Our Thoughts on Some Struggling Stocks

Jason’s Random Words

When safe isn't safe anymore

Law of unintended consequences. Knock-on effects. However you want to describe it, I continue to believe that most people are underestimating the implications of higher interest rates to upend the investing world in unexpected ways. For instance, there's a little niche in the utility world that I follow pretty closely and have been generally bullish on for years that's getting absolutely smashed right now: independent renewable energy producers, also called yieldcos. This group of companies and publicly traded partnerships include Atlantica Sustainable Infrastructure (AY), Brookfield Renewable (BEP)(BEPC), Clearway Energy (CWEN)(CWEN.A), and NextEra Energy Partners (NEP).

In less than a month, the majority of the stocks in this sub-sector have lost between 14% and 56% of their value. The biggest reason is the impact of interest rates moving sharply higher, impacting these companies' ability to raise capital to fund their growth plans becoming increasingly apparent, following a press release from NextEra Energy Partners "...revis(ing) growth expectations and limits equity needs."

The short version of what NextEra Energy Partners did was acknowledging that the combination of sharply rising interest rates and its stock price falling meant that capital had become too expensive. At the market close the day before NextEra Energy Partners' press release, its stock price had already fallen enough to push its dividend yield above 7%, up 65% since the beginning of 2020. At the same time, its credit rating of BB+ according to Fitch as of March, is shy of the investment-grade rating. And we have seen interest rates move even higher for high-yield (or junk) debt, with the BofA high-yield index effective yield moving above 9% in October, and has been consistently above 7.5% since May 2022.

So what does that mean exactly?

These businesses build, invest in, and acquire utility-scale renewable energy assets like wind and solar farms. They sell the power on long-term (20 years in most cases) contracts, with annual escalators built in, largely for things like foreign exchange and inflation. The key: They don't generally fund these investments with cash flows or money on their balance sheets. They tend to pay out the bulk of cash flows in distributions to shareholders, historically using debt and secondary stock sales to raise capital. And while it may not seem like that big a difference, when your cost of capital increases from 5.5% to 9% on debt (using high-yield bond averages to illustrate the point) and below 4% to over 7% on equity yield, you're talking about essentially doubling your cost of capital.

The markets have, to some degree, been seeing this threat coming. Over the past year, the four yieldcos above have lost between half and three-fourths of their value. NextEra's press release just hammered the message home to some degree. So far, none of these yieldcos have cut their dividends; even NextEra's press release was just a slowing of growth and lowering its dividend growth expectations.

So the worst is over, right?

I'm not so sure. The trio of Brookfield, Clearway, and NextEra have all more than tripled their debt, while Clearway and NextEra have also increased their share counts more than five-fold over the past decade. The debt in particular is concerning; without significant cash reserves, this entire cohort is faced with a wall of debt maturities that will have to be refinanced at much higher rates. The money to service the higher-interest debt will have to come from somewhere.

My fear is that NextEra's announcement is management slow-walking a more concerning future that will require cutting dividend payments, and maybe even having to sell off assets that are no longer economic in this interest rate environment. And this doesn't strike me as the sort of environment where you want to be a forced seller.

What's an investor to do?

As always, this isn't individual or even general investing advice. You need to figure out your own answer. But I think anyone who is looking for "safe" income probably shouldn't be overexposed to yieldcos. I wouldn't buy a single one without going through their annual reports to get a handle on when their debt matures, how much they pay now, and the implications of refinancing it on future cash flows. After years of growth, it's possible one or more of these businesses may have to go backward just to stay solvent in coming years, possibly cutting dividends, selling off assets, or some combination of both. Now is an excellent time to research balance sheets and cash flow statements before taking any action as a buyer.

Jason

Jeff’s Random Words

This past week will be one I look back at as being formative in my investing journey. One of my favorite companies, Outset Medical (OM) just had about as bad of a week for its stock as a company can. I really like this company and it’s one of my picks for our Smattering Portfolio Contest (interestingly, even with this stock down 87%, my three-stock portfolio is still up 16%. There’s a lesson here for another newsletter post).

Outset is a medical device company that sells a kidney dialysis machine called Tablo. This machine, the size of a mini-fridge, can be used in the acute medical or home setting for less cost and can be operated easily by the patient. It can be life-changing for those who need kidney dialysis. I love this company because I know how difficult dialysis treatment is.

Here’s a quick recap of what happened this week for those who don’t follow the company (which I assume is most of you).

After the market closed on Tuesday, Novo Nordisk (NVO) announced that its diabetes/weight loss drug Ozempic showed positive results in treating kidney disease. This news sent the stock prices of all kidney-related companies plunging. Outset stock closed on Tuesday at $9.69 and opened on Wednesday at $7.95, an 18% drop overnight.

The bad news continued from there. The stock closed on Wednesday down another 4% and then fell an additional 11% over the course of Thursday before Outset pre-announced its Q3 earnings results Thursday afternoon.

One thing I have learned is that typically when companies pre-announce earnings, it’s not good news. This release was no exception. The company announced that Q3 revenue would grow only 9% year-over-year, a substantial slowdown, and lowered its full-year guidance. At the market open on Friday, Outset shares were trading for $3.76 and closed at $3.39.

To recap, Outset stock opened the week at $9.88 and closed at $3.39. That’s a drop of 66% in a week.

Outset isn’t a huge position in my portfolio. It represents less than 1% of my invested wealth. But because I had (and kinda still have) such high hopes, this loss felt worse than some others. The speed at which this all happened was also quite spectacular.

I have a few thoughts. I hesitate to call them takeaways because I don’t know if the stock is done falling yet. I hope to revisit this post a year from now to see how things have turned out. But for now, here’s where my head is

I kinda think the company will still be ok. Unless management is lying or is completely delusional, things could still turn out okay. Let’s break down this week’s news into two buckets; the impact of Ozempic and other GLP-1 drugs that are being used for weight loss, and the revised guidance.

When it comes to GLP-1 drugs, management seems to think the impact will be significantly less material than the stock’s decline would indicate. One point they made was that GLP-1s could actually keep patients on dialysis longer because weight loss in patients would reduce cardiovascular disease-related deaths. My own view is that it’s still too early to know exactly what impact these drugs will have. But what I see is market reactions as if it's a foregone conclusion that the world will change because of these drugs. Maybe it will? But it’s too early to know for sure.

Turning to the guidance revision, management stated that customers are slowing their sales decisions due to the impact of higher interest rates. Additionally, Outset paused the sale of one version of its Tablo device back when it announced Q2 results. This was a voluntary pause in order to submit more documentation to the FDA. Customers are also choosing to delay their purchase until this is resolved. The bottom line is that Outset’s management stated over and over again that they haven’t lost any deals, but that the deals are delayed. If we take them at their word, there’s a scenario where this all gets resolved over the coming quarters.

Okay, at the risk of going on for too long, here’s my conclusion. I don’t know what to do so I am doing nothing for now. I know I don’t want to sell. I have enough conviction to hold my shares and hope for the best. If it never recovers, it will have no impact on my goals for retirement. I don’t think I want to buy, although I am way less pessimistic than the market. But I am tempted. What a great story to look back and say I knew it was going to work out!

But that’s not the right reason to make any investment decision. So for now I will hold, watch, read, learn, and see what happens in the coming quarters. There is a long-time member of the Motley Fool who had a saying that I like. I’m paraphrasing, but essentially the quote is: “If this stock is the next big thing, a little is all I need, and if it’s not, a little is all I want”. I’m glad I only had a little of this one.

Jeff