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TransAlta: Turnaround Story With Attractive Current Yield

|Includes:TransAlta Corporation (TAC)

Transalta has been a disappointing stock over the last 3 year having lost ~50% of its market capitalization over that time. TransAlta's fall from grace can be broadly explained as follows:

1) Fundamentals - the company has faced weak results in the Canadian and US Coal businesses, which are struggling with a host of issues including lower realized prices, higher penalties, higher coal costs, and higher unplanned outages.

2) Shift Away From Coal - the nation's gradual shift away from Coal to Natural Gas and alternative energy has created some obvious regulatory / policy uncertainty amongst investors given that coal represents a significant percentage of its total portfolio.

3) Dividend Surprise - the need to preserve capital for future growth forced TransAlta to slash its dividend recently. This is the right long-term, strategic decision, but came as a surprise to many investors.

4) Management Credibility - management has (rightfully) been viewed as lacking execution competence, transparency and accountability in the face of its various business challenges. Recent accusations that the company deliberately manipulated electricity markets has not helped.

Today, Transalta continues to face a number of challenges and must make significant progress to turn around its business. This will take time and there are no overnight fixes. But the good news is that the negative news cycle seems to be at an inflection point:

1) Stabilization of the Coal business appears to be underway and management does not expect further deterioration. The Canadian Coal business in particular is a focus for management as it attempts to recontract output.

2) The company made an important step in creating Transalta Renewables, as a growth vehicle. Effectively, it has given the growth assets a chance to be unencumbered by the issues plaguing the company and allowing them to realize their full potential.

3) No one likes seeing a company slash its dividend, but at least now the dividend has been adequately right-sized and the probability of further cuts is low given the coverage cushion that exists. At the current dividend of $0.72, Transalta yields 6% - significantly higher than the 3-4% you get on comparable companies.

4) Management is aware that has dropped the ball. The company announced management changes earlier this year, which signals that the management understands that change is necessary.

Importantly, TransAlta's valuation also looks compelling at current levels, suggesting that long-term investors looking for a turnaround story should feel comfortable revisiting the name. TransAlta currently trades just above 8.0x 2014E EBITDA vs. peers at 10.0x - 14.0x making it one of the cheapest names in its group. Some kind of valuation discount is warranted given its recent history and the continued issues facing the company, but at a 33% discount to the midpoint of the peer range the case can be made that downside valuation risk appears limited.

Longer-term, TransAlta continues to have significant earnings (and dividend) re-acceleration potential. You will have to be patient for this re-acceleration to materialize, but it is on the horizon. The re-acceleration story is a relatively straight-forward one. Currently, Transalta is locked into Purchase Power Agreements (NYSEARCA:PPA) in Alberta, where a significant portion of TransAlta's power generating assets are located. The PPAs are legacy commitments stemming from the deregulation of the Alberta power market to which Transalta owes its founding. Basically, the PPAs in place fix the price at which Transalta can sell its power to utilities, but as these PPAs expire over time the price of power will revert to higher market prices. Based on conservative electricity price assumptions, EBITDA is expected to increase by ~$100mm in 2018-2019 and an additional ~$300-$400mm in 2020 just from the expiration of the PPAs. In short, within 5 years you could see a $400-$500mm increase in EBITDA due to the PPA expirations alone, which represents ~40%-50% increase in EBITDA. Not bad for a boring electricity generation company.

Bottom line, if you buy TransAlta you are getting paid to wait right now. The dividend yield is attractive at 6% and over the next 2-3 years TransAlta has upside potential as investors become more positive on the post-PPA reality. In the meantime, there are also a number of important catalysts that could re-accelerate interest in TransAlta:

1) Partnership announcements to grow generation capacity

2) Financial sponsor interest in TransAlta as an LBO target

Stocks: TAC