Exclusive: Renewable firms in Mexico must contribute to grid backup

© Reuters. Federal Commission of Electricity (CFE) Director Manuel Bartlett attends a news conference at the National Palace in Mexico City

By David Alire Garcia

MEXICO CITY (Reuters) – Private renewable energy firms in Mexico should pay for part of the baseload power underpinning the flow of electricity on the grid, the head of the state power company said on Friday, as a dispute on the future of the local industry roils the market.

Manuel Bartlett, director of the Comision Federal de Electricidad, or CFE, told Reuters that his company nevertheless favors more clean energy and will seek to further reduce its use of fuel oil as a major source of power generation.

“Wind and photovoltaic (plants) don’t pay the CFE for the backup,” Bartlett said in an interview, referring to the cost of power generation from fossil fuels to ensure a uninterrupted flow to the grid. “And I can’t allow that.”

Last month, Mexico’s power grid regulator CENACE issued a ruling supported by Bartlett that prevented several dozen new renewable energy plants from connecting to the network.

CENACE cited the national crisis over the coronavirus pandemic as a justification, arguing that the intermittent nature of wind and solar power is not consistent with ensuring constant electricity supply.

The decision prompted letters of complaint to the energy ministry by the European Union and Canada, whose governments were upset that their companies had been shut out.

Mexican business associations also criticized the move, saying it puts more than $6 billion in renewable power plants scheduled to begin operating this year or next in limbo.

In a provisional ruling this week, a judge ordered CENACE to back down and allow the renewable firms to continue with tests needed to bring plants online.

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Pinnacle West Capital: Renewable, Fixed Income (NYSE:PNW)

Pinnacle West Capital (PNW) is a regulated utility company operating in Arizona, serving 1.3 million customers, including the metropolitan area of Phoenix. While Arizona has seen a slight uptick in employment, the state carries one of the highest population growth rates at 1.7% versus the national average of 0.6%. Additionally, utilities are one of the few industries where investors can hide from COVID-19, as they provide essential services and stand among those with the least exposure (along with technology, telecoms, pharmaceuticals, consumer staples, etc.).

For many utilities, shifting sources of energy from coal into renewables has become mandated by the EPA and other federal guidelines. Fortunately, PNW stands ahead of the curve relative to most other electric utilities, with only 22.7% of the composition coming from coal. Management anticipates that the company’s coal consumption will be zero by 2031, and to have completely carbon-free energy production by 2050. Creating such goals and already making significant progress insulates against harsh decisions from the Public Utilities Commission and allows for the prospect of stronger returns for equity holders.

Operating Performance

PNW has been performing as most utilities should with a steadily growing customer base in combination with typical rate hike schedules supporting clockwork earnings growth.

Data by YCharts

Healthy depreciation in combination with the lowered corporate tax code has placed PNW’s effective tax rate ranging from 0% to 30% in the last few years. While high capital expenditure budgets have neutralized any free cash flow generation, management has needed to tap debt markets to finance its shift away from coal into natural gas and renewables. Fortunately, PNW is ahead of the curve relative to competitors and will enjoy lower transitional capex spend in the future.

Staying Conservative

PNW management has still managed to maintain one the strongest balance sheets in the industry. For example, it carries one of the lowest debt-to-capital ratios relative to industry peers, including large caps:

ChartData by YCharts

Alternatively, financial leverage remains low relative to operating performance as well, trending at only 3.9x, whereas most other utilities trend around 5x.

