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Getting TransAlta Shares For Less Than Free – Sui Generis Investment Partners

Capitalize for Kids: Sui Generis Investment Partners – The Understandably Misunderstood TransAlta, May 18, 2017

Understandably Misunderstood

  • TransAlta Corporation (TA) is an intriguing company whose complexity is masking deep value
  • Independent Power Producer (IPP) with coal, hydro, wind and natural gas power generation assets in Canada and US, making it the second largest generator of renewable energy in Canada
  • Long book is typically made up of strong FCF generating companies and TA fits the description well, though with some unique characteristics

Structure

  • Following an aborted private equity takeover of TA at $39/share in 2008, stock began falling and didn’t stop until last year
  • Oversimplification but the easiest description of the company is that TA had historically been a coal-fired power producer originally focused on Alberta and over time had built up a reasonably large renewable portfolio
    • In 2013, spun out renewable portfolio into TransAlta Renewables (RNW)
    • Subsequently, engaged in several transactions with RNW, referred to as “drop downs”
    • TA currently owns 64% of RNW
  • Quality of the assets and higher multiples afforded to renewable power generators have conspired to give RNW a market cap well in excess of TA, making TA’s ownership in RNW worth more than its entire market cap

TA stake in RNW

Why Are We Getting TA Shares For Less Than Free?

  • TA, net of their RNW investment has traded as high at $8/share inside of the last 3 years, so why does the market think that TA proper is worth -$1.64/share now?
  • Issue: Coal-fired power generation is being phased out across North America and this process was accelerated by the Alberta NDP government in 2015 with a plan to rid the province of coal by 2030
    • Solution: Was a legitimate concern as the idea that 40% of TA’s generating capacity in Alberta could be forced into obsolescence by 2030 without compensation was a frightening notion in 2015. The provincial government did the rational thing and in November announced a compensation agreement with TA whereby TA will be paid $37.4 million cash for the next 14 years for a total of $524 million to compensate for stranding capital TA had invested in their coal business, and to aid in the transition from coal to gas-fired power generation at several of TA’s power plants
  • Issue: Alberta’s power market suffers from chronic oversupply and thus low power prices given that it is an unregulated “merchant” power market in what is arguably the most carbon rich area of the world
    • Solution: Most legitimate concern for us right now. Power prices in Alberta have been depressed for years and the government announced changes in the fall – the goal is to transition the market from “merchant” based to a more common “capacity” based, or one that pays companies like TA both for the capacity they could offer the market as well as for the electricity they actually generate. TA estimates that the cost to convert a coal-fired plant to gas is less than 10% of the cost of building a new gas-fired generation facility, so TA has a 90% cost advantage vs. any new companies considering entering the market and starting from scratch
  • Issue: TA has too much debt
    • Solution: US$4.103B of total recourse debt – believe it is fully supported by very strong FCF and this is where the opportunity for strong equity returns lies. A company that has a large debt load (like TA) may appear over-levered and thus expensive on an EV/EBITDA basis – in this case, TA trades at about ~7.5x EV/2017E EBITDA. TA’s 2017 FCF guidance at the midpoint is $332 million with a stated goal to continue reducing debt. If you assume net debt is reduced by $300 million in 2017 and assuming EV/EBITDA multiple remains constant, shares should appreciate by the amount of the net debt reduction

The Stub

  • If an investor wished to isolate just the value of TA, shorting RNW while being long TA will lead to what we call a “stub” – what’s left over after deducting the value of RNW shares is -$1.64/share when simply looking at market cap
    TA Stub
  • The more interesting calculation is working to establish the operating earnings that can be assigned to that stub, or trying to figure out the EV/EBITDA of just the stub
  • Buying the stub gives you exposure to a fully functional, strong FCF generating IPP producer at an EV/EBITDA multiple of 3x, while peers all trade above 10x – even RNW itself trades at 10.1x

Conclusion

  • Investors will make a good return owning TA shares over the next several years given our belief that strong FCF generation, multiple expansion and regulatory certainty should all come together to drive the shares higher
  • TA looks like a prime takeover candidate to us
    • Worth noting that Brookfield Asset Management, operator of many power generation assets, has taken a 5% stake in the company
    • TA management dramatically increased their “change of control” compensation from a combined $23.4 million to $34.7 million for the top 5 executives this past year
  • While we do not need a takeover for the trade to work and we believe a higher return will be achieved if this does not happen, management now seems aligned in one particular direction
Image Source: YCharts, ModernGraham
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