2023-05-09 08:03:53 ET
Summary
- I wrote about TransAlta Renewables a few months back, only a short time before the company significantly declined. My own small position is double-digit in the negative.
- Going by valuation, you might think something is wrong in the company's fundamentals or near-term future. However, I will argue that this is not the case.
- I consider TransAlta Renewables to still be a solid "BUY" - with the following fundamental upsides.
Dear readers/followers,
I believe it's time to update the thesis for a smaller investment in my portfolio - TransAlta Renewables ( OTCPK:TRSWF ). The company is one I reviewed a few months back in December of -22. My returns for the investment until then have been somewhat sub-par, with double-digit declines compared to a 1-2% RoR from the S&P500 in the meantime. Obviously, not an ideal sort of result, but any investor will inevitably go into an investment "too early" - and will certainly make mistakes, going for companies that he or she shouldn't be in.
So which one is TransAlta Renewables?
I believe this one is a company that was bought somewhat too early, despite what I considered to be an attractive valuation at the time. Now we're down lower, and we'll see what the company delivers at the current price.
TransAlta Renewables - Plenty to Like, but plenty of volatility as well
As I mentioned in my initial piece, TransAlta Renewables comes at a bit of a risk - but also with some safety, not in the least due to its close ties to the Canadian Giant TransAlta ( TAC ), where it is a daughter company.
I do invest in several monthly dividend payors. These usually come in the shape of very qualitative operations, such as Realty Income ( O ), and Agree Realty ( ADC ). Even when they're somewhat smaller, I'm still very cautious about investing in them, such as Exchange Income ( OTCPK:EIFZF ). TransAlta is one of the remnants in my portfolio of a time when I was a lot more liberal with my investments and focused much more on the income side of things. I still like my income, but I now demand a much more qualitative base to work from - which is why I'm no longer buying royalty-based business trusts or the like - at least not until they're excessively cheap.
However, TransAlta's underlying operations are superb. The company has billion in equity value and is a monthly dividend payor with over a 7% yield. That dividend hails from a diversified asset base in the, as the name suggests, renewables sector in key geographies in the USA, Canada, and Australia, respectively. The company now has over 45 facilities. Most of these assets are contracted, with an average contract life of around 12 years, which is conservative, to say the least.
The way the stock has moved would suggest to you that this company is in some type of trouble in terms of debt. However, this is not the case. RNW has a debt/equity of less than 0.46x, a debt/EBITDA of below 2x, and interest coverage of over 2.4x. While it doesn't "win" in cash/debt and doesn't have sector-best RoE and RoA/ROIC numbers, it still impresses with high gross margins, high operating margins, and high net profit margins - which is generally what I want to see first of all.
In short, TransAlta operates a working business , where top-line growth is turned into profit for its shareholders. It is not excessively laden with debt, and has, generally speaking, been able to grow its stockholder equity decently over time. It isn't until the last few years that growth has become somewhat anemic, which is also expressed by the way the share price has been moving.
A quick glance at cash flows and returns confirms that while revenues have been climbing, with records in 2022, the actual cash flows from those top-line results have been flat or declining for a few years at this time.
In fact, looking at financials, you could be excused to think that this company is slowly falling into the "dividend trap", focusing excessively on income while the company's fundamental operations decline. From a business model side, nothing really springs out as worrying. The company is taking solid revenue and turning it into a solid net income at a margin of over 13%. This is neither bad nor worrying.
The risks to the Renewables daughter of TAC are operational and specific. Specifically, the company had to excessively spend on sustained CapEx on some major portfolio assets - and this is a picture that won't improve in the near term.
The positives to this company though, is that TAC remains a major owner of this company, which means that what RNW decides to do with its dividend won't depend on what debt markets or S&P Global thinks - it doesn't have a credit rating. Any decision will likely be made on the management/c-suite level. Even if the company were to cut that dividend, I wouldn't be selling, I would probably be flirting with the idea of adding more to my holding, based on a fairly few set of simple assumptions/stances.
First off, RNW is extremely conservatively leveraged. At 1.7x net debt/EBITDA it can't even be compared to something like Algonquin ( AQN ), which was above 6x. It's been extremely good about using debt, meaning very little, and mostly low-cost project debt, and also has access to plenty of credit when needed.
I wouldn't give much credence to the historical growth rates and value creation on a historical basis beyond confirming that; "Yes, the company did indeed manage that."
