CA - Brookfield Renewable: A Good Place To Hide During The Next Recession

2023-04-17 08:01:48 ET

Summary

• Brookfield Renewable could be a good investment during a possible forthcoming recession as demand for renewable energy is likely to increase even in a weak economy.
• The company is well-positioned for growth, having secured 13 GW of development projects for the next three years, and government incentive programs are expected to help in that regard.
• The company's recent acquisition of Origin Energy is expected to be immediately accretive to cash flows and deliver significant sustainability benefits.
• Despite recent modest increases in its share price, the company's valuation remains attractive.

There is increasing talk of an imminent recession, especially with the March Fed minutes predicting a potential mild one later this year. It is also not difficult to find headlines such as the one below from Bloomberg, giving extremely high odds a recession is about to arrive in the next 12 months.

One of the best predictors, the yield curve, is also flashing warning signs. The Estrella and Mishkin probability model is currently estimating a 57% chance of recession. As can be seen in the graph below, rarely does the probability get this high without a recession, shown with grey bars, actually occurring.

With that in mind we started reflecting on which companies could remain good investments even during a weak economy. We think Brookfield Renewable ( BEP )( BEPC ) could benefit from such circumstances for a number of reasons, and that demand for renewable energy should continue to increase.

We last covered the company a few months ago after they reported results, but thought it would be relevant to revisit the thesis given the increasing probability of a recession, the roughly 10% higher share price, the acquisition of Origin Energy, and efforts to dispose 50% of the Shepherds Flat wind farm in Oregon. Shepherds Flat is a good sign that the asset recycling efforts continue, with the company buying it roughly two years ago, implementing a re-powering strategy, and why we still don't know the price at which the stake will be sold, given the operational improvements to the asset, it is likely to be at a higher valuation than the $700 million it paid for the acquisition.

Growth should remain strong, especially considering the benefits from multiple government incentive programs including the US Inflation Reduction Act, the UK Energy Security Strategy, and Repower EU. Brookfield Renewable has already secured 13 GW of development projects in the next three years, and given the strong incentive programs and the need to transition the world economy to sustainable energy, it is likely that several other projects will be completed. We add to the list of tailwinds that the levelized cost of energy for renewable power is well below that of traditional options like coal and gas.

Recession Benefits

The biggest benefit that a recession would likely bring to Brookfield Renewable is lower interest rates, as the FED would be forced to eventually start decreasing rates again. This would help Brookfield Renewable in several ways. First it would make refinancing cheaper, and reverse the current trend where the average cost of debt has been ticking higher. Second, financing for new developments would also become cheaper, making a larger number of projects viable. Third, the dividend would appear more attractive in comparison to other fixed income alternatives, helping drive shares higher.

As can be seen in the table below, higher rates have increased the average funding cost at the project level more rapidly than at the corporate level. The average interest rate for corporate borrowings has increased by ~20bps within a year, while the non-recourse project borrowings have experimented a much more dramatic increase to ~4.9%, up about 70bps from the previous year. If the interest rate trajectory changes, refinancing and funding new projects will start getting cheaper again.

Growth

Given that so many development projects have been secured, growth is almost guaranteed for the next few years. This means revenue is likely to grow even during a recessionary period. It's possible a recession would make launching some new developments more challenging, but the fact that the company is sharing that it considers ~8% basically locked in should provide investors with a lot of reassurance. There is also some additional optionality from M&A activities, where the company has been doing a lot. As we'll analyze below, just the Origin Energy acquisition could add meaningful growth.

Origin Energy

M&A will play an important role turbo-charging growth, with management estimating that it can up to 9% annual growth to funds from operations. Brookfield Renewable recently made a big acquisition together with some institutional partners, purchasing Origin Energy which is Australia’s largest integrated power generation and energy retailer. Origin Energy has 24% market share and an industry leading cost to structure.

Brookfield Renewable expects to invest up to $750 million with the remaining equity invested by institutional partners. Additionally, this will open the opportunity to invest at least A$20 billion to build up to 14 gigawatts of renewable energy assets over the coming decade. Importantly, the transaction is expected to be immediately accretive to cash flows. This acquisition will also deliver significant sustainability benefits, as Brookfield is planning on retiring one of Australia’s largest coal-fired power generation plants and replacing it with renewable power.

Valuation

All of these would not be enough to make Brookfield Renewable an attractive investment during a recession if the valuation was not very reasonable as well. The good news is that despite the price modestly increasing in recent weeks, the valuation remains quite decent. Based on the net present value of our estimates for future funds from operations, and using a 10% discount rate, we believe the fair value for the shares is around ~$31.

Risks

We believe the fundamentals of Brookfield Renewable should hold up well during a recession, and the company could even benefit from the possible lower interest rates it would bring. That said, these are also circumstances during which investors panic and sell whatever they can, whether is warranted or not. Still, we firmly believe that Brookfield Renewable is probably one of the better places to be invested during a weak economy, at least compared to stock alternatives.

Conclusion

There are few companies that could benefit more from a recession compared to the negative impacts it would bring. One of the companies that we think could experience a net positive impact from a recession, mostly as a result of the lower interest rates it would bring, is Brookfield Renewable. A recession would likely reverse the recent trend of interest expense rising on its corporate and project level debt. At the same time, the company has basically locked-in very attractive growth, which would probably not be too impacted by a recession. The current valuation remains attractive, with shares trading very close to our fair value estimate. As a result, we maintain our buy rating on the shares.

Editor's Note: This article was submitted as part of Seeking Alpha’s Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!

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