Published by Nick McCullum on June 13th, 2017
The renewable energy sector has not historically been a source of satisfactory investment returns.
Case-in-point: 112 major E.U. and U.S. renewable energy companies went bankrupt between 2009 and 2014, according to The Daily Caller.
Unfortunately, many alternative energy companies tend to go bankrupt after their government subsidies are cut off.
The markets tend to value these companies accordingly. Many renewable energy companies trade at attractive valuations based on earnings or assets, as well as above-average dividend yields.
Pattern Energy (PEGI) is one example of this. The company is currently trading at a dividend yield of 7.2%, making it a member of the elite group of stocks with 5%+ dividend yields.
Pattern Energy’s dividend yield is very attractive, but there are certainly risks associated with investing in the renewable energy sector. Further, Pattern Energy is experiencing company-specific issues that are contributing to its low valuation and high dividend yield.
This article will analyze the investment prospects of Pattern Energy in detail.
Pattern Energy is a renewable energy power company that owns and operates a portfolio of assets that generate power via wind and solar.
The company typically finances its assets with long-term debt and generates revenue through long-term contracts (called Power Purchase Agreements, or PPAs) with creditworthy counterparties. Pattern Energy’s debt is often non-recourse or occasionally limited recourse, and the company sometimes has a partial ownership in its power-generating assets (rather than complete ownership).
Pattern Energy currently owns 2.6 gigawatts of generation capacity. More details about the company’s business model can be seen below.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 3
Note that the company’s main yardstick by which it measures its performance is cash available for distribution (CAFD), which the company defined as follows in its most recent 10-K:
“We define cash available for distribution as net cash provided by operating activities as adjusted for certain other cash flow items that we associate with our operations. It is a non-U.S. GAAP measure of our ability to generate cash to service our dividends.”
Source: Pattern Energy 2016 10-K, page 59
Cash available for distribution is useful for evaluating the viability of Pattern Energy’s dividend.
Pattern Energy benefits considerably from its relationship with Pattern Development, a separate entity that operates as a developer (not operator) of renewable energy assets. Pattern Development has substantial industry expertise and a strong track record of completing projects on-time and on-budget.
Pattern Development has installed 4.8 gigawatts of renewable energy capacity since it was founded in 2009. It is a privately-held company. Importantly, Pattern Development owns approximately 19% of Pattern Energy’s outstanding common stock, incentivizing it to act in the best interests of Pattern Energy.
More information about the track record of Pattern Development can be seen below.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 11
Pattern Development’s completed projects are often sold to Pattern Energy in what are known as ‘drop-down deals’. The relationship between the two companies is very shareholder-friendly and is a key component of this stock’s investment thesis.
In addition to this stock’s unique relationship with Pattern Development, Pattern Energy’s portfolio benefits from considerable geographic diversification. The company owns and operates assets across the world, including the United States, Canada, Chile, Puerto Rico, and Japan.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 21
Moving on, the next section will discuss Pattern Energy’s pertinent recent events in detail.
Shareholders of Pattern Energy will recall that in the company’s November 7th earnings release, the company announced some weaknesses in internal financial controls that did not materially affect the company’s financial reporting.
Here’s an update from the company’s 10-K filed earlier this year.
“Based on our assessment as of December 31, 2016, our management believes that our internal control over financial reporting was not effective due to the aggregation of internal control deficiencies related to the implementation, design, maintenance and operating effectiveness of various transaction, process level, and monitoring controls. These deficiencies largely have arisen during fiscal 2016 because of growth of the Company, increases in employee headcount to support growth, and frequent changes in organizational structure that were not adequately supported by elements of our internal control over financial reporting.”
Source: Pattern Energy Group 2016 10-K, page 77
Concerns about internal financial controls could be very bad, or it could just be disclosed as a regulatory requirement and be immaterial to the stock’s long-term growth prospects. Looking for more details about the company’s internal control problems is necessary to understand the investment prospects of Pattern Energy.
Later in its 10-K, Pattern Energy gave considerable clarity about the nature of the financial control problems. The company noted five main areas of reporting deficiencies.
