Description

TransAlta (TAC)

TransAlta is a Canadian IPP with an aggressive decarbonization plan that will transform it into a growth company focused on renewable energy. Decarbonization plays in the power sector can be very lucrative, AES is a good example, and a similar story could be unfolding here. TAC has been written up numerous times on VIC, and I would read those for context, but I think this is a very interesting time to revisit the stock. Despite numerous positive developments, the stock has declined -16% YTD vs. +28% for their closest comp Capital Power Corp. and +20% for a basket of renewable focused Canadian IPP’s. A short-term collapse in Canadian natural gas prices and a weak quarter due to a hedging mismatch are the culprits. Both are onetime items and should reverse. Alberta power prices have skyrocketed recently to an average level of $215/MWh currently vs. company expectations of $130/MWh. An all-time high of $762/MWh was hit on Thursday and forward curves for the next two years are responding positively. TAC is 75% hedged for the remainder of the year, so there won’t be a massive jump in earnings, but this bodes well for cashflow in 2023/24 as they lock in profitable hedges. In the medium term, TAC should approach $15/share (+60% upside) as investors appreciate the increased earnings power and the shift to renewables.

The long-term appreciation potential is even better. This is the chance to own an established renewable energy platform right as they are becoming incredibly scarce. M&A in the space has accelerated and the passage of the IRA will only increase it. TransAlta shifted their strategy last year to go “all in” on renewables and accelerate their coal retirements which will be one of the largest contributors for Canada’s clean grid ambitions. The re-rating potential for TAC is robust as the runway for EBITDA growth after 2025 becomes clearer. None of this is lost on TAC’s largest shareholder Brookfield who is the most likely candidate to own these assets in the future. BEP trades at 17x EBITDA and could easily justify an “accretive” purchase of TAC at a low-teens EBITDA multiple once they are fully off coal. 2025 will be a pivotal year with Brookfield’s hydro purchase option maturing right as TAC’s EBITDA is set to grow materially. A takeout could garner +$18/share (+90% return).

To recap, here are the positive developments since the last VIC write up at the beginning of 2021:

1)  TAC has retired their remaining coal plants in Canada and will be fully off coal by 2025 when Centralia is shut down. The coal-to-gas repowering strategy is complete which de-risks the capital plan by rotating the $1B of planned capex into contracted renewables and dramatically improves the terminal value. By 2025, renewables will generate 70% of EBITDA and by 2030 it will be close to 100%.

2)  At the 2021 investor day, the company unveiled their Clean Electricity Growth plan consisting of a 2GW renewables backlog and a goal of a 5GW pipeline by 2025. Construction is underway on 40% of the backlog and the pipeline is already at 3-4GW. This buildout should return EBITDA to growth in 2025.

3)  IRA passage in the U.S. has created a renewed search for platforms and TAC is a scarce asset. M&A has heated up including renewable yield assets. Most recent example would be the CWEN purchase by GIP/Total.

4) New CEO is looking to “clarify the structure” of TAC and RNW...ultimately this could lead to a collapse in the structure or accelerate an outright sale.

5) The merchant hydro fleet has performed better than expected and their value has probably increased. Annual EBITDA is now closer to $300mm vs. previous expectations of +$200mm.

Longer Term Catalysts:

1) Portfolio repositioning has made a BEP takeout much more palatable. Our takeout example in the valuation section implies +2x upside in 2025.

2) The 2023 investor day should validate our growth thesis as pipeline and backlog numbers will most likely increase and EBITDA growth becomes more visible.

3)  The Canadian Clean Energy plan will be out by year end and create a medium-term runway for the gas plants to operate profitably and discourage new build gas plants.

4)  Competitors with large repowering/CCS projects on the drawing board are likely to see delays and cancellations causing power prices to stay firm in the middle part of the decade.

5)  Centralia could flip from a liability to an asset. It represents an amazing repowering opportunity for solar+storage. The site qualifies for 40%-50% ITC and has a large interconnect asset.

Background:  In early 2021, John Kousinioris took over as CEO after being president of TransAlta Renewable for several years. The previous CEO was more of a power trader and was reluctant to fully shift the strategy. John’s emphasis on renewables is key to our thesis of a faster growing decarbonized TAC. The company now owns three main assets: 60% ownership of their yield co. TransAlta Renewable which owns a portfolio of contracted green power assets, and a portfolio of merchant hydro and gas units in Alberta. Most analysts are modeling EBITDA flat/down for the foreseeable future as power prices in Alberta are expected to decline and TAC’s last coal plant goes offline in 2025. While I agree EBITDA will be flattish, the mix shift will increase the value of the portfolio substantially. By 2025, if the stock hasn’t reflected this change, I believe John will surface value for shareholders by either collapsing the TAC/RNW structure, tendering for stock or sell the company outright or some combo of the three.