ChartData by YCharts

Balance sheet resilience has palpably weakened across the industry, especially in the last 5 years, for the sake of boosting EPS and adhering to continuous dividend hikes. Given PNW’s position, it carries a relative advantage. Another challenge that many public companies are working through are underfunded pension programs; these not only drag on long-term returns, but they have also been so devastating to even cascade companies into bankruptcy. Fortunately, PNW has made a concerted effort to have their employee pension almost entirely funded on an annual basis, while conservatively lowering their expected long-term returns:

Another interesting dynamic for utilities are the credit ratings. Nearly the entire utilities ratings universe is rated BBB, with only a small fraction A-rated or non-investment grade. The effective borrowing rate for A-rated operators is only 200bps, whereas BBB-rated peers have costs of 350bps or higher, plus or minus based on the industry factor. Given utilities that have most of their capital stack financed with debt, this cost basis has a significant impact for residual earnings. Fortunately, PNW maintains A credit ratings from all three bond rating agencies. Circling back to my comment from a previous article, PNW carries a leading cost position and has a solid maturity schedule:

Pinnacle West Capital

The Dividend

Perhaps the dividend yield of 4% isn’t the most impressive; however, it does exceed the Utilities Select Sector SPDR ETF (XLU) dividend of 3.6% and there is certainly room for distribution increases in the future. Based on their historical earnings growth and dividend rate hikes, the annual dividend should exceed $4 by 2025, which would translate to a ~5% dividend yield today.

ChartData by YCharts

Bottom Line

In the COVID-19 world, utilities are a relatively safe place to park your money and it’s one of the few categories that will actually realize dividend increases going forward. Perhaps underfollowed relative to large cap utilities, PNW has a good story with its solid customer profile, well-diversified energy sourcing mix, strong capitalization, and having one of the safest balance sheets in the industry. Thank you for reading and please comment below.

Disclosure: I am/we are long PNW. 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.

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NRG Energy: Interesting Renewable Energy Play, But Debt Is Reason For Pause – NRG Energy, Inc. (NYSE:NRG)

NRG Energy (NYSE:NRG) is a company that first attracted my attention through its ownership of Green Mountain Energy, one of the largest producers of wind power in the United States, which I have been using to power my home for many years. The company is much more than just this though, as NRG Energy produces the power that it sells to its customers via many different sources, both renewable and otherwise. As is the case with many utilities too, it should be reasonably well-positioned to ride out the current coronavirus pandemic and any resulting recession. Despite this, though, the market has not been particularly friendly to the stock and has punished it along with everything else, which may create an opportunity for investors.

NRG is one of the largest electrical utilities in the United States, serving 3.7 million customers in Texas, Connecticut, Delaware, Illinois, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Ohio, and Washington, D.C. This current customer count is the largest that the company has ever had. NRG has steadily grown its retail base over the years, as we can see here:

Source: NRG Energy

As might be expected, this growing customer base has resulted in the company’s customers consuming more electricity in aggregate than they did in previous periods. This has generally translated into cash flow growth over time. We can see this here:

Source: NRG Energy

It would be reasonable to assume that the company’s retail customers may be consuming even more electricity than normal in the current environment since we have all essentially been ordered to remain at home, so things like televisions would see more use than usual. Businesses will likely be consuming less energy than usual though, so this will certainly offset that potential gain. This does illustrate how utilities are somewhat better equipped to weather through the current economic conditions than many other companies. When times are tight, people will generally prioritize paying their utility bills over more discretionary spending. This is doubly true when they are stuck at home as nobody wants to have their service cut off in such a situation.

As may be expected, NRG Energy is a leader in renewable energy generation. In 2010, NRG Energy purchased Green Mountain Energy, which is one of the largest producers of wind and solar power in the United States. This entity offers their various renewable-sourced products, which include things like chargers for electric cars and carbon offsets, in markets where electrical utilities have been deregulated. The company is also working to reduce its carbon emissions and has even set a goal of having net zero carbon emissions by 2050:

Source: NRG Energy

In addition to increasing the proportion of renewables in its portfolio, the company is working to accomplish this goal by reducing the percentage of its electricity that comes from coal. In 2014, 29% of NRG Energy’s revenue came from electricity that was generated by coal. The company managed to reduce this to 13% in 2019:

Source: NRG Energy

In the past few years, we have seen a surge in popularity of ESG investing, especially among young investors. This is a form of investing that seeks positive returns by investing in companies that have a positive impact on society. While it is debatable exactly what is considered a positive impact, it would generally include those companies working to move the world towards renewables and away from fossil fuels. Obviously, NRG Energy would fit into this category. As the funds in this space have been receiving large inflows of capital, there has been buying pressure on companies that are appealing to ESG investors that exceeds that of companies that are not. This could cause NRG Energy to outperform the broader utility sector going forward.

