The FTSE 250’s known for its growth opportunities. But it’s also home to a diverse range of dividend-paying enterprises, some of which offer impressive yields. Among the most generous in June this year is NextEnergy Solar Fund (LSE:NESF).
The stock currently offers an impressive 11.7% yield. To put that in perspective, for every £1,000 worth of shares, investors are earning £117 in passive income. Considering the average is closer to 4%, it’s a pretty spectacular income return.
Sadly, high yields also have a habit of being unsustainable. And while income generation in the short-term can be sweet, the long-term performance can eventually sour investor’s moods. However, there are always some exceptions to this. So is NextEnergy a terrific income stock to buy and hold? Or should investors steer clear? Let’s take a closer look.
What does the business do?
As the name suggests, the firm operates within the renewable energy industry, owning a portfolio of 103 solar and storage assets scattered across the UK as well as the rest of the world. The business model is similar to other firms in the renewable space like Greencoat UK Wind and Foresight Solar Fund. Clean electricity is generated by its solar assets and then sold to energy companies for redistribution.
Given that demand for electricity continues to climb, the firm’s had little trouble generating cash profits. And while earnings are dependent on the weather, increasingly hot summers are proving advantageous to solar farms. The end result is a predictable and steady stream of cash flow funding a generous dividend policy. In fact, May marked the 11th consecutive increase in shareholder dividends.
This income-bolstering’s certainly part of today’s 11.7% yield. But most of it actually stems from a decline in share price. Over the last 12 months, the stock’s down almost 30%, trading at a massive discount to its net asset value. What’s going on?
Renewables and interest rates
Building and maintaining renewable energy infrastructure isn’t cheap. And the situation’s only exacerbated for real estate investment trusts (REITs) since they aren’t able to retain the majority of their earnings. As such, many businesses in this space have racked up considerable amounts of debt. And NextEnergy Solar Fund’s no exception.
As of May, the firm has just under £338m of outstanding loans on its books, a third of which is subject to fluctuating interest rates. As capital structures go, the firm isn’t overly leveraged, with some analysts suggesting there’s nothing particularly wrong with the fundamentals of the business. So why has the stock tumbled?
There are a lot of moving factors, but it seems the renewable space as a whole is currently out of favour with investors. Higher interest rates not only make debt more expensive but also drag down the valuation of its solar assets. If that’s indeed the case, then when the Bank of England eventually cuts borrowing costs, these shares may be primed for a resurgence.
The bottom line
NextEnergy Solar Fund suffers from a lot of similar weaknesses as its peers. The group has virtually no pricing power and is constantly negotiating with debt lenders to secure future growth. However, the FTSE 250 stock’s impressive yield looks like it’s here to stay. At least, that’s what I think.
