High-Yielding Energy Stocks to Watch

According to a report by Bloomberg, Pattern Energy (NASDAQ:PEGI) has drawn interest from several potential suitors that would like to acquire the renewable energy company. Among the interested parties is Brookfield Asset Management (NYSE:BAM), which wants to merge Pattern with its majority-owned renewable arm TerraForm Power (NASDAQ:TERP). Pattern Energy has since confirmed the reports, though the company made it clear that it hasn't reached a deal and might not agree to a transaction.

It's no surprise to see that Brookfield has approached Pattern about joining forces with its renewable energy yieldco. That's because the combined companies would be able to leverage its larger scale to reduce costs and improve its profitability and dividend growth profile.

An excellent track record

Brookfield and its hydropower-focused subsidiary Brookfield Renewable Partners (NYSE:BEP) took control of TerraForm Power in late 2017 after the latter's former parent went bankrupt. The companies quickly implemented a strategy to turn around the struggling TerraForm, which had a bloated balance sheet and cost structure. Their plan has paid big dividends, as TerraForm's financial results have improved dramatically over the past two years.

The actions TerraForm has undertaken have set it up for sustainable success. The company was able to reinstate a high-yielding dividend last year, which the company is on track to grow at a 5% to 8% annual rate through at least 2022. Meanwhile, thanks to the support of Brookfield Renewable, TerraForm was able to make a needle-moving acquisition last year. The company has since followed that up with another deal, which it's funding by following the blueprint Brookfield laid out.

A similar opportunity

Pattern Energy isn't in quite as rough shape as TerraForm was when Brookfield took control a few years ago. However, the company still fits the profile of a Brookfield acquisition target. That's because Pattern Energy's financial profile is a bit weak as a result of its aggressive growth in the years following its IPO in 2013. The company's initial focus was on expanding the size of its portfolio so it could rapidly increase its dividend.

However, Pattern Energy was eventually unable to continue that strategy because investors wouldn't provide it with the capital needed to fund growth. That's because its financial profile had weakened as leverage rose to an elevated level while its dividend payout ratio was up over 100%. As a result, the company had to stop increasing its dividend in 2017.

Pattern Energy has since implemented a turnaround strategy. It's currently working on a two-year plan aimed at increasing its cash flow per share at a 10% compound annual rate through 2020. That will help push the company's dividend payout ratio down to a more comfortable 80%, which matches TerraForm's target.

Given Pattern Energy's recent struggles, it's an ideal target for Brookfield, which favors buying companies that need help turning around their financials. While Pattern Energy does have a solid strategy, it still needs the funding to make the acquisitions required to achieve its cash flow growth plan. That's an area where Brookfield's expertise would come in handy.

A deal that makes lots of sense

Pattern Energy and TerraForm Power would make an ideal combination given their similar profiles. Pattern Energy currently owns 2.8 GW of renewable power-generating capacity in North America and Japan, consisting primarily of wind farms. The company sells the energy these assets produce under long-term power purchase agreements (PPAs) with end-users like utilities. That enables the company to generate steady cash flow, the bulk of which it uses to support its 6.6%-yielding dividend.

TerraForm Power, meanwhile, controls about 3.7 GW of renewable energy production capacity in North America and Western Europe. While TerraForm also has a wind-heavy portfolio at 64% of its total capacity, the mix will shift more toward solar when it completes its latest acquisition. The company also sells the bulk of the power it produces under long-term PPAs. That provides it with predictable cash flow that it uses to support its 4.8%-yielding payout.

A merger between these two companies would do several things. First, it would further bolster TerraForm's scale, which would help reduce costs and improve profitability. Meanwhile, it would enable TerraForm to leverage the best practices it has gleaned from Brookfield to maximize the value of Pattern Energy's assets. Finally, the deal would enhance the long-term sustainability and growth prospects of TerraForm's high-yield dividend, likely powering growth at or above the top end of its range.

Something to keep an eye on

Just because Brookfield and other potential buyers approached Pattern Energy about a deal doesn't mean it will agree to a transaction. The company has already started implementing a turnaround strategy, which it believes will deliver healthy growth while also bolstering its financial profile. Still, the news that it might join forces with Brookfield and TerraForm is an intriguing development given their track record of success. That's why investors should keep an eye on this potential outcome since it could drive enhanced value creation for all three companies.

Read more at The Motley Fool.

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