NRG Energy appears poised to see rising demand for its generated electricity over the next several years. As we can see here, over the 2020 to 2024 period, the company expects electricity consumption to increase at a 3.2% compound annual growth rate:

Source: NRG Energy

In order to support this growth, the company plans to invest $675 million in 2020 to improve its grid and increase its generation capacity. This is the same amount that the company plans to return to its shareholders through dividends and share buybacks. This is clearly shown here:

Source: NRG Energy

It is admittedly rather disappointing that the company has not yet decided where the majority of this money will be allocated. As we can see above, fully $614 million of the total $675 million has not been committed to any capital project. While we can assume that management will assign this money to various projects as they are identified, it would still be nice to have more visibility here.

As some investors that have followed this company know, NRG Energy was forced to restructure in early 2018 following a period of extreme distress. What happened is that, when the price of natural gas fell significantly in 2014 as a result of rising production, those companies operating natural gas-fired power plants were able to drop their prices substantially. Those operators with other types of plants had to cut their prices to compete, which caused severe pressure on margins and profitability. NRG Energy was not alone in having this problem, though. For example, FirstEnergy (NYSE:FE) also had to restructure because of this.

The company is nowhere near as financially strong as I would like to see despite the restructuring. We can see this by looking at the debt-to-equity ratio, which tells us how the company finances itself. As of December 31, 2019, NRG Energy had $88 million in current debt and $5.803 billion in long-term debt for a total of $5.891 billion. This compares to a scant $1.658 billion in shareholders’ equity, which gives the company a debt-to-equity ratio of 3.55. This is significantly worse than what DTE Energy (NYSE:DTE) has (see here) and that company has also been investing heavily in renewables and reducing carbon emissions.

As is the case with most utilities, NRG Energy pays out a dividend to its investors. The recent decline in the stock price has increased the yield on it, and it is now much more appealing than it has been in the past. The company currently pays out a dividend of $1.20 per share annually, which gives it a 4.25% yield at the current price. This is substantially better than the 3.53% paid out by the utilities sector (NYSEARCA:XLU) as a whole. This dividend is also much higher than what the company has paid out in the past. Here is NRG Energy’s dividend history over the past five years:

Source: Seeking Alpha

As we can see, the company was smartly limiting the dividends that it paid out during the time that it was facing the financial stress that ultimately forced it to restructure. Now that those problems appear to be resolved, the company has resumed its commitment to its owners, which is nice to see.

In conclusion, NRG Energy appears to have been unfairly beaten down by the market and may thus offer an attractive opportunity for an investor willing to stomach the current volatility in the market. The company may also prove appealing to the ESG crowd, given its focus on reducing carbon emissions and expanding the presence of renewable energy in the United States. The company’s financial structure is concerning, given the amount of debt relative to equity that the company is using to finance its operations. Personally, I would take DTE Energy, which I discussed in a recent article (linked above), over NRG Energy, given the company’s stronger financial structure and similar appeal to the ESG crowd.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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Hybrid Renewable Systems With Storage Makes For Revolution

Co-location of wind and storage: Greentechmedia Sourced from Invenergy

The coronavirus pandemic is causing chaos, leaving only the brave to do anything but look from the sides to see where it is all going. My take is that this is a time to look strategically at one’s portfolio to see whether it is future-proofed. Readers who follow me will be aware that in addition to two very rare events (COVID-19 and oil price war) happening now, this decade is the one when humanity decides if it wants a future. This means exit from fossil fuels.

Here I review the changing face of renewable energy as both solar PV and wind power shed their “intermittent” badge and start to become dispatchable power sources through strategic adoption of storage, which is mostly big batteries and pumped hydro. Wind projects are the new entrants in this new view of renewable energy. Major wind companies Vestas Wind Systems (OTCPK:VWDRY) and Siemens Gamesa Renewable Energy (OTCPK:GCTAF) both see storage becoming part of many (most?) wind projects in the future. These developments have positive implications for investment in solar PV, wind and battery storage.

