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NextEra Energy Partners: Strong Yieldco With Considerable Upside

Summary Solid base of long-term, stable cash flow-producing electricity generation assets. Strong partnership sponsor willing to step up with equity contributions when required to grow the dividend. Currently priced at an attractive level due to the market’s over-reaction to acquisition and financing of natural gas pipeline assets. NextEra Energy Partners (NYSE: NEP ) is a limited partnership formed and sponsored by NextEra Energy (NYSE: NEE ), with the sponsor maintaining approximately three quarters interest in the underlying operating company. NextEra Energy Partners focuses on the acquisition of energy projects, primarily in the renewable space, with long-term stable cash flows. These stable cash flows are then levered in order to generate a high rate of return in a sustainable long-term dividend. The company’s primary focus is a collection of renewable energy assets currently under long-term power purchase arrangements in eight states and one Canadian province. These assets currently have capacity to generate 1,923.2 megawatts of energy, approximately 84 percent from wind generation. This will be further expanded by 149 megawatts of wind generation from the Jericho assets being purchased from its sponsor, which will be discussed later along with the partnership’s recent developments. Also in terms of recent developments for further discussion, the company has recently acquired substantial natural gas transmission pipeline assets. In terms of forward guidance, NextEra Energy Partners has indicated that it expects to generate $400-440 million in adjusted EBITDA for 2015, increasing to $580-620 million of adjusted EBITDA in 2016, primarily on the back of the NET Midstream acquisition, which we’ll cover along with some other recent developments. This should leave the company with approximately $170-190 million in cash available for distribution in 2016. The partnership has currently set its target distribution to $1.23 per share annualized at the end of year, reflecting an increase to approximately $0.3075 per share quarterly or a dividend yield, based on the September 10 closing price, of 4.7 percent. From a long-term perspective, the company expects to continue to grow this dividend at an average annual growth rate of 12-15 percent. As a note to investors, the partnership expects its distributions to be treated as though they are dividends received from a corporation for U.S. federal income tax purposes. This income will be reported on a 1099-DIV form. While we’re not in the position to offer expert tax advice, and readers should consult their tax advisors, we believe this is certainly an easier-to-understand tax structure than many partnerships out there, albeit perhaps trading off some of the benefits. Recent Developments In NextEra Energy Partners’ second-quarter release, the partnership announced that they had entered an agreement to acquire NET Midstream, an owner and operator of natural gas pipelines located in Texas. This operation maintains 3.0 billion cubic feet per day in ship or pay contracts, with an average life of 16 years, and, according to NextEra Energy Partners, an average investment-grade counterparty credit. Current growth and expansion projects are expected to grow this contract volume by an additional 1 billion cubic feet per day upon completion. The pipelines, in particular, look to be a relatively high-quality asset, with a current capacity of 4 billion cubic feet per day, which could later be expanded to 5 billion cubic feet per day. The primary shipment of gas on these pipelines is from the Eagle Ford shale gas region into Mexico. Additional volumes served include volumes from the ENSTOR Katy Hub to residential consumers and industrial users in the Houston area, and additional volumes supplied to the city of Corpus Christi, Texas. The acquisition of NET Midstream is expected to provide $145-155 million in 2016 adjusted EBITDA, and by 2018, following the completion of the expansion projects, up to $190-210 million in EBITDA. On a whole, this isn’t really an exciting acquistion from a purely cash flow accretion standpoint, but it does offer some diversification to the partnership’s energy infrastructure business at little dilutive cost. Overall, we’re pretty neutral to the acquisition, but the impact the financing has had on the stock price has driven our current short-term excitement about the stock. One further smaller acquisition announced by the company is the Jericho wind assets being purchased from the partnership sponsor NextEra Energy. The Jericho wind project is a 149 megawatt installation in Ontario, Canada. This transaction is expected to close in the fourth quarter due to Canadian tax rules. Both of these acquisitions have created substantial financing needs for the company. In order to raise the money required to complete these acquisitions, NextEra Energy Partners has put in place the following as announced in the August 31 conference call: Raising $600 million of non-amortizing 2-5 year NextEra Energy Partner debt. Issuing $200 million of NextEra Energy Partnership units to the public. NextEra Energy slowing its rate of ownership dilution by investing $700 million in NextEra Energy Partners on the same terms as the public unit issuance. In beginning the execution of this financing plan, on September 10, NextEra Energy Partners confirmed the issuance of 8,000,000 common units at a price of $26 per unit to the public in an underwritten deal. On the same terms, NextEra Energy has agreed to purchase $702 million in common units at the same price via a private placement. This would complete the equity issuance portion of the capitalization plan, setting up the company to complete the transactions. Raising $900 million in equity for the partnership on September 10 certainly puts the firm in a relatively healthy position in terms of financing these new acquisitions. In fact, management suggested in the August 31 conference call that they are affirming their 2015 through 2018 guidance based on this financing plan, with the difficult piece now squared away in the equity