Description

TransAlta Corporation (TA-T)

I believe this is a timely idea so I will spend a bit more time on the narrative and the mosaic theory behind the investment. The investment thesis is that TransAlta (TA) is cheap because of regulatory uncertainty and currently weak power markets in Alberta, exacerbated by forced selling due to both index ejection and a dividend cut. Finally, with Brookfield Asset Management’s involvement, some of the downside risks associated with: 1) potentially poor management capital allocation, and 2) ability to navigate its more levered balance sheet are meaningfully reduced.

Background

TA is a power generation company with ~ 2/3 of its generation capacity in Alberta Canada.

Looking at TA’s price chart over the last few years, the understandable reaction for the reader would be “what the heck happened here?. There are a number of reasons for this but primarily, the “investment thesis” for TA a few years ago would have been that TA deserves to trade at a high multiple (low required yield) given its stable dividend, robust power demand growth in Alberta (especially from oil & gas industry) and the option to generate a lot more cash as its Power Purchase Agreements (struck at contracted prices below spot prices at the time) roll off.

As background, back in 2001, Alberta’s power market transitioned from a regulated market into a market-based system. To ensure some stability, predictability and reasonable return for power generating assets through this transition, PPAs (generally running from say 2001-2020) were created and backstopped by a government entity called the Balancing Pool.  Because these PPA’s were generally struck in the $40/MWh range, TA holders thought there was significant upside once these PPA’s rolled off and TA went merchant, as spot prices in the past few years reached $60-80/MWh.

In the last 2 years, TA faced multiple challenges that virtually erased the long standing investment thesis of investors – some of these problems were self-inflicted and some were beyond their control. The two biggest headwinds are:

1. Drop in oil prices and power demand – with the slump in oil, Alberta’s power demand growth went from ~3% to practically flat at 0-1%. As a result, power prices followed suit, dropping to currently below $20/MWh. Ironically, TA’s PPAs went from being a hindrance to a form of downside protection, providing near to medium term cashflow despite the drop in power prices,

2. Change in regulatory environment – Back in 2012, the Canadian government wanted to limit Green House Gas (GHG) emissions by allowing Coal power generation units a useful life of up to 50 years and $15 per tonne of GHG emission. To the market’s surprise, the Alberta government in late 2015 decided to (plan to) phase out coal generation completely by 2030 and increase GHG emission costs to $30 per tonne by Jan 2017 (with TA’s emissions per MWh at ~ 0.9, one can roughly assume coal generation costs would be $30/MWh higher with this). This created significant uncertainty for TA as to how they may (or may not) be compensated for the early retirement of its coal fleet and how exactly the government plans to make this transition.

Of course, TA’s management team, in my humble opinion, made numerous unforced errors as well, including (back in 1999) expanding into the US to generate coal-based power in the Pacific North West, and “diversifying” into Australia (since 2011) due to good expected power demand growth from the iron ore producers. Also, reviewing transcripts over the past couple of years will reveal some operational and reliability issues – having to outsource operations, maintenance and administration costs to third party suppliers to rein in costs speaks to this concern. We recognize there are a couple of bright spots including having Donald Tremblay join as CFO back in 2014 (previously as CFO of Brookfield Renewable Power) and TA creating TransAlta Renewables (RNW) in 2013, which served as an “MLP” like vehicle where TA could drop renewable assets into (which the market presumably more favourably values)

Valuation

Clearly, the two biggest variables in driving TA’s valuation are power prices and how the new environmental regulations are implemented. There is a lot of uncertainty how things will play out (and many possible scenarios) and these two variables (in Alberta anyway) are probably fairly correlated (i.e. if coal is abruptly phased out, power prices would be a lot higher as ~40% of power generation capacity in Alberta is coal fired right now).

As value investors, we know uncertainty does not equal risk. While it is hard to pin down how things will shake out, I kept things simple and have 2 scenarios for TA:

1. A downside case $5.00 – Coal gets phased out by 2020 and TA gets no compensation. TA harvests FCF in the near-term (as the PPA’s allow TA to pass on environmental costs) and relies completely on renewables post 2020 (without going to too much detail, currently the PPA counterparties are attempting to put the PPA’s back to the Balancing Pool, the net impact to TA should be minimal, although TA could receive net book value of the asset in return for cancelling the PPA)

2. An upside case $12.50 – The phase out of coal gets pushed out until 2030 with no new emissions costs i.e. before Alberta’s new environmental policy framework. While this is not exactly realistic, it is intended to better capture the probable impact of significantly higher power prices and/or TA being somehow compensated for its stranded capital in its coal assets (i.e. additional emission credits, incentives to convert coal to gas or new gas PPAs meant to compensate TA for coal plant closures, etc.)

