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Summary TransAlta’s share price has fallen sharply over the last six months in response to the return of cheap petroleum and the election of pro-environment governments in Alberta and Canada. Planned and unplanned downtime in Q2 prevented the company from taking full advantage of hot temperatures in Canada, resulting in a large earnings miss for the quarter. Looking ahead, the company is faced with the prospect of either converting its existing coal facilities to natural gas or writing off a large amount of relatively young assets. While a large forward yield could catch the eye of dividend investors, the company’s outlook is too negative to be an attractive long investment opportunity at this time. Author’s note: This article refers to a Canadian company and all dollar figures represent Canadian dollars unless otherwise stated. The share price of Canadian electricity generator TransAlta Corporation (NYSE: TAC ) has plummeted in 2015 to date as the prices of natural gas and petroleum have halved and regulatory concerns have mounted in its primary markets. This volatility has only increased over the last week in the wake of Canadian voters bringing the country’s pro-environment Liberal party to power in national elections and a rumored buyout attempt, although the company’s shares have rebounded by 27% over the last four weeks. This article evaluates TransAlta as a potential long investment opportunity in light of this uncertainty. TransAlta at a glance TransAlta owns and operates power plants in Canada, the United States, and Australia. Owning more than $9 million in assets, including more than 5,200 MW of generating capacity in the Canadian province of Alberta alone, the company utilizes a diverse mix of coal, natural gas, wind, and hydro to generate electricity that is then sold to nearby electric utilities via power purchase agreements. TransAlta is heavily reliant on coal despite this diversity, however, owning 4,931 MW of coal-fired capacity, 88% of which is contracted out for an average period of 5.5 years. This capacity has an average age of 17 years, making it relatively young given that coal-fired capacity can remain operational for up to 50 years. Another 1,447 MW of TransAlta’s capacity relies on natural gas, of which 95% is contracted out for an average period of 10.9 years. The company also utilizes 1,271 MW of wind power, 65% of which is contracted for an average of 10 years; and 914 MW of hydro, 96% of which is contracted for an average of 5.3 years. While electricity generation operations provide the majority of the company’s earnings, it also operates an energy trading division that has historically generated roughly $50 million in annual EBITDA. TransAlta has reported steady annual EBITDA growth since FY 2009, including 6% annually since FY 2012. This growth has been made possible primarily due to its heavy exposure to Alberta, which has been home to rapid economic and construction growth in recent years due to its large reserves of unconventional petroleum in the form of oil shale and tar sands. In addition to being substantially more energy intensive than conventional petroleum extraction, Alberta’s unconventional reserves became the subject of heavy demand in the early years of the current decade as rising energy prices made their extraction commercially attractive. This set off a resource boom in the province that in turn led to population growth, demand for new housing, and ultimately higher electricity demand. Unfortunately for TransAlta’s shareholders, electricity generators responded to this demand with a sharp increase in supply. Oversupply in Alberta was the ultimate result, leading to lower electricity prices. FY 2010 and FY 2011 proved to be the high points for the company’s annual revenue and EBITDA results, respectively, although both have also rebounded from their FY 2012 lows. It was on the verge of returning to its pre-glut earnings level in FY 2014 when petroleum prices swooned, making the extraction of Alberta’s unconventional petroleum reserves unattractive. The province’s economy has reversed course and the construction industry has faltered, further increasing its electricity glut and hurting electricity prices. TransAlta has responded to the poor situation in Alberta by diversifying its operations in terms of both geography and fuel mix. It has expanded its capacity in Australia, building 1,000 MW of new natural gas-fired generating capacity and acquiring 136 MW of existing renewable capacity. Recognizing its heavy exposure to the North American coal market, however, with North American coal generating capacity contributing 45% of its Q2 2015 consolidated EBITDA and Canadian coal contributing 39%, the company is also moving forward with an effort to expand its share of Alberta’s generation market from 11% currently to 30% by 2021. Perhaps the most important development, however, is TransAlta’s 2013 decision to form a subsidiary focused on renewable generation, the aptly-named TransAlta Renewables (OTC: TRSWF ). In May, TransAlta dropped down $1 billion in Australian assets to its subsidiary in exchange for $217 million in proceeds, which it used to reduce