Dispatchable renewable power solutions easier sell

In an earlier article concerning the Tesla (NASDAQ:TSLA) Megapack battery, I indicated that adding a big battery facility is going to become a major market for complex battery suppliers. Two major wind suppliers concur that this is where the market is headed, confirming that the battery opportunity and makes clearer how competitive the renewables market is becoming for new large scale power provision. Indeed the first of the solar, plus wind, plus battery plants are now being developed.

To attempt to forestall a sea of comments along the lines of “but a battery can’t possibly store all the power that a wind or solar farm produces,” it is worth mentioning that electricity is all about moving electrons around and batteries provide breathing space for these movements. There is not necessarily a need to keep the stored power in the battery for long if “downstream” there are further balancing opportunities. And of course in a modern grid there are other levers, such as time switching of power needs and demand management. The batteries are a vehicle for increasing the flexibility of the system.

Wind is the new entrant in hybrid renewable energy/storage projects

For a number of reasons, especially involving new energy policy, solar PV has pioneered the development of hybrid facilities with battery storage. However, wind projects are rapidly catching up. Indeed, the now-famous Neoen (OTC:NOSPF) Hornsdale Power Reserve, a 100MW/129MWh Tesla big battery project in South Australia, is an adjunct to Neoen’s major 309 MW Hornsdale wind farm.

A number of wind farms are now at the stage where refurbishment is being considered. Swedish company Vattenfall has completed both wind-plus-solar and wind-plus-storage projects in the UK. Vattenfall’s Jake Dunn makes the obvious comment “If you were to repower a wind project, you would have to look at the option of storage – you’d be foolish not to”.

The trifecta: Solar PV, wind, plus batteries

While it seems that in the future few big solar PV projects will proceed without at least some big battery component, it is clear that there are times when a solar PV-plus-batteries facility will fail to provide planned power delivery, especially in the evening peak power time slot. In recent studies, it has been found that adding a wind component to a solar PV + battery project could overcome many of the times when delivery of power is constrained. Vestas recently acquired New York-based Utopus Insights which focuses on energy analytics. Battery storage systems are getting bigger, having a storage capacity to smooth wind production over a day, with some even bigger projects planned. The goal of these hybrid facilities is to make gas-fired peaker plants redundant.

Utopus makes the point that the late arrival of use of energy storage in wind projects (or combining solar PV, wind and storage) is in part due to policy issues such as the Investment Tax Credit for solar power includes battery storage, while the wind production Tax Credit (which currently expires at the end of this year) does not. The Democrats are seeking support for the renewable energy industry as part of a COVID-19 stimulus package. If successful such a stimulus might help straighten out some of the inconsistencies between the solar PV, wind and battery storage industries and help coordination of integrated solutions. IEA chief Faith Birol is seeking support for investment in renewable energy as a central part of plans for economic recovery from the coronavirus pandemic.

There is a recent concrete example in the US of a hybrid renewables project that breaks new ground. NextEra Energy (NYSE:NEE) has contracted to complete by 2023 a 250MW wind/250MW solar/200MW/800MWh storage project in Oklahoma. This configuration is an economic alternative to a natural gas peaker plant. This will be the first substantial triple hybrid project in the US. It is new territory as there are a number of variables: optimising each component (wind/solar/batteries), with storage duration a curve ball to make it more complicated. And the battery is big! However, the project got a life when it was realised that it was cheaper than a comparable gas peaker plant. And the performance is better than a peaking plant, with a fast battery response plus the capacity to absorb extra power on windy days.

The above NEE project comes hard on the heels of a project with Portland General Electric (to be completed 2021) which is a 300MW wind/50MW solar/30MW/120MWh storage project.

The point about these projects is that the planning and management of the different components is a key issue in getting the best solution. These are dangerous times for gas peakers, which are expensive and have limited utility.

