TRP:CC - NextEra Energy Partners Stock: The 5 Stages Of Grief

2023-09-29 11:26:21 ET

Summary

• NextEra Energy Partners LP has revised its growth rate to 5%-8% per year through 2026, down from its previous target of 12%-15%.
• NEP stock tanked 40% confounding investors at the depth of the reaction.
• We go over the five stages you should be watching for as this story develops.

On our last coverage of NextEra Energy Partners LP (NEP) we focused on the fact that growth plans were completely out of touch with reality and a downgrade was coming soon.

NEP has backed itself into a corner with promises of high distribution growth. While the ZIRP allowed this to flourish, we think the 12%-15% distribution growth is simply not possible in today's world. NEP stuck to its tag line despite a first half of 2023 that was significantly weaker than expected. Adjusted EBITDA and Cash Available For Distribution, i.e. CAFD, both coming in under 2022 levels. That's going to make those lofty growth rates difficult. But we think the time is drawing closer when NEP resets the distribution growth expectations for the 2024-2027 timeframe. That will likely create some panic in the stock. In addition, the payout ratio for NEP is likely to cross 100% in 2023-2024 timeframe, further pressuring the stock.

Source: 3 Reasons We Prefer Brookfield Renewable

While we would love to take full credit for the bloodbath that followed, we were a bit surprised at the magnitude of the move.

A 40% rewrite obviously changes things. We give our latest thoughts below.

Market Does Not Believe Even The Damaged Story Yet

The announcement did not seem too bad.

NextEra Energy Partners, LP. today announced that it is revising its growth rate to better position the partnership to continue to deliver long-term value for unitholders. The partnership is revising its limited partner distribution per unit growth rate to 5% to 8% per year through at least 2026, with a target growth rate of 6%. "NextEra Energy Partners is revising its long-term growth rate expectations for limited partner distributions to increase its flexibility as it continues to execute on its growth opportunities," said John Ketchum, chairman and chief executive officer. "Tighter monetary policy and higher interest rates obviously affect the financing needed to grow distributions at 12%."

Source: NEP (emphasis ours)

Growth rate was cut in half but honestly, nobody who has been following the renewable space (massive margin compression) or looking at financing conditions, was buying the 12% growth story. So one might have expected a celebration of sorts. After all, the stock already was down by about half from its 2021 peak, before this announcement.

So what we think is happening is that the market is not even buying those growth rate assumptions. The reason is that the distribution growth is tied to debt and unit count.

Without growing either, distribution growth of any variety will be impossible. After all, NEP is paying most or all of its CAFD back as distributions. Sure, most contracts have inflation escalators so there's some natural growth from that. But it won't be enough to counteract the debt reset. You have $3.4 billion coming due in the next 4 years at a weighted average of about 2.6%.

That needs to reset to over 7.5% in today's market. So roughly you would be jumping up 5% on $3.5 billion or about $175 million annually. So what does that mean for the company? The company did $400 million of CAFD on an annualized basis in the first half of 2023. If you take away $175 million from that, you can kiss your growth and your current distribution goodbye. Even assuming a baseline run-rate growth from current operations of about 10% total over the next four years, your CAFD falls to $260-$280 million and with probably 94 million units outstanding, even the current distribution is very hard to finance post-2026.

The 5 Stages Of Roll-Up

With these LP setups, we have seen the tango and the drama, and they follow a predictable arc. Though, each time it happens, investors act surprised.

The first stage is coming to grips with the end of the growth story. This seems like a benign event but marks the limits to what the market will tolerate in a company that sends all distributions back to investors and then keeps tapping the market for equity and debt issuance. This is when the company goes from a regular dividend payer to a "high yield" as the stock falls a lot. We have this happen for NEP already.

Woo-hoo double-digit yield!

The second stage is investors piling in just for the income. Hey, no growth is not a problem as long as the distribution can be maintained, right? We can sympathize, but investors tend to forget two important facts. The first is that these companies require capital spending beyond what they classify as maintenance capex to actually maintain the distribution. Most of these assets have a limited life, and maintenance capex alone is not enough to even sustain the distribution in the long run. The second is that their general partner did not throw them out there to throw a steady distribution back. It was designed as a drop-down vehicle and a way to access capital without destroying their own credit ratings. They have zero use for a regular distribution back to them when there's no growth.

So that leads to the third stage, which is a distribution cut. It's blamed on capital markets, asset specific problems, specific events and occasionally the Easter Bunny. The company may even say they are cutting to fund growth, which is about the silliest thing they can say, but that's where this ultimately goes. In the case of NEP, well, you have the capital market clause already in play. The numbers don't lie. One point we want to make is that the debt profile shown earlier in the article is from December 31, 2022. By June 30, 2023, this was another $1.2 billion higher.

Of course, the cut is not coming tomorrow. In the interim, the yield chasers will be up in arms against us every time the CEO mentions "distribution is important," or "we have a plan to fund the distribution." This is a long-term issue and NEP is likely to play out over a very long timeframe as the current payout is not a problem. So have patience with this.

The final stage is the roll-up. The cut should take the equity down, and depending on market conditions, these stocks can trade very cheap. We would not be surprised to see 6X distributable cash flow at the trough. Then the sponsor NextEra Energy Inc. (NEE) will come in with "Hey would you like to see that distribution grow once more?" There will be a premium involved, though it won't make investors whole. Anyone that got in before this guidance cut will struggle to make even positive total returns.

TC Pipelines

There are a ton of examples, but one that immediately comes to mind is the TC Pipelines (formerly TCP ticker) rollup in TC Energy (TRP). The growth story was already tottering due to the problems with the Bison Pipeline. Then the FERC decision of 2018 (no income tax collection for LPs) threw this down the gutter.

TC Pipelines boasted a distribution coverage of 1.8X prior to going down this rabbit hole. NEP can barely cover its current distributions. So keep that in mind as you try and dismiss the possibility for NEP. TC Pipelines froze the distribution for some time, and if you look back, it was still all going to be ok according to management. Then there was a 35% decrease in the distribution.

Finally, the grand overture.

TC Energy (TRP) offers to acquire all TC Pipelines units it does not already own in a deal that values the natural gas pipelines company at $1.48B.

Under the deal terms, TC Pipelines unitholders would receive 0.650 common shares of TC Energy for each issued and outstanding publicly-held TCP common unit, which would value TCP shares at $27.31 each, a 5.4% premium based on Friday's closing price.

Source: Seeking Alpha

The premium was eventually bumped up , but still left notable scars. TCP traded as high as $70 at one point before this downdraft started.

The Fifth Stage

The fifth stage of grief is acceptance, and that coincidentally is the fifth stage of this roll-up saga as well. The wheels are in motion already, and the capital stresses from trying to fund a massive distribution while refinancing a huge debt load can be seen. Debt to EBITDA will be past 6X pretty soon. But don't expect a cut even in the next 24 months. NEE has given NEP a lifeline till 2026 by suspending the IDR payments and allowing NEP to deleverage a bit by selling pipeline assets.

As part of the May announcement, NEP stated it has entered into an agreement with majority owner and former parent, NEE, which currently owns 53.1% of the company, to suspend incentive distribution rights fees through 2026. By suspending approximately $157 million of annual IDR fees, NEP will largely offset the loss of cash flow associated with the assets being sold. We expect the net result of these transactions to be credit neutral to NEP's financial profile and that NEP will continue to maintain a stable financial profile.

Source: Moody's

But the idea then was that NEP's share price would rise, and we would be back to the old funding model. Since the price has crashed, 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 into TRP in 2021 . These things take a long time to play out.

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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