TA:CC - The TransAlta Merger: Thoughts And A Potential Double-Digit Yield Play

2023-07-11 15:57:54 ET

Summary

• On our last coverage we had chosen TransAlta Corporation over TransAlta Renewables.
• The offer this morning for TransAlta Renewables by the parent was likely less than what long suffering bulls wanted.
• We analyze the offer and tell you why it's close to adequate if not adequate.
• We go over a potential play that could be a low risk double-digit yield down the line.

Note: All amounts discussed are in Canadian Dollars

On our last coverage of TransAlta Corporation ( TAC ) ( TA:CA ) and TransAlta Renewables Inc. ( RNW:CA ) ( OTCPK:TRSWF ), we appreciated the potential in both the parent and the daughter companies. We stuck with TAC as our calculations showed that it was significantly more undervalued than RNW.

Brookfield has shown an interest in RNW assets in the past and currently holds a stake in TAC . We still like TAC here and are maintaining a "Buy" rating on it. For RNW, there is still value and the sum of the parts suggests that it is undervalued. It is still trading at 9.0X EV to EBITDA vs. 13.5X for AQN and 16X for BEP. We are maintaining a Buy rating there, with the disclosure that we primarily hold TAC.

Source: Why We Still Prefer The Parent

The plot thickened significantly since then. We were looking pretty smart for our choice until the news came out this morning.

That news was that TAC would buy out RNW at a modest premium.

"A special committee of independent directors of RNW undertook a comprehensive process with its own independent advisors to negotiate the Agreement to ensure fair value for RNW, and we are pleased to recommend this Agreement to our shareholders."

Under the terms of the Agreement, each RNW Share will be exchanged for, at the election of each holder of RNW Shares ("RNW Shareholders"):

• 1.0337 common shares of TransAlta (each, a "TransAlta Share"), or
• $13.00 in cash.

The consideration payable to RNW Shareholders is subject to pro-rationing based on a maximum aggregate number of TransAlta Shares that may be issued to RNW Shareholders of 46,441,779 and a maximum aggregate amount of cash of $800 million. The transaction will be effected by way of an arrangement under the Canada Business Corporations Act (the "Arrangement").

The consideration payable to RNW Shareholders represents an 18.3% premium based on the closing price of RNW Shares on the Toronto Stock Exchange ("TSX") as of July 10, 2023. The total consideration paid to RNW Shareholders is valued at $1,384,051,812 on July 10, 2023, of which $800 million will be paid in cash.

Source: Seeking Alpha

We will now explore this deal from both sides and weigh in on the fairness of the merger. We also will look at what the odds are for a higher closing price.

The RNW Perspective

RNW was one of the most promising renewable energy plays on TSX. Alongside a parent who had multiple assets to drop down, the company also boasted of a very low debt to EBITDA base. It got off to a fantastic start with rapidly-rising revenues and it threw in a few dividend raises as well.

The dividend did flatline after 2018 and RNW struggled to move its cash flow per share higher. This was unusual in a way as RNW was maintaining a debt to EBITDA of close to 2.5X at the time . Generally markets tend to reward such players with a higher equity multiple and that allows them to grow accretively. But RNW was always valued at the very low end of the sector. Issuing equity at those prices was not feasible and the growth story was done before it really got going.

Still, it made for a solid dividend stock and a rare value play amongst the expensive names in 2021. Unfortunately, RNW had to grapple with the fallout at Kent Hills Wind Energy Project.

The Kent Hills 1 and 2 wind facilities are not currently in operation following the tower failure event that occurred in September 2021. This event has taken approximately 150 MW of gross production offline temporarily as the Company replaces all 50 turbine foundations at the Kent Hills 1 and 2 wind facilities. The extended outage is expected to result in foregone revenue of approximately $3 million per month on an annualized basis (to the extent all 50 turbines at the Kent Hills 1 and 2 wind facilities are offline), based on average historical wind production, with revenue expected to be earned as the wind turbines are returned to service. Each turbine at Kent Hills 1 and 2 wind facilities will return to service as soon as its foundation is replaced and the turbine is reassembled and tested. Rehabilitation of the Kent Hills 1 and 2 wind facilities is well underway. All of the towers have been fully disassembled with foundation demolition and removal nearing completion. Construction of new foundations is progressing well, with approximately two-thirds of foundations poured. Tower reassembly is also progressing with 13 turbines reassembled to date and associated commissioning activities commenced. We continue to target returning all turbines to service in the second half of 2023. The current estimate of the capital expenditures is approximately $120 million, inclusive of insurance proceeds.

