also offers a safe and growing distribution. Over the last couple of years, the distribution has been growing at an around 5% clip and this sort of pace is expected to continue as Brookfield is working towards its goal of achieving a 70% FFO-based payout ratio. For 2019, the FFO payout ratio came in at 89.8%, representing a meaningful improvement from the 95.4% reported for FY2018 but still some distance away from the targeted 70%. However, given that FFO is expected to increase by high-single-digits to low-double-digits, the current 5% growth in distributions will allow Brookfield to reach that target within a few years.
Long term, it is targeting to raise distribution by 5-9% which at the top end would represent very strong growth in income for an investor and given the outstanding opportunity this market offers, I am very confident that long term in that case could easily represent a few decades.
The unprecedented crisis gripping the whole world has pushed back Brookfield’s yield to pretty attractive levels down from a record low of 3.6% to around 5.5% which is much more in line with its 4-year average yield of 6%.
The stock could certainly drop lower given that we are witnessing historical price movements on the stock markets amid maximum uncertainty but that does not mean that today’s price below $40 isn’t a good price long term.
In times of crisis and when pundits are fervently declaring a near apocalypse, it is important to keep calm as best as possible and focus on business models that are most resilient. Utilities certainly fall into that category and Brookfield Renewable Partners, with its very strong balance sheet, prudent capital allocation and recession-resistant business model, should be able to even weather the darkest of storms.
When these businesses go on sale following indiscriminate selling it is time to strike, especially when stock prices are in free fall across the board by gradually taking a position. I certainly started my buying spree too early at prices of $48.5, $49.8, $46.98 and today at $37.58 but long-term all these entry points should be creating value. On top of that in that highly volatile market, stocks can instantly rise 20% or more on a day without any “warning” as for example, today stocks like Southern Company (SO) or Dominion Energy (D) soared close to 20% erasing all losses of Monday’s historical market rout.
The crisis is sharply showing that even for the biggest corporations in the world, it is important to have several months of expenses on hand in cash in case the unthinkable happens. Take for instance McDonald’s (MCD), a business which has always been seen as recession-resistant since people will always eat but when businesses are shut down due to health concerns I don’t think that the drive-through option can make up entirely for this. As a result, MCD is now considering unprecedented rent deferrals to some franchises which will further drain its own balance sheet which has been levered up to fund aggressive buybacks since the Great Recession.
Once this crisis is over, I am very confident that corporate America will have to dramatically change and be regulated in a way that enforces sufficient liquidity on the balance sheet rather than distributing most of it to shareholders even if taking on debt is cheap. How that could impact utilities though is a different question given that it is a systemically-relevant sector where revenues could only dry up if businesses and consumers can no longer pay their contracts and utility bills.
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Disclosure: I am/we are long BEP, SO, D, MCD, MPLX, RDS.B, BP, ET, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not offering financial advice but only my personal opinion. Investors may take further aspects and their own due diligence into consideration before making a decision.