“The deficiencies can be grouped generally as follows:
Our training program was not effective at ensuring internal control responsibilities were properly communicated to and performed by new and existing personnel. Specifically, training was not timely communicated regarding the required documentation to demonstrate and ensure that controls consistently operated at a sufficient level of precision to prevent and detect potential errors. This led to inconsistent performance of controls throughout the control environment.
Our accounting policies and procedures were not effective in providing reasonable assurance that accounting transactions are consistently recorded as necessary to permit the preparation of financial statements in accordance with generally accepted accounting principles. This led to varied understanding of the risk of material misstatement to the financial statements and the related inconsistent performance of controls throughout the environment.
Our monitoring controls and management review controls were not effective at ensuring the timely detection and prevention of all potential material errors within our consolidated financial statements. In addition, we need to improve our review of the completeness and accuracy of information used to execute these controls, including key spreadsheets. This led to varying levels of review by management in the performance of monitoring and key spreadsheet related controls.
Our controls for the review of contracts were not effective to ensure the completeness of contracts reviewed or to ensure the appropriate identification and timely accounting for provisions within our contracts. This led to inconsistent performance of contract review controls.
Additionally, based on our assessment, our management believes that our procure-to-pay procedures were not effective as of December 31, 2016 because an aggregation of internal control deficiencies resulted in a material weakness relating to the design, operation, enforcement and effective communication of changes to our delegation of authority policy.”
Source: Pattern Energy Group 2016 10-K, pages 77 & 78
In addition to this second excerpt from the company’s regulatory finding, the company discussed the internal controls issue in detail on its third quarter conference call last year. This was the conference call where management first reported the reporting deficiency.
I believe that the following statement from Pattern Energy’s management on that call is much easier to digest and accurately portrays the company’s current position with regard to internal controls.
“Finally, one of the challenges of growing so quickly is the ability to scale the organization from an employee perspective. Ensuring everyone is properly integrated on the internal controls and procedures is a top priority for us, but in 2016 we encountered a few speed bumps. This morning we filed our form 10-Q, in it we outlined that we have identified a material weakness in our internal control over financial reporting.
After full consideration, we have concluded that are consolidated financial statements present our financial position, results of operations, and cash flows for the periods presented fairly in all material respects. I’d encourage you to review item four in the MD&A where we have identified the areas of remediation that we will be actively taking. We’re also contemplating additional action to ensure we address the weaknesses in an appropriate and timely fashion over the coming quarters. We are confident in our ability to work through this plan to ensure the organization is capable of scaling as we continue to grow our asset base.
We’re very confident in the results we’ve reported. The internal control conclusions are all about thinking about potential mistakes that could be made. And so it is effectively a forward-looking risk assessment, and we felt it was important to be clear today rather than wait until the 10-K filing about the conclusions that we’ve made midway through the year.
Based on management’s statements on the third quarter conference call, I believe that the financial controls issue is something to be monitored closely by Pattern Energy’s investors, but it does not necessarily rule out Pattern Energy as a potential investment.
Fears surrounding these issues created a compelling buying opportunity last November, after the news was originally announced. Notably, this news was broken just two days before the results of the Presidential election, and both factors drove Pattern Energy’s stock price downwards. This can be seen below.
This can be seen below.
Later, it will be determined whether this short-term issue is still presenting a buying opportunity for the investors of Pattern Energy.
Pattern Energy’s growth prospects are highly dependent on the ability of Pattern Development to identify and source new deals.
As mentioned, the unique relationship between Pattern Energy and Pattern Development creates a considerable incentive for the development company to offer economically favorable deals to its operating counterpart.
Pattern Energy also actively recycles its assets when the markets value them in excess of Pattern Energy’s perception of their intrinsic value. This capital recycling process can be seen below.
Source: Pattern Energy Group Investment in Development White Paper, page 5
Pattern Energy will also have a meaningful long-term tailwind in the form of the growth of the renewable energy industry.
Importantly, renewable energy investments are currently attracting approximately twice as much capital as their fossil fuel counterparts.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 9
Investors may rightly be concerned about the impact of the new Presidential administration on the growth prospects of Pattern Energy. President Trump has been generally unsupportive of renewable energy initiatives.
Pattern Energy believes that these impacts are manageable. The company’s perception of the impact of the new U.S. administration can be seen below.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 27
Competitive Advantage & Recession Performance
Pattern Energy’s largest competitive advantage comes from its unique relationship with Pattern Development.
