2023-12-15 10:00:00 ET
Summary
- Atlantica Sustainable Infrastructure's stock value closely aligns with the fluctuations in bond yields.
- Its dividend yield is expected to become more appealing as rate cuts kick in, potentially leading to a significant increase in the stock price.
- Simultaneously, the company's predictable cash flows, and fixed interest expenses support the security of its dividend and limit uncertainties in its investment case.
Atlantica Sustainable Infrastructure ( AY ) is one of my favorite YieldCos and the only stock I would recommend for exposure to renewables with a wide margin of safety.
In late September, I shared an article in which I went through its asset base, explained why shares have been under pressure over the past year, and suggested a strategy through which investors can combine the stock's 8.6% yield along with writing covered calls to generate a ~15% income yield.
After a temporary decline in shares subsequent to my earlier article, they have since rebounded to comparable levels, once again presenting an attractive dividend yield of 8.6%. However, in contrast to endorsing a strategy involving covered calls (potentially relinquishing shares if they surge above a specific price), my current stance is that opting for a straightforward long position in the stock offers a more compelling investment proposition.
This conviction is bolstered by the recent Federal Reserve meeting, where signals pointed to the likelihood of three rate cuts in 2024 . In anticipation of potential rate cuts, I believe that Mr. Market will reevaluate Atlantica favorably, as its robust yield becomes increasingly appealing when bond yields begin to dwindle.
To illustrate this viewpoint, consider the accompanying chart depicting the movement of five and 10-year U.S. Government yields alongside Atlantica's dividend yield.
Bond Yields & AY's Dividend Yield (Koyfin)
As shown, given Atlantica's status as a YieldCo and the prevailing expectation that dividends will drive the majority of its future returns, the stock's yield mirrors a trajectory akin to that of bonds.
Essentially, with interest rates on an upward trajectory over the past two years, fixed-income investments (such as T-bills) gained favor among investors, providing higher yields with lower risk compared to YieldCos like Atlantica.
In simpler terms, the diminishing yield spread between high-yield stocks and secure fixed-income securities eroded the appeal of the incremental risk associated with Atlantica, leading to a sustained sell-off of the stock - hence its yield advancing higher over the past two years.
This phenomenon is rooted in investors attempting to price in Atlantica's risk premium relative to bond yields, explaining the consistent spread between Atlantica and bonds.
Drawing from this inverse relationship between Atlantica's stock price and bond yields, a reversal is poised to occur next year. In other words, as yields decline, investors will be motivated to gravitate toward Atlantica's substantial yield, propelling the stock price significantly higher in the process.
In that sense, the stock's total returns are likely to be way more attractive by just holding it, versus selling covered calls for some extra income as I had suggested before.
Futures traders anticipating a shift in the Federal Reserve's policy rate are currently factoring in the likelihood of rate cuts commencing in March. Furthermore, they are projecting a policy rate at the close of 2024 that stands 1.5 percentage points lower than the existing level.
Assuming Atlantica's dividend yield follows this trend (i.e., investors chase it toward ~7%), the stock could rally toward $25.50 by this time next year.
In this scenario, investors could enjoy significant returns from the underlying price appreciation (about 23% from Wednesday's closing price of $20.75) plus the yield on cost of about 8.6%.
Naturally, this scenario is speculative, subject to influence from various factors. The frequency and extent of rate cuts by the Federal Reserve next year remain uncertain. Concurrently, the underlying price of the stock may be influenced by numerous other variables, leading to fluctuations in returns.
Nevertheless, the example presented serves as an illustrative portrayal of a typical situation, demonstrating how the stock has the potential to yield exceptional returns in a declining interest rate environment.
Regardless, betting on Atlantica's shares primarily following the movement of bond yields makes a lot of sense, as there are few other factors to impact it. There are not really many uncertainties from an operating point of view, as Atlantica's renewable energy assets remain fixed under long-term contracts with pre-determined hikes embedded.
Specifically, the company's portfolio of 44 operating assets with 2,161 MW renewable energy generation capacity features an average PPA (Purchase Power Agreement) life of 13 years signed with highly credit-worthy off-takers like The Government of Peru and The Kingdom of Spain, or industry giants like Enel Generacion Chile ( ENIC ), amongst others.
In the meantime, 90% of the company's total debt is in USD or hedged, and 92% of interest rates in project debt are fixed or hedged.
Portfolio Breakdown Based on Estimated CAFD (Atlantica Sustainable Infrastructure Q3 Presentation)
To illustrate how Atlantica's PPA contributes to highly predictable revenues, the company's top line for the first nine months of 2023 was $858.6 million, in line with the result in the prior-year period.
Moreover, to underscore the robust protection of Atlantica's profitability against interest rate fluctuations—especially noteworthy as interest expenses constitute the company's primary costs, given its nature as an asset manager— the company incurred $243.1 million in finance (interest) expenses during the initial nine months of 2023. This figure remained stable year-over-year despite the surge in interest rates during this period.
Atlantica Sustainable Infrastructure's Q3 Income Statement (Atlantica Sustainable Infrastructure's Q3 Results)
With Atlantica's PPA ensuring highly predictable cash flows (revenues) and its borrowings structure ensuring highly predictable interest expenses, there is little speculation when it comes to the company's future CAFD (Cash Available For Distribution). The table below illustrates this.
Atlantica Sustainable Infrastructure CAFD (Atlantica Sustainable Infrastructure's Q3 Presentation)
Given the anticipated stability in CAFD (Cash Available for Distribution) going forward, not only does this affirm the security of the company's foundational dividend, but it also underscores the limited uncertainties linked to Atlantica's investment case.
This explains my earlier argument: The trajectory of Atlantica's share price is expected to be predominantly influenced by the prevailing trend in interest rates, as has been the case in recent years. Therefore, it makes sense to bet on the prospects of a rising share price in the face of declining interest rates.
As mentioned earlier, this scenario holds the promise of yielding substantial returns, particularly when coupled with the existing dividend yield.
For further details see:
Atlantica Sustainable: Grab The 8.6% Yield Before Rate Cuts Kick In