Description

Executive Summary
Given long-term locked-in contractual cashflows with creditworthy counterparties, the Atlantic Power Series 1 Cumulative Preferred Stock offers an attractive risk/reward skew with a low probability of permanent capital loss while providing an annual 7.6% effective coupon. Over the longer-term, these Preferreds provide long-duration upside optionality via capital gains appreciation driving total IRR (dividends + capital gains) to 15.2% annualized through 2026 as a base case.

Atlantic Power is a diversified independent power producer generating revenue through the sale of power via long-term contractual agreements with primarily investment-grade utilities and industrial customers.   Approximately 95% of the companies operating cash flow for the 2020-2024 period is contractually locked-in and sensitivity of these cashflows to market conditions is immaterial.  COVID has no impact on the cashflows or the thesis.  The business is managed by an incentivized and shareholder friendly management team who has flawlessly executed a coherent deleveraging strategy since 2015.  

Note:

• Figures in this writeup are as of 12/31/2019 for simplicity unless otherwise noted.
• Financials are in USD and therefore all figures in this writeup are in USD unless otherwise specified.   Importantly, the Preferreds are priced in CAD and the price noted in the headline of this writeup is in CAD.  The Preferreds have been converted to USD throughout the writeup (for example, the Prefs in the 'Capital Stack' are in USD).
• Low trading volume - $54k USD traded per day. 

Overview
Atlantic Power (abbreviated “AT” given the underlying common stock ticker) is an independent power producer operating power generations assets, selling power to both utilities and industrial customers.   Revenues are derived from Power Purchase Agreements (PPAs) - PPA's are long-term contracts to sell the output from AT's power assets to its customers and are structured to largely mitigate commodity spot price risk.  

AT common stock has been previously pitched on VIC in 2015 and 2016 - the story is generally the same given management's continued execution on the strategy laid out in 2015 - the purpose of this writeup is to highlight the attractive upside/downside specific to the preferreds given management's execution.  

Capital Stack

AT remains a highly leveraged business which adds to its perceived riskiness presenting an opportunity for a variant view.   See below for the current capital stack -

Preferreds
There are three series of preferreds outstanding which account for the $137mm in Par value shown in the capital stack above.  I believe the Series 1 are interesting given the low interest rate environment but all three offer similar characteristics and may be more attractive given your books existing exposure.  See below for information on all three: 

Contractual Cash Flow Profile 

AT's clients are largely investment grade counterparties and its revenue/cashflow is locked in to long term PPA contracts with defined expiration dates (AT’s corporate credit rating itself is at the top tier of non-investment grade - rated Ba3 by Moodys and BB- by S&P). In many cases, once a PPA expires the contract is renegotiated albeit at a lower rate in recent times given the prolonged bear market in power prices.
 

The below shows a breakdown of AT's assets and existing PPA's for each asset-  including asset type, customer credit ratings, expected contractual cashflows via existing PPA’s and contractual PPA expiration dates.  This cashflow profile assumes no cashflows subsequent to the expiration of PPAs (with the exception of Manchief, which AT has agreed to sell at 3x EBITDA after PPA expiration in 2022), despite the fact that in many cases these PPA’s can and will be renegotiated at current market rates unless uneconomical to AT (of course, the asset can be sold as well). 
 

Preferred Dividend Sustainability
To demonstrate the sustainability of the preferred dividends, the below analysis walks through 1) the remaining Debt Repayment Profile and 2) the conversion of Project Adjusted EBITDA from above to FCF available to the Preferreds through 2035.

The results of this analysis suggest a strong likelihood of continued payment on the preferreds.   Unrestricted cash remains >$100mm for the majority of the forecast period before consideration of the $102mm credit facility available to AT which can likely be refinanced as AT continues to delever.  

Management Incentives and Capital Allocation
CEO 2019 Q3 prepared remarks:  "We don’t have a predetermined plan for capital allocation. Our approach is to assess the impact on our estimates of intrinsic value per share, while balancing risk and reward. We would invest externally only when we believe the returns are superior to those we can achieve by investing internally or repurchasing shares"

Current management ownership

• Since January 2015 when the CEO/his management team joined the company, Execs and Directors have purchased $5.1mm (avg price ~$2.20; all open-market purchases). 
• Insiders today own 3.4% of the company (~$6.4mm).  
• The CEO and 2 other execs have not had a salary increase since 2015.   Equity to salary ratios are as follows: CEO = 3.74x; CFO 2.75x; COO 4.35x.
• In terms of recent purchases, in May 2020 the CEO purchased $50k and EVP Commercial Dev purchased $35k common.  The CEO also purchased $50k in March 2020.   

