Investor Update

Mar 25, 2019

Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the TransAlta Corporation Announcement Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. Thank you. Sally Taylor, Manager of Investor Relations, you may begin your conference. Thank you, Denise. Good morning, everyone, and thank you for joining us this morning. With me today are Don Farrell, President and Chief Executive Officer Brett Gellner, Chief Strategy and Investment Officer Christoph DeHout, Chief Financial Officer and John Cusanares, our Chief Growth Officer. Today's call is webcast, and I invite those listening on the phone lines to view the supporting slides, which are available on our website. A replay of the call will be available later today, and the transcript will be posted to our website shortly thereafter. As usual, all information provided during this conference call is subject to the forward looking statement qualification, which is set out on Slide 2 and incorporated in full for the purposes of today's call. All amounts referenced during this call are in Canadian courtesy unless otherwise stated. On today's call, Dawn will provide an overview of the transaction announced this morning. After her prepared remarks, we will open the call for questions. With that, let me turn the call over to Dawn. Thanks, Sally, and thanks to everyone for joining us to hear about our new strategic arrangement with Brookfield Renewable Partners. It's a transaction with a Canadian based global leader in clean energy generation that is supported by our largest institutional investor RBC. For TransAlta, it's a transformative deal and the benefits extend beyond the $750,000,000 capital injection. It's a strategic financing that will advance our transition to clean energy by funding our coal to gas investments, supporting our drive to grow TransAlta Renewables and allowing us to use our own free cash flow to enhance our balance sheet. And because we've entered into this important arrangement with Brookfield, all of our shareholders will benefit as we return capital earlier than expected through a significant share buyback program. Effectively, this arrangement allows us to complete our transition more quickly than expected with benefits to shareholders as we move through our final execution stages of our strategy. This transaction also crystallizes the value of our hydro assets today by entering into a transaction that bases the value of our hydro operations on higher cash flows, expected following the expiry of the PPAs in 2020 at a strong EBITDA multiple. Brookfield will also bring their vast and deep operational skills to our operations. And most importantly, the Brookfield team is aligned with the TransAlta team on the overall strategy for the company and its performance. By increasing their ownership of TransAlta to 9% through open market purchases of shares and by adding 2 experienced and highly revered directors to our Board slate, Brookfield is aligning with us to build a strong TransAlta for many years to come. So in summary, the transaction together with the strength that we have in our own free cash flow increases the ownership of a trusted and credible long term Canadian investor, advances our 100% clean energy strategy, crystallizes the value of our hydro assets, enhances our financial flexibility and maintains our ability to reduce our senior bonds to $1,200,000,000 by the end of 2020, add significant renewable and operating expertise to our Board, and finally, allows us to start the process of returning some capital to shareholders. And by also adding Bob Flex into our Board, we've increased our capability to be ready when the capacity markets start here in Alberta in 2022. Now let me address some key questions. 1st, why now and how did this transaction come about? Over the past several years, we've had many discussions with several strategic and financial players, including Brookfield, on ways to advance and accelerate our transition to a clean energy company so that our shareholders can share in the benefits in the near and the longer term. Over the last few years, we have assessed many alternative growth opportunities, many of which we've had to leave on the table. We have always known that the heavy lifting to reduce costs and deleverage would get us to the end goal. But like our investors, we too were frustrated by the time it would take to prove the value in our strategy. In recent months, we heard from institutional shareholders that while our strategy is on track, it's taking too long to execute and it lacks the catalyst needed to build the confidence of investors in this final leg of the journey. We also heard loud and clear that until we crystallize some of the value of the hydro through a market transaction, investors could remain skeptical for many years to come. As we closed on this potential transaction with Brookfield, our Board with the support of an independent special committee and our financial and legal advisors concluded that the overall arrangement with Brookfield would in fact accelerate our strategy to the benefit of our shareholders. This arrangement was by far the best option and it was far superior to continuing on the path of going it alone. So why Brookfield? One of our institutional investors told me, I've made lots of