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  TransAlta's shifting power price problems

BENJ GALLANDER and BEN STADELMANN

Monday May 25, 2015

As contrarian investors we are used to corporations dealing with a host of problems. Sometimes these are self-inflicted — often technological change and an evolution of the competitive landscape is to blame. On occasion though, a stock will get hit by a bolt from the blue, causing an immediate knee-jerk reaction from the market.

Such was the case on May 6, when traders went into a tizzy after the historic landslide NDP win in Alberta. While fund managers rued the new government's promise to review royalties and the potential impact on industry giants such as Canadian Oil Sands, Cenovus and Suncor, electricity generator TransAlta (TA-TSX) also took it on the chin. Why the knock on a utility, especially since, as some political wags have suggested, a socialist Alberta indicates that hell has finally frozen over? Mightn't we need to turn up the thermostat?

This comes down to dirty old coal, on the way out in much of Canada but still hanging in for more than half of electricity production in the Wild Rose province. The federal government already has a long-term plan to phase out coal, with all such plants to be retired at the end of their 50-year lifespan. The fear is that premier-elect incoming Premier Rachel Notley will stomp down on the accelerator so that coal will disappear into the rear-view mirror more quickly.

This notion appears to have more to do with general uneasiness among the business elite about a shift to the left on the political spectrum than actual fact. The NDP election platform made no mention of a tighter timetable; it merely echoed Ottawa's commitment to phase out coal and support renewable alternatives. Given the experience of Ontario, where the decrease in coal generation has been a key driver in the doubling of electricity rates over the past decade, whacking Alberta consumers with rate increases during the current economic difficulties would hardly seem to be a way for the NDP to maintain its new-found popularity.

Nonetheless, while in opposition, Ms. Notley did press the government to end coal-generated power by 2030, stressing its contribution to air pollution and greenhouse gas emissions. How would this affect TransAlta?

Surprisingly little. The utility has seen the writing on the wall for a long time and has its own phase-out plan. Two of the older units at Sundance are slated for closing in 2019, with the four remaining there, plus two units at Keephills, all retiring by 2029. That would leave Keephills 3 as the only coal plant remaining, a new-generation facility with advanced pollution controls and lower emissions.

TransAlta's real problem is not the future of coal, but what is currently happening with power prices in its primary markets. A year ago, the average wholesale price for electricity in Alberta was $61; now it's just $29. In the Pacific Northwest, the corresponding figures are $44 and $18. To a large extent the company has been shielded from this price collapse by its power purchase agreements (PPAs), long-term contracts that guarantee the price of electricity delivered. About 80 percent of generation is covered by PPAs; the remaining 20 percent is still significant and is hurting revenue. This is making CEO Dawn Farrell's job tougher, as she is already fighting a multifront battle, attempting to simultaneously reduce debt, improve the reliability of the company's generating plants and invest in new projects to deliver EBITDA growth.

TransAlta was purchased for the vice-president's portfolio last December at $9.81 with a price target range of $25.75 to $28.75. The corporation has certainly been through a rough patch, and it waited too long to cut its dividend as losses mounted. Management seems to have a better handle on a turnaround, and the majority stake in subsidiary TransAlta Renewables (RNW-TSX) is an attractive asset.

Much depends on the prevailing price of power when PPAs start to roll over in 2018. In the past, TransAlta's management has been confident that these would be renegotiated at better terms, leading to higher cash flows to spur future growth. Is this still a realistic prospect? The view here is that not too much can be read into the current disruption in power prices. Recoveries rarely occur as quickly as downfalls, whether they are economic or political, but we know a lot can change over the next three years.


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