TransAlta: The Shareholders Have Spoken & TransAlta Closes On Initial Investment From Brookfield Renewable Partners

Summary

• Why the position was doubled in December 2018.
• Brookfield and TransAlta battle Mangrove Partners and Bluescape Energy Partners.
• The annual general meeting results are in and Brookfield wins.
• Insiders pad their positions adding support to a positive outlook.
• The changing political landscape in Alberta and Canada may present investors with uncertainty.

Introduction:

TransAlta (NYSE:TAC) is an electrical utility with a significant installed base in Alberta. It also has assets in the United States, Australia, and other Canadian provinces. TransAlta’s portfolio is comprised of coal and natural gas, as well as hydro, wind, and other renewables. In addition to trading on the NYSE, it is listed on the Toronto Stock Exchange under the symbol TA. The stock’s current yield is roughly 1.8%. The enterprise also offers half a dozen preferred shares for income focused investors, and is the parent company of TransAlta Renewables (OTC:TRSWF), which has a yield over 6.75%. Though it has many peers, its closest publicly traded competitor is Alberta-based Capital Power Corporation (OTCPK:CPXWF).

At Contra the Heard Investment Newsletter, we first purchased TransAlta in December 2014 at CAD $9.81; that purchase was far too early. Since then, the utility has reduced its dividend and the shares have fallen. In December 2018, we purchased again, and doubled our original position at a price of CAD $6.95. As a result, the average cost base is now CAD $8.38. (For full disclosure, I also own some of the preferred shares personally, as do the principals at Contra the Heard).

Why the position was doubled in December 2018:

We doubled our position in December for a variety of reasons. The first one was because the turnaround plan made sense to us and it appeared to be gaining traction, albeit slowly. The turnaround called for a variety of measures, including:

• Improving the balance sheet and reducing leverage
• Improving operational performance and reducing operating costs through internal programs like Project Greenlight
• Transitioning away from coal and towards gas and renewables
• Preparing for Alberta’s 2021 shift from an energy to a capacity market
• Replenishing its development pipeline

In December, we felt TransAlta was making progress on these fronts. Debt had fallen from around CAD $4.5 billion in 2015 to CAD $3.2 billion as of the third quarter 2018. Net debt to EBITDA and other metrics were getting better too. Operating results were improving, as expressed by fleet availability, and Project Greenlight was reducing costs. The transition away from coal and toward gas and renewables was also firming up, and the path from an energy to a capacity market seemed clearer than it had been in prior quarters. Long story short, the corporation looked to be on the right track.

Valuation was the second reason we doubled our position. Though the shares were more expensive than they had been at other times since the stock bottomed in late 2015 / early 2016, many of the risks had subsided – but the market didn’t appear to reflect the reduced risk or brighter outlook. Since the December purchase, the shares have rallied and the valuations have increased, but the company is still considered a buy here at Contra the Heard.

Part of the reason why the market may have undervalued TransAlta (at least in our estimation) was because revenues have been more or less flat for years, and they continue to lose money. Understandably, consistently losing money does little to encourage investor confidence or patience. Another reason could be the difficulty in conveying the story. The company is complex with many moving parts, and that makes it hard to understand. Market, government, and regulatory changes (among others) that require pricing, contract, or operational revisions pop up with enough regularity to confuse and disorient, or at least make it hard to follow the new iterations and requirements in different operating locations. This has perhaps made it difficult for the C-suite to convey the turnaround story.

Outsiders do Battle: Brookfield vs. Mangrove Partners and Bluescape Energy Partners:

The timing of our December purchase looks fortuitous, as the ticker rallied recently along with the rest of the market. Though good 2018 results drove part of this rally, involvement by two groups of opposing investors spurred it too.

In March, American firms Mangrove Partners, Bluescape Energy Partners, and Cove Key Bluescape Holdings jointly disclosed a 13-D with the Securities & Exchange Commission. A 13-D implies they wish to exert control over the entity. Their proposals included better board oversight, operational excellence and cost control, and broad strategic initiatives including potential acquisitions and divestitures.

The 13-D’s ink had barely dried when TransAlta’s management team announced Brookfield Renewable Partners (NYSE:BEP) would increase their ownership in TA from 4.9% to 9% and invest another CAD $750 million. This capital would be for a minority position in the utility’s hydro assets and would be funded via an exchangeable debt and preferred share offering. Brookfield also got to nominate two of its employees for board consideration at TransAlta’s annual general meeting (Harry Goldgut and Richard Legault).

Source: TransAlta’s Strategic Investment by Brookfield Presentation – March 25, 2019.

