Published by Nick McCullum on July 6th, 2017
The renewable energy industry is not well-known for housing high-quality, recession-resistant businesses. It seems that every quarter there is an announcement of a large-scale bankruptcy in this fledgling industry.
Because of this, most investors stay far away from renewables…
…which means this industry might be interesting for contrarian investors.
“The time to get interested is when no one else is. You can’t buy what is popular and do well.”
TransAlta Renewables (RNW.TO) (TRSWF) is one example of an under-appreciated company in the renewable energy industry.
Most investors are likely unfamiliar with this company, yet it is attractive for dividend growth investors for a number of reasons. First and foremost, it has an exceptionally high dividend yield of 5.7%.
That is nearly three times the average dividend yield of the S&P 500, and makes TransAlta Renewables a member of the short list of publicly-traded securities with 5%+ dividend yields.
Beyond its high dividend yield, TransAlta Renewables is also quite unique because it pays monthly dividends, instead of the traditional quarterly distribution schedule.
Monthly dividend payments are highly superior for investors that need to budget around their dividend payments (such as retirees). There are very few companies that pay monthly dividends.
TransAlta Renewables’ high dividend yield and monthly dividend payments are two of the largest reasons why this company will stand out to income investors.
However, extensive due diligence is required for any high yield security, to ensure that its payout is sustainable.
This article will analyze the investment prospects of TransAlta Renewables in detail.
TransAlta Renewables is a renewable energy infrastructure company with headquarters in Calgary, Alberta.
With an enterprise value of CAD$4 billion+ and a market capitalization of ~$3.5 billion, TransAlta is Canada’s largest producer of wind energy and is one of the country’s largest producers of renewable energy as a whole.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 4
The company operates through fives segments in two distinct geographies: North America and Australia. TransAlta Renewables’ Australia presence was initiated in March of 2015, when the company agreed to acquire Australian assets from its sponsor, TransAlta, for ~CAD$1.8 billion.
Today, TransAlta Renewables’ 5 segments are:
- North American Gas Fired
- North American Wind
- North American Hydro
- Australian Gas Fired
- Australian Gas Pipeline
The number of facilities in each segment along with its generating capacity can be seen below.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 5
TransAlta is a relatively new publicly-traded entity. The company’s initial public offering was completed in August of 2013 at a price of CAD$10.00 per common share. Today, the stock is trading at ~CAD$15.50.
Since its spin-off, TransAlta Renewables has delivered exceptional total returns, beating its benchmark (the S&P/TSX Composite Index) handily in every meaningful performance period.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 10
As shown in the previous section, TransAlta Renewables has delivered fantastic total returns since its initial public offering in 2013.
The company’s fundamental performance has justified its security-level performance, largely because of its strong track record of accretive asset acquisitions.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 9
From the above table, the majority of TransAlta’s asset acquisitions since its spin-off have been purchased from its sponsor TransAlta (TAC).
When TransAlta sells assets to TransAlta Renewables, it is called a ‘dropdown transaction’. These ‘dropdown’ asset sales have been a large component of the company’s growth since its inception.
TransAlta and TransAlta Renewables have a very strong relationship, driven primarily by TransAlta’s significant ~64% ownership stake in TransAlta Renewables. This aligns the interests of both companies and ensures that the dropdown transactions are beneficial for both counterparties.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 7
Looking ahead, dropdown transactions are expected to continue driving growth for TransAlta Renewables.
In fact, the companies have identified ~1,000 megawatts of potential dropdown candidates currently owned by TransAlta (shown below).
Source: TransAlta Renewables December 2016 Investor Presentation, slide 18
Unfortunately, TransAlta Renewables often issues additional shares to fund these dropdown transaction.
The company’s share count has more than doubled since its IPO in 2013, a bad sign for existing shareholders.
Prospective investors should keep in mind that if this company executives a poor asset acquisition, it will be hit with the double-sided negative effects of 1. poor absolute performance and 2. further shareholder dilution. This will result in very disappointing performance on a per-share basis.