A primer on Canadian power prices: The Canadian government is rolling out a clean electricity standard to decarbonize the grid by 2035. Final plans should be out by end of year, but they are generally favorable for TAC in their draft form. In addition, there is a federal carbon pricing mechanism which sets a minimum floor of $50/ton of CO2e and is set to move to $170/ton by 2030. This is causing a lot of uncertainty in the power markets, especially in Alberta where most of TAC’s assets reside. There is 18GW of generation on the books to be built out which could create a trough for power prices in the middle of the decade. Forward curves assume most of this is built out and is the main risk for TAC’s free cash flow. However, I think earnings will remain strong for the following reasons:

-  This massively incentivizes renewables buildouts and TAC has an enviable pipeline to execute on. TAC shelved plans to repower their larger coal facilities which has left ample cash to put towards this plan

-  Converted gas plants, like TAC’s, get preferential treatment in the current carbon plan and would be more profitable through 2030 compared to new builds.

-  A large part of the 18GW build out includes repowering of large coal plants to gas AND fitting them with CCS to make them competitive. The government would have to fund a large amount of the buildout to make this happen. To assume these projects will reach FID, get gov’t funding, and be built within a handful of years seems wildly optimistic.

We see TAC’s merchant gas plants generating good levels of EBITDA in the future. Even when modeling a step decline in these assets, which we do below to be conservative, there is ample upside due to the repositioning towards renewable power. This is supportive of our view that EBITDA can return to growth in 2025 AND that the hydro assets are incredibly valuable.

Reminder on Brookfield financings: In 2019 Brookfield invested $750mm in TAC via convertible securities with a 7% coupon and a right to convert them into a percentage ownership of the merchant hydro fleet. In 2025, Brookfield can convert the $750mm at a price of 13x the three-year average EBITDA - $10mm m-capex. So if the average EBITDA is around $300mm than Brookfield would own 20% of the hydro fleet. They have the option to top off their investment up to 49%, but only if the stock trades above $17 Canadian ($13 US). Brookfield gained two seats on the board and agreed to buy stock in the open market to approach a 9% ownership. They have since increased their ownership to 13%. Brookfield is incentivized to increase the share price so they can own more of the hydro assets, but if the stock is still depressed by 2025, it would be MUCH more accretive for them to buy the TransAlta complex outright.

Valuation: This modeling will focus on EBITDA and SOTP’s, but I wanted to touch on FCF. The company gives guidance on FCF using a sustaining capex number which comes out to $1.85/share 2022. While that is a compelling yield, I don’t consider this true owner’s FCF since most of it will be invested in renewables to replace the shuttered thermal fleets. If you add up the current dividend, historical buyback and remaining discretionary FCF, I model around 3%-5% annual true FCF yield until 2025 when the portfolio should flip to growth. At that point, I do believe that TAC’s true owner’s FCF should be well above $2/share as I’m willing to count their capex as true growth.

I’ll use a three-prong approach to valuation starting with the stub TAC value. Ex-RNW stake, you’re buying excellent hydro assets plus some merchant gas assets for less than 6x EBITDA. Assuming Brookfield’s mark is a good value estimate, then you’re getting paid to own some well-placed gas assets that kick off lots of FCF.

So what is TAC worth today? The SOTP’s below is a good back of the envelope estimate. Bottom line, there are many ways that TAC is worth mid-teens today and likely high-teens in a takeout scenario.

As a way to double check this value, it’s interesting to see what range of values Brookfield might pay for TAC in the future based on their growth plan. As noted above, I assume power prices moderate into 2025, but then pick up again into 2030, similar to how the company has framed their outlook. For simplicity, I model this by assuming the merchant gas EBITDA declines steeply. I assume hydro mostly retains it’s pricing power, but that Brookfield exercises it’s purchase option, thus EBITDA declines by $60mm net to TAC. The contracted renewables EBITDA should grow by $115mm which is consistent with the remaining growth plan. I use that same ratio of $100k EBTIDA/MW and apply it to the 5GW pipeline goal by 2025 which could be larger. That equates to $500mm of incremental EBITDA by 2030 which is around 5% annual growth.

Conclusion: Brookfield could easily justify paying $17-$18 share today for TAC.

Risks:

-   Alberta power prices could decline. There are multiple hedging opportunities to reduce this risk.

-   “Dead money” until 2025 is a possibility. I think the movement up in the power curve for 2023 will help alleviate this.

-   Brookfield takeunder

Catalyst

Buyout, EBITDA growth, Decarbonization