money by buying what Brookfield buys and selling what Brookfield sells. Today, they are buying into and partnering with TransAlta and supporting our strategy. This is very good news for all of our shareholders. Of equal importance, due to their operational expertise in hydro assets, Brookfield's team could construct a deal based on the future value flows of our hydro assets, something that others simply could not do. Frankly, there was no one that we talked to who could meet their mark. And since we were not prepared to sell an interest in these valuable assets at today's valuations, we needed a buyer who was prepared to recognize the future value that will be realized once the PPAs have rolled off. Brookfield was that buyer. Personally, I had to finally admit to myself that despite all our hard work to convince investors that the value was there, the only way to make that case credible was to execute a transaction that made the case for us. So why us? Brookfield recognized that our strategy is sound, our assets are high quality, our team is experienced and our future upside is significant. Additionally, the strength of our balance sheet today allowed Brookfield to invest confidently in TransAlta. Quite simply, our work to deleverage over the past 3 years provided Brookfield with the confidence to safely invest their capital with us. Finally, we both know that the future is gas and renewables. By coming on to the TransAlta Board, they gain great insight on how markets will work in the future. This is truly a win win transaction that is constructed in a very strong and powerful way to benefit both TransAlta and Brookfield. So let me turn to the financial part of the transaction. Over the next 2 years, Brookfield will invest $750,000,000 into TransAlta. We will receive $350,000,000 in exchange for exchangeable debentures later this year and $400,000,000 exchange for redeemable preferred shares in October 2020, both at a coupon of 7%. What makes this transaction so compelling and why we chose to do a conference call with you this morning is that these instruments can convert into a share of our hydro assets after December 31, 2024. The value exchange is based on a 13 times multiple of the average EBITDA for the 3 years prior to the conversion. They have the right to make their conversion starting in 2025 and if they haven't made their conversion by January 1, 2028, we can choose to redeem the instruments at par value. So why is this transaction so attractive to TransAlta? Those who know us well know that 2022, 2023 2024 are the 1st 3 years the hydro assets are fully off their PPAs and can sell into the market. Brookfield's share of the Alberta hydro assets is based on future value, not today's value. These cash flows are also adjusted for normal energy and ancillary volumes over a 10 year average. If we use the 2018 disclosure as a proxy for the future, this would value our hydro in the range of $2,500,000,000 with Brookfield owning approximately 30% of the assets upon conversion in 2025. There are also other benefits to the deal. Brookfield owns and operates approximately 18 gigawatts of renewable assets globally, a significant portion of which is hydro. As part of this deal, we will immediately set up an operating committee with Brookfield and TransAlta experts to ensure that we have the very best expertise running our fleet. TransAlta under all circumstances retains 51% ownership or more of a very important set of assets here in the Alberta system. We have ensured that all shareholders benefit from our strategic arrangement with Brookfield through incentives for their team to stay the distance on our overall strategy. Brookfield has the right to buy up to 49% of the hydro assets on conversion if our share price is over $17 a share by 20.25 and they still own over 8.5 percent of our shares. This alignment between TransAlta and Brookfield means that net cash flow reductions from their ownership stake in our hydro must be replaced by other investments. And $17 a share is a growth of about 11.5% per year from now until then. Now let's turn to our coal to gas conversion program. We told you on our last call that coal to gas conversions are highly economic and offer a strong return. And we told you that the sooner we get it done, the better. By ensuring that we have the capital to inject $350,000,000 into our strategy now, we can advance our conversions easily to the 2020 to 2022 period and we can be more aggressive about evaluating the benefits of an investment in a hybrid generator. Our new Board nominee, Bob Flexen, who formerly comes from Dynegy, has great experience and deep experience with this strategy and with the ups and downs of merchant markets. He will be a great addition to our decision making process as we move forward. So why return capital to shareholders through this transaction? We understand that TransAlta that TransAlta shareholders have waited a long time to see capital return to them since we reduced the dividend in January of 2016. We believe that over the long term, shareholders need to know that our margins will support the sustaining capital we need, we'll find our best and highest value growth and that there will also be a share for investors as we go. The share buyback element of this capital injection program is a very strong