|Shares Out. (in M):||121||P/E||0||0|
|Market Cap (in $M):||325||P/FCF||0||0|
|Net Debt (in $M):||1,745||EBIT||0||0|
|TEV (in $M):||2,283||TEV/EBIT||0||0|
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(All currency in US$, unless otherwise noted)
I am recommending a long in Atlantic Power (ATP), a levered equity trading at a ~35% maintenance free cash flow yield that should de-risk over the next few years through the combination of strong and stable cash generation, operational stabilization, and debt paydown. At current levels, I believe the stock offers a compelling ~30% multi-year IRR opportunity.
Overview and History
Atlantic Power is an independent power producer that operates a diversified fleet of 28 power generation assets in the US and Canada with 2,024 MW of total proportionate generation capacity, ~90%+ of which is derived from clean power sources (50% from natural gas, 25% from wind, 10% from biomass and 5% from hydro).
ATP was formed and listed on the Toronto Stock Exchange on November 2004 to acquire a portfolio of power generation assets from funds managed by ArcLight Capital Partners and Caithness. ATP was externally managed by an affiliate of ArcLight until October 2009, when the Company simultaneously converted to a common share Company, dual-listed itself on the NYSE (providing access to both US and Canadian public markets to pursue acquisitions), and internalized its management structure.
In the years following the IPO, ATP grew rapidly through a series of accretive roll-ups of power generation projects, culminating in a highly-leveraged $2bn acquisition of Capital Power LP ("CPLP") on November 2011. Shareholders were well-rewarded for many years, and at its peak in October 2012, ATP had achieved a market cap of $1.8bn and a total shareholder return of 160% from the IPO date (compared to 20% for the S&P 500).
ATP's stock price has been decimated by a series of events (discussed below), falling from a peak of ~CAD$15 per share in October 2012 to CAD$3.35 today.
Due to fears around its financial distress, a small market capitalization, and lack of mainstream research coverage, ATP now trades at ~37% 2015E maintenance free cash flow yield.
I believe this is an attractive entry price for the following reasons:
Refinanced capital structure improves debt maturities and future cash flows
In 1Q14, ATP redeemed $415mm of debt maturing in 2014, 2015 and 2017 with a new "APLP term loan" that matures in 2021 and gradually amortizes by ~$60mm each year (based on 1% amort and a 50% sweep of APLP cash flows). The new term loan eliminates near and medium-term liquidity risks (no bullet maturities through March 2017), sets an amortization schedule consistent with the pace of cash flow generation, and is expected to reduce cash interest by ~$10mm in 2015.
As a result of these one-time refinancings in 2014, ATP incurred $49mm of charges within interest expense in 1Q14 that are not expected to recur in 2015. As these charges get lapped in 2015, 2014 maintenance free cash flow of $45mm should expand by an additional $59mm ($49mm of non-recurring charges + $10mm of interest savings) in 2015, significantly improving free cash flows and alleviating interest coverage ratios.
Additionally, I note that while leverage is quite high, the situation is partially mitigated by the structure of financing: ~$370mm of non-recourse project financing (~20% of total 2014E year-end debt).
Path to compliance on debt covenants
Furthermore, the $49mm of refinancing charges caused ATP to technically trip its fixed coverage ratio on a restricted payment covenant in 1Q14. As a result, ATP was forced to cut its dividend to 2% of net assets (~$63mm maximum annual limit) through the year. Because the covenant is calculated on a four quarter rolling basis, once the refinancing charges are lapped in 1Q15, ATP should return to covenant compliance by 1Q15 and will have greater capacity to increase dividends (though Management is likely to focus on debt paydown before materially increasing dividends)
Stable, contracted free cash flow supports debt pay-down and equity accretion
Over the next 3 years, ATP should generate ~$100mm - $120mm in PF free cash flow that will likely be directed towards debt paydown and low-risk, growth capex projects.
ATP's cash flows are generally stable and well-diversified, which provides an attractive glide path towards de-risking ATP's levered balance sheet.