Emerging markets, India

Siemens Gamesa claims to have completed the world’s first commercial solar and wind hybrid on-grid plant at Kavital in India in 2018, with the installation of 50MW wind power to an existing 28.8MW solar PV plant. Subsequent to its completion, this plant was reported to be including lithium battery storage to improve the operation of the plant. This solar/wind/battery project will be used to review such hybrid systems with a view to further implementation in other Indian projects. The Solar Energy Corporation of India issued a request for 2.5GW of hybrid solar and wind projects to be connected to the Interstate Transmission System.

Renewable plus storage combinations are becoming competitive with coal in Indian tenders

A recent oversubscribed 1.2GW hybrid tender for firm power supply has shaken up the Indian energy sector as it is competitive with coal power. The Chairman of the National Solar Energy Federation of India Pranav Mehta put it bluntly: “thermal power in India has become priced out.” The results of the competitive bid led to 900MW from Greenko ($US0.086/kWh peak tariff; $US0.040/kWh off-peak tariff, with weighted average $US0.0561/kWh) and 300MW from ReNew Power ($US0.096/kWh peak tariff; $US0.040/kWh off-peak tariff) for 6 hours/day during peak and off-peak hours on a day-ahead demand basis. To achieve the firm power requirements, storage capacity of at least 3GWh was needed. This tender is a first in India for firm power from renewables and it provides a viable alternative to peaker plants on the grid.

The most recent thermal power tenders in India produced tariffs in the range $US0.0694-0.0972/kWh. The peak hybrid tenders described above were also competitive with international markets (e.g., USA $US0.1111-0.1250/kWh).

With the rise of renewable energy, it is perhaps significant that India’s 205GW of coal-fired capacity is averaging just a 56% utilisation rate. I think it is clear where this is heading.

What can go wrong?

In the above sections, I’ve documented projects involving wind, solar and batteries to provide low emissions power solutions and documented that even in difficult markets (e.g. India) these solutions are proving to be competitive with traditional fossil fuel approaches. There is little doubt that we are in a major energy transition. For example, the ability to finance coal power developments in India is very challenging with 46GW of coal projects cancelled in 2019 (bringing total coal plants cancelled to 600GW and leaving 37GW under construction). India will have 175GW renewables by 2022 and it has a 450GW renewables target by 2030. There is little doubt that the market opportunities are massive.

In the short term, there are many issues caused by the COVID-19 pandemic. China is a major global supplier. Some see that China has passed the COVID-19 crisis and is on the way towards a quick recovery. It is true that the Chinese response to the outbreak has been remarkable, but it was achieved by complete lockdown. Now that the reins are being loosened with businesses restarting and travellers coming back to China, infections are beginning to rise again (as yet from a low base). Virtually everyone in China is still susceptible to infection. Given lockdowns around the world, there is little doubt that current business activities are going to be dramatically affected.

There may be a silver lining during this emergency as there is a lot of money being spread around. It will be interesting to see if governments use this time constructively to move action on emissions reductions forward.

Both Vestas Wind Systems (market cap $14.47 billion) and Siemens Gamesa (market cap $9.43 billion) are substantial companies with very strong technical capacities and major business opportunities in front of them. Siemens Gamesa is interesting as there may be a consolidation play in the wings as the parent Siemens AG (OTCPK:SIEGY, OTCPK:SMAWF) is planning to IPO Siemens Energy. Christoph Liu has explored this in a recent article. The GCTAF share price has been resilient in the COVID-19 disaster (falling from ~$17.50 to ~$14). Vestas has been more affected falling from ~$34 to the low $20s. From a personal perspective, it is comforting that my VWDRY shares are still above my acquisition price.


