Description

All dollars are Canadian dollars.

Transalta (TSE:TA) is a non-regulated electricity generation company with assets in Canada and the US. Transalta owns about 60% of Transalta Renewables (TSE:RNW) which TA IPOed in 2013 to own its higher multiple renewable assets. Using Friday’s closing prices, TA currently has a market cap of $3.1 bn and its RNW stake is valued at $3.5 bn. In other words, the market is assigning negative $400 mm to TA’s standalone assets.

Outside of RNW, TA owns 800 MW of hydro assets in Alberta (“Alberta Hydro Assets”), 2,500 MW of coal assets in Alberta undergoing coal-to-gas (CTG) conversion, 450 MW of natural gas plants in Ontario and Alberta, and a 1,340 MW coal facility in Washington. 

Hydro 

The Alberta Hydro Assets currently generate $90 mm of EBITDA (RNW’s hydro fleet generates about $20 mm EBITDA which gets consolidated into TA’s results), but their PPAs expired in 2020 and this fleet started operating in Alberta’s capacity market this year. As such, the Alberta Hydro Assets are no longer liable for $135 mm of net obligations to the Alberta Balancing Pool under the PPAs, and would generate ~$200 mm of pro forma EBITDA at $55/MWh electricity price. Each $5/MWh change in pool price leads to $18 mm change in EBITDA. 

In March 2019, Brookfield Renewable Partners (BEP) agreed to invest $750 mm in TA in order to eventually own a stake in the Alberta Hydro Assets. The investment is structured as $350 mm of 7% exchangeable debentures (closed in 2019) plus $400 mm of 7% preferred shares (closed in October 2020). Starting in 2025, BEP would have the option to convert its $750 mm investment to a stake in the Alberta Hydro Assets valued at 13x average “EBITDA minus $10 mm maintenance capex” over the past three years, all of which would be post PPA expiration. TA management estimates that the Alberta Hydro Assets would be valued at $2.5 bn based on historical performance. So if converted, BEP’s $750 mm would result in a 30% stake in Alberta Hydro Assets. 

BEP has the option to acquire another 10% in Alberta Hydro Assets if TA trades above $14. It has the option to top up its stake to 49% if TA trades above $17. 

BEP also got two seats on TA’s board. In addition, BEP and TA formed a joint operating committee, consisting of two members (not board members) from each company to maximize the value of the Alberta Hydro Assets. 

Hydro plants are wonderful. They are considered perpetual assets. They are renewable and need to be owned for ESG reasons. They require little capital to maintain. Greenfield opportunities are scarce because permitting is difficult and has very long lead time. They are the perfect asset in a ZIRP world. BEP trades at 20x (up from 12x in 2019) and being able to buy a hydro portfolio of this size at 13x EBITDA would instantly create value for BEP. If rates stay where they are, I think it’s highly likely that BEP would convert their $750 mm and do everything in their power to increase TA’s stock price in order to top up their stake in Alberta Hydro Assets. BAM has been buying TA stock on the open market, and currently owns 12.4% of TA, above the 8.5% threshold required to exercise its top-up options. 

Coal to gas conversion 

When announcing its Q320 earnings, TA announced it would accelerate its goal of being off coal in its Alberta thermal fleet from 2025 to 2021. It will convert boilers on Sundance 6, Keephills 2 and Keephills 3 ($120~200 mm total spend, to be completed in 2021). It will repower Sundance 5 ($800~$825 mm spend, to be completed in 2023). It will gas fire Sundance 4 and Keephills 1 at reduced capacity. The coal plants were scheduled to be retired by 2029. Boiler conversions would extend plant life to late 2030s and repowering would extend plant life to late 2040s. After completing these projects, this fleet would have a capacity of 2,200 KW. At $50/MWh, I estimate in 2024 the fleet would generate $200 mm of EBITDA. In conjunction with the earlier transition off coal, TA would cease operations at its Highvale coal mine at the end of 2021, which would also eliminate ~$40 mm of mine capex. Post conversion, this fleet would only require $60 mm of maintenance capex. The CTG projects would significantly extend the cash flows of the Alberta thermal fleet and should eliminate the coal stigma.

Renewable growth and CTG capex fully funded

TA also outlined a growth pipeline of 2,500 MW growth projects (all renewable) in various stages of development, 700 MW of which would be delivered by 2024. TA typically develops a project and drops it down to RNW at a profit. In December, TA announced the dropdown of $440 mm of assets (mostly wind) to RNW. 

TA will be able to use its internal free cash flow to fund the renewable and coal-to-gas conversions in the next few years. Inclusive of dividends from RNW and uplift from Alberta hydro PPA expiration, TA should generate $300 mm of deconsolidated FCF after dividends (disclosed deconsolidated FFO-MCX-pref divs-common divs) each year over the next three years. This plus the $400 mm second tranche investment from BEP will cover the growth and gas conversion capex for the next three years. The Skookumchuck and Windrise wind projects in the table below have already been sold to RNW. 

Other assets

Other assets under the TA umbrella are fairly small. The Canadian gas segment generates $35 mm of EBITDA and has long-term contracts lasting another ~10 years. Comps for the Canadian gas and CTG operations include Capital Power (8x EBITDA; also undergoing gas conversion and repowering projects), Atlantic Power (being bought out at 6x with expiring PPAs), NRG Energy (8x) and Vistra Energy (6x). 

The Centralia plant in Washington will close in 2025 but TA does not have environmental obligations for the plant. Until closure, it will throw off ~$200 mm of cash flow. I didn’t include Centralia in my valuation because I assume cash flow will be used for CTG. 

TA also receives $37 mm of off-coal payments annually from the Alberta government until 2030. TA has already monetized this cash stream by issuing $345 mm of amortizing non-recourse bonds in 2018. In my SOTP, I subtract the balance of these bonds from the debt load but also do not include the PV of the off-coal payments. Finally, the energy marketing business roughly offsets corporate EBITDA loss.

Valuation

Another way to think about valuation is today you are paid $400 mm for the stub equity. Add $2 bn pro forma debt, you are paying $1.6 bn EV for the stub. TA’s future interest in Alberta Hydro Assets alone is worth $1.7 bn, so you are getting the rest for free. Granted there’s execution risk with the CTG projects, but Brookfield has an interest in overseeing these projects and making sure they are successful. 

While one could hedge RNW out to create the stub at negative value, I think it makes more sense to go long TA outright. In my low valuation case, RNW has to trade at $14 to arrive at the current TA price. Brookfield also owns TA equity not the stub, and has an incentive to help TA trade above $17. 

Catalyst

Off coal in 2022

Increased Alberta hydro EBITDA materializes

Brookfield buying stock on open market 

Brookfield stake conversion in 2025