Better Buy: Brookfield Asset Management vs. TerraForm Power

Matthew DiLallo, The Motley Fool

Brookfield Asset Management (NYSE: BAM) is one of the best alternative investment managers in the world. The company has a knack for investing in mismanaged companies and turning them around. That strategy has created significant value for investors in Brookfield as well as in its private funds and publicly traded entities.

One of the companies it's currently working to turn around is renewable energy generator TerraForm Power (NASDAQ: TERP). The strategy Brookfield implemented has already paid big dividends for TerraForm's shareholders. So far, the renewable energy company has generated a total return of more than 34% since Brookfield took control.

While both companies have the potential to continue creating value for investors, most will likely only want to own one of these entities in their portfolio. Here's a look at the bull and bear case for both companies, which shows a clear winner as the best one to buy right now.

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The bull and bear case for Brookfield Asset Management

Brookfield Asset Management makes money in two ways. First, it generates recurring fees for managing assets such as private equity funds and publicly traded entities like TerraForm Power. In addition to that, the company has several direct investments, including TerraForm, which enables it to make money from the cash these entities distribute to their investors. This business model generates significant cash flow for Brookfield, with it on track to produce $2.11 billion in free cash this year. The company uses that money to pay a modest dividend that currently yields 1.3%, buy back stock, and make direct investments.

The company anticipates that its fee-related earnings, as well as the distributions from its investments, will rise significantly over the next few years. In its estimation, it will produce $4 billion in free cash in 2023. With Brookfield's current market value around $48.7 billion, it only trades at 23 times 2019's free cash and 12 times 2023's forecast. That suggests its stock price could nearly double in the next five years if it maintains its current valuation multiple.

However, several things must go right for Brookfield to nearly double its free cash flow in five years. First, its fee-bearing investments need to perform as expected so that they earn the profits it anticipates. Likewise, its investments need to grow their cash flows as it forecasts so that they achieve its targeted distribution levels. If market conditions deteriorate -- especially in commercial real estate where Brookfield is a major investor -- its results might not meet expectations. Any underperformance could weigh on its stock.

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The bull and bear case for TerraForm Power

TerraForm Power makes money by selling the renewable electricity it generates to utilities and other end users under fixed-price contracts or at regulated rates. Overall, the company has locked in the price for 95% of the power it expects to produce this year, which provides it with visible cash flow. TerraForm aims to pay out 80% to 85% of that cash flow to investors via a dividend that currently yields 5.6%. Meanwhile, it uses the money it retains to invest in high-return expansion opportunities.

The company anticipates that it has enough embedded growth within its existing portfolio to support 5% to 8% annual dividend increases through 2022. Two factors drive that forecast. First, the company intends on increasing its dividend payout ratio from the current level of around 75% up to its target range. Furthermore, the company expects cash flow to grow as it reduces costs, improves earnings at its legacy assets, and benefits from investments in high return expansion opportunities.

While TerraForm Power has come a long way since Brookfield took control, it still has more work to do. For starters, the company has a lot of debt and a high leverage ratio. Because of that, it has a non-investment grade credit rating, which makes it harder to borrow money as well as increases its costs. That could impact the company's ability to make acquisitions and invest in expansion projects.

The other concern is its overall upside potential. TerraForm currently anticipates that it can generate between $1.14 to $1.22 per share of cash flow in 2022, which is only about 10% above last year's level. That muted growth profile could cap its total return potential over the next few years since it already trades at 12 times 2022's anticipated cash flow level.

Verdict: Brookfield Asset Management is the better buy

TerraForm Power has been a terrific investment since Brookfield took control and appears poised to continue creating value as it delivers on its dividend growth plan. However, it doesn't have as much visible upside potential as Brookfield. As a result, Brookfield could outperform TerraForm over the next several years, which makes it the better buy between the two right now.

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Matthew DiLallo owns shares of Brookfield Asset Management and TerraForm Power. The Motley Fool owns shares of and recommends Brookfield Asset Management. The Motley Fool has a disclosure policy.