Competitive Advantage & Recession Performance
Like most energy infrastructure companies, TransAlta Renewables’ competitive advantage comes from its asset base and customer relationships.
The company also benefits from its exposure to Australia, giving it a presence in a new country and adding some geographic diversification to its revenue stream.
The company sells its power generation to high-quality counterparties such as the Ontario Power Authority, BC Hydro, and NB Power – the governmental Canadian utility companies.
Source: TransAlta Renewables December 2016 Investor Presentation, slide 6
TransAlta Renewables was not a publicly-traded entity at the time of the last recession, so it can be difficult to determine how recession resistant this business is.
However, I would expect the company to perform reasonably well during a downturn. It is reasonably capitalized, with only $757 million of long-term debt at the end of the most recent quarter compared to $3.9 billion of total assets.
Further, the high degree of creditworthiness of its counterparties suggests that there is little default risk in its business model.
However, investors should keep in mind that the renewable energy industry as a whole is known for common bankruptcies. This stock should not be seen as a defensive portfolio position like a Johnson & Johnson (JNJ) or a Procter & Gamble (PG).
Valuation & Expected Total Returns
TransAlta Renewables’ expected total returns are composed of valuation changes, dividend payments, and growth in its profits (as measured by the non-GAAP metric of funds from operations).
As an owner and operator of energy infrastructure assets, TransAlta Renewables incurs significant non-cash depreciation and amortization charges that impair our ability to assess its valuation using the traditional price-to-earnings ratio.
The best alternative is to compare the company’s current dividend yield to its long-term average. Since stock price and dividend yield have an inverse mathematical relationship, higher yields mean more attractive valuations, all else being equal.
TransAlta Renewables currently pays a monthly dividend of $0.07333 per share, equivalent to an annual payment of ~$0.88. The company’s current stock price of $15.52 is trading at a dividend yield of 5.7%.
The following diagram compares TransAlta’s current dividend yield to its average dividend yield since inception.
TransAlta’s dividend yield is noticeably lower than its average dividend yield since inception, which indicates that this is likely not the best time to add to or initiate a stake in this company.
With that said, TransAlta Renewables’ dividend appears to be very safe even in light of its high dividend yield.
The company measures its dividend safety using the non-GAAP financial metric ‘cash available for distribution’, or CAFD for short.
In the most recent quarter, TransAlta reported CAFD per share of $0.37. The company paid dividends of $0.22 in the quarter for a payout ratio of 59%. TransAlta targets a payout ratio of 80%-85% using CAFD, which indicates that the company may accelerate its dividend growth in the near future.
It is quite rare to find a company with such a high dividend yield trading at such a reasonable payout ratio. The reason why this is possible is the use of a non-GAAP financial metric (cash available for distribution) rather than earnings-per-share.
Accordingly, it is important to understand exactly how TransAlta computes this metric. A reconciliation between CAFD and net income for the company’s most recent quarter can be seen below.
The remainder of the company’s future returns will be composed of profit growth, as measured by funds from operations (FFO).
The company’s FFO per share history since inception can be seen below.
TransAltra Renewables’ per-share funds from operations are actually lower than they were at inception. In part, this has been caused by the substantial increase in the number of shares outstanding.
With that said, I believe that secular tailwinds in the renewable energy industry combined with future dropdown transactions should allow this company to achieve 2%-4% per year FFO/share growth over full economic cycles.
All said, the company’s future shareholder returns are expected to be composed of:
- 5.7% dividend yield
- 2%-4% FFO growth
for 7.7%-9.7% returns over full economic cycles, before the impact of valuation changes.
TransAlta Renewables’ high dividend yield and monthly dividend payments are immediately appealing to income investors such as retirees.
However, due diligence is required to ensure that such a high dividend yield is sustainable.
This analysis suggests that the company’s dividend is very safe, as measured by the non-GAAP metric Cash Available For Distribution. Unfortunately, the company appears to be relatively overvalued compared to historical norms.
With that said, TransAlta Renewables still has appeal for investors seeking current yield.