TransAlta: The Best Way To Play The Renewables Segment

Summary

• As a result of projects coming online in 2022, I expect at least modest AFFO growth for 2022.
• RNW is among the cheapest in the renewables segment and most conservatively leveraged.
• As a result of the low leverage and affiliation with TAC, I should expect Moody's, S&P, and Fitch to take notice and their cost of capital to improve over time.

CHENG FENG CHIANG/iStock Editorial via Getty Images

*** Please note all figures are in CAD unless otherwise noted.

I have decided to begin coverage on TransAlta Renewables (OTCPK:TRSWF) which trades under RNW on the TSX. I believe it presents a solid income/value play in the renewables segment which are few and far between these days.

The EIA anticipates renewable capacity to expand by over 1,800 GW (60%), in its main case forecast to 2026, accounting for almost 95% of the increase in total power capacity worldwide.

Overall, China remains the leader, accounting for 43% of global growth, followed by Europe, the United States and India. These four markets alone provide almost 80% of renewable capacity expansion worldwide. We have revised the forecast up from last year, with China alone accounting for about 60% of the revision. For China, last year’s forecast reflected the phase-out of subsidies at the end of 2020 and the resulting policy uncertainty for onshore wind and solar PV. However, China’s subsequent commitment to net zero by 2060 has led to new targets, such as 40% of all electricity consumed to be from non-fossil generation by 2030 and a capacity target of 1, 200 GW wind and solar PV by the same year, all reflected in our updated forecast.

In Europe, the upward revision stems from larger auction volumes in most EU member countries to accelerate deployment towards 2030 renewable energy targets, a growing market for corporate power purchase agreements (PPAs) and the increasing attractiveness of self-consumption for distributed PV. In the United States, favourable wind and solar PV economics, and increased ambition at the federal level drive renewables to new highs. The continuation of federal tax credits in December 2020, a growing corporate PPA market and increasing federal and state-level support for offshore wind all drive higher capacity additions in our main case forecast.

Source: EIA Renewables 2021 Analysis and Forecast to 2026

Source: EIA Renewables 2021 Analysis and Forecast to 2026

Renewable energy may end up being one of the highest growth industries over the next 20 years as well as requiring the most capital, as nations try to meet net zero emissions targets required. Investing in high growth industries is not necessarily the way to generate high returns, especially if the price is too high for that growth. As will be demonstrated throughout this article, RNW has greater potential to deliver positive and consistent returns than its "pure play" counterparts.

Background

RNW is one of the largest generators of wind power in Canada and is among the largest publicly traded renewable power generation companies in Canada. RNW is owned 60% by its parent company TransAlta Corporation (TAC).

RNW's operations span three countries: Canada, the United States and Australia, although assets located in the United States and Australia are held through an economic interest in those assets rather than direct ownership. The operational results of these assets are not consolidated into their financial statement results but instead receive finance income.

RNW has 50% of its portfolio in wind energy, however it would not be considered a "pure play" renewable energy company as it has 43% of its assets in natural gas. Natural gas is significantly cleaner than coal and oil, and the company is actively making investments only in the pure renewable space, which will shrink the percentage of the asset base that is allocated to natural gas.

Source: Q2 2021 Investor Presentation

The company has long-term contracts for its facilities, with a weighted contract life of 12 years. Long-term contracts are important for any income investment as it ensures predictable results.

Source: Q2 2021 Investor Presentation

Although RNW has a respectable 6% yield, its performance has been disappointing throughout 2021.

Data by YCharts

9-months into fiscal 2021 and profitability is down on all metrics that matter despite an 8% rise in revenue.

While the Corporation delivered higher comparable EBITDA in the three months ended Sept. 30, 2021 compared to the prior year, overall the Corporation's comparable EBITDA year to date is lower than the same period in 2020 and is lower than expected. The Corporation's results have been impacted by lower wind resources throughout the year and a steam supply disruption at our Sarnia facility in the second quarter of 2021 that resulted in a provision for liquidated damages expected to be resolved later in the year or the first quarter of 2022. During the second quarter, the Corporation announced an update to the previously reported guidance. A further update has been provided as a result of the Kent Hills 2 turbine collapse.

Not only did management revise their guidance downward for 2021 in their Q3 report, but no dividend increase for the "income salivating" investor for the 4th year in a row. What is more disappointing is the increasing share count over the last 5 years to realize flat, even declining profitability at points.

Source: Q3 2021 MD&ASource: Q2 2021 Investor Presentation

Data by YCharts

I do however believe RNW is set up for positive returns going forward with the amount of projects in the pipeline. Most notably, all turbine erection activities have now been completed at the Windrise wind project with final commissioning activities currently underway and began full commercial operations in November 2021. The project is expected to have an average annual EBITDA contribution in the range of $20 to $22 Million.

In April, 2021, RNW acquired an economic interest in the 29 MW Ada cogeneration facility and a 49 per cent economic interest in the 137 MW Skookumchuk wind facility. Both facilities are fully operational and will increase capacity from 949 MW to 978 MW.

Source: Q2 2021 Investor Presentation

The facilities will be fully operational throughout 2022 and has therefore increased analyst guidance on profitability for fiscal 2022 by as little as 7% and therefore a near-term dividend cut would appear unlikely. This EBITDA growth may seem paltry but considering how competitive the renewables space has gotten anyone getting more than 5% growth will look like winners. RNW has managed to keep their AFFO payout ratio well above 1x in recent years. What is more remarkable is that the $700M credit facility was undrawn as of Q3 implying additional liquidity has not been required to finance the dividend.

Data by YCharts

Data by YCharts

Valuation

RNW is among the cheapest when taking into account analyst estimates for 2022 at 11x EBITDA and even cheaper than it's been for the past year at 14x. RNW also sports the highest dividend yield in the peer group which arguably makes it the best income play of the group.

Data by YCharts

Data by YCharts

Canadian Solar Inc. (CSIQ) and Atlantica Sustainable Infrastructure (AY) are marginally cheaper and Northland Power Inc. (OTCPK:NPIFF) is only slightly more expensive but RNW is far and away the most conservatively leveraged.

Data by YCharts

***Pay close attention to Brookfield Renewable Partners' (BEP) astounding 50x debt to EBITDA

As a result of the low leverage and affiliation with TAC, I expect Moody's, S&P, and Fitch to take notice and their cost of capital to improve over time. For example, TAC has provided a Construction Cost Guarantee related to the Windrise wind project acquired on Feb. 26, 2021 whereby, upon completion of the Windrise wind project, if the construction costs exceed the guaranteed cost, TAC will reimburse RNW for up to $6 Million and if the construction costs are below the guaranteed cost, the Corporation will reimburse TAC for up to $6 million.

Conclusion

It doesn't take a university mathematics professor to see that RNW sports the best risk-reward trade-off in the renewables space. If the renewables segment is worthy of your love, then this is one of the better options to play the space and will provide the most stable income. That being said, at the current share price I would not expect market beating returns. In October 2021 I sold puts at a $17.75 strike price with a March 2022 expiry for $0.60/share. If the options exercise ATM or ITM it will still be a slightly more favourable entry at 15.5x TTM AFFO, but if the options don't exercise it will be an 8% annualized return on the cash secured puts. If option premiums improve on the stock, I will look to increase the position via cash secured puts.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TRSWF either through stock ownership, options, or other derivatives. 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.

Long via cash secured puts.