Description

I believe these TransAlta (TA) prefs series E provide a well covered yield of 7.5% (sorry for delay in getting this write-up out as it moved a bit since late last year) and opportunity for a re-rate. Although the absolute return potential is not high, I believe there are enough reasons to make me feel comfortable these prefs are mispriced:

1)     In Canada, many preferred shares are fixed-resets which means there is a reference floating rate that gets fixed for a period of time. With a drop in Canadian yields in late 2018, there has been indiscriminate selling these prefs generally

2)     Uncertainty in the Alberta power market structure

3)     Credit downgrade

4)     TA prefs being removed from S&P preferred index

Because of the above, I think the market is missing these positives:

1)     Prefs are well covered by EBTDA (basically EBITDA after debt interest)

2)     Brookfield agreed to receive prefs this year on the same basis as existing ones at a 7% yield

3)     Funding is secured for the capex plans so FCF should remain positive, although depressed in the near-term

4)     TA tried to cancel/reduce these prefs before via a conversion offer that didn’t work

5)     TA provided solid guidance and near-term visibility to its EBITDA

Background

I previously wrote up TransAlta (common) – please refer to it for company background: https://www.valueinvestorsclub.com/idea/TRANSALTA_CORP/4717374933

Basically, TA is a power producer that largely generates power in Alberta, Canada from coal. To sum up the last few years’ in a few sentences, I would say TransAlta common shares were attractive back in 2016 because the market really disliked:

1)     Low power price environment due to energy slowdown in Alberta

2)     Uncertainty around carbon tax and, implicitly, the phase out of coal based power production in Alberta

3)     Uncertainty around the power market structure in Alberta (regulated to a capacity market)

Back then, it was difficult to predict how things will turn out for TA but it was not reasonable to assume power prices stay low, TA’s coal assets get stranded and TA stays unprofitable for extended periods of time – hence the “high uncertainty, low risk” opportunity. It turns out power prices did recover and the Alberta government did reimburse TA for the stranded coal assets – although the power market structure was still uncertain.

Most recently, TA is entering a phase where it plans to:

1)     Wind down or convert its existing coal plants into gas fired plants

2)     Unlock value by investing in its hydro assets, especially as those assets exit set purchase power agreements (and get a lift)

3)     Continue invest in renewable energy assets, primarily via its TransAlta Renewables vehicle

Generally speaking, the above initiatives make sense but was inherently hard to execute on due to significant capex requirements in the C$2 bln range (on top of maintenance capital of ~$250 mln a year) – in the context of TA estimated to generate C$900 mln to C$1 bln of EBITDA per year.

Already under pressure from activist shareholders, TA tackled the potential funding gap issue by announcing a C$750 mln agreement with Brookfield Renewable Partners that will help fund the coal to gas plant conversions, share buybacks and other general purposes. Brookfield will provide $400 mln through getting exchangeable debentures and $350 mln in preferred shares in October 2020.

https://www.transalta.com/investors/press-releases/transalta-announces-strategic-investment-by-brookfield-renewable-partners/

It is important to highlight that a sophisticated and large common shareholder, Brookfield, is willing to take a 7% preferred issue (i.e. Brookfield probably thinks a fair yield for the prefs is lower than 7%) in October 2020 that is on the same terms as the publicly traded prefs. Granted it has conversion rights in 5 years (but is illiquid compared to the publicly traded prefs), the public markets continue to price TA prefs in the 7.5%-8% which seems bizarre.

So Why are the Prefs Mispriced? Lower Yields, Credit Downgrade and Index Deletion

I think the TA prefs are mispriced for 3 main reasons.

First, there is an idiosyncratic aspect to Canadian pref shares in that many are structured as fixed-resets – meaning they reference a Government of Canada benchmark yield plus a spread and it gets set/reset at pre-determined intervals. In the case of the TA pref series E, it was initially fixed at 5%, then reset to the 5 year Canadian Government benchmark rate + 3.65% in 2017 and gets reset every 5 years thereafter. With the 5 year Government of Canada yield dropping from ~2.5% to ~1.55% in late 2018, sentiment for these types of prefs turned sour, especially amongst retail investors (target market for these prefs).

Second, despite securing a funding agreement with Brookfield (i.e. positive), backward looking rating agencies decided to downgrade TA’s debt (to BB+ from BBB-) and pref rating (to B+ from BB) in June 2019 – presumably on uncertainty with power markets, heavy expected capital spending, etc.

https://www.spglobal.com/marketintelligence/en/news-insights/trending/grCF6TIfzh4yKpdfPFk1YQ2

Third, a month later (July 2019) S&P Dow Jones decided to kick TA prefs out of the S&P/TSX Preferred Share Index.

Naturally, between retail investors and institutional investors that have to pay attention to index constituents and debt/pref ratings, there are not many types of investors left who would be interested in these prefs – exactly why its interesting.

Prefs Well Covered on Fundamentals

Obviously, there are lot of assumptions required to estimate TA’s annual EBITDA. Roughly speaking, I would say under most circumstances, TA should generate between $700 mln to $1 bln in EBITDA annually in the near to medium term. With ~$240 mln per year in interest expense, there is $460 mln to $760 mln “leftover” to service $60 mln in preferred dividends. In addition, it is highly unlikely TA would want to jeopardize its cost of debt ($3 bln in net debt) by messing with the prefs.

Interesting, TA just released its guidance for $925-$1,000 mln in EBITDA for 2020 and increased its common dividend: https://www.transalta.com/newsroom/news-releases/transalta-announces-2020-outlook-and-esg-targets-declares-increased-common-dividend-and-appoints-john-p-dielwart-as-the-next-chair-of-the-board/

TA Interested in Reducing/Getting Rid of These Prefs

Back in 2016 when the entire TA capital structure traded poorly, TA attempted to reduce its pref obligations by announcing a somewhat one-sided “preferred share exchange”. As these prefs have a $25 par value, an actual redemption would have been a big premium to their trading price at the time and TA thought they could reduce their pref obligations via a share exchange.

The point is TA probably sees these prefs as an expensive form of financing. I would suspect once the capital spending is done and their debt refinanced/extended, TA would do a combination of pref buybacks and, ultimately, redeem them.

https://www.transalta.com/newsroom/news-releases/transalta-corporation-announces-preferred-share-exchange/

Catalyst

TA issues prefs to Brookfield at 7% in Oct 2020

Credit agencies / Index committee realizes change TA is going through