Repurchases
In addition to $72mm (33.3mm shares) of commons repurchased since 2015, management has demonstrated a willingness to repurchase the preferred shares as well, which expresses a future willingness to accelerate these repurchases as the balance sheet deleverages.   Since 2015, management has repurchased $26mm across all series of preferreds (2.2mm shares). 

In Q1 2020 alone, management repurchased 382k shares of the Series 1 (roughly 10% of the remaining Series 1 shares).  

History of debt paydown and expense management

• The company has reduced debt by > $1.2bn since 2013 resulting in $89mm in annual interest savings (and improved credit ratings -> cheaper cost of capital)
• The company has reduced overhead costs by 56% since 2013.  In 2015, the CEO moved the headquarters from the financial district in downtown Boston to the suburbs in Dedham, Massachusetts to save costs.

Recent asset purchases and sales
Management has opportunistically deployed capital and raised cash through asset purchases/sales.  These deals make it clear that there is likely some value to the underlying assets upon PPA expiration.  

• In 2018 - acquired remaining 50% interest in Koma Kulshan (Hydro Asset) for $13.2 million.  ~10x estimated pro forma Project EBITDA. 
• In 2019 - acquired 4 biomass plants (South Carolina, North Carolina, Michigan) paying ~3-4x Project EBITDA.
• In 2019 - reached an agreement to sell Manchief (Natural Gas Asset) to the customer under the PPA in May 2022 following the expiration of the PPA. (AT retains ownership and will continue to realize the cash flows for the remaining PPA term).  Sold for $45mm or 3x Project EBITDA.  

Valuation
Management's primary objective is to continue to execute on its deleveraging strategy resulting in a ~$0 net debt company at the end of 2025, resulting in the $137mm of preferreds sitting at the top of the capital stack.  Management has flawlessly executed on its deleveraging strategy since joining the company in 2015 and there is little reason to suggest this will not continue. 
 

To the extent the market acknowledges the deleveraged balance sheet, the preferreds will benefit from a repricing of the 4.85% fixed coupon to par (probably worth a premium to par if rates stay low and power prices rebound).   At a $15.95 purchase price, assuming $1.21 is collected each year via coupons (4.85% fixed * $25 par) and assuming these do not reprice to $25 par until 2026, the total IRR = 15.2% annualized.  Management has demonstrated a willingness to repurchase the preferreds depending on relative attractiveness to the debt/common & will likely do this at an accelerated rate as debt is repaid - to the extent repurchases continue and accelerate the repricing to par, IRR would of course be higher.  

Beginning 2026, the company will have cumulative $387mm of locked in contractual cash flow through 2035; assuming G&A reduced by 25% given ~50% drop in assets and assuming ~$50mm in capex, FCF available for prefs would be roughly $169mm cumulative through 2035 which covers the preferreds.   Another way to look at this is to assume the Hydro assets can be sold at a lowballed 5x EBITDA and the remaining assets can be sold at a draconian 1x EBITDA multiple, which would equate to $355mm in EV, also completely covering the preferreds.   (Hydro assets have very long useful lives, low marginal costs, and management believes these are the most significant component of the terminal value given expectations of strong cash flows post PPA expiration).

Why does this opportunity exist?

• Long term capital is required - this is a long-term deleveraging which may take a few years to reap the rewards of capital appreciation, despite the attractive IRR

• Perceived exposure to commodities prices in a bear market

• Canadian listed preferreds, US assets

• Low trading volume

Risks

• Interest Rate Risk specific to the preferred coupons (note that as of 12/31/2019, more than 99% of the debt in the capital stack is carried either a fixed rate or a variable rate that has been fixed through interest rate swaps & through December 2021, approximately 93% of the companies debt is either fixed rate or swapped)

• Prolonged and worsening power markets coupled w/ a reversal from the strong capital allocation exhibited to date by management

• Operational risk in executing contracted PPAs

Catalyst

Continued deleveraging resulting in a tightening of credit spreads -> capital appreciation