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Is TransAlta Corp. a Value Trap or an Opportunity for Patient Investors?

As a contrarian value investor I seek out those companies which have fallen deeply into disfavor with the market and are trading at a significant discount to their intrinsic value yet have a fundamentally solid underlying business.

One company which I believe is fast shaping up as a deep-value investment opportunity, is troubled Canadian electric utility TransAlta Corp. (TSX: TA)(NYSE: TAC). Since slashing its dividend by over a third earlier this year and bleeding red ink for the last two years, the company has fallen into disfavor with the market so much that it is now trading at a 15-year low.

Let’s take a closer look at why the tide is turning for TransAlta and how it shapes up as a deep-value investment opportunity for patient investors.

Recent capital initiatives have strengthened the balance sheet

Slashing the dividend is always bad in the eyes of investors, but I believe it was a smart move because it allowed TransAlta to preserve much needed capital and shore up its balance sheet.

Even more promising, TransAlta was also able to significantly boost its capital through a debt raising and asset sales in the second quarter 2014. These included the completion of a $400 million senior note offering, the sale of its 50% interest in CE Generation, the Blackrock Development Project and CalEnergy for $168 million and the conclusion of a secondary offering of TransAlta Renewables Inc. (TSX: RNW) for $129 million. The proceeds were directed into paying down TransAlta’s debt, further strengthening its balance sheet.

Business initiatives will boost capacity and core profitability

TransAlta has a range of initiatives underway to expand its electricity generating franchise. These include the construction of a 150 megawatt gas power station in South Headland Western Australia, which will be commissioned in 2017, and the construction of a gas pipeline to its Solomon power station.

TransAlta has also promised investors that the expiration of its Alberta purchase power agreements between 2017 and 2021 will see a significant hike in cash flow, which could boost EBITDA by as much as $400 million. If realized, this would significantly bolster its financial performance, ultimately translating into a significant share price hike.

Impressively despite its troubles a well as the distractions associated with asset sales and debt raisings, TransAlta was able to boost capacity in its core business. Both availability and electricity production were up 4.4% and 14.5% respectively in the second quarter 2014, when compared to the equivalent quarter in the previous year.

A wide multifaceted economic moat and growing electricity production bodes well for future earnings

Electric utilities by their very nature possess a wide multifaceted economic moat, with steep barriers to entry and high degrees of regulation reducing competition. When coupled with electricity being an inseparable component of our modern lives making demand virtually inelastic, TransAlta’s competitive advantage and future earnings are almost guaranteed.

A juicy dividend yield continues to alleviate the pain for investors

Even after slashing its dividend by over a third in January 2014, TransAlta’s dividend still yields a very juicy 6%. While there are still concerns over the sustainability of the dividend, primarily because of recent net losses, there are signs its sustainability is growing. Not only has TransAlta boosted its capital, but first-half 2014 funds flow from operations grew a healthy 4% compared to the equivalent period in 2013, boding well for future dividend payments remaining unchanged.

All of these improvements coupled with TransAlta’s increasingly positive outlook bode well for it to continue rewarding patient investors as business initiatives gain traction and its financial performance continues to improve. But it may take some time for this to be reflected in TransAlta’s share price, with the market yet to recognize its intrinsic value.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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