Not long ago, to claim feasibility of hybrid renewable energy projects including solar PV, wind and batteries would have been thought of as complicated and fanciful. The dramatic cost reductions for all three technologies as well as smart integration of different technology solutions is dramatically changing this landscape. As shown here in several emerging domains around the world, hybrid renewable energy/battery solutions are challenging traditional gas peaker plants and coal power. This is a big change. Here I’ve focused on some major wind manufacturers (Siemens Gamesa Renewable Energy, Vestas Wind Systems) who are seeing new market opportunities for their technologies, and elsewhere I’ve focused on big batteries through an article concerning the Tesla Megapack.

Solar technology is of course the glue for these hybrid solutions. Think about these opportunities as the markets work themselves out. My view is that now is a good time to reposition your energy portfolio towards future opportunities rather than investing in the fossil fuel past and hoping it might return.

I am not a financial advisor, but I am paying attention to the revolutions happening as energy gets electrified and decarbonized. If my perspective helps in your decision making about investment in this space, please consider following me.

Disclosure: I am/we are long VWDRY. 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.

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A 4% Merger Arbitrage Opportunity With Brookfield And TerraForm – Brookfield Renewable Partners L.P. (NYSE:BEP)

On January 13th, TerraForm Power (TERP) received an unsolicited offer from Brookfield Renewable Partners (BEP). The proposed offer is 0.36 shares of BEP for each share of TERP. At the time, this represented a premium of 11% according to Brookfield but due to the strong performance of BEP, the value of the offer has increased and TERP trades 35% higher than the day prior to announcement. Year to date, TERP has gained almost 38%.

This may sound great, but it is not the point. What is truly special about this deal is that the market values TERP at a 4.1% premium to the offer. I think that any uncertainty around the offer works in the disadvantage of TERP and that if anything, TERP should be trading at a discount to the offer instead of at a premium. Entrepreneurial investors could profit from this situation by buying shares of BEP while simultaneously selling shares of TERP.

Background of companies and the offer

Brookfield Renewable Partners and TerraForm Power are both renewable energy YieldCos. They own and operate long-term contracted renewable energy assets and pay a high percentage of cash flow out as dividends to shareholders. The companies are viewed by the market as both a play on renewable energy and a stable yield also known as bond proxies. This combination has led the sector that was previously low beta, not very popular and quite cheap, to perform extremely well over the past 12 months.

Performance of YieldCo stocks. Source: Seeking Alpha.

It is also important to understand that YieldCos are just owners and operators of the assets they own. Traditionally, a YieldCo has a sponsor that develops assets and drops these down (sells assets) to the YieldCo. Part of this arrangement is usually that the sponsor holds the majority of (voting) shares in the YieldCo. It happens to be so that Brookfield Asset Management (BAM) is the sponsor of both TERP and BEP. The offer by BEP was for the 38% of outstanding TERP shares that were not owned by BAM already. Interestingly, BAM owns 60% of BEP and 62% of TERP which means that in economic terms, little changes for BAM after a merger. The main driver was to simplify the structure of the company, according to BEP.

We believe this transaction will create significant value for investors in both companies through a simplified corporate structure and continued sponsorship from Brookfield Asset Management”

Sachin Shah, CEO of Brookfield Renewable.

There are other reasons, such as that the transaction is accretive on multiples to BEP and that it will enable TERP to profit from the investment grade balance sheet of BEP. Personally, I see the advantages as minimal, and this was reflected in the minimal premium of 11% and the negative initial response by the stock market on BEP. That said, what we have is just a proposal, not an actual committed offer.

Possible outcomes

The offer was unsolicited and in a display of a good corporate governance practice, independent directors of TERP have formed a committee to evaluate it. Though it remains somewhat strange that the management of TERP says that the offer was unsolicited. TERP and BEP share the same corporate parent which must exert significant influence over the capital allocation decisions of both companies.

There are a few things that could happen from here. The first question is whether the committee accepts the offer. If it does, the deal is practically sealed and we can count our arbitrage profits. However, if it insists that the offer is too low, there are three possible alternative outcomes aside from still accepting the offer:

1) Brookfield offers more

This is not a likely outcome for several reasons. To start, the value of BEP’s offer has improved substantially over the past month. As the market value of BEP is 3.5 times that of TERP and BEP published well-received earnings two weeks ago, we should expect BEP to put most weight on the scale. In my view, TERP holders should be happy that they can profit from the offer by getting a large share of the pie and I think that the ultimate parent, BAM, will have the same view.

