(The following statement was released by the rating agency)
Fitch Ratings-New York-March 26:
Fitch Ratings has affirmed TransAlta Corporation's 'BBB-' Issuer Default Rating (IDR) and its 'BBB-' senior unsecured debt rating. The Rating Outlook for TransAlta has been revised to Negative from Stable.
The Negative Outlook follows the announcement that Brookfield Renewable Partners will invest CAD750 million in TransAlta and reflects uncertainty regarding TransAlta's commitment to reduce parent level debt consistent with Fitch's previous expectations. Brookfield's investment is expected to be composed of convertible debentures and preferred shares resulting in higher leverage. Proceeds will be used to fund share buybacks, advance coal-to-gas conversion capital projects and repay corporate debt. At YE 2018, Fitch estimated parent-level adjusted debt/EBITDA was 3x, after deconsolidating it's 61%-owned subsidiary, TransAlta Renewables Inc. (RNW) and other material assets with project level debt and this metric was estimated to decline to 2.5x in 2020.
Following this transaction, parent-level adjusted debt/EBITDA is estimated to increase to 4.0x in 2020. A key credit concern remains the change in the Alberta electricity market construct as the market transitions to a capacity market by 2022, adding uncertainty to TransAlta's earnings profile and business risk as its exposure to the merchant market grows. Fitch estimates that contracted assets will generate about 60% of consolidated EBITDA post-2022.
TransAlta's low cost hydro assets could receive material incremental revenue from capacity payments, offsetting the variable power prices. However, in Fitch's opinion, the transaction could be considered negative if the company moves to an aggressive growth strategy to boost shareholder return to satisfy activist investors. Brookfield's large operating scale and strong track record as an experienced long-term strategic investor, in Fitch's opinion, is positive. Brookfield brings its expertise as a hydroelectric plant operator, owning 218 plants with 7.9GW of hydroelectric capacity, and knowledge of implementing operating efficiencies and developing new capacity as TransAlta's Alberta plants move to a competitive market.
KEY RATING DRIVERS Parent-Level Deleveraging: Credit supportive measures taken in 2018 reduced debt by about CAD1 billion funded from FCF, proceeds from the coal purchase power agreement (PPA) termination and off-coal payment monetization, and equity funded drop downs to RNW. Given RNW's increase in project-level non-recourse debt, RNW's separate credit facility in place in mid-2017 and access to the equity market (issued CAD150 million in May 2018), Fitch is focusing on parent-level financial obligations at TransAlta, deconsolidating RNW and other material assets with project-level debt. Fitch expects TransAlta's parent-level adjusted debt/EBITDA to increase to around 4.0x by 2020, up from 3.0x in 2018. Near-term debt maturities are manageable, with the next repayment occurring in 2020 expected to be paid from the Brookfield proceeds.
Long-Term Merchant Risk Exposure: Fitch estimates that contracted assets will generate about 60% of consolidated EBITDA post-2022, and EBITDA generation is expected to become more volatile as the remaining Alberta coal PPAs terminate. The early termination of the Sundance 3-6 PPAs in 2018 reduces the portion of contracted cash-flow on a go-forward basis, compared to 82% in 2018. Fitch expects that under the new market construct to be in place by 2022, capacity payment pricing may fluctuate over time, as seen in other North American capacity markets, in response to changes in supply, demand and company strategy. While the introduction of forward-looking capacity auctions and financial support for the expansion of carbon-free generation capacity in Alberta could improve TransAlta's long-term earnings, their impact remains unquantifiable. Market Construct in Alberta: Concern over the change in the Alberta electricity market construct remains, adding uncertainty to TransAlta's earnings profile and business risk as its exposure to the merchant market grows.
The Alberta Climate Leadership's Plan to retire all coal-fired plants by 2030 and raise the tax on carbon for coal-fired generation in 2018 facilitated agreements and payments for early retirement or conversion of TransAlta's coal-fired plants to gas fired facilities by 2021-2023. Using the proceeds from the Brookfield investment, TransAlta will accelerate these conversion projects, lowering operating costs and retiring the coal plants in compliance with environmental requirements. As the market transitions to a capacity market by 2022, Fitch would expect TransAlta's portfolio of renewable capacity, especially the nearly 1 GW of hydro capacity, to be favorably positioned in the dispatch curve. Progress made to date on compensation for early retirement of assets, development of a capacity market and guidelines for coal-to-gas conversion are, in Fitch's view, supportive of TransAlta's long-term earning potential.
Environmental Regulations Drive Capital Plans: Federal environmental regulations regarding the tax on carbon and 15 year extension of the useful life of units converted to gas from coal appear supportive of TransAlta's strategy to convert some of its coal-fired generation assets after PPA termination. The coal-to-gas conversion, for up to six generation units at a cost up to CAD300 million, presents modest financial and technological risk. Construction of the Brazeau pump storage hydro project would present higher execution risks, while the financial impact of this initiative remains uncertain and beyond the current scope of Fitch's ratings.
Adequate Financial Flexibility: TransAlta has adequate liquidity, in Fitch's view, to support some volatility in its operating cash flows and meet upcoming debt maturities. TransAlta had access to about CAD700 million of liquidity at Dec. 31, 2018, including cash of CAD16 million, and is expected to remain FCF positive through 2020. The reduction of CAD1 billion senior TransAlta debt maturities in 2018-2019 provided some near term flexibility to execute the parent level debt reduction strategy.
