Value Investing

Sui Generis Long Thesis For TransAlta

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Sui Generis Investment Partners is an absolute return investment fund that combines intensive research driven stock selection with a disciplined and robust risk management program.

The Fund is managed to protect capital through a proactive hedging strategy with low volatility and low correlation to equity markets.

The research team conducts in depth macroeconomic, political and financial research to identify sectors with the highest conviction for both long and short opportunities. Thorough fundamental company analysis is then conducted along with a variety of valuation methods including free cash flow generation, or cash burn analysis.


Understandably Misunderstood TransAlta

There are companies we analyze whose value (or lack thereof) is apparent after very little research. A straightforward business model, corporate structure, or financial statements typically allow us to discern fairly quickly whether or not we have an interest in the company, on either the long or short side. And then there are the companies that at first glance you can barely tell what you’re looking at.

Often, a convoluted corporate structure and opaque financial statements point us in the direction of shorting a stock as there is an instinctive compulsion to look critically at something you don’t fully understand. From time to time, however, we come across an intriguing company whose complexity is masking deep value we can (eventually) identify – in today’s case it’s TransAlta Corporation (TA-T). For the uninitiated, TransAlta is an Independent Power Producer (IPP) with coal, hydro, wind and natural gas power generation assets in Canada and the US, making it the second largest generator of renewable energy in Canada. Our long book is typically made up of strong free cash flow (FCF) generating companies and TA fits the description well, though with some unique characteristics.


Following an aborted private equity takeover of TA at $39/share in 2008, the stock began falling and essentially didn’t stop until last year. We are going to spare you the pain of an organizational chart of Transalta’s business, but needless to say, there are an awful lot of arrows. It’s an oversimplification but the easiest description of the company is that Transalta had historically been a coal-fired power producer originally focused on Alberta, and over time had built up a reasonably large renewable energy portfolio. In 2013 that renewable energy business was spun out into the creatively named TransAlta Renewables (RNW-T). Subsequent to the spin out, TA has engaged in several transactions with RNW, referred to as “drop downs”, whereby TA effectively sells RNW additional renewable energy projects from the TA portfolio in exchange for shares of RNW. The result is that TA currently owns 64% of RNW, which is where things get interesting. Both the quality of the assets that have been dropped down and the higher multiples afforded to renewable power generators have conspired to give RNW a market capitalization well in excess of TA’s, making TA’s ownership stake in RNW worth more than its entire market cap – much more, in fact.


Why Are We Getting TA Shares For Less Than Free?

For context, TransAlta net of their RNW investment has traded as high at $8/share inside of the last three years, so why does the market think that TransAlta proper is worth -$1.64/share now? Unsurprisingly, it’s a bit complicated but let’s go through the perceived issues and whether they may be misguided.

1. Issue: Coal-fired power generation is being phased out across North America and this process was accelerated by the Alberta NDP government in 2015 with a plan to rid the province of coal by 2030.

Solution: This was a legitimate concern. The idea that 40% of TA’s generating capacity in Alberta could be forced into obsolescence by 2030 without compensation was a frightening notion in 2015. Somewhat surprisingly, the provincial government did the rational thing and in November announced a compensation agreement with TransAlta whereby TA will be paid $37.4 mm cash for the next 14 years for a total of $524 mm to compensate for “stranding” capital TA had invested in their coal business, and to aid in the transition from coal to gasfired power generation at several of TA’s power plants.

2. Issue: Alberta’s power market suffers from chronic oversupply and thus low power prices given that it is an unregulated “merchant” power market in what is arguably the most carbon rich area of the world.

Solution: This is the most legitimate concern for us right now. Power prices in Alberta have been depressed for years and the government, recognizing that there was no economic incentive to invest in power generation, announced changes in the fall. The goal is to transition the market from “merchant” based (read: free market) to a more common “capacity” based, or one that pays companies like TA both for the capacity they could offer the market as well as for the electricity they actually generate. While the result should be far more predictable cash flow for TA, there has been little clarity provided by the NDP government surrounding their goal to transition this market to capacity by 2021, so the direction is positive but the details remain sparse. Neatly, this ties in nicely with solution number 1. TransAlta estimates that the cost to convert a coal-fired plant to gas is less than 10% of the cost of building a new gas-fired generation facility ($137 per KW vs. $1,600 per KW), so TA has a 90% cost advantage vs. any new companies considering entering the market and starting from scratch, and you may recall that TA’s conversion costs have been largely subsidized by the government via their compensation package.

3. Issue: TransAlta has too much debt.

Solution: TransAlta does in fact have a lot of debt…US$4.103B of total recourse debt. We believe it is fully supported by very strong free cash flow and this is where the opportunity for strong equity returns lies, so this is the topic on which we will spend the bulk of our time. TransAlta fits into a FCF-driven concept we call Enterprise Value (EV) accrual. The idea is our attempt to identify who has the largest claim to a company’s underlying assets. If the company is heavily indebted, most of the value accrues to the debt holders; if the company has no debt, it’s all for the equity holders. Then there are interesting situations where you can identify a shift from one to the other, and that is what we believe is happening here. Effectively, a company that has a large debt load (like TA) may appear overlevered and thus expensive on an EV/EBITDA basis – in this case, TA trades at about ~7.5x EV / 2017E EBITDA. TransAlta’s 2017 FCF guidance at the midpoint is $332 mm with a stated goal to continue reducing debt. Let’s assume that TA reduces their net debt by ~$300 mm in 2017, which translates into a $300 mm drop in enterprise value. Assuming the EV / EBITDA multiple remains constant, the shares should appreciate by the amount of the net debt reduction. Given companies with cleaner balance sheets typically enjoy multiple expansion, the benefit to shareholders could be even greater if TA’s EV/EBITDA multiple expands rather than remaining flat.

The Stub

Ideally we’ve just convinced you that TA is a reasonably cheap stock – this is the point in the note where we make it painfully clear, so please bear with us. If an investor wished to isolate just the value of TA, shorting RNW while being long TA will lead to what we call a “stub”; what’s left over after deducting the value of RNW shares is -$1.64/ share when simply looking at market capitalizations. The more interesting calculation is working to establish the operating earnings that can be assigned to that stub, or trying to figure out the EV/EBITDA of just the stub. This is where it gets more complicated, but more compelling.


Buying the stub gives you exposure to a fully functional, strong free cash flow generating independent power producer at an EV/EBITDA multiple of 3x, while peers all trade above 10x; even TransAlta Renewables itself trades at 10.1x.


We think investors will make a good return owning TA shares over the next several years given our belief that strong free cash flow generation, multiple expansion and regulatory certainty should all come together to drive the shares higher. However, we suspect you will not get the opportunity, as TA looks like a prime takeover candidate to us. It is worth noting that Brookfield Asset Management, operator of many power generation assets and ubiquitous purchaser of cheap assets, has taken a 5% stake in the company. Perhaps not surprisingly, TransAlta management dramatically increased their “change of control” compensation from a combined $23.4 mm to $34.7 mm for the top five executives this past year. As egregiously high as these numbers are, it appears they are readying themselves for what we think is inevitable. While we do not need a takeover for the trade to work and we believe a higher return will be achieved if this does not happen, management now seems aligned in one particular direction.

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