The reason I am saying this is because we need to consider an entirely different environment for RNW going forward, one with low growth due to most of the company's funds going to the payment of the dividend. The dividend payout ratio is climbing, and I consider it likely that it will go above 100% during this year.
There is also the danger of near-term contract expirations, which combined with the already-present pressure on cash flows could cause the company to have to cut that dividend, unless they find suitable replacements in time. The RNW company was created to provide income with exposures to an attractive set of renewables assets, and while in the longer-term future it might achieve this goal with stability, it currently does not meet this objective with the stability a conservative income investor would desire.
For that reason, I'm being careful here, and keeping my exposure relatively small.
However, a few things make the company at least theoretically attractive here.
TransAlta Renewables has a lot of potential upside - but you're required to be patient
I forecast TransAlta on the basis of OCF and EV/EBITDA. Accuracy for these forecasts based on analysts I follow is so-so. There's a 25% 2-year forward miss ratio on a negative basis, but a 25% tendency for the company to beat, and a 50% to hit the target accurately. That's for FactSet. The current upside based on that OCF growth is reverting in 2023, going back down due to CapEx and expirations in 2024, only to go back up again in 2025.
The relative upside to a 12.5x P/OCF in this context is around 20% per year - which combined with the near 7.5% yield should explain to you why I'm generally positive about this company.
That makes this a not-uninteresting play for income-oriented investors, though I wouldn't go so far as to call this a "retirement stock". There's too much risk baked into it for it to be that.
Still, the company does have a sort of upside. Results could send the company trading at less than 7.5x OCF, it's currently at 11.4x, and you'd still be "making" money based on the current yield. That's a decent safety cushion. Also, S&P Global analysts consider the company, despite massive target cuts from $19/share average to $13.4, to be 6.3% undervalued here - though few of those following the company consider it a "BUY" here.
Being a contrarian investor with an eye for value, I do say that RNW does have a certain amount of risk here - and that should not be underestimated. However, by every consideration and metric, RNW has now fallen "far." Over the past few years, the company has typically traded at a NAV on a per-share basis of 1.1x, and that is now 1x. Even with the forward assumptions of flat EBITDA, or low growth rate, I still say the market has moved a bit far with the company in sending it down.
The company has not touched its dividend since 2018. The current forecasts from S&P Global do not allow for that dividend to increase, which is something I agree with. However, the current forecasts also do not see that dividend decline, which is something I also happen to agree with, at least at this time.
You should not mistake the current results for the company having a weak or underfunded balance sheet though. RNW's balance sheet is strong, and despite signals to the contrary when it comes to growth, recent earnings calls trends do support the prospect of more growth moving forward.
You're right. The balance sheet is strong. We're still doing a significant amount of growth. It's in the hundreds of millions of dollars of spend -- we do have just under 400 megawatts of advanced stage projects that we're looking on , on pushing forward. And again, that's a significant dollar amount to be able to invest and see that forward. And as you've seen, we've been very much focused on share buybacks over the quarter and then actually into April. I think, Todd, we've collectively done over the last few months to something like $65 million of share buybacks. I mean, so right now, the 2 major levers that we're pulling on would be share buybacks given where the share price is trading and also making sure that we're positioned well for growth as it comes in.
(Source: John Kousinioris, 1Q23 Earnings Call )
So the combination of share buybacks with further growth, coupled with this company's solid fundamentals, means that I don't think it's wrong to continue to take a positive stance at this particular time. By previous PT for RNW was a $16 CAD price, and I'm not shifting that here - these things and potentials were already considered when that was calculated.
My thesis for the company here is as follows.
Thesis
- RNW is a class-leading renewables operator, that is the daughter of a solid company, namely TransAlta. At times, the parent is the better buy - but at these valuations view TransAlta Renewables, with its monthly "paycheck" and a 7.4+% to be an absolutely solid choice, provided you recognize the risk the company does hold in case of a cut or a downturn.
- The company is fundamentally sound, has an attractive pipeline, and is very well-managed.
- I give the company a $ 16 CAD price target for RNW and consider it an appealing "BUY".
Remember, I'm all about:
- Buying undervalued - even if that undervaluation is slight and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
- If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
- If the company doesn't go into overvaluation but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
- I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
The company fulfills all of my criteria, despite currently lacking a credit rating. However, I view it as safe enough despite this. The most conservative of us should look elsewhere though, and I wouldn't go more than 0.5% in this particular investment.
For further details see:
TransAlta Renewables: High Risk, But Good Opportunity