CA - NextEra Energy Partners: Cry Yell Or Fold?

2024-01-15 18:00:00 ET

Summary

• We had discussed NEP in the context of the five stages of grief and maintained a hold rating on the stock.
• The stock is flat since then.
• We update our outlook on the stock based on our macro expectations.

On our last coverage of NextEra Energy Partners, LP. ( NEP ) we made the case that investors will go through five stages of grief as they try and stay attached to this broken distribution growth story. While we had high confidence on how things would play out, we also thought the rumors of its immediate demise were exaggerated.

Since the price has crashed, NextEra Energy, Inc. ( NEE ) has little to gain by continuing the suspension beyond 2026. A lot can happen between now and 2026, but outside a rapid resurgence of ZIRP, we think this will follow the five-stage model. Keep in mind that TC Pipelines cut the distribution in 2018 and were assimilated TC Energy Corporation ( TRP ) in 2021 . These things take a long time to play out.

Source: The 5 Stages Of Grief

While the moves were riveting in between, the "hold" rating was justified as NEP did a stunning 0.23% total return over this period, confounding both the bulls and the bears.

We update our outlook and tell you why the current distribution rate can hang on a bit longer, but probably should not, if NEP wants a longer term future.

Key Events

Since that article there have been 3 major events for the stock. The first being its quarterly earnings release. The adjusted EBITDA was up sharply and even beat estimates by a fraction driven by renewable tax credits. Excluding those, things were above in line. The company stuck to the party line of maintaining its growth rate for distributions.

Yesterday, NextEra Energy Partners' board declared a quarterly distribution of 86.75 cents per common unit or $3.47 per common unit on an annualized basis, which reflects an annualized increase of 6% from its second quarter 2023 distribution per common unit. From a base of our second quarter 2023 distribution per common unit at an annualized rate of $3.42, we continue to see 5% to 8% growth per unit per year in LP distributions per unit, with a current target of 6% growth per year, being a reasonable range of expectations through at least 2026.

Source: NEP Q3-2023 Conference Call Transcript

That obviously helped the animal spirits. Nothing gets the distribution crowd going faster than a management who simply says the distribution will be maintained/grow, even if they have repeatedly had to backtrack in the past.

The next major event was the sale of the Texas gas assets.

NEP entered an agreement with Kinder Morgan, Inc. ( KMI ) to sell its Texas natural gas pipelines for about $1.8 billion. That worked out to about what the analysts expected, although there were some projecting more than a 10X adjusted EBITDA multiple on those. The sale will happen in two parts with STX going out in 2024 and Meade Pipeline in 2025. From our perspective, this of course reduces the big risk of the buydowns. Total funds after-tax, and after debt paydown will be close to the CEPF buydowns required in 2024 and 2025. So on that front everything checks out.

The third major event was the complete collapse in credit spreads. While October looked to be the beginning of an epic bear market, the Powell pivot created the largest easing of financial conditions in a long time. We show just one metric here, the BB (coincidentally NEP's credit rating) high yield spread.

Outlook

NEP can pay a high distribution and pray for the markets to fix themselves. Here, by fix, we mean the stock price rising over $60.00. That is right, for the distribution to be sustained beyond 2025 where the parent's IDR waiver generosity runs out and more buyouts need to be funded, the stock price would need to rise over $60.00. That is just the basic math. Total buyouts are close to $4.0 billion between 2026 and 2032. You can run that against NEP's current market capitalization and EBITDA generation. At present price the potential equity dilution with issuance of units, the distribution will definitely need a 50% haircut over 2026 and 2027. What could push the unit price high enough to sustain the distribution? We would speculate here that full and complete return to ZIRP (zero interest rate policy) would be required. In the absence of that, the distribution is not sustainable over the medium (that does not mean next quarter) term. The markets are obviously egging the Federal Reserve to get back to the bubble blowing ways and are now pricing in 7 (yes 7!) rate cuts by year end 2024. Those not into reading the Fed Funds Futures but having a strong math inclination, can figure this out by the differentials between current policy rates and 1 and 2 year Treasury yields.

Our take is that inflation will prove stickier than expected and even the normalization of the 3-month-10 Year Treasury relationship suggests a 5.5% 10 year note. If that outlook comes to pass, NEP and its distribution will be toast by year end 2024. In the alternative scenario, where we actually justify more than 175 basis points of cuts, because we hit a severe recession, expect the BB spread to blow out and once again, NEP distribution will be toast. Of course there is the perfect soft landing. You know, the scenario where the Fed cuts 7 times, we have no recession, no inflation reacceleration and higher for longer becomes a reference to the stock market. Look, these things have never really occurred with such tight unemployment levels and such a rapid policy tightening. They certainly have not occurred when the Fed starts easing after months of LEIs dropping . So if you believe this happens and it actually does, well yes NEP will sustain the distribution. Realistically the distribution should be reduced to the start repairing the balance sheet but NEP knows that the money saved from the reduced distribution is too small to help. They need that higher unit price or all hell will break loose down the line. It is always about the unit price. We saw the same with the popular "hand over fist" stock called Enviva ( EVA ), which played in the same renewable pool. Life and credit rating changes come at you fast.

Based on our outlook, we think investors should use the bounce to exit these. We are pretty certain the next two distributions will be maintained and at that point management will start coaching you on how you will be better off when they lower the distribution. Risk-reward on the short side is not compelling here so we are going with a "hold", but if we get $35 it might be better setup for that.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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