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This 6.6% Yielding Dividend Growth Stock Could Generate 20+% Annual Returns Over The Coming Decade

Posted On August 16, 2018 9:28 am
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Dividend Profile: Rich Yield, Fast Growth, And Market Crushing Return Potential

The most important part of any income investment is the dividend profile, which is what ultimately determines total returns. This is composed of three parts: yield, dividend safety, and long-term growth potential.

Stock Yield Cash Flow Payout Ratio Projected 10 Year Annual Dividend Growth Potential Annual Total Return Valuation Adjusted Total Return Potential
NRG Yield 6.6% 58% 10% to 20% 16.6% to 26.6% 20.1% to 30.1%
S&P 500 1.8% 38% 6.20% 8% 2% to 5%

 

Sources: Gurufocus, FastGraphs, management guidance, Multipl, Yardeni Research, BlackRock, Vanguard, Morningstar

 

NRG Yield’s attractive yield is over three times that of the S&P 500, and also about double the average utility’s 3.3%. More importantly with a CAFD payout ratio of just 58% that dividend is very well covered by its rock solid, recurring, and recession resistant cash flow. Over the long-term management wants to take that payout ratio to 80% to 85%, which is about average for the yieldCo industry. That will ensure that NYLD’s dividend remains safe in the future but also that payout ratio expansion will allow the dividend to continue growth very quickly for many years.

The second half of the safe dividend formula is the balance sheet. Due to the highly capital intensive and growth oriented nature of this industry investors need to know that a yielCo isn’t taking on dangerous amounts of debt that might threaten its dividend in the future.

  • Debt/Adjusted EBITDA: 6.2 (utility average 3.9)
  • Corporate Debt/Adjusted EBITDA: 1.6
  • Interest Coverage Ratio: 3.5 (utility average 4.9)
  • Corporate Interest Coverage Ratio: 14.1
  • S&P Credit Rating: BB
  • Average Interest Rate: 4.6%

Now at first glance investors might think that NYLD’s debt levels are dangerous, thanks to its above average (compared to regular utilities) leverage ratio and below average interest coverage ratio (operating cash flow/interest cost). However, it’s important to know that the yieldCo business model is built on what’s called “self amortizing, non recourse project level debt”. You can think of it kind of like a mortgage that yieldCos take out. Each project is financed with its own long-term fixed rate loan, and the guaranteed cash flow from the asset then pays both the interest and principle over time. Each loan is also structured so that it’s completely paid off before the PPA contract providing its cash flow expires. In the event of a worst case scenario (like a project being destroyed and not generating cash flow) creditors would receive the asset itself and not be able to come after the yieldco’s other cash flow.

Source: investor presentation

Or to put another way, the use of non recourse, self amortizing project level debt (which makes up 75% of its total debt) builds a wide safety moat around the yieldCo’s overall cash flow and dividend. This is why it’s important to focus on the corporate level debt which is what investors are actually responsible for. NYLD’s corporate leverage ratio is just 1.6, about half that of the average utility’s. Meanwhile its corporate interest coverage ratio is a sky-high 14.1 indicating the balance sheet is far safer than it initially appears. And while NYLD does have a junk bond credit rating (all but one yieldCo does) it can still borrow at highly attractive interest rates that are less than half the cash yield on new investments. This means that NYLD’s debt is extremely profitable, and safe based on how its structured and where the cash flow repaying it is coming from.

Finally we come to the biggest reason to own this stock, the excellent long-term dividend growth potential. Management’s previous payout growth guidance only lasts through the end of 2018 (15%, via 3.7% quarterly hikes). However, with GIP taking over as its sponsor NYLD has promised it will soon provide updated and longer-term growth plans. Analysts currently expect GIP’s sponsorship and global asset base to actually accelerate the yieldCo’s long-term dividend growth from an already impressive 15% to 20% annually over the next 10 years. Even if NRG Yield can only achieve half that growth rate it should easily generate 16.6% total returns over time (6.6% yield + 10% dividend growth). That’s because for stable business model stocks like this total returns tend to track yield + long-term dividend growth (if the dividend doubles the shares usually do too).

But keep in mind that this 16.6% total return assumes that the stock’s valuation multiple (yield and price/cash flow) won’t improve from its currently low levels. Even if that occurs NYLD is likely to achieve at least three times better total returns than the S&P 500 from current valuations. This is because Morningstar, BlackRock, and Vanguard are estimating the broader market, from today’s historically high valuation, will return just 2% to 5% annually over the next 10 years.

But as I’ll now show, when we adjust for NYLD’s low valuation, the stock’s total return potential soars to 20%, even using conservative growth estimates.

About author

Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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