Providing an essential service with revenue backed by long-term contracts, Canadian power generation stocks occupy an enviable position in late 2011. No matter how bad things get in the credit market and economy, they’ll keep getting paid–and passing the profit along in dividends to investors.

That point is widely acknowledged by investors, demonstrated by power stocks’ generally solid performance over the past two months. What’s less well known is their robust and low-risk road to long-term growth, as they lock in cash flows by adding desperately needed generation.

And both October High Yields of the Month feature an added bonus: They’re in the midst of transforming mergers that will juice up future growth even more while further strengthening them financially and safeguarding dividends.

The latter is particularly important as a catalyst for future stock price gains at Capstone Intrastructure Corp (TSX: CSE, OTC: MCQPF). The stock currently yields more than 10 percent, based largely on the perception that its distribution is at risk. Easing investors’ fears is an obvious catalyst for a fast return trip to a price of at least USD8 for the stock, a range it held up until mid-summer.

Such a roundtrip became a lot more likely this week, as management announced it would use the remaining dormant cash on its books to buy a 70 percent stake in Bristol Water from Suez Environnment (France: SEV, OTC: SZEVY). Suez will retain a 30 percent stake in the company.

The purchase comes with a CAD214 million price tag plus CAD440 million in long-term debt, which will remain an obligation of UK-regulated Bristol. Capstone will also use a CAD150 million loan from parent Macquarie Group Ltd (Australia: MQG, OTC: MQGAU) to fund the transaction, another demonstration of the benefit of its relationship with the giant Australian bank and global infrastructure investor.

Over the past couple of years UK water utilities have had to adapt to a new regulatory regime that’s forced them to cut costs and control capital spending. Capstone’s purchase price of approximately 1.2 times regulated capital (or book value) seems to reflect that reality. As a result of the deal, management has raised its cash flow projection for 2011 to CAD75 million from a prior forecast of CAD60 million. The 2012 estimate is now CAD140 million, up from CAD80 million.

Capstone management has long maintained its high payout ratio of recent quarters is only temporary, caused in part by the large amount of cash still on its books from the sale of its 42 percent stake in Leisureworld. Management has taken its time investing the money, which has resulted in a large portion of assets earning only meager returns.

This deal essentially deploys all of this cash to generate cash flow, or roughly CAD65 million. At this point it’s purely a financial investment, as Suez will continue to operate Bristol’s assets through its AGBAR unit (Sociedad General de Aguas de Barcelona). But it does forge a partnership with a world leader in water and wastewater infrastructure, opening the door to future investment for Capstone in a market estimated to reach USD772 billion a year by 2015.

By 2012 Bristol will generate approximately 18 percent of the company’s adjusted funds from operations (AFFO), the account from which dividends are paid. Approximately 42 percent of AFFO will come from the Cardinal power plant, 11 percent from the district heating business in Sweden, 10 percent from the Erie Shores Wind Farm, 7 percent from hydro facilities, 5 percent from the Whitecourt biomass facility, 5 percent from the newly opened Amherstburg Solar Park and 2 percent from the Chapais biomass facility.

All of these projects are operated under long-term contracts with very predictable cash flows. Bristol, meanwhile, earns money under a regulated return on investment formula that’s reset every five years according to system needs. Rates are adjusted upward for inflation from a base return on equity of 6.6 percent, and Bristol is expected to grow what amounts to rate base by 26 percent over the next several years, versus 8 percent for UK water utilities as a whole.

Capstone management now anticipates a payout ratio of between 85 and 90 percent for 2012, based on AFFO. Thereafter it expects the payout ratio “will remain less than 100 percent through 2014, subject to the continuing execution of (its) growth strategy.”

With the Leisureworld proceeds now deployed, the most important item on the agenda is still the re-contracting of the Cardinal natural gas power plant. Talks continue with the Ontario Power Authority on a new deal for 2014 and beyond. CEO Michael Bernstein commented during the company’s second-quarter conference call that they are “moving the re-contracting process forward” after “working to prepare for this opportunity for more than two years.” He went to say that a new contract for Cardinal was one of his two priorities for 2011.

Should Cardinal get a new contract that’s perceived favorable to Capstone, we may not have to wait long for a return move to USD8, and eventually well beyond. In the meantime, management continues to grow the portfolio, eventually setting the stage for a return to dividend growth once the uncertainty with Cardinal is resolved.

I reported on Brookfield Renewable Power’s transformational merger in a Sept. 14 Flash Alert. To review, the key details are Brookfield Renewable Power will combine its assets with the other renewable energy assets of its parent Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) to form Brookfield Renewable Energy Partners LP.

Henceforth the new entity will conduct all of Brookfield Asset Management’s renewable energy business. This essentially consists of building and acquiring primarily hydroelectric power plants worldwide and locking in sales under long-term contracts. Plants are currently located in Canada, the US and Brazil, with 4,800 megawatts across 179 facilities. The balance of output is wind farms.

All three markets have massive potential to grow output and the combined company will start out with 2,000 megawatts currently in development. Management has had little trouble locking up new output under long-term contracts at preferential prices. The existing fleet is under sales contracts with an average duration of 24 years.

In past years Brookfield Renewable Power–formerly known as Great Lakes Hydro–was known for massive fluctuations in cash flow from quarter to quarter, depending on the level of water flows. This it compensated for with a hefty cash reserve, which it used to cover dividends and needed capital spending when there was a shortfall.

The new Brookfield will face far fewer problems in this regard. Mainly, Brazilian regulators ensure hydro plants against weak water flow years, while US facilities are protected by water storage capabilities. The result should be far fewer ups and downs for cash flow, even as the underlying asset base continues to expand generation potential.