The Company expects $80 - $85mm of mandatory debt amortization per year (~$60mm of APLP term loan amortization and ~$20 - $25mm of project-level debt amortization), which are sufficiently covered by projected cash flow levels.
Furthermore, Management expects to significantly narrow the scope of capital allocation, focusing future capex away from large-scale, expensive development projects historically financed at 50% debt / cap towards annual $5 - $10mm of low-risk, optimization investments that can generate 20% yields with short payback periods and can be funded completely out of free cash flow.
Management is also pursuing reductions in Corporate overhead, targeting $15mm of run-rate G&A savings by 2015 from 2013 levels.
Distortions to historical valuation metrics creates confusion
ATP has historically emphasized valuation on the basis of cash-available-for-distribution (CAD) and dividend yields. Due to the amortization schedule of the new APLP term loan described above, CAD will now be burdened by an incremental $60mm of annual amortization. The impact on CAD financial metrics is distorting research price targets. For example, BMO writes in its 11/7/14 note that “Nevertheless, we still don’t see free cash flow increasing meaningfully until at least 2017, unless accretive asset sales are completed. As a result, we are maintaining our Market Perform rating.”
Therefore, ATP appears to generate relatively little CAD, but this methodology understates the true degree of upside because the APLP term loan amortization is still building equity value at a rate of 20-25% per annum.
New leadership with highly attractive operating track record
James J. Moore was appointed CEO and President on January 23, 2015, following a strategic review process in response to the disastrous share price performance over the past few years.
Moore joins the Company from private-equity firm Diamond Castle Holdings, where he was Chairman of their energy and power practice from 2008 to 2015. From 2001 - 2008, he was CEO of Catamount Energy Corporation, an operator of wind farms, which was sold to Diamond Castle in 2005 and then sold to Duke Energy in 2008. Prior to Catamount, he was CEO of National American Power, another independent power producer.
By all indications, James Moore was very effective during his tenure at Catamount. Diamond Castle bought the Company for $73mm and exited for $240mm within 3 years (http://www.greentechmedia.com/articles/read/duke-energy-buys-more-wind-power-1056). Moore was then retained by Diamond Castle as an executive after the sale.
According to Michael Ranger, a senior managing director at Diamond Castle, "Catamount’s management team took an early stage wind business and grew it into a strong operating company with a great development function.”
While he hasn't provided his own blueprint yet, Moore's private equity and restructuring experience, experience building two different independent power producers, network of industry relationships, and track record of creating significant equity value are all hopeful initial indicators for his tenure at ATP. My presumption (guess) is that he is also joining the Company because he sees upside potential in this opportunity (his initial stock grant of 523k shares is worth ~$1.4mm)
There have been a series of relatively small but consistent open market purchases by a variety of directors through 4Q14.
Activist shareholder and take-out potential
Following a strategic review by the Board in 2014 that explored but then called off a potential sale of the Company, the Clinton Group sent a letter to ATP's Board on 10/17/14 calling for the Company "to re-engage with the potential buyers and solicit the best available deal. Given the strength of the auction as we understand it, we believe there is a deal to be achieved at prices above $4.00 per share."
According to The Deal magazine, Management was unwilling to sell because they thought the Company was worth at least $7 - $8 per share, and that there was a large amount of strategic interest especially for ATP's renewable assets. (http://www.thedeal.com/content/energy/clinton-group-prods-atlantic-power-to-restart-sales-process.php). The ATP Board has responded to the letter by declaring that it "did not receive any offers that the Company's Board of Directors believed could be consummated at or above the closing share price of $3.04."
While the M&A rumor mill is highly speculative, it generally suggests the potential for strategic value at prices meaningfully above current levels. Furthermore, activist involvement in the stock will likely exert greater pressure on the Company to deliver strong operating results in the absence of a sale process.
ATP pays virtually no cash taxes and has $254mm of NOL carryforward deferred tax assets as of the latest 10K. The NOL balance has actually grown over time and may likely continue to grow due to the heavy interest expense and depreciation of assets, providing additional valuation support.
My price target is based on a simple cash flow waterfall, which assumes no re-rating.
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