[Editor's note, March 28: GTM published a contributed article yesterday that contained an error regarding the number of shares eligible for distributions. The corrected version follows. GTM regrets the error.]
Solar YieldCo 8point3 Energy Partners' (CAFD) stock has been selling off, due in part to overblown reporting comparing it with troubled renewable energy developers SunEdison and SolarCity. SunEdison went bankrupt in an industry-shaking implosion last year, while struggling SolarCity was recently rescued through a takeover by Tesla (TSLA).
The analyst quoted in a recent Benzinga article, Gordon Johnson, has long been skeptical of solar names (as have I, for that matter). In this case, Johnson's bearishness was blown out of proportion by the headline's emphasis on the scary SunEdison name. Some shareholders are spooked. A mutual fund manager who holds 8point3 in his fund told me that he was forwarded the article by an adviser with a panicked client. (The fund manager asked not to be identified because of his firm's disclosure rules.) Privately, he described the comparison between 8point3 and SunEdison as “crazy.”
SunEdison and 8point3 are fundamentally different types of companies. SunEdison was a developer. That is, most of its revenues and earnings came from building solar farms and other energy infrastructure and then selling them. This can be a risky and unpredictable business, because unexpected project delays or changes in the market for finished projects can leave the developer with a lot of debt but no cash on hand to pay when it comes due.
The primary business of 8point3, or any YieldCo for that matter, is owning the solar farms after they are operational and are delivering power to buyers under long-term contracts. Their income stream is as steady and reliable as the power produced by a home solar installation: There will be some variation due to weather, and the inverter might need to be replaced after a decade or two, but overall, the income is very reliable. Every day, the sun comes up and produces power, and we even know approximately how much more power it will produce in the summer than in the winter. For YieldCos, surprises are few and far between. For developers, surprises are part of the ordinary course of business.
Behind all the fuss, the real issue that has led to recent analyst downgrades are 8point3's plans to refinance company-level interest-only debt. The plan is to replace it with amortizing debt backed by the individual solar farms the YieldCo owns. The difference is that amortizing debt includes payments of both principal and interest, and so a switch to amortizing debt will have the effect of reducing cash available for distribution.
The problem with interest-only debt is that it needs to be refinanced before it comes due. SunEdison could not refinance its debt, hence the bankruptcy. Unlike SunEdison, 8point3's assets are solar farms which have long-term contracts, known as power-purchase agreements (PPAs), to sell electricity to creditworthy borrowers. The average remaining length of 8point3's PPAs is 20 years, and lenders are happy to make loans backed by this sort of low-risk asset.
In other words, there's no reason to believe 8point3 will have trouble refinancing its debt. The only question is, how much will the shift to amortizing debt hurt cash flow available for distribution? As Johnson himself put it:
“This is an optics problem, not a problem of solvency. 8point3 has a better credit profile than many of its peers. They should just go ahead and refinance some of their company level debt and put their emphasis on the great assets they have in their [right of first offer] pipeline."
Note: A previous version of this article contained an error regarding the number of shares eligible for distributions. That error has been corrected.
So a bankruptcy like SunEdison's is not in the cards for the company, but the question remains: Can 8point3 pay principal on amortizing debt while still making its promised distributions? Using numbers from 8point3's 2016 annual report and earnings call slides, we see that the YieldCo made $20.2 million worth of distributions to common shareholders and $12.3 million to its sponsors, SunPower (SPWR) and First Solar (FSLR).
The YieldCo had a weighted average 21.4 million common shares outstanding during 2016, with 28 million shares outstanding at the end of the year. In August 2016, 51 million B shares owned by its sponsors became eligible for distributions as well, for a total of 79 million shares.
The company's guidance is for distribution growth of 12 percent per share for 2017, or $1.06 per common share. Total distributions to common shareholders and sponsors would then be approximately $84 million.
With the recent acquisition of two new solar farms in December, the YieldCo expects $91 million to $101 million in cash available for distribution in 2016. However, the 2017 guidance reconciliation (on slide 17 of the earnings presentation slides) shows only the payment of cash interest, with no payment of principal on loans, so we have to assume that this guidance does not assume any amortizing debt.
All 8point3's debt matures in 2020, and it has $683 million outstanding. 8point3 would naturally use its projects with the highest-quality offtakers and longest contract terms to refinance its debt, which should allow it to refinance all of its debt with an average term of 20 years and an interest rate of 4.5 percent. Most of its current debt is at Libor plus 2 percent, or a little less than 4 percent interest-only, for an annual payment of $27 million. If it refinanced all of its debt at 4.5 percent, amortizing over 20 years, any mortgage calculator will tell you that the annual payment would increase by $25 million to $52 million.
Subtracting this from 8point3's 2017 cash available for distribution guidance, we are left with $66 million to $76 million, which is not sufficient to pay the current quarterly dividend of $0.2565 per share, or $81 million annually, let alone the $1.06 which the company's guidance would lead us to expect for the full year.
Worse, the company raised its dividend on March 24, after its plans to refinance its debt were announced, implying it plans to stick to its distribution growth guidance, even though it cannot responsibly pay a dividend at this level and refinance all of its debt.
The company seems to be hoping that it can refinance its debt slowly in the three years remaining until its current debt becomes due in 2020. If it refinances just one-third of its debt this year, its 2017 CAFD will likely only be reduced by $5 million to $10 million, putting its 2017 cash available for distribution at approximately $90 million or $1.13 a share.
This leaves little capital for growth, which will be needed to avoid a dividend cut in 2018 or 2019, as more debt is refinanced. The company is clearly hoping that steady dividend raises will reinflate the stock price, allowing it to raise additional equity and grow its way out of its problems.
It's a big gamble, but it could pay off. If it works, the company's management will congratulate itself on its brilliance, and shareholders who buy at the current price will make a very nice return. If it fails, we can expect a big dividend cut, which only gets bigger the longer company management plays chicken with its inevitable refinancing.
8point3's sustainable annual dividend is something on the order of $0.70 to $0.80 a share. Most YieldCos are currently valued at a 6 percent to 8 percent yield, but in the wake of a dividend cut, the stock price usually overshoots, so the stock price could temporarily fall as low as $8 per share before returning to a more reasonable valuation of $10 to $11 (the stock currently sits around $13.90 per share).
Looking to the future
The good news is that while 8point3 Energy Partners needs to refinance its debt, its high-quality assets mean that it will have no trouble doing so. The bad news is that it cannot simultaneously refinance its debt and pay its current dividend, let alone raise it.
Management is currently playing a dangerous game of chicken with its debt by continuing to raise the dividend at an unsustainable pace. They are hoping that the increases will draw new investors, and bring the share price back up to a level where the company can issue new equity and use stock market investors' money to buy its way out of its problem.
The gamble could work. Speculators might want to buy the stock in hopes that it does. Cautious investors should sit on the sidelines, and might consider buying below $11.
Disclosure: Tom Konrad manages and has a stake in the Green Global Equity Income Portfolio (GGEIP), a private fund which invests in YieldCos and other high-income green stocks. GGEIP currently owns CAFD, but is reducing its position.