The promise of solar power is simple and dramatic: it’s a renewable resource that does not need to be dug out of increasingly remote and expensive holes in the Earth.

That means continuing technology improvements can steadily reduce solar power costs. In contrast advances in drilling technologies have merely enabled us to access, at a rising cost, the fossil fuel reserves remaining in increasingly hostile environments.

Until recently, though, the oil and gas industry did have something solar lacked: access to cheap capital courtesy of master limited partnerships (MLPs), popular investment vehicles that have delivered market-thumping capital gains over the last two decades, while catering to investors’ growing hunger for tax-deferred income.

An attempt to extend the MLP tax treatment to renewable power has failed to get out of committee in Congress. But where there’s a will on the part of clients Wall Street generally finds a way, and it has certainly found one for the solar industry in yieldcos.

As the name suggests, yieldcos are investment vehicles spun off with income-generating assets to provide a predictable tax-deferred yield in exchange for cheap equity capital.

They are not automatically exempted from the corporate income tax like MLPs, but accelerated depreciation provisions of the tax code and other tax breaks offered to renewable power producers mean that they are able to report net losses for 5 years at least, while paying out positive cash flow to investors via dividends that will be classified as a return of capital.

Perpetual Motion?


Source: SunEdison presentation

Early returns suggest this proposition is generating plenty of enthusiasm. When NRG Energy (NYSE: NRGY) became the first company to spin off a yieldco subsidiary holding solar generating assets last July, the offering price for NRG Yield (NYSE: NYLD) provided for a 5.5 percent yield at the promised dividend rate. Less than 11 months later, NYLD’s share price has more than doubled, so even though it has already raised its dividend the yield is down to 2.7 percent.

Two yieldcos stuffed with wind and hydropower projects debuted in NYLD’s wake last year, and have delivered impressive albeit less spectacular results.

Now comes a second yieldco to include solar assets, from Spain’s Abengoa (NASDAQ:  ABGB). Abengoa Yield (NASDAQ: ABY) will own two newly constructed concentrating solar power plants in the US (in California and Arizona), as well as two smaller ones in Spain. Other assets include a wind farm in Uruguay, a fossil fuel cogeneration plant in Mexico and electric transmission lines in Peru and Chile, along with an equity investment in a transmission venture in Brazil.

Abengoa Yield is expected to trade for the first time Friday, and priced an upsized offering late Thursday at $29, above the suggested range of $25 to $27. That pegs its yield at 3.6 percent given the initial annualized distribution of $1.04 per share.

I’m skeptical that the yieldcos will prove smart investments in the long run. The starting yields are too low, and therefore subject to losing much of their current appeal should interest rates meaningfully rise, as they’re likely to do sooner or later.

And while energy MLPs have a full and indefinite shield against the corporate income tax, yieldcos can only shield income to the extent they can carry forward net operating losses, which will largely depend on their ability to keep growing so that new projects provide additional depreciation.

This matters because solar is a relatively new, dynamic and technology-dependent industry, and as such is subject to dramatic changes in the economic and competitive landscape. It’s also sensitive to changes in public policy, notably in relation to the looming expiration in 2016 of the production and investment tax credits for renewable projects. So while it’s true that fixed-rate 20-years solar power purchase agreements provide excellent revenue protection, only continued growth will maintain the tax shield on the distributions.

But that’s not really Abengoa’s problem at the moment. Its American Depositary Receipts have rallied 37 percent in the last three weeks in anticipation of a successful offering, and have doubled in value over the last six months.

And this has interesting implications for SunEdison (NASDAQ: SUNE), the first all-solar company on the verge of spinning off an all-solar yieldco. According to the updated prospectus filed by SunEdison with the Securities and Exchange Commission on May 28, TerraForm Power (NASDAQ: TERP), as its yieldco will be known, will own solar projects with 524 megawatts (MW) of aggregate generating capacity in the US, Canada, UK and Chile.

For comparison’s sake, NRG Yield controls 303 MW of utility-scale solar power representing 21 percent of its total capacity. In addition to its starting dowry, TerraForm Power will retain the right to buy additional projects with 900 MW of capacity, which would generate an additional $175 million in annual cash flow, and meet some but not all of its projected cash flow target for 2016.

The filing proposes raising up to $50 million via the IPO, but does not fill in the blanks on the shares to be sold in the offering, their expected price or the initial distribution rate. It does outline the goal of growing the distribution by 15 percent annually for the next three years, and suggests than distributions are expected to qualify as a return of capital for the next decade.

But I’m primarily interested in the IPO’s potential to propel the shares of the sponsor, which I view as the more promising play. Like our old friend First Solar (NYSE: FSLR), SunEdison has gone through a wrenching transition after its solar modules business got hit with subsidized Chinese competition earlier in this decade, and like First Solar it survived by shifting focus to the finance and management of primarily utility-scale US projects.   

While First Solar retains a manufacturing business based on proprietary technology, SunEdison, formerly known as MEMC, has exited solar panels and is spinning off its semiconductor wafer business. It’s hard to get a good handle on its underlying profitability, because the company has been investing heavily in new projects (and therefore racking up net losses) in preparation for the yieldco spinoff.

First-quarter revenue reported May 8 was up 34 percent year-over-year but down 40 percent from the prior quarter and shy of estimates. The aggregate capacity of project completions is expected to ramp up 90 percent this year, which will merely match the average annual growth rate since 2009.

Solar energy segment’s operating bottom line lurched from a $162 million profit in 2012 to a $189 million loss last year. That was driven by the retention of more completed projects for inclusion in the yieldco, but also by the decline in average selling prices per watt.

How to extrapolate from all of this the earning power of the yieldco and its value proposition for SunEdison is frankly a bit above my pay grade. The company does note that it loses out on long-term profits every time it sells a completed project, and access to cheap equity via yieldco will certainly help it keep more in-house.

SunEdison will retain a majority stake in TerraForm Power, and its CFO told Reuters in November the IPO could value the entire yieldco at $800 to $1 billion.

One outside estimate of the yieldco’s potential value to SunEdison comes from David Einhorn’s Greenlight Capital, the high-performance hedge fund that invested $184 million in SUNE during the first quarter and has already earned a 24 percent return on its seventh-largest position.

According to Greenlight’s April letter to shareholders, if TerraForm Power provides a yield as high as 5 percent and trades at a 25 percent discount to NRG Yield based on a valuation of 9x EBITDA, it would provide its sponsor with an implied value of $34 a share, which is 76 percent above a current price.

Even if Greenlight’s only half right on the upside potential, this is a bet worth taking ahead of the potential IPO catalyst. Solar power has a bright future, and SunEdison has assembled an enviable income stream that it’s about to begin refinancing with cheap equity.

Source: SunEdison May 8 earnings presentation

Just like the general partner of many an MLP, it’s also reserved for itself generous incentive distribution rights that will cream off half of incremental growth in yieldco’s cash flow once its distribution doubles from the initial level.

While others chase yield on such terms, it could prove profitable to speculate in the sophisticated operators selling it. We’re adding SunEdison to our Aggressive Portfolio. Buy SUNE below $22.