signal that we still believe our company is undervalued based on its current and future cash flow generation and it rewards shareholders who stayed the course. Many of our institutional investors wanted to see this kind of program and we responded as we constructed this transaction. Now why add new nominees to the Board? Make no mistake, we have strong expertise on our Board. It's this Board that approved this transaction for all shareholders. We believe there is also significant benefit to having a Cornerstone shareholder represented on the Board in terms of the long term stability that it will bring the company. For me, the real value will come when you dig into the credentials and the track records of our 3 new Board members. Together, they bring decades of additional experience in international renewables projects, U. S. Capacity markets and thermal investments. They are a perfect complement to our current Board, bringing the right type of expertise at this stage in our transformation to 100% clean energy. In summary, as a result of this transformative financing, all of the ingredients for value creation are now in place at TransAlta. It is indeed a huge endorsement of our work to transform the company, our strategy and our future upside potential. Thank you for joining us today. We are available for a few questions now and we will be meeting for the rest of the day with those who want more extended discussion 1 on 1. And with that, I'll turn the call back over to Sallie. Thank you, Don. Denise, could you please open up the call for questions? Certainly. Your first question comes from Ben Faim with BMO. Your line is open. Hi, thanks. Good morning. I was wondering on the stock buybacks, what's going to turn the pace and expect it, how that's going to materialize? Sorry, say that again, Ben. Just what is going to determine how quickly we do that? Yes, exactly. Yes, and I just wanted to also clarify, is it is the mandatory that you buy back $250,000,000 in there for the No. In our agreement, we've agreed that we'll buy back up to $250,000,000 and we have 3 years to do it. And I think frankly, the pace and the amount depends on where the share price is. And as you know, we believe the share price has significantly undervalues the company and we'll be using that buyback strategically. Okay. And another question I had is late 2020, 2 years away from now, you're generating a lot of free cash flow, at least when you look at the next 3 years. So it seems like when you factor in this investment, there's going to be a lot of cash that you can really look to deploy towards better growth investments. Is there am I thinking the right way? And should we be thinking about additional investments outside of Alberta? Yes. I mean, a couple of things, Ben. First of all, the $350,000,000 of this goes into the coal to gas, which as you rightfully see generates more cash. The hydro generates more cash. We know that right now TransAlta Renewables is under levered, so we now have the opportunity to start to really find the right kinds of investments for that vehicle. I agree with you that those kinds of investments would likely be outside of Alberta because of our market share here in Alberta. And there's we don't see a lot of growth in the next couple of years in the rest of Canada. So our teams right now are focused on where those kinds of investments are in the U. S. And in Australia. Okay. And can I check lastly, TransAlta Renewables, has this changed anything there with the strategy and how you're going to use that vehicle? No. TransAlta Renewables will continue to grow it the way we have been. All right. That's great. Thank you. Thanks, Ben. Your next question comes from Robert Kwan with RBC Capital Markets. Your line is open. Good morning. Don, you mentioned it or talked to at the beginning some background to the transaction. Just wondering when did discussions on this specific structure begin? And can you talk about just some of the alternative structures, whether it was with Brookfield or others that you contemplated seriously? Well, no, I'm not going to talk about stuff that we discuss with others because I think that's water under the bridge now. But we've been in discussions several times with Brookfield over the last 4 years on a number of different ways to figure out how to bring together what we know how to do and what they know how to do. So as you know, Brookfield is big on renewables, particularly hydro. We're big on renewables, but we also have had coal in our portfolio that we're converting to gas. Brookfield has really never entered into the gas business. So I think where this really started to come together is when we started to think about was there as we were listening to our shareholders in sort of late Q4 and early Q1, there was really a lot of pushback for us to really find a way to catalyze our strategy from all of our shareholders, all of our institutional shareholders. They like the strategy. They like the long term nature of it. They think it's a strong strategy, but it takes too long for us to execute on our own. So as we were listening to that, listening to people give us pushback that we really would never convince them no matter what we did that there was value in the hydro. We had those ongoing discussions. So we again went after