Source: RNW Q1-2023 MD&A

The remediation work there blasted a hole through its dividend coverage and put the final seal on its growth prospects. Further complications arose as cash taxes were slated to rise in 2024 and push dividend coverage well below 100% on a sustainable basis.

Was the company still undervalued at $11.00 CAD, before the offer? Yes. Look at Brookfield Renewable Partners L.P. ( BEP ), Algonquin Power & Utilities ( AQN ), and Northland Power Inc. ( NPI:CA ) below in the same sector. Note that the 7.27X EV to EBITDA for RNW is after the 18% price jump today.

The TAC Perspective

RNW directors have a duty to maximize the share price and the sale is in line with that. The rub here is that the parent has a controlling stake and TAC is not interested in getting rid of that regular cash flow. TAC's non-RNW business is a higher risk play and it's a power provider, not a regulated utility. Most investors confuse the two and there's at least some justification that TAC is valued at a 5X EV to EBITDA.

RNW's assets help make the business a little less volatile. Could they sell the whole RNW outfit to a third party? We think they must have explored that but likely did not get enough interest at a price that made sense.

Is The Price Fair?

There are two ways to look at that. The first way is that you're giving up RNW, a stock that is inarguably undervalued. But you can get TAC in return, a stock that at least we would wager is far more undervalued . Yes, you can take the cash but you also can opt for the TAC shares. We think the TAC shares will be undersubscribed. We will add here that we have had to choose between TAC at the about the current price and RNW at $13.00 CAD, several times, and each time we choose to invest in TAC. So that should show you what we think about the two at around these prices. We like the deal from that perspective.

The second way is to examine the cash value and there's a case that could be made that TAC is being a bit stingy. But things are not as rosy for the renewables segment as the perennial optimists believe. Here's one recent example with commentary from Morningstar.

Duke Energy Corporation ( DUK ) is one of the last U.S. utilities to sell its commercial renewable energy portfolio. In February, American Electric Power sold its 1.4 GW commercial renewable energy portfolio for $1.5 billion, including debt. While there are some differences between the portfolios, Duke's sale price marks a significant decline in prices in just four months as the macro environment remains challenging. The company's net $1.1 billion in proceeds was in line with our expectations, which we had lowered after Duke took nearly $1.5 billion in write-offs the past two quarters. Duke expects to take an additional $800 million pretax impairment charge in the second quarter.

Source: Morningstar (emphasis ours)

How To Play

TAC has the controlling stake here and is offering up its undervalued shares for those interested. Yes minority shareholders need to be given consideration but under the circumstances things are unlikely to get much better. Money is fleeing from yield plays as the risk-free interest rate continues to rise. Now, this deal is not written in stone. There could be challenges from large shareholders and we might not know for some time. A slightly higher bid is possible and we would definitely not rule it out. If you want to bid on that outside chance, the call premiums are extremely cheap. Below we show the $13.00 calls for June 2024 trading at just 50 cents.

Certainly the collective does not believe a much higher bid is coming and hence those options are cheap. For our part if we had the RNW shares, we would tender for TAC and call it a day. The company is firing on all cylinders and has raised its guidance twice in the last 12 months.

For those "yield-hungry" we would suggest exchanging RNW for TransAlta Preferred shares. We like TransAlta Series A shares ( TA.PRD:CA ).

They currently yield 5.85% and reset on March 31, 2026 at Government of Canada five-year bond yield plus 2.03%. At the current price and the current yield for the benchmark, the reset would be at 6.01% on par . That on the current price would work out to a 12.22% yield . So for those believing that we are in a higher interest regime, that is the play we would go for.

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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