financing. Positives Opportunity to get in at an attractive price: Although the current financing was telegraphed by the company in late August, the market responded negatively to the deal yet again, with the partnership falling 7.65 percent in Thursday’s trading following the announcement. The company is down 40 percent over the last three months from its highs in early June, and is now priced extremely attractively, with a high but easily sustainable, and even growing, dividend. We believe that the recent price moves have been partially macro-driven and do not reflect a material change in the future prospects of the firm. Also, it’s worth keeping in mind that the partnership’s sponsor had no concerns about stepping up in a big way to buy additional units at this price. This should be comforting that those closest to the operational realities of this firm are putting their dollars on the line. While not exactly comparable to insider buying from executives or directors, this is, in our books, a vote of confidence in the assets being purchased and the ongoing dividend sustainability of the firm. Multiple Jurisdiction Exposure: One of the risks facing independent power producers is regulatory and political change in specific jurisdictions. While, on balance, the push towards greener or renewable energy sources has been strong in most North American and European jurisdictions, the costs of these green energy programs are beginning to mount. By having assets in eight different states and an additional 516 megawatts of capacity (following the Jericho acquisition) in Canada, the partnership has effectively hedged exposure to political change in any one jurisdiction. Long-term Stable Cash Flows: According to the partnership’s 2015 European investor presentation , the firm is sitting on an average capacity-weighted remaining contract life of 20 years. Given that the majority of counterparties are investment-grade rated or better, these long-term, stable cash flow projects provide the underlying support to the partnership’s dividend. Strong Sponsor in NextEra Energy: The partnership’s sponsor in NextEra Energy is certainly one with many advantages. Through maintaining a majority ownership stake in the partnership, NextEra Energy is certainly engaged in the success of the venture. Further, the company’s expertise is directly applied to the operations and management of the partnership through its controlling interest in the general partner. The other advantage of the partnership’s relationship with the parent is the potential future stream of cash flow-generating assets that it could acquire from a trusted developer. NextEra Energy has 1,766 megawatts of contracted wind development coming onstream over the next few years, and another 1,417 of contracted solar development. These offer potential assets for the partnership to purchase for the purposes of expanding its cash flow available for distribution at potentially attractive rates. NextEra Energy also announced a new dividend policy in its second-quarter presentation, reflecting a more aggressive stance. Without management’s confidence in the underlying performance of NextEra Energy Partners, this new dividend strategy by the parent would be risky and ill-advised. We believe that this shows confidence in the ability of NextEra Energy Partners to distribute the required cash to sustain its sponsor’s own dividend policy. Risks Access to Capital Markets: Continued access to capital markets at attractive rates is more or less required to sustain growth in any “yieldco” type of company. With the firm paying out much of its free cash flow to investors, any incremental acquisitions are generally financed with a mix of equity and debt. In the event that capital markets are unwilling to provide additional financing due to macro conditions or particular developments within the firm, the growth trajectory can be severely impacted. In the case of NextEra Energy Partners, its sponsor does seem willing to put up additional capital when required, as illustrated by its over $700 million commitment to additional equity for the NET Midstream acquisition. Pipeline acquisition could fail to achieve EBITDA projections: With the current commodity price collapse, natural gas shipments on these assets could potential fall, or the company could fail to obtain contracts to fill the addition 2 billion cubic feet per day of capacity coming onstream with the NET Midstream assets. Failure to reach its EBITDA projections on this acquisition could make this deal look extremely dilutive in the future. However, we believe even with this factored in, there isn’t considerable further downside to the share price, as the market seems to have already taken a very skeptical view of this transaction. In context, the pipeline assets will comprise approximately a quarter of the firm’s 2016 EBITDA. Valuation We approach the valuation of NextEra Energy from a few angles, but we’re primarily focused on that cash flow available to equityholders. We’re comfortable with the mid-range of the company’s projection following the closing of its equity financing, with $180 million in cash available for distribution in 2016. The expected growth rate, potentially fueled by a pipeline of currently in development project acquisitions from the sponsor, of 12-15 percent per year put forward by management also seems reasonable. At the current share price of $26.18 (as at September 10), and assuming a 12 percent growth rate in cash flow available to equity interests, this would suggest an equity cost of 24 percent, which is far in excess of what would be reasonable for a company with this kind of stable, long-term cash flow. This is determined on a basic FCFE calculation using the cash available for distributions and adjusted on a per share basis, based on the share count, giving consideration to the September 10th announcement. By comparison, Brookfield Renewable Energy Partners LP (NYSE: BEP ) is currently priced at a roughly 16 percent equity cost on a lower 9 percent growth target (per the company’s materials ), and targets a 15 percent return on equity on its investments. If NextEra Energy Partners was priced at an 18 percent return on equity (to give effect to a smaller, less diversified portfolio), with a 12 percent growth rate, we’d be looking at a share price of approximately $50 per share. This would be our one-year target on this stock, and we believe this is a still a conservative valuation providing a great return to equity investors. This isn’t entirely unfounded in past performance either, as the company traded at these levels earlier in the year on the same basic cash flow fundamentals. This further reflects our thesis that the current market price is not driven by cash flow realities, but by market sentiment and overreaction to this recent acquisition and financing. And all of our valuation is priced without any substantial upside to the NET Midstream acquisition, which the company indicates could be another $45-55 million in incremental EBITDA beyond the initial 12-15 percent growth target included in our valuation. Summary Overall, we believe that NextEra Energy Partners currently offers a very compelling valuation for a portfolio of long-term cash flow-generating energy infrastructure assets. The current market reaction to the financing arrangement for its NET Midstream and Jericho acquisitions seems to be considerably overdone, and the stock is current available at a substantial discount to other players in the space. With a solid and competent sponsor in NextEra Energy, this “yieldco” would fit nicely in a portfolio of dividend-paying stocks, providing a solid, growing dividend into the future. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

White Mountains Insurance Group Is Preparing For A Financial Storm

WTM is slowly selling off its insurance businesses. The insurance industry is not what it once was. The WTM management team is one of the few who are awake to the risks. The CEO of White Mountains Insurance Group (NYSE: WTM ), Ray Barrette, has voiced concerns about the insurance industry and the general economic environment in his management reports over the last several years. Barrette’s comments are often times indirect by referring to the insurance market as highly competitive. Other times his statements are blatant, claiming that low interest rates and highly competitive insurance pricing do not offer insurance companies an adequate return for their risk exposure. He has voiced concerns with government debt, inflation and rising interest rates, which of course could bankrupt an insurance company if these scenarios happened sharply and unexpectedly. The investment management of WTM coincides with Barrette’s viewpoint. WTM has kept its bond portfolio very short term, far more conservative than the industry average. Large cash holdings are always on the books. WTM has also favored insurance lines that are short tail, as long tail lines can take many years for the claims to settle and are exposed to inflation risks. In my opinion, WTM is one of the most conservative and cautious insurance holding companies operating in the insurance space. There are other cautious holding companies, such as Fairfax Financial Holdings (OTCPK: FRFHF ) and Alleghany Corporation (NYSE: Y ), but WTM has them beat in its paranoia. Not only does WTM have shorter term bonds than these other companies, but WTM has been selling its insurance companies off whereas other insurance holding companies have been buying them and trying to consolidate. On July 27th WTM announced its sale of Sirius Group for 127% of its book value in cash. I found this surprising, as this company accounted for nearly half of WTM’s consolidated premiums and was by far its most profitable underwriter, having combined ratios in the 70-80% range. Selling a core asset such as this implies a bleak outlook for the insurance industry. The sale of Sirius Group is not the whole story. WTM is also selling its portion of Symetra Financial Corporation (NYSE: SYA ), of which it owned 17% of the outstanding shares alongside other partners such as Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). After selling Sirius Group and Symetra Financial, only one of its three major insurance companies are still on WTM’s books, and that is OneBeacon Insurance Group (NYSE: OB ). WTM also has several other insurance holdings such as HG Global/BAM, but they’re small compared to what has been sold off. I believe these actions taken by WTM are very wise. The insurance industry has come under a lot of pressure in recent years. The macro environment has interest rates near zero percent interest. In normal times during the last several decades, low interest rates would push insurance companies to charge higher premiums to balance lower investment returns. However, the current state of the world comes with pathetically low rates, high debt both public and private, and irresponsible governments that simply will not operate within a balanced budget. Low interest rates and overpriced bond and stock markets are forcing other investment managers to seek returns elsewhere by invading the insurance space. Because of the new entrants, existing insurance companies cannot raise their prices during low interest rate environments. This is squeezing the profit margins out of the industry in an unprecedented manner. Warren Buffett has recently commented on the poor state of the insurance industry. Buffett stated that insurance has become “fashionable” for investment managers. I can understand his frustration, but I don’t think fashionable is the right explanation. Other investment managers are going into insurance because there are few other places to go with their money. The investment environment is dismal right now, and additional profits from insurance float are seen as a relatively safe way to enhance returns with few other options. WTM is cashing out of the insurance business, and at a premium to book value. This is truly contrarian when the rest of the insurance industry is trying to consolidate through mergers and acquisitions to become more competitive in a crowded industry. WTM is playing it smarter. WTM is accumulating large cash holdings and investing in startup companies, mostly services, that require minimal capital upfront. WTM’s portfolio is slowly being transitioned into a barbell, with a highly defensive cash