The assumptions used above are numerous but I generally go with company guidance and assume some rebound in power prices in the $50-$55 range 2020+.

Another way to frame the downside is to look at TA’s (levered) equity FCF over the next few years. Because of TA’s PPAs and in place hedges, TA’s exposure to power prices are 87% locked in ($45-50/Mwh range) in 2016 to 70% locked in for 2019. With TA’s guidance of ~ $1/share in FCF (the real FCF figure should be slightly less as TA just nets out dividends from RNW to minority shareholders instead of netting out net income to minority shareholders), we can broadly guess that we can get just under $4 in FCF plus whatever residual after that which is highly uncertain (but not zero).

The biggest pushback to the above analysis is that it is a levered FCF number (TA has a good amount of debt) which requires the company to navigate this environment and manage its balance sheet (and execute on shifting to non-recourse project debt or shift some debt to RNW). As well, the risk to the downside case is that poor capital allocation by management is hard to handicap – i.e. in the case of coal shutdowns, a hail mary by management to lever up and make big acquisitions could be particularly problematic. The next section about the “setup”(why this opportunity exists) and expected catalyst (using mosaic theory) should adequately address this.

The “Setup”, Forced Selling

So far in the write-up, I’ve laid out why I think uncertainty does not make TA a risky investment, especially based on a valuation range that, although wide, provides good downside protection given the near-term FCF from TA’s largely contracted portfolio. The intellectually honest questions to ask here are: 1) why does this opportunity exist and 2) are the parties taking the other side of the trade more informed?

This is where the “setup” gets me very excited. Examining TA’s shareholder base, one would find the big holders are primarily Canadian passive mutual fund managers (i.e. Canadian banks and large asset managers). As well, TA was a member of the S&P TSX 60 (the 60 large cap names passive managers typically hold to mimic the index or at least not deviate too far from), the MSCI Canada Index and the S&P TSX Composite High Dividend Index.

Starting in 2Q15, the combination of weakness in Alberta’s energy patch and concerns over a more stringent environmental regulatory backdrop began taking a toll on TA’s stock price. In addition, there were concerns over the sustainability of its dividend and investment grade rating (both of which TA management team attempted to defend).

With a smaller market cap, TA was removed from the S&P TSX 60 and replaced by Dollarama effective September 18, 2015.

http://www.newswire.ca/news-releases/sp-dow-jones-indices-announces-changes-to-the-sptsx-canadian-indices-526811491.html

This led to what I believe was significant forced selling as passive managers and closet indexers began indiscriminately selling as the TA stock “wasn’t working”, “creating tracking error” and “increasingly risky”. Interestingly, the hedge fund Luminus Management LLC began accumulating shares.

Creating another round of forced selling, TA was then subsequently removed from the MSCI Canada Index effective November 12, 2015

https://www.msci.com/eqb/gimi/stdindex/MSCI_Nov15_STPublicList.pdf

As if that wasn’t enough, TA finally came clean in mid-January and significantly reduced its dividend (to $0.04 a quarter from $0.18) – likely ejecting some of the yield oriented funds. Predictably, TA was also removed from the S&P/TSX Composite High Dividend Index.

http://www.theglobeandmail.com/globe-investor/news-sources/?mid=cnw.20160311.C7548

The Catalyst, Mosaic Theory

I started this writeup by explaining why TA is cheap and has good downside protection. Next, I laid out why the setup is interesting given likely significant index driven forced selling – making TA much more likely to be trading below fair value compared to a market with strictly informed and fundamental participants.

The final question that needs to be answered is: “What is the catalyst then?”

Based on the various data points I uncovered, I believe mosaic theory suggests Brookfield Asset Management (and maybe Brookfield Renewable Partners) is likely to reveal its hand soon – at which time I speculate it will either pursue a takeout of TA or become actively involved in unlocking value at the company.

First, it is interesting to note that amid index driven forced selling, TA shares rallied briefly in October on rumours of a potential take-out:

(BN) TransAlta Said to Have Talked to Potential Buyers for Month
s (2)

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TransAlta Said to Have Talked to Potential Buyers for Months (2)
2015-10-21 20:45:56.391 GMT


     (Updates with analyst's comment in fourth paragraph.)