DERIVATION SUMMARY The credit profile of TransAlta (BBB-/Stable) is weaker than PSEG Power LLC (BBB+/Stable) and Exelon (NYSE:EXC) Generation Co. LLC (BBB/Stable). TransAlta's lower long-term IDR is due in large part to its higher leverage metrics and relatively smaller scale compared with its peers. With this transaction, Fitch expects TransAlta will achieve parent-level debt/EBITDA of more than 4.0x by 2020 whereas PSEG Power and Exelon Generation are expected to maintain leverage of less than 2.8x and 2.0x respectively. PSEG Power and Exelon Generation also benefit from greater financial flexibility from affiliation with utility parent holding companies.
TransAlta's asset base is comparable with PSEG Power. The former has a slightly smaller, but more diversified generating fleet: TransAlta owns 8.0GW of net capacity located in Canada, the U.S. and Australia whereas PSEG Power's 12GW of capacity are concentrated in the Northeast U.S. Exelon Generation's stronger business profile is supported by roughly 35GW of capacity spread across the U.S. and a strong track record as a nuclear operator. TransAlta benefits from a higher proportion of long-term contracts resulting in more stable EBITDA generation than its peers in recent years but Fitch expects contracted cash flow to decline closer to 60% by the end of 2021.
KEY ASSUMPTIONS Fitch's Key Assumptions Within Our Rating Case for the Issuer - Operate under contracted Alberta PPAs remaining in place with current market conditions; - Power prices in Alberta of approximately CAD38 /MWh in 2018 and escalating thereafter (Fitch uses Wood Mackenzie as its third-party consultant) without any capacity payments through 2021; - Stable ownership level (61%) of RNW; - RNW project-level debt for construction funding of U.S. wind projects, either through operating level debt or tax equity; - Capital spending ranging from CAD200 million-CAD300 million from 2019-2020; - Debt issuance limited to refinancing, no equity issuance over the rating horizon with the exception of DRIP at RNW in 2019; - Common dividend of CAD46 million, preferred dividend of CAD41 million and RNW dividend payout of 80% of cash available for distribution annually.
RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action - Upward rating action is unlikely given the uncertainty surrounding the market construct for electricity in Alberta and its impact on TransAlta's EBITDA generation post-2020. - Although not expected over the rating horizon, ratings could be upgraded if adjusted parent-level debt/EBITDA declined to 2.5x or less, on a sustainable basis.
Developments That May, Individually or Collectively, Lead to Negative Rating Action - The ratings could be lowered if Fitch believes that adjusted parent-level debt/EBITDA will remain materially above 3.7x beyond 2018. - Other factors potentially leading to a negative rating action include less than 50% of EBITDA comes from long-term contracted assets beyond 2020; and/or cash flow volatility increases due to wholesale electricity price volatility over 2018-2020. LIQUIDITY Adequate Liquidity: TransAlta has adequate liquidity, in Fitch's opinion, with modestly positive FCF generation over the rating horizon, supplementing significant availability under committed credit facilities. As of Dec. 31, 2018, TransAlta had a CAD2 billion credit facility, of which CAD0.9billion was available, and CAD89 million of cash. TransAlta's credit facilities were recently amended and renewed until 2020-2022. TransAlta and RNW have independent financing facilities but TransAlta provides financial support to RNW through currency hedges and PPAs with RNW's wind and hydro facilities in Alberta. TransAlta repaid about CAD1 billion of corporate debt with the redemption of the USD500 million senior notes due May 15, 2018 and early repayment of CAD400 million debentures due November 2019 using the proceeds from the Sundance B and C coal units PPA termination payments, off-coal payment monetization proceeds, RNW equity proceeds and available cash. The next significant maturity is CAD400 million due in 2020. TransAlta is in compliance with the terms of the credit facilities. Additionally, RNW has CAD775 million project level debt with limitations on distributions based on project specific coverage tests. All of RNW's projects have met their tests and will not limit distributions. Under Fitch's rating methodology for hybrid instruments, TransAlta's CAD942 million preferred shares are given 50% equity credit.
FULL LIST OF RATING ACTIONS Fitch has affirmed the following ratings: TransAlta Corporation --Long-Term IDR at 'BBB-'; --Senior unsecured debt at 'BBB-'. The Rating Outlook is revised to Negative from Stable.
Contact: Jodi Hecht Primary Analyst Director +1-646-582-4969 Fitch Ratings, Inc. 33 Whitehall St. New York, NY 10004 Secondary Analyst Michael Ruggirello Associate Director +1-416-644-6586 Committee Chairperson Philip Smyth, CFA Senior Director +1-212-908-0351 Media Relations: Hannah James, New York, Tel: +1 646 582 4947, Email: hannah.james@thefitchgroup.com. Additional information is available on www.fitchratings.com Applicable Criteria Corporate Hybrids Treatment and Notching Criteria (pub. 09 Nov 2018) https://www.fitchratings.com/site/re/10051058 Corporate Rating Criteria (pub. 19 Feb 2019) https://www.fitchratings.com/site/re/10062582 Corporates Notching and Recovery Ratings Criteria (pub. 23 Mar 2018) https://www.fitchratings.com/site/re/10024585 Additional Disclosures Dodd-Frank Rating Information Disclosure Form https://www.fitchratings.com/site/dodd-frank-disclosure/10067488 Solicitation Status https://www.fitchratings.com/site/pr/10067488#solicitation Endorsement Policy https://www.fitchratings.com/regulatory
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