Shares of TransAlta Corporation (TO:TA)(NYSE:TAC) have been terrible performers of late, falling 73% over the last five years and 53% over the last year.
All sorts of things have happened to what was once one of the S&P/TSX Composite's former dividend darlings. The company's coal-fired power plants started to get up there in age, requiring an increasing amount of expensive and unscheduled maintenance, which affected earnings. Alberta's power prices declined as the province's economy slowed after the boom times of 2004-08. The Canadian dollar strengthened against the U.S. dollar, which depressed results from TransAlta's U.S. subsidiary.
These pressures all culminated in early 2014, when the struggling company finally threw up its hands and cut the dividend, slashing the payout from $0.29 per quarter to $0.18.
You'd think the pain would be over at that point, but for TransAlta, it was just getting started. Investors suddenly woke up to the fact that it generated about 40% of its EBITDA from coal, a fuel the market has come to hate. Spot power prices in Alberta were weak throughout 2014 (TransAlta locks in about 80% of its production into Power Purchase Agreements, but sells 20% to the open market). And earlier this year, Alberta elected an NDP government, whose leader had indicated that she'd like to see Alberta focus on a more environmentally sustainable path. Note that there was nothing in the actual NDP platform regarding coal-fired power besides agreeing with an already agreed to plan to slowly phase out TransAlta's coal presence in the province. More on that later.
Long story short, shares are now currently trading under $6 each, which I think are a screaming buy.
The valuation angle
TransAlta has two parts. It has its own portfolio of assets, which include coal-fired power plants in Alberta and Washington State. It also has a bunch of gas-fired plants scattered around Alberta, Ontario, and Australia. Finally, it has a basket of renewable power sources in Alberta, Ontario, the U.S., and Australia. The gas-fired and renewable portfolios are showing decent EBITDA growth, while the coal-fired business continues to struggle with low prices and unplanned outages. There's also an energy marketing division which usually adds to the bottom line. This most recent quarter was an exception; it posted a slight loss.
Then there's the company's investment in TransAlta Renewables (TO:RNW), a drop-down subsidiary. TransAlta owns 76% of Renewables, which was recently bumped from 70%. TransAlta dropped down most of its Australian gas assets to the subsidiary, getting $215 million in net cash from the deal, as well as taking ownership of extra Renewables shares, enough to boost the ownership stake.
Because TransAlta owns so much of Renewables, it consolidates the results on its financial statements. It basically treats Renewables as a minority partner in everything, taking its share of the profits. This is important to know when trying to figure out what TransAlta itself is actually worth.
There are two ways we can value Renewables. We can either look at the market cap (which is $2.04 billion) or we can look at the equity, which is worth a little less, at $1.91 billion. We could also look at what it earns, which we will later.
To be conservative, let's take the lower value, the $1.91 billion in equity. TransAlta owns 76% of that equity, which values the stake at $1.45 billion. TransAlta's entire market cap as I type this is $1.63 billion. Thus, the market is not only valuing TransAlta's coal assets at nothing, but it's also severely discounting the other assets it owns.
This is when TransAlta becomes a bit of a mess. The company owns various gas, wind, and solar projects that haven't been dropped down to Renewables. Over the last 12 months, Renewables did $181 million in EBITDA, but the two companies have just completed the Australian transaction, which will definitely affect earnings going forward.
According to the investor presentation Renewables gave to tell investors about the transaction, it said FFO would more than double from $140 million to $290 million. Thus, we'll assume EBITDA doubles from $181 million to $360 million.
TransAlta is still guiding that it will hit $1 billion in EBITDA this year, as the small hit it will take from losing those Australian assets (remember, it still "earns" 76% of what it used to from those assets), so let's assume that for the parent company.
Confused yet? Essentially, here's what it means. Out of the $1 billion TransAlta looks to do in 2015 EBITDA, approximately $270 million of it will come from Renewables.
Firstly, let's value TransAlta as a whole entity vs its peers, Canadian Utilities Limited (TO:CU), Fortis Inc. (TO:FTS), and Emera Incorporated (TO:EMA), using EV/EBITDA:
- TransAlta: $6.52B/$1B = EV/EBITDA of 6.5
- Fortis: $23.81B/$2.246B = EV/EBITDA of 10.6
- Emera: $10.54B/$1.04B = EV/EBITDA of 10.1
- CU: $18.00B/$1.667B = EV/EBITDA of 10.8
As you can see, TransAlta is pretty darn cheap. What happens if we take coal's contribution away from TransAlta's EBITDA?
TransAlta (no coal): $6.52B/$600M = EV/EBITDA of 10.9
You're getting the coal business for free. This is a business that has generated $400 million in annual EBITDA pretty consistently over the last decade, through unplanned outages, weak Alberta power prices, and increasingly stringent environmental regulations. As long as it doesn't get shut down completely, it's worth something.
Valuing the coal business at 10x EBITDA probably isn't realistic. Say it's worth 6x EBITDA. That adds an additional $2.4 billion onto TransAlta's $1.63 billion market cap, which indicates potential upside of 150% from today's price of $5.80 per share. Valuing the coal business at 6x EBITDA still only values the whole business at between 8 and 9x EBITDA, which is still a pretty substantial discount compared to its peers.
The future of coal
TransAlta has already committed to decommissioning most of its Alberta-based coal plants, with the majority of them going offline (or being converted to natural gas) in the mid-to-late 2020s. A few of the newer ones will stick around until the 2040s, assuming the government in the province doesn't force something to happen sooner.
The plant in Washington state is also scheduled to go offline in the 2020s, but that's not that big of a deal, only contributing about $80 million in annual EBITDA. The market's concern right now is with Alberta.
I find it incredibly unlikely the NDP government would order anything drastic. TransAlta is a huge part of the province's power generation, with some 30% of the province's power coming from TransAlta plants. You can't just take away that much power supply from the grid without there being consequences. And like I mentioned, the NDP made zero mention in its platform about changing anything to do with coal-fired power in the province.
There's also the risk that TransAlta cuts the dividend again, putting it in line compared to what its peers pay. TransAlta actually has the cash flow to pretty comfortably afford the payment, but it's easy to see the logic in cutting again. A 50% dividend cut would save between $80-$90 million per year which could be spent growing the business or paying down debt. There's a lot of debt, some $5 billion worth when you could the preferred shares.
The case for buying Renewables instead
I'll touch on this quickly, because this is already getting long.
There's a pretty compelling argument for forgetting about the parent company and just buying Renewables instead. Renewables trades at a very slight premium to book, and at approximately 8.6x EV/EBITDA. That's a full 20% cheaper than its peers, and it has zero coal exposure. It's also sold off quite a bit lately, and I'm not sure why. I'd have to more due diligence before being more sure on this, but upon first glance it does look interesting.
Let's wrap it up
From an asset perspective, investors are getting most of TransAlta's plants for free, paying just for the stake in Renewables. Those assets generate some $700 million per year in EBITDA. Or, looking at it from the earnings perspective, investors are paying market price for the good assets, and they're getting the coal assets for free. I sure do like to buy stocks that are cheap on both an asset basis and an earnings basis.
Disclosure: Long TransAlta