TerraForm Power (NASDAQ: TERP) has been an abysmal investment over its short life as a public company. Overall, the stock is down nearly 60% since its IPO in 2014, while the S&P 500 has rallied more than 26% over that same time frame. That said, TerraForm's outlook has brightened considerably now that leading Canadian alternative asset manager and renowned value creator Brookfield Asset Management (NYSE: BAM) is on track to take over control later this year. Given the steps Brookfield plans to take to reposition the renewable power company, as well as its proven track record, TerraForm looks like a compelling buy right now.
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Repositioning for success
One of the reasons TerraForm Power has lost so much value over the past few years is that the company's now-bankrupt former parent loaded it up with debt to finance growth. In just a few short years, TerraForm's debt ran up from a few hundred million dollars to more than $4.5 billion. That leverage became an unsustainable weight when its sponsor's financial situation deteriorated, which ultimately forced TerraForm to suspend shareholder distributions and use that cash to reduce debt. While the company has since gotten debt down to $4 billion, that's still too much leverage for a company of its size. As a result, TerraForm Power can't access the capital markets at favorable rates to finance growth initiatives.
Brookfield plans to help get TerraForm back on track by acquiring a 51% stake in the company, which will enable it to take control. The company also plans to provide it with a $500 million sponsor line of equity to support growth, as well as the right of first offer on an extensive portfolio of acquisition opportunities, including operating wind farms and development-stage wind and solar projects. Furthermore, Brookfield also plans to assist in the deleveraging of TerraForm Power so that it can eventually achieve investment-grade credit ratings. That would reduce TerraForm's cost of capital so that it can eventually grow without any additional support.
A proven track record
That plan stands an excellent chance of creating value for investors given Brookfield's history of success at generating superior returns. For example, its other renewable power company, Brookfield Renewable Partners (NYSE: BEP), has achieved a 14% compound annual return since its inception in 2011. Meanwhile, its infrastructure subsidiary has delivered a 19% annualized total return since inception. In addition to that, the annual investment returns of the company's privately managed funds have averaged 12% to 22%, which are within their stated target ranges.
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Given the similarities with Brookfield Renewable Partners, it's worth taking a closer look at the factors driving that company's success. One of the leading drivers is that Brookfield manages the company to conservative financial metrics, including keeping a low leverage ratio of 38% debt to capitalization. Furthermore, the company generates healthy free cash flow since it only distributes about 70% of its funds from operations to investors, which is well below the 90%-plus rates of most other yield-focused renewable power companies.
These more conservative levels have enabled the company to maintain an investment-grade credit rating, which, when combined with its excess cash flow, has provided it with ample fuel to build and buy additional renewable power assets. Brookfield Renewable Partners uses its internally generated cash flow to fully fund its organic growth initiatives, which enables it to deliver 3% to 5% annual earnings growth without touching its balance sheet. Meanwhile, when the company does make acquisitions, it buys for value, typically seeking high-quality assets that sell for less than their replacement value due to operational or financial issues. That value-focus is why Brookfield Renewable Partners plans to invest a combined $500 million into the TerraForm Power deal as well as Brookfield's related acquisition of TerraForm Global. These factors position Brookfield Renewable Partners to pay a lucrative distribution -- currently yielding 5.4% -- that it intends to grow by 5% to 9% per year, which should continue to power double-digit total annual returns for investors.
The odds of outperforming are excellent
Brookfield Asset Management set its sights on TerraForm Power because it saw a mismanaged company that's ripe for a turnaround. Brookfield has developed a plan that it believes will put TerraForm back on solid ground and position it to create value for investors over the long term. Given Brookfield's exceptional track record, that plan has a high probability of succeeding, which is why I think that TerraForm's stock is worth buying.
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Matthew DiLallo owns shares of Brookfield Asset Management and Brookfield Renewable Energy Partners. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.