- NEP's external management team at NextEra Energy, Inc. recently amended its management agreement to freeze incentive distribution rights fees at basically their current level.
- This is a great move for both companies but especially for NEP, as it will incrementally increase NEP's cash flow and reduce its payout ratio.
- In the future, each new dollar invested in portfolio expansion will become more and more accretive to cash available for distribution.
Thesis: Freezing IDR Fees Bolsters Future Growth
NextEra Energy Partners ( NEP ) is a renewable energy YieldCo sponsored and managed by the Florida utility giant and world's largest renewables developer, NextEra Energy, Inc. ( NEE ).
Recently, management made an impactful move that should prove beneficial to both NEP and NEE by deciding to freeze the incentive distribution rights ("IDR") fees NEP is obligated to pay to NEE at basically their current level. According to the original sponsorship agreement, these IDR fees would continue to grow along with NEP's distributions in perpetuity.
Below, we'll discuss why this is a good move for both parties but especially for NEP unitholders (the LP equivalent of shareholders), in addition to some other notable developments.
For instance, management also announced an extension of their 12-15% annual distribution per share growth target by another year, now spanning through 2025.
Meanwhile, in 2022, the payout ratio is expected to remain in the low 80% territory. In my last article on NEP , I worried a bit that the payout ratio was creeping up, but the flattened IDR fees should put an end to this upward creep.
The bear market of 2022 currently offers investors the chance to buy NEP at a dividend yield of 4%. And this is for a stock that not only has delivered 15%+ distribution per unit growth since its IPO but also beaten the market ( SPY ) and utilities ( XLU ) on a total return basis.
In short, NEP is a well-managed and rapidly growing way to play the massive green energy transition.
Quick Update On NEP
For a fuller picture of NEP's business structure and portfolio, I recommend checking out " NextEra Energy Partners: The Green Energy Revolution Has Just Begun ." In this article, we'll just provide an update assuming readers already know the basics of the LP.
(By the way, NEP is a publicly traded LP, but it is structured so as not to generate a K-1 Form for tax purposes. Distributions are reported on the 1099 Form.)
NEP and NEE enjoy a symbiotic relationship. Basically, NEP acts as a financing vehicle for NEE (specifically NextEra Energy Resources) to fund its large pipeline of wind and solar projects. The renewables developer sells or "drops down" completed and stabilized projects with long-term contracts in place to NEP, then uses the proceeds to reinvest in new projects.
Meanwhile, NEP hungrily gobbles up everything NEE wants to sell to it (plus some third-party acquisitions and repowering investments) in order to expand its portfolio and thereby raise its distribution to unitholders.
This is a nice complementary relationship that has so far worked out well for both parties. It's no wonder, then, that the two stocks generally trade in a pretty tight correlation to each other.
Because NEE is such a large developer of renewable energy assets, NEP has been able to enjoy rapid portfolio expansion since its IPO in 2014. In fact, NEP is now the 12th largest producer of wind and solar power in the world.
Portfolio expansion has been incredibly rapid for the YieldCo, exploding by a factor of 8 since its IPO eight years ago.
Moreover, as you can see above, NEP's distribution per unit has soared at a remarkably fast pace of around 15% annually for a total increase of ~290%.
This rapid growth is not expected to slow anytime soon. This is both because the government continues to favor renewables in tax policy and because demand for renewable-produced power from utilities and corporations continues to grow.
NEP enjoyed a strong first quarter of the year, bolstered by above-average wind production. (A mere 1% change in wind production, higher or lower, should alter EBITDA by $8-10 million for the final nine months of 2022.)
Seemingly following the cue from fellow renewable energy producer Clearway Energy, Inc. ( CWEN , CWEN.A ), which recently agreed to sell its thermal energy assets in order to become a pure-play renewables owner, NEP announced the sale of a ~156-mile natural gas pipeline in order to focus more heavily on renewables.
From a cash flow perspective, I am not sure how smart of a move this will prove to be. Sometimes the gas pipelines would perform better than the renewables, or vice versa. Weakness in one is often offset by strength in the other. For example, during the winter storm in 2021, natural gas pipeline revenue spiked while revenue in the renewables side declined due to frozen wind turbines.
Excluding the impact of the winter storm, both adjusted EBITDA and cash available for distribution ("CAFD") rose year-over-year in Q1, but it's difficult to say what the numbers would show without the beneficial effect of the natural gas pipelines last year.
Even so, it's nice to see that, holding weather constant, NEP's cash flows have continued to rise impressively.
Freezing Of IDRs Is A Big Positive
The biggest development for NEP recently was the announcement by management that NEE and NEP had amended their management agreement to freeze IDR fees at $157 million per year. That is only a little above the amount that NEP is paying to NEE in IDR fees right now. Once NEP's distribution per unit rises above $3.05, unitholders will begin to benefit from lower-than-otherwise IDR fees.
Management says:
The changes to the IDR fees are expected to provide more cash available to limited partner unitholders, require fewer asset additions to achieve growth objectives, extend NextEra Energy Partners' distribution growth runway and provide the partnership with more flexibility to finance its growth over the coming years.
It's useful to remember that NEE owns over half of the NEP OpCo limited partnership shares. Thus, over half of the distributions generated from NEP's portfolio are still flowing to NEE. Management still has a financial incentive to grow NEP's portfolio and distributions per unit as much as reasonably possible.
Plus, if NEP's stock performs better as a result of this move, NEE will benefit from that as well. This is true not just as it can report a higher asset value for its NEP units on its balance sheet, but NEE also benefits from a higher-than-otherwise stock price for NEP because it makes equity issuance more profitable for growth purposes.
Meanwhile, for NEP, this move will allow the YieldCo to retain a greater and greater percentage of its cash flow going forward, thus gradually reducing its need to issue equity.
As recently as the end of the first quarter, management expected NEP's IDR fees to end 2022 at a run rate of $165m to $175m.
For this year, the change should only render a few cents of additional CAFD per unit that would have otherwise gone to IDR fees. But that number will steadily grow over time as the portfolio expands.
Partially as a result of this change, management raised run-rate CAFD expectations for year-end 2022 by $10 million (about $0.05 per NEP unit attributable to common unitholders).
But, again, that number will grow exponentially over time as the portfolio generates more and more CAFD.
Bottom Line
Investors often (rightly) worry about possible misaligned interests between management and shareholders in cases of external management. But I think NEP is one of the few cases wherein what is technically an external management structure works quite well. This freezing of IDR fees is proof of that.
Instead of trying to milk NEP for all the cash it can get, the management team at NEE has decided that it would be best for both companies to keep the IDR fees NEP pays to NEE flat from here on out. I think that is a great decision that will keep NEP's payout ratio from rising, allowing NEP to retain more cash and reduce the need to issue as much equity.
This move is a demonstration that incentives truly are aligned between NEP and NEE. In my estimation, it further bolsters the safety of NEP's rapidly growing dividend and makes future growth more assured.
For further details see:
NextEra Energy Partners: The Growth Story Just Keeps Getting Better