The initial deal will boost Brookfield Renewable Power’s distributable cash flow by a projected 10 percent over five years. That’s enough for the company to declare a boost in the now quarterly dividend to an annualized rate of CAD1.35 per unit when the deal closes. And management has targeted annual distribution growth of 3 to 5 percent thereafter, with a projected payout ratio of 80 percent of distributable cash flow.

Brookfield Asset Management will start out owning 73 percent of the new Brookfield Renewable Energy Partners, with current owners of Brookfield Renewable Energy Power Fund owning the remaining 27 percent. If past is prologue, it’s likely to monetize at least a portion of that interest from time to time in coming years, depending on market conditions.

The parent’s record in the past, however, has been to manage its sales effectively, with little or no impact on the share price. And there’s no reason to expect it won’t continue to do the same, given the predictability of cash flow–and the helpful effect of rising dividends on its bottom line.

Per the terms of the deal, Brookfield Asset Management will enter an energy revenue agreement for all generation in the US not currently under contract–and on favorable and inflation-adjusted terms. The parent will also retain a master services agreement for the partnership, providing oversight as well as the key executives, all of who have been with Brookfield’s renewable energy business since the 1990s.

Brookfield Asset Management will also receive a CAD20 million base management fee and incentive-based distributions linked to asset and distribution growth. That strongly links the interest of general and limited partners in a way that encourages growth for each.

Getting this deal done will require a two-thirds “yes” vote from Brookfield Renewable Power Fund unitholders, other than parent Brookfield Asset Management. A special unitholders’ meeting is now scheduled for Oct. 25.

I strongly urge a “yes” vote on this deal. The conversion of the company from income trust to partnership will be on a unit-for-unit basis, so no one will experience any change in ownership. US investors should be assured by the fact the new partnership is going to be listed on the New York Stock Exchange (NYSE), which should improve liquidity.

The deal also qualifies as a “reorganization” for tax purposes, meaning it won’t be a taxable event. And it will qualify for the exemption from the registration requirements of the Securities Exchange Act of 1934, meaning there will be no cash-out of US investors as was the case for Bell Aliant Inc’s (TSX: BA, OTC: BLIAF) conversion to a corporation. And by reorganizing as an MLP, Brookfield Renewable Energy Partners will be able to pay tax-advantaged distributions to US investors for the first time.

What can go wrong at Brookfield Renewable and Capstone Infrastructure? Like all infrastructure owners and operators, both companies do carry large amounts of debt, both at the parent and project level. The Bristol deal will boost Capstone’s debt-to-capital ratio from its current level of around 37 percent to around 60 percent. Brookfield Renewable will also add debt as it dramatically expands its asset base.

There’s also the challenge of greater complexity, as management is forced to run more assets effectively. That should not come as a problem for Brookfield Renewable, as managers are already effectively running the entire portfolio anyway. And retaining AGBAR/Suez as the operating partner at the Bristol plant, Capstone won’t have to manage its investment day to day.

No matter how simple their cash flow models, however, companies that expand always run the risk of growing pains. A negative change in government in Brazil, however unlikely, could wreck the economics of Brookfield Renewable’s plants in that country. Similarly, another tightening of regulation in the UK would hurt Capstone’s ability to profit from the Bristol acquisition.

The biggest risk at either company is Capstone’s ongoing negotiations with the Ontario Power Authority over the Cardinal plant. The Bristol deal makes this asset slightly less critical. But bringing home a favorable contract is the single biggest potential positive catalyst for Capstone stock. And until there is one, the prospect of failure will hang over the stock like a dark cloud.

A significant increase in interest rates would also hurt both companies’ ability to make profitable investments in new infrastructure. That possibility, however, would seem to be quite far in the future, given the economic weakness. And at that point, other positive factors such as rising demand would kick in.

Brookfield Renewable is the safer of these two stocks. But both companies should generate very predictable and growing cash flows for a long time to come.

Buy Brookfield Renewable Power up to USD25 and Capstone Infrastructure up to USD9 if you haven’t yet.

For more information on these companies go to How They Rate and click on their names to go directly to their websites. Both Brookfield Renewable and Capstone Infrastructure are tracked under Electric Power. Click on their US symbols to see all previous writeups in Canadian Edge and CE Weekly. Click on the Toronto Stock Exchange (TSX) symbol to go to their Google Finance pages for a wealth of information, ranging from news releases to price charts.

Brookfield Renewable is the larger of the two, with a market capitalization of CAD2.63 billion. It will more than triple that when the merger with Brookfield assets is completed, ranking it among the largest renewable power pure plays in the world. Capstone Infrastructure, meanwhile, is somewhat smaller at CAD401.5 million, though it, too, is likely to issue equity as it absorbs the purchase of Bristol Water of the UK. Both stocks trade with good volume on their home market, the TSX. They also trade decent volume under the US over-the-counter (OTC) symbols, particularly Brookfield Renewable. And note that Brookfield Renewable plans to list on the NYSE when the deal is completed.

Whether you buy these stocks in the US or Canada, you get the same ownership of solid, growing and big-dividend-paying companies. Your dividends will be paid in Canadian dollars, and US investors will score capital gains when the loonie rises against the greenback.

At this point, both companies’ distributions are 100 percent qualified for US income tax purposes. Capstone is a Canadian corporation and so dividends paid into a US IRA are not subject to 15 percent Canadian withholding tax. Brookfield Renewable Power is still organized as an income trust, so dividends are still withheld 15 percent by Canadian authorities if held in an IRA. The company’s tax treatment in the US will change when it adopts a master limited partnership structure. This will help US investors shelter more income from taxes. I’ll report details and they become available.

Dividends that are withheld by Canada can be recovered as a credit by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can generally be carried forward to future years.