its debt load, and a post-transaction ownership interest of 76%. The subsidiary’s focus on renewable generation assets provides it with a number of advantages over TransAlta, including attractive financing rates and lengthy contracts as Canada’s government incentivizes the move away from fossil fuels to renewable energy. TransAlta, in turn, intends to use TransAlta Renewable’s distributions (it has a forward yield of 9.3% at the time of writing) to provide it with the cash flow necessary to finance its own debt and future capex. TransAlta Renewable will play an important role in TransAlta’s ability to meet its target of $50 million annual EBITDA growth and 8-10% annual shareholder return moving forward, the latter being something that it hasn’t achieved since FY 2011. Q2 earnings report TransAlta reported Q2 earnings that demonstrated the negative effects of its exposure to the North American coal markets and Alberta’s unconventional petroleum market. Revenue came in at $438 million (see figure), down by 10.8% YoY, as availability at its generating facilities declined from 85.4% to 80.9% over the same period (8,820 GWh generated versus 9,283 GWh YoY). The revenue decline came despite an increase in Alberta’s average electricity price from $42/MWh to $57/MWh due to abnormally hot weather during the quarter and was primarily due to one of its coal facilities experiencing damage-induced unplanned downtime that lasted most of the quarter and another facility undergoing planned downtime at the same time. TransAlta financials (non-adjusted) Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Revenue ($MM) 438.0 593.0 718.0 639.0 491.0 Gross income ($MM) 238.0 356.0 450.0 362.0 279.0 Net income ($MM) -131.0 7.0 148.0 -6.0 -50.0 Diluted EPS ($) -0.47 0.03 0.54 -0.03 -0.18 EBITDA ($MM) 133.0 231.0 359.0 238.0 158.0 Source: Morningstar (2015). Gross profit came in at $238 million, down from $279 million YoY. Surprisingly, given the earnings reports of other North American electricity generators, TransAlta’s cost of revenue fell only slightly over the same period from $212 million to $200 million despite the presence of much lower energy prices in the most recent quarter. As a result, net income fell to -$131 million from -$40 million in the previous year. Some of the decline was attributable to a non-cash adjustment to the fair value of the company’s energy hedges as well as the presence of a higher base tax rate in Alberta. Accounting for these factors resulted in an adjusted net income of -$44 milllion compared with -$12 million YoY. Adjusted EPS fell to -$0.16 from -$0.04, missing the analyst consensus by $0.14. EBITDA also fell, declining from $213 million to $183 million YoY. The company’s emphasis on coal-fired generation hurt, with its coal segment reporting the only YoY decline to EBITDA; the wind segment was flat and the natural gas and hydro segments reported gains, albeit insufficient to offset coal’s performance. Beyond its generation segments, however, TransAlta’s trading segment reported a $22 million YoY decrease due to volatility in the energy markets. Free cash flow increased slightly by $3 million to $23 million over the same period, although the company’s operating cash flow fell from $51 million to -$39 million. Outlook TransAlta took steps to reduce the uncertainty in its outlook during Q2, although several new headwinds have developed that will likely offset the positive impact of these steps. First, the company agreed to pay $56 million to settle market manipulation allegations in Alberta, bringing a multi-year saga to a close. Furthermore, the company’s aforementioned drop-down to TransAlta Renewables was the first stage of a process to reduce its debt load via further drop-downs. Moody’s recently announced that it is reviewing the company’s bond rating for a downgrade to junk status in light of its high debt load. In July, TransAlta agreed to purchase 71 MW of renewable capacity in the U.S., and this, too, could become part of a second drop-down to TransAlta Renewables that the company intends to use the proceeds from to further reduce its debt. The presence of very warm temperatures in Canada caused the company’s number of cooling degree-days to increase in Q3, allowing management to reaffirm its previous FY 2015 EBITDA guidance during the earnings call , albeit at the lower end of the given range, despite the Q2 earning miss. The current year’s guidance is likely to receive further support by the development of a historically strong El Nino event, which is expected to keep temperatures higher than normal through September, potentially boosting air conditioner use and supporting electricity prices. These positive impacts could become negative in FY 2016, however. Past El Nino events have been associated with below-average winter precipitation levels, especially in Canada’s western half. Many regions of Canada are already suffering from drought and, given the large number of hydroelectric facilities that TransAlta operates in many of those same regions, it is feasible that an especially strong El Nino could ultimately result in lower availability starting in Q2 2016. TransAlta’s outlook worsens still further beyond 2016. May saw