it to say to ourselves, with Sachin and I really tried to think about, okay, what is a creative way to do what we need to do here. And I think what we've come up with is very creative because Brookfield becomes a cornerstone shareholder. They can see pull the gas through their Board members. They can really start to understand what that looks like as we go to the future. And at the same time, we've been able to crystallize the value of the hydro. So it's been a long set of discussions over many years. Got it. And I guess the bid ask was just too wide to actually crystallize the actual amount today based on the uncertainty of the future EBITDA? Yes, I think that's right. And also I think what we were very conscious of as we were entering into discussion with almost anybody was that our shareholders that are in the stock today have been very, very patient. They have high expectations about where the company is going and they wanted to participate in the upside. And so this transaction as constructed really allows people to participate in the upside and RBC was really clear on that point. And in the end, I think because of the creative way we put the transaction together, we got their support out of this arrangement. Got it. So you've got the 1 shareholder support agreement in place. I'm not asking for any specific names, but are there any other support agreements that have been signed? No. We're just going to meet with shareholders here today like we always have. Got it. And just to finish, the EBITDA calculation has this specific deduction for maintenance CapEx. I'm just wondering what's in behind the tax adjustments and what might that be? Yes. I'm going to turn it over to Brett for that. Yes, Robert. It's just simply to given the deal happens in the future, we want to be able to true up, if you will, the tax pools. So it's just an adjustment to the formula when we get out at that time. Okay. So is that just in terms of like is there a projected tax pool figure and if it's above the or if there's a variance that's going to be adjusted on an annual? Yes. It's a variance. I kind of look at it like a working capital adjustment, almost similar thing when given the deal is in the future. We just needed a mechanism for what actual tax pools are in the entity at the time we bring Brookfield into it or they convert into it. Got it. So it's contemplated to be 0 subject to any unforeseen changes, correct? Well, again, it's again going to be dependent on what we can't predict unfortunately what it looked like 5, 6 years out. So we just wanted a mechanism that accommodated for that. So I wouldn't say we're projecting it to be 0, but it's just a way to make sure that it's trued up at that time. And so all I would say is, Dawn mentioned, based on current the 2018 EBITDA, what their ownership and we've shown there's a range of $30,000,000 to $35,000,000 and part of that could be due to some tax adjustments. It could be just the EBITDA at that time. Got it. Okay. Thank you very much. Great. Your next question comes from Andrew Kuske with Credit Suisse. Your line is open. Thank you. Good morning. I guess, first question just on the ownership cap at 49% and when you were negotiating the transaction, was your aspiration to land in that 30% to 35%? Is that the expected EBITDA that's for Brookfield lands? And was a majority position in the hydro assets really a non starter for you? Yes. The majority position in hydro assets was a non starter for us. And I go back to what I said earlier. People who are in our stock want to participate in the upside and they wanted to have a piece of that. Sorry, what was the first part of your question? No, I guess, did you really want it to land at the 30% to 35% and then the 49% cap is just to it prevents the majority because you don't want to give away the majority? No. The way that we thought about it is we think we will land in the 30% to 35%. We've got pretty strong confidence in the value of those cash flows in those years. Brookfield wanted some way to get to 49,000,000 so they could have a block for themselves. They were not concerned about having majority, so that wasn't a big deal. But they to get to the $49 and to keep us both aligned, we created this structure where the stock price has to be over $17 by then, which keeps them aligned to the overall strategy of the Board, right, of the company. Because remember, our overall strategy is grow TransAlta Renewables, get the coal to gas conversions and get the value in the hydro. So if you take those three elements of our strategy and you put that $17 marker there, it kind of keeps them with us side by side really growing the company. So we thought that was really worth it. That's helpful. And then just to follow-up on Brookfield ownership position. So the 4.9% that they have now, they're not obligated to move to the 9%. It's just they have a target. Yes, that's correct. Is that correct? Yes. But if they don't yes, if they're not over 8.5%, they can't exercise the options that they have. And remember when they exercise those options there's additional capital that will be injected into the company for those options. Yes. So you set up an embedded effectively sweetener for TA and for Brookfield, but Brookfield has to be above that 8.5 percent. Okay, that's perfect. Yes. Okay, that's