By Scott Deveau and Rebecca Penty
     (Bloomberg) -- TransAlta Corp., the embattled Alberta power
generator under pressure from regulators and because of its
indebtedness, has held talks with more than one potential suitor
in the past several months, people familiar with the matter
said.
     The Calgary-based power generation and energy marketing
company was near a sale to a group of buyers last week before
that transaction fell through, said the people, who asked not to
be identified because the matter is private.
     TransAlta, which has more than 70 power plants in Canada,
the U.S. and Australia, had a market capitalization of about
C$1.8 billion ($1.4 billion) as of Tuesday’s close, after the
stock plunged 44 percent since the end of April amid price-
fixing charges, rising carbon costs and lower power prices in
Alberta, and as it struggles with C$4.2 billion of debt.
     “Fundamentals have changed here in Alberta and that creates
an opportunity for a buyer who might take a more constructive
view,” Patrick Kenny, an analyst at National Bank Financial in
Calgary, said in a phone interview. Private-equity investors
could be drawn to TransAlta’s high cash flow, relative to its
beaten down share price, Kenny said. The company’s free cash
flow yield is now about 20 percent, he said.
     TransAlta shares rose 1.3 percent to C$6.79 at 4 p.m.
Wednesday in Toronto, after gaining as much as 3.6 percent
earlier.

Second, I think it is no coincidence BAM bought 13 mln TA shares and filed with the SEC on November 13, 2015 *requesting confidential treatment of this position*. The confidential treatment expired in February 2016 (partially why TA rebounded at that time).

https://www.sec.gov/Archives/edgar/data/1001085/000095012316014945/xslForm13F_X01/primary_doc.xml

https://www.sec.gov/Archives/edgar/data/1001085/000095012316014945/xslForm13F_X01/form13fInfoTable.xml

Also, it is interesting that YTD, Instinet was acting as a significant buyer of TA – could this be BAM or Brookfield Renewable Partners? If so that would put them at > 10% owner of TA.

Did I mention TA’s CFO, Donald Tremblay came from Brookfield Renewable Power?

http://www.transalta.com/about-us/leadership/corporate-officers/donald-tremblay

Paying attention to Donald’s former employer Brookfield Renewable Partners. There are some very interesting tidbits.

https://www.brookfieldrenewable.com/_Global/44/img/content/file/2016/BREP%20Q1%20Interim%20Report%20May%203%20Final.pdf

• Notes in BEP’s statements show US$17 mln of investment securities in 1Q.

• Level 1 Available For Sale securities jumped to US$43 mln from US$13 mln at end of 2015.

• Also booked US$12 mln gain in the quarter for those securities.

• This gain seems to jive with TA’s rebound in price in 1Q

Also interesting is BEP’s commentary on power asset valuations was interesting:

<A - Sachin G. Shah>: Yeah. I guess, Andrew, there's obviously a meaningful disconnect today between public market valuations and companies trading at a healthy discount to their intrinsic value. And in particular, where you see this is when you see private market transactions trading anywhere from, in our space, 20% to 30%, in some cases, more than that, higher than where their public valuations would be. And so, in there lies both opportunity for us, but also, I'd say, a real advantage relative to many of our competitors. We're one of the few organizations in the power space that has access to ample private equity capital or private institutional capital ...


As is this commentary in the BEP 1Q16 Letter:

In North America, we are finding numerous hydro opportunities from owners who are looking to raise capital. We are also seeing wind and solar assets which for the first time are being priced at attractive returns, as a result of many of the public yieldcos having capital constraints.

We are acquiring hydro at the bottom of the cycle. We have acquired 1,500 megawatts of high quality hydro in the northeastern United States, investing over $3 billion recently. These assets were acquired during a historically low power price environment, providing stable cash flows today, with significant upside either through price signals or long term contracts which will be needed to incentivize continued investment in utility-scale power technologies.
https://www.brookfieldrenewable.com/_Global/44/documents/relatedlinks/7416.pdf

Most recently, BAM filed its latest 13F showing they added another ~800K shares of TA.

https://www.sec.gov/Archives/edgar/data/1001085/000095012316016692/xslForm13F_X01/form13fInfoTable.xml

Have they done more subject to confidential treatment? Is there an amendment filing coming? Or is BEP doing more buying instead?

Obviously I don’t know for sure BAM/BEP will take a more active role but there are an awful lot of pieces of info outlined above that would support my educated guess.

Having gone through the argument there is good value in TransAlta equity, I would encourage smaller accounts to look at TransAlta Preferred (various series) as they are generally trading at a steep discount to par ($25 – but obviously up to the investor to consider their view on rates etc.)

Disclaimer: The write-up is only intended for VIC members and not for dissemination (especially to the issuer).

Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

Catalyst

Brookfield reveals significantly higher ownership in TA and takes action (active role or takeout)

FCF Generation