the election of a left-of-center provincial government in the historically conservative Alberta. More recently the centrist Liberal party, which favors restrictions on greenhouse gas emissions, won Canada’s national election and will replace the outgoing pro-business Conservative party. The new governing party is expected to support clean energy initiatives, in part by placing national restrictions on coal-fired generation facilities. Given an average contract term of 5.5 years, TransAlta’s coal segment will need to establish new power purchase agreements relatively soon after any new environmental policies become entrenched. Two of its alternatives, the use of carbon capture and sequestration at its coal-fired facilities and conversion to natural gas from coal, offer ways around this hurdle while incurring additional costs. Carbon capture and sequestration, in particular, is unlikely given the high costs that it incurs despite years of industrial R&D. Conversion to natural gas is more important and while this will incur conversion costs, it is preferable to simply shutting down coal-fired assets that have up to 30 years of effective productivity remaining. A more pressing matter is the continued presence of low petroleum prices in North America. The health of Alberta’s economy has long been linked to petroleum prices, with the province experiencing lower growth and falling construction rates during previous petroleum bear markets in the early 1980s and again in 2009. Likewise, TransAlta’s share price lost most of its value in late 2008 and early 2009 as petroleum prices fell, although crude’s rapid rebound prevented this from being reflected by a steep drop to its annual earnings in either year. The duration of the current low price environment is very important to TransAlta’s outlook due to its current debt situation. The company has $1.1 billion (mostly denominated in U.S. dollars) of debt that matures in FY 2017 and FY 2018, with another $400 million maturing in FY 2019. Its ability to repay these loans while also financing its planned capex and potential acquisitions will be very dependent on the economic health of Alberta, especially given the company’s plans to increase its share of the province’s generation market. While I do not expect petroleum prices to remain at their current levels for such an extended period of time, potential investors should be aware of the potentially severe financial repercussions to the company that would result from such a situation. Valuation The consensus analyst estimates for TransAlta’s FY 2015 and FY 2016 earnings have been revised significantly lower over the last 90 days in response to its missed Q2 earnings report and mounting headwinds, management’s reaffirmed guidance notwithstanding. The FY 2015 diluted EPS estimate has fallen from $0.23 to $0.12 while the FY 2016 estimate has fallen from $$0.29 to $0.23. Both of these results would be well below the company’s 5-year highs. Based on a share price at the time of writing of $5.25, the company’s shares are trading at an adjusted trailing P/E ratio of 105x and forward ratios of 43.8x and 22.8x, respectively. Even the FY 2016 ratio is well above the company’s respective historical range, suggesting that the company’s shares remain very overvalued despite their poor performance in FY 2015 to date. While a recent anonymous report suggested that TransAlta had been very close to selling itself , buying at the current price level would require the presence of very optimistic assumptions regarding future operating conditions for the company. Conclusion Shares of Canadian electric generator TransAlta have lost nearly half of their value over the last six months and are currently trading at only a fraction of their historical high price. While such a negative market reaction often indicates the presence of a value investment opportunity, potential investors in the company should be wary of the numerous pitfalls that sit in its path over the next several years. Low petroleum prices are already causing Alberta’s economy and construction market to slow, hindering the company’s plans to further increase its share of its largest market. Likewise, the removal of the Conservatives from both Alberta’s government as well as Canada’s national government since May make it likely that the company’s heavy exposure to the coal-fired power segment will hamper its overall earnings in the coming years as existing restrictions on greenhouse gas emissions are strengthened and future ones are enacted. With a share valuation that is much larger than its foreseeable earnings potential, a large debt load, and free cash flow per share that has been less than half of the company’s dividend per share in recent quarters, TransAlta is a very risky prospect for investors. There is a chance that a buyout could occur on favorable terms, resulting in a modest gain for new investors. I consider the probability of this occurring to be quite small compared to the potential for further losses in light of how overvalued the company’s shares are at the time of writing, however. Yield-seeking investors are encouraged to look elsewhere. Scalper1 News
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