TransAlta Corp.: A Superior Choice To TransAlta Renewables
Summary
- TransAlta Corporation has delivered superb results in 2021.
- The stock is getting zero credit for the deleveraged balance sheet and its large ownership of TransAlta Renewables.
- A direct sale of the company at a 50% premium is highly probable.
- Alternatively, buybacks should start scaling up soon to create value.
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Note: All amounts shown and discussed are in Canadian Dollars and refer to shares trading on TSX.
We have covered TransAlta Corporation (NYSE:TAC) and its controlled subsidiary TransAlta Renewables (OTCPK:TRSWF) previously. When we last wrote about TAC, we exited the preferred shares as we felt the bulk of the price gains were in the rearview mirror. On TRSWF, we felt that the company was relatively the best value in the renewables space, but still maintained a neutral/hold rating on the company. Recent market turmoil, alongside specific issues that impacted both companies, have created a lower entry point in both.
We give you our thoughts as to why TAC is the better choice here.
2021 Results
TAC delivered for 2021 in style and the free cash flow per share was particularly impressive.
2021 Results (TAC Presentation )
The consistent operating cash flow alongside tons of free cash flow, have been the hallmark of TAC for many years.
Free Cash Flow (TAC Presentation )
This has made a substantial dent in the corporate debt.
TAC Debt (TAC Presentation )
Note the reduction of $1.5 billion of debt since 2017. TAC's market capitalization has actually moved up by just $1.0 billion since then.
Generally, one would expect a multiplier effect as when riskier debt is eliminated, the equity gets a stronger boost. But TAC has failed to even capture the full upside from debt reduction. There are two other areas that are worth noting here. The first being that TAC has managed to do all this while spending on converting its coal plans to gas usage.
TAC 2021 Accomplishments (TAC Presentation )
TAC has also been hitting its ESG targets and continuing to create loftier goals for the future. Hence the lack of recognition here seems a bit off. There are probably a couple of reasons here that we think played a role.
The first is that while TAC's free cash flow has been impressive, that has not all been available for shareholders. TAC runs free cash flow by subtracting sustaining capex from operating cash flow. That makes sense. However, total capex has dwarfed the sustaining capex. Have a look at the sustaining capex for the last 3 years, which play into the free cash flow definition.
Sustaining Capex (TAC Presentation )
Now compare that to the total capex.
Total Capex (TAC Presentation )
The difference between the two is what TAC considers as growth capex, but a lot of that was for turnaround on the coal to gas conversions. We think that we are reaching an inflection point where progressively higher amounts of the free cash flow figure will actually be available for shareholders. For 2022, TAC has guided for a midpoint free cash flow of $1.88 per share. This is despite some unexpected issues at Kent Hills which now look to be fully operational only in 2023. Of course this is ignoring the "growth capex" as we highlighted above. But even after this growth capex, there should be $250 million available to shareholders. 2023 should improve even further as growth capex moves lower and there should be over $350-$400 million available for shareholders. This creates a floor for the stock in our opinion and TAC will start returning increasing amounts of this back to shareholders.
Comparatives?
TAC is a big renewable play and comparatives could include the pure renewable energy companies Brookfield Renewable Partners L.P. (BEP) (BEPC) or Atlantica Sustainable Infrastructure plc (AY). Renewables unfortunately is not the full story and TAC is also an unregulated power-generation and energy-marketing company. A blend valuation is very hard to come up with. One thing to consider though is TAC's ownership of TRSWF. TAC owns 60.1% of TRSWF or about $2.75 billion worth.
Yes, there is that corporate level net debt and preferred equity as well, but overall that ex-TRSWF stake is trading close to 5X EV to EBITDA. That is a pretty remarkable multiple to get in on the action, especially if you believe TRSWF is also cheap in the first place.
TRSWF Numbers
We know the Ex-TRSWF stake is extremely cheap, but is TRSWF worth buying? The company has had some difficulties of late with its Kent Hills Wind Energy project being shut down for repairs. What seems remarkable to us is that everyone has written this off and assumed no insurance or other third party recoveries. We think some compensation is highly likely but even if it is not, this merely shifts the higher EBITDA out 18 months to the point when things are repaired and fully functioning. The dividend cut, which has been speculated on, is not even remotely an issue. The worst case payout ratio of 102% for one year is not going to create a cut.
TRSWF Payout Ratio (TAC Presentation )
The bulk of TransAlta's dividends flows up to the parent and while we respect the idea of looking at the payout ratio, this is one instance where it conveys useless information. TRSWF's dividend is safe for the next 12 months and we are keeping our Kenny Loggins Scale rating unchanged.
Kenny Loggins Scale (Trapping Value)
TRSWF is also the cheapest among the renewable plays when one examines EV to EBITDA for 2023 or the current dividend yield. Hence, we think TRSWF is worth investing in at present.
Verdict
We think TRSWF is buyable from an income perspective but we are still maintaining it at a neutral rating at present. The current valuation calls for a buy rating instead on the parent. As the capex roster clears up we see the odds of a big buyback increasing. The probability is also very high that TAC agrees to go for a sale and would likely fetch at least a 50% premium. This is not rocket science. BEP trades at close to 19X EV to EBITDA while TRSWF is at 11X (both 2023 multiples). The ex-TRSWF stake is trading at 5.0X EV to EBITDA. Brookfield Asset Management (BAM) has invested in unregulated power generation via Vistra Corporation (VST) and remains bullish on its prospects. It also has a big interest in TAC. Whichever way things pan out, we think, TAC is likely to deliver good returns from here.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in TAC over the next 72 hours. 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.
Additional disclosure: We also have a small long position in TRSWF.