great. That's all for me. Perfect. Thank you. Your next question comes from Jeremy Rosenfield with Industrial Alliance Securities. Your line is open. Yes, thank you. Just the first question, just in terms of how investors should think about the dividend and dividend policy going forward? And I'm not thinking short term because clearly there's a capital allocation preference towards share buyback here, but just longer term in terms of the dividend and dividend policy? Yes. I mean, we talked earlier on the call about additional cash really starts to come in the company. I think the Board at that time can start to think about its dividend policy for sure. And I think the way investors are watching companies these days, it is a balance of some dividend growth. And we know that if you can consistently grow your dividend, there's lots of funds that will own you because they like that. But at the same time, I think there's also people that like you to make share buyback decisions on an annualized basis. So you're kind of balancing between the 2. But for sure, that dividend question comes back in that 2020, 2021, 2022 timeframe. Okay. And then maybe just the other question as it relates to TransAlta Renewables and you stated that it really doesn't change much for renewables at this point. But I'm just curious, when you think about strategic options for the company going forward and ways to surface value, renewables still exist as a good way to surface value. So are you sticky in that ownership stake that you have today? And or can you see dilution over time as renewables itself continues to grow and potentially much faster going forward after these strategic initiatives? Yes. I think perhaps the most exciting thing about what we've done here is we've been able to get Richard Leggot on our Board. And of course, you all know that he spent 25 years building Brookfield Renewables and we have tons of opportunities that we've looked at at that are different than the opportunities that they look at. So especially in our Australian business and some stuff that we're looking at in the U. S. So I think as we go forward here and we'll be able to actually reignite some of the growth that we haven't been doing. And with Richard on the Board and his experience, I think it will really give us some opportunity to think about how to grow that vehicle, when to sell down, when to sell up, because you saw that all the way through his tenure. So I think that's really terrific. Him and Harry are terrific adds to the Board. No doubt about that. Maybe just one final one. With regard to other activist shareholders. I know in the past you said you've had previous conversations with them. Are you going to continue to engage them in terms of if they have potential additions to the Board that they would like to put forward? How is your approach going to shift here? We engage with all of our shareholders and we'll continue to engage with them as well. So those discussions will continue. Okay, great. That's it for me. Thank you. Your next question comes from Patrick Kenny with National Bank Financial. Your line is open. Yes, good morning. Just to follow-up on the last question and I think you've answered it, but just wanted to clarify that today's transaction nullifies any potential cooperation agreement that may have been proposed by Mangrove and Bluescape or maybe you can just clarify where your discussions are at with that group today? Well, I think those discussions are ongoing. And this transaction I think is pretty exciting for the Canadian market and for Canadian institutional investors. And this transaction we believe really solidifies the strategy that we've been on. I really can't tell you what the outcome of those discussions will be. That's handled by the Board. Got it. Okay. Thanks for that. And then with respect to the new entity to be formed here to hold the hydro assets and the tax adjustment, how should we think about this new entity being capitalized on a tax efficient basis? Do you envision some asset level debt or some other form of tax shield? Yes. I mean, again, given we're a few years out, we'll certainly evaluate that at the time, Patrick, it's Brett, and decide whether or not there's tax efficient debt and low cost debt to put at the entity. But certainly, that's a secondary thing right now. We're really a few years away from having to think about that. Sure. And then how should we think about the energy marketing margin under this new structure as well? I mean, will the hydro entity have a claim to a certain portion of that margin or does the energy marketing business just stay fully under TA Corp? Yes. No, the energy marketing business stays fully under TA Corp. Okay, great. That's it for me. Thanks. Your next question comes from Mark Jarvi with CIBC Capital Markets. Your line is open. Good morning. Just wanted to wonder if you guys could shed some color on the timelines for the formation of the hydro operating JV in terms of and in 2024, why that was the right timeline? Yes, Mark, it's John Koussienhoris. We are going to begin doing the work that we need to do internally to make sure that we can drop the hydro assets into an appropriate vehicle. We think we can get that done pretty comfortably over the course of the next year. And I think the agreement