We must also consider that the initial response from BEP shareholders to the deal was negative, the stock was down remarkably on the announcement day while AY, NEP, CWEN and TERP were all up.

2) TerraForm finds a better offer

Very unlikely. At this point, all YieldCos have appreciated by a lot, but TERP is up most YTD with the exception of BEP. The run-up has made TERP very expensive on multiples. It has recently overtaken NEP with regards to CAFD yield; TERP now has the lowest CAFD yield. Another dynamic that rules out the outcome of a better offer from third party is that BAM owns the majority of TERP shares and it has not shown an interest in selling.

3) The deal falls through

Another unlikely outcome as it would probably entail both management and shareholders to reject the offer. It would be very puzzling if they did, considering the value of the offer. If the deal does fail to materialize, that would send shares of TERP lower. It would also be the best-case scenario for anyone acting on this merger arbitrage opportunity.

After combing through the SEC filings of TERP, I concluded that there is no information that refutes my thesis. I did find an interesting quote in these filings from BEP’s Feb. 6 earnings call:

Really, the TERP transaction should be thought of separate and really was about simplifying the structure between BEP and TERP. It is really just trading the TERP public shares for BEP public shares. … And that the strategy around the proposal for TERP was really around simplifying that structure and just moving those TERP shareholders up into the BEP structure.”

Wyatt Hartley, CFO of Brookfield Renewable Partners.

Clearly, the CFO of BEP doesn’t seem to care much about the merger and it almost seems like BAM pushed BEP to make the offer.

There is one more factor that can sow confusion which is that the shares to be issued to TERP shareholders will be BEPC, a new corporate share class. It is created to accommodate shareholders who want to own shares of a corporation instead of a partnership. The shares will have the same economic characteristics as BEP units and they will be convertible as well. I regard this as a minor detail to the thesis.

Spread details

The spread between TERP and the fair value of the proposal is the most intriguing or worrisome part about this story. As you can see in the chart below, the spread (at close) has mostly moved between $0.50 and $1 or 3% and 6% and is currently close to 4%.

Spread between TERP and offer for TERP using daily closing prices. Source: author’s own calculations.

This implies that either my math is wrong or that there is a good chance of a better offer, but the latter is unlikely as discussed. Let us continue with the math.

The proposal from BEP is quite simple: 0.36 shares of BEPC for each TERP share. The calculation of BEP in the January 13 press release states that the offer is a premium of 11% over the last close. At the time, the last closing prices of BEP and TERP were $48.07 and $15.60, respectively. The math then is: $48.07 * 0.36 = $17.31 & 15.6 * 111% = $17.32, practically spot-on. So it is not the numbers that are off. Dividends are also not the reason for the stable spread, as yields on the stocks are quite similar to each other.

The discussion above leads me to believe that there is an opportunity here because the market mistakenly believes that TERP could fetch a higher price than the proposed offer.

Investment conclusion

As it looks, we have a deal where the majority owner offers an attractive premium to public owners of a subsidiary. That subsidiary is 3% to 5%% overvalued and that is an opportunity. If anything, TERP should be trading below the offer, not above it. TERP shareholders could exploit this situation by selling their shares and buying shares of BEP instead at a ratio of 25 TERP shares for 9 units of BEP. Investors who like to get into special situations could instead sell TERP short while buying BEP in the same 25/9 (1/0.36) ratio. Each ‘package’ of 25 TERP and 9 BEP shares traded like this has an expected pay-off (if merger happens at proposed terms) of $21.20, or 4.15% using Wednesday’s closing prices.

Last but not least, it is uncertain when -if ever- the arbitrage trade will be profitable but it still looks like a very favorable risk/reward deal to me.

Disclosure: I am/we are long BEP, CWEN.A. 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.

Additional disclosure: I am short NEP, TERP.

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