Pattern Development’s ownership stake in Pattern Energy means that Pattern Development is incentivized to deliver economically favorable deals to Pattern Energy, benefitting both entities immensely.
The company also benefits from its long-lived, contract-based revenue stream. So long as the company can finance its debt at reasonable levels, Pattern Energy would seem to be a relatively safe investment.
That begs the question – how will Pattern Energy react to our current rising interest rate environment?
First of all, it is important to note that the debt that Pattern Energy uses to finance the majority of its assets is long-term and fixed-rate, meaning that the company will not experience any meaningful increase in interest expense until its existing debt matures. Even then, the increase in Pattern’s weighted average interest rate will be modest and gradual as maturing debt is refinanced at (likely) higher interest rates.
Further, an increase in rates across the yield curve will increase the discount rates of future cash flows, which means that Pattern Energy’s acquisition purchases will be at lower prices, since future cash flows will be worth less in today’s dollars.
The impact on rising interest rates on Pattern Energy can be seen in more detail below.
Source: Pattern Energy Group March 2017 Investor Presentation, slide 28
Pattern Energy’s IPO was in 2013, so the company was not a publicly-traded entity during the last major economic recession. Thus, it can be difficult to estimate the company’s recession resiliency. operates a utility-like business model, generating revenues through which means that investors can expect the company
With that said, Patten Energy operates a utility-like business model, generating revenues through long-term, inflation-adjusted contracts. This means that investors can expect the company the generate stable cash flows during most economic environments.
Valuation & Expected Total Returns
Pattern Energy’s future shareholder returns will come from valuation changes, the company’s current dividend yield, and growth in cash available for distribution (CAFD).
As mentioned, Pattern Energy’s stock price has been experiencing downwards pressure thanks to the company’s financial controls disclosure and fears of the company’s future under the new presidential administration.
It is likely that this is presenting a buying opportunity for today’s investors. However, assessing the valuation of Pattern Energy is more difficult than many other companies because of its business model.
As an owner and operator of long-lived renewable energy assets, Pattern Energy records substantial non-cash depreciation and amortization charges which artificially reduce the company’s earnings-per-share and makes the price-to-earnings ratio irrelevant as a valuation metric.
Thus, the easiest (and most effective) method to assess the valuation of Pattern Energy is to compare its current dividend yield to its historical dividend yield. This is done below.
As per the above diagram, Pattern Energy’s current dividend yield is above its long-term historical average. Historically, right now is an opportune time to add to or initiate a stake in this company, and valuation expansion will likely be a positive contributor to future shareholder returns.
Pattern Energy currently pays a quarterly dividend of $41.80 which yields 7.2% on the company’s current stock price of $23.09. For context, the S&P 500 currently pays a dividend of ~1.9%, which means that dividends will be the largest contributor to Pattern Energy’s future shareholder returns.
The remainder of the company’s total returns will come from growth in its per-share profitability, which the company measures by the non-GAAP metric Cash Available for Distribution (CAFD).
On Pattern Energy’s most recent quarterly conference call, management guided for 15% growth in CAFD next year. This rate of return, while certainly welcome by investors, is unsustainable for long period of time.
Over full economic cycles, I believe the company’s growth will slow, though it is likely capable of delivering 4%-6% growth on this metric. The company’s stock price will track this growth rate barring any meaningful valuation changes.
To sum up, Pattern Energy is highly capable of delivering double-digit total returns, composed of:
- ~7% dividend yield
- 4%-6% growth in cash available for distribution
For expected total returns of 11%-13% before the impact of valuation changes.
Pattern Energy’s internal financial controls disclosure and the election of President Trump had a meaningful negative effect on this company’s stock price. While the company’s
While Pattern Energy appears far from being ‘on the operating table’, it is still trading at an attractive valuation right now. The company’s current financial disclosure issues are likely just symptoms of its growing pains, and the effect of rising interest rates and the Trump administration will be immaterial in the long-term.
Thus, Pattern Energy is a buy or a strong hold at current prices. Current or prospective investors in Pattern Energy should keep a very close eye on the company’s financial reporting disclosure to ensure that this is just a ‘speed bump’ as management stated.