basically contemplates that. We just want to make sure that we do it in a thoughtful way so that it's all set up in the event that Brookfield comes in, in the middle part of the next decade. I guess my question was why end of 2024 for them to come in and flip from the exchangeable securities into equity ownership? Yes. Again, as Don mentioned earlier, that was the timeframe that we thought that there would be a sufficient period of sort of normalized EBITDA in the company following the expiry of the PPA, which the hydro units are currently subject to. So with the capacity market coming into place in 2022, 2023, 2024, we just felt that that was the appropriate period that would be really, really reflective of what the true value is of the hydro assets in that period of time. So from a value perspective, it was important to our company to make sure that any conversion into the hydro would take place when we had that kind of normalized rate of cash flow from those hydro assets. That's what set up the timeframe. Okay. And then and just to clarify, I mean, there's some adjustments to tax adjustments you talked about sustaining CapEx. Just what about sort of corporate OM and A? Any sort of cost to get associated with the hydro operations and how that might be shared? Yes. The way that the formula is going to work is that the OM and A that is directly associated with the hydro assets will be deducted from the revenue stream to come up with the EBITDA that the multiple is applied to. So that's all contemplated in the formula. Okay. Thanks. Sure. Your next question comes from Adam Mitchell with Polar Asset Management. Your line is open. Hi, guys. Just curious, it looks like the Board has a 30 day option to terminate the transaction if 2 or more company nominated Board members, excluding Brookfield nominees are not elected. Can you explain the rationale behind that clause? Sure, Adam. What we wanted to make sure was that in the event that there was a change that occurred to the slate of Board members following the AGM, that there would be an opportunity for the Board as constituted at that time to reevaluate the transaction and make a determination, effectively a fresh determination, whether to proceed with the transaction or not. And really, that was the purpose of the provision. Thank you. Sure. Your next question comes from Garnet Selman with Private Investor. Your line is open. Hi, good morning. Just wanted to know as an investor, if this transaction was accelerated by the Bluescape activists? And also this transaction seems fairly very much conditional on so many things. And if BlueScape presents something better going forward, is this something that you guys would look at? No, this was not accelerated by that. This transaction really came out of, as I said earlier, darn it. We have been out meeting with investors extensively over the last 6 months. There's been frustration in our inability to really catalyze our strategy. People really liked our strategy, but there just wasn't enough capital to get it all done at the same time. And so, this transaction came out of that. And actually, this transaction is a very solid transaction. It was signed on Friday. It's going forward. So, it won't be changed as we go ahead. And it's very strong for existing shareholders. Your next question comes from John Mould with TD Securities. Your line is open. Thanks. Just one question on the coal to gas conversions. So you secured some funding for those here, so you can proceed with those as quickly as you're is realistic. There could be changes on the carbon pricing regime, both at the Alberta and federal levels with elections in both jurisdictions this year. And I'm just wondering, is there a scenario where a large changing in carbon pricing policies makes you not reconsider the investment, but the pace or timing at which you might make those conversions? John, it's Brett Gellner. As we mentioned in our last call, there were there are a number of factors driving our strategy. Does it change a little bit of the timing from here to there? Maybe, but directionally, our strategy is to fully convert for all the reasons we discussed. The main one being you have to be off coal starting at the end of 2026 in some of our facilities and right through then at the end of 2029 at the latest. On top of that, there's significant NOx and SOx requirements we would have to meet. So we'd have to put significant capital in and operating costs incurred to manage those. So carbon price is important, but we also believe, generally there will be probably a large some carbon regime for large emitters like us. And so yes, our strategy directionally has not changed. And also this allows us to, as we mentioned on the call last time, really evaluate the repowering option of the combustion turbines tying into the steam turbines and gives us that financial flexibility to really look at those because those are very promising and high returning projects. Okay, great. I'll leave it there. Thank you very much. Thanks, John. There are no further questions queued up at this time. I'll turn the call back over to Sallie Taylor for closing remarks. Thank you, Denise. Thank you everyone for joining us to hear about the significant milestone for TransAlta today. With that, our call is concluded for the day.