component, and a small but highly aggressive component composed of start up companies. A barbell such as WTM’s is the best way to play the current macro environment, in my opinion. If deflation sets in, their large cash position will rise in purchasing power and provide many opportunities in an ensuing market correction. If inflation sets in, WTM’s cash will devalue to some extent but at least their insurance exposure will be reduced. Insurance companies could drop substantially in value under a scenario of high inflation and/or rapid interest rate increases. WTM is a very well managed company. I have been a fan for many years. However, I do not own shares of WTM right now because I perceive them to be fairly valued. The premium over book value that WTM is receiving in its sales of Sirius and Symetra is already reflected in the current share price. The share price has risen substantially since the sales have been announced at the end of July. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

It’s Better With Beta

The title of Larry Swedroe’s latest book, The Incredible Shrinking Alpha, raises a question: what happened to the idea that skilled managers can consistently beat the market? In a recent interview with Swedroe, we discussed the idea that this ability hasn’t really disappeared: it’s just that “alpha has become beta.” What exactly does that mean? In investing jargon, alpha is the name given to the excess return a fund manager achieves through skill. Beta , on the other hand, refers to the returns available to anyone who is willing to accept a known risk. When Swedroe says “alpha has become beta,” he simply means that anyone who understands how to structure a portfolio can increase their expected returns by simply changing their exposure to specific types of risk, known as “factors.” A factor is a characteristic of a stock that affects its expected return and risk. Factor investing (sometimes marketed as “smart beta”) means identifying which of these characteristics might predict higher returns in the future-even if it also brings more risk-and then building a diversified portfolio that captures those returns in a systematic way, without resorting to picking individual stocks. And then there were three As I’ve written about before , the so-called Fama-French Three Factor Model was a revolution in investing. In a landmark 1993 paper , Eugene Fama and Kenneth French argued that the vast majority of a stock portfolio’s returns could be explained not by the manager’s genius, but by its exposure to beta (market risk), small-cap stocks (which are expected to outperform large caps over time) and value stocks (companies with low prices relative to fundamentals such as book value, dividends and earnings, which tend to outperform growth stocks). But it didn’t end there. Later in the 1990s, a fourth factor was identified: momentum , or the tendency for stocks that have recently performed well (or poorly) to continue in the same direction. In the last few years, researchers have identified several more. First was the profitability factor : companies with a high ratio of gross profits to assets tend to outperform, even though these are generally growth stocks, not value stocks. That was followed by the investment factor , which is based on the counterintuitive idea that capital expenditures on new acquisitions and ventures usually fail, and therefore lead to lower stock returns in the future. The factor zoo If you this all sounds overly complicated, you’re not alone in that opinion. One finance professor famously described the “zoo of new factors” now in the academic literature. “Something like 300 factors have been identified,” Swedroe says. “Because there is a big premium on being published, you want to be the professor who finds a factor: then you can go and get a job on Wall Street.” One commentator reported that “some quant shops now use an 81-factor model to build equity portfolios.” The good news, says Swedroe, is that no one needs anything close to an 81-factor portfolio. “The thing to understand is that some of these factors are really just manifestations of some other factor,” Swedroe says. In a new paper , Fama and French acknowledge that once you consider beta, size, value, profitability and investment, none of the other factors have any meaningful explanatory power. (This idea is discussed in the final appendix to The Incredible Shrinking Alpha .) Five is enough In our interview, Swedroe used an analogy to explain why simple portfolios get you most of the way there. “Say you’re taking a drive across Canada, and it’s 3,000 miles. And let’s say that during each leg of your journey you drive halfway. So the first leg you drive 1,500 miles, and the next leg you drive 750 miles, and so on.” You make progress every day, but each successive leg of the journey has less of an impact. “It’s the same thing with a portfolio: if you add bonds to a stock portfolio, that’s a big move. Then you add international stocks, and that’s a pretty big move too, though not as big as adding bonds. Then you start adding small-cap and value. Once you’re at that eighth or ninth asset class, yes, you will pick up something, but you’re already most of the way there. So we want to focus on the factors that really matter the most: the ones with the big premiums, as well as the ones that help diversify. And I think the literature is pretty clear now that we’ve got these five.” Swedroe also points out that more factors may mean fewer stocks. “If you keep adding screens, what happens is you get a less and less diversified portfolio. You could start out with a small-cap portfolio that is 2,500 stocks, and then you make it small-value and you’re down to 1,500. Add another screen and you’re down to 700. At some point you don’t have enough of a diversified portfolio. So you have to make decisions about how to do this.” One decision might just be to stick to a plain-vanilla Couch Potato strategy. In fact, if you’re a DIY investor you probably should . Factor investing may be able to increase your returns slightly over the long term, but only if you have the expertise to manage a more complicated portfolio. Consider it the icing, not the cake itself .