TransAlta stated that Brookfield’s involvement will accelerate the organization’s turnaround strategy. More specifically, the utility will use CAD $350 million to assist in the coal to gas conversion, $250 million for a share buyback over three years, and the remainder for other projects. The proceeds will make it easier to pay off the CAD $400 million note due in November 2020, will help meet the corporation’s long-term debt reduction goal, and, according to CEO Dawn Farrell, will increase the odds of dividend growth in the 2021 to 2022 time frame. In addition to having the support of TransAlta’s board and officers, its largest shareholder, RBC Global Asset Management, blessed the deal as well.

Source: TransAlta’s Strategic Investment by Brookfield Presentation – March 25, 2019.

Brookfield’s proposed deal and the nomination of two directors stung the activists. In the weeks leading up to TransAlta’s annual general meeting in late April, Mangrove tried to stifle Brookfield’s aspirations. They suggested there were better deals out there than the Brookfield offer, and threatened to put forward their own five names for board consideration and launch a proxy battle. They made applications to both the Ontario and Alberta Securities Commissions to delay the shareholder meeting and have shareholders vote on the Brookfield deal, and they launched a lawsuit to try to derail the deal under the oppression remedy provision of the Canada Business Corporation Act. All this resulted in a heated response from members of TransAlta’s executive team and board of directors.

Annual General Meeting Results and the Aftermath:

In the end, the activists abandoned their complaint to the securities regulators and did not engage in a proxy battle. Instead of a board battle, shareholders elected Brookfield’s nominees Harry Goldgut and Richard Legault to the tune of 89.12% and 98.36% respectively. TransAlta also closed the initial tranche of Brookfield’s CAD $750 million strategic investment shortly thereafter. In the end, it appears the American activists (who were a relative unknown on the Canadian investment landscape) could not find enough support to go up against the board or take on Brookfield, who are well known within the Canadian investment community, and came to the table with a very clear plan.

Source: Annual General Meeting Election Results – April 26, 2019

Insiders pad their positions:

It isn’t just large players like Mangrove Partners and Brookfield Renewable Partners who have taken an interest in TransAlta’s prospects. According to INK Research, the chief executive officer, chief financial officer, other officers, and directors have all purchased shares over the last 12 months. In total, there has been CAD $785,699 in net buying.

Source: INK Research, as of May 2, 2019

In our opinion, watching what insiders do is more important than listening to what they say, watching outsider investors, or reading the prognostications of analysts. Insiders have their fingers on the pulse of the company and a better idea of what is really going on. This recent insider activity affirms a bullish appraisal of the enterprise, and investors should be encouraged by the support among TransAlta’s officers and directors. INK Research is a fantastic resource and can provide more details for those interested in recent insider activity or ownership.

A short note on Canada’s political landscape:

Though there could be unanticipated developments in the Brookfield vs. Mangrove story, it has probably been put to bed. There are, however, political items to consider. There is a new provincial government in Alberta, and a Canadian federal election this fall. These developments may have consequences for the utility given that the carbon tax is a key political issue, and carbon pricing in part drove TransAlta’s coal to gas conversion goals. On the March 25, 2019 conference call, management stated that a number of factors drove the coal to gas strategy, and that while the timing may change based on a new government’s policies, the strategy’s direction would not. Investors, analysts, and curious onlookers may want to tune into the May 14, 2019 conference call to see if these comments still hold. We suspect the commitment to convert from coal to gas will remain, but there may well be uncertainty here for the rest of the year as the Canadian political landscape settles out.

Conclusion:

TransAlta’s turnaround looks to be progressing as planned. During the December selloff, we took advantage of the lower valuations to double our position. While the shares have rallied since December, it is still considered a buy here at Contra the Heard Investment Newsletter. The CAD $750 million investment by Brookfield Renewable Partners should accelerate TransAlta’s strategy. At the recent annual general meeting, owners approved two nominees put forward by Brookfield, and shortly thereafter the enterprise closed an initial tranche of the Brookfield investment. This should put to rest any counter proposals suggested by other investors, including Mangrove Partners, Bluescape Energy Partners, and Cove Key Bluescape Holding. A bullish take on the outfit’s prospects is supported by insider buying to the tune of CAD $785,669 over the last year. Although there are many reasons to be optimistic, the final verdict is still out, and hard work remains ahead. Going forward, TransAlta and Brookfield Renewable Partners will have to deliver on their strategy to drive valuations higher while preparing for Alberta’s move from an energy to a capacity market, and considering potential shifts in carbon pricing as a result of changes in the political environment.

Disclaimer:

All amounts are in CAD unless otherwise noted.

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long TAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.