DBRS Comments on TransAlta’s Australian Assets

DBRS Limited (DBRS) notes today that TransAlta Corporation (TAC or the Company; rated BBB with a Stable trend by DBRS) announced that it has entered into an agreement to have TransAlta Renewables Inc. (OpCo; 70.3% owned by TAC as at December 31, 2014, and approximately 76% to 77% upon closing) invest in TAC’s Australian power generation and gas pipeline portfolio, including the South Hedland gas-fired project under construction for a combined value of approximately $1.78 billion (the Transaction; $220 million in cash to be raised through subscription receipt offerings and the remaining in OpCo’s common equity). The Transaction is expected to close in May 2015.

Initially, the Transaction is expected to have a minimal impact on the credit quality of TAC as the Transaction is to be funded with all equity at OpCo. In the medium term, the ratings of TAC will likely be influenced by OpCo’s funding strategy related to the South Hedland gas-fired project under construction which requires a substantial investment of approximately $570 million (approximately $70 million spent in 2014). OpCo is contemplating funding alternatives associated with the South Hedland project. In the interim, the intercompany credit facility increase from TAC gives OpCo time to assess alternatives. DBRS will treat the funding alternative review as an event and assess OpCo’s actions and the resulting impact on TAC’s ratings when the funding plan is finalized.

From a consolidated perspective, the Transaction would have a minimal impact on TAC’s business risk profile because of the strong level of integration between TAC and OpCo as evidenced by (1) TAC’s majority ownership of OpCo; (2) the 20-year term of the management service agreement between TAC and OpCo (executed in 2013); (3) power purchase agreements (PPAs) between TAC and OpCo which accounted for approximately 36% of OpCo’s total PPA in terms of generation capacity in 2014; and (4) financial support from TAC which accounted for nearly 50% of total debt outstanding as at December 31, 2014. The remaining debt is related Canadian Hydro Developers, Inc. (CHD; rated BBB with a Stable trend by DBRS) which was sold to OpCo as part of the initial public offering in 2013. The credit quality of CHD is essentially predicated on the strength of TAC. As a result of the strong tie between TAC and OpCo, DBRS has continued to assess TAC on a consolidated basis. DBRS will consider analyzing TAC on a deconsolidated basis should there be a material size of third-party debt issued at OpCo or should the level of integration weaken significantly.

Initially, the Transaction is expected to have a minimal effect on TAC’s financial risk profile as the Transaction is to be funded with all equity at OpCo. In addition, TAC intends to pay down debt with the cash proceeds from the Transaction (through subscription receipt offerings), which is estimated to be $220 million. As a result, the decrease in interest expense (implied yield of 4.5% to 5.0%) is expected to partially offset the impact from the moderate increase in external distributions (estimated to be approximately post-tax 6% or $13 million per annum based on OpCo’s closing stock price as at March 20, 2015) related to OpCo’s secondary offering.

DBRS acknowledges that the new OpCo structure creates another source of equity and could serve as a lower cost of capital for future growth opportunities; however, as TAC’s ownership in OpCo decreases and OpCo’s asset portfolio grows, the integration between TAC and OpCo could weaken. In this case, DBRS will increasingly weigh in on deconsolidated analysis for both TAC and CHD, which could ultimately result in a rating differential between TAC and CHD. TAC’s rating could be pressured if it significantly increases its exposure to construction and development risk as well as merchant risk of greenfield projects, and funds new projects with debt. This may not have a material impact on CHD if OpCo continues to fully hedge power production through PPAs with investment-grade counterparties and maintains reasonable financial metrics. Construction cost overrun risk associated with the South Hedland project is manageable given that the majority of the budgeted investment is either under fixed- price engineering, procurement and construction contracts or fixed fee to the off-taker, Horizon Power, a state government-owned corporation for existing assets.

Finally, since the lower-risk assets of TAC have been transferred to OpCo and this trend is expected to continue, holders of TAC’s direct external debt are facing structural subordination risk should OpCo raise a material amount of third-party debt in the future. OpCo has not raised any new external recourse debt since its inception in 2013 as TAC has provided virtually all necessary funding requirements to date. As such, TAC’s rating has not taken meaningful structural subordination effects into account, except outstanding debt related to CHD (which was grandfathered to OpCo at its inception in 2013). TAC’s ratings will likely be affected negatively should OpCo issue a material amount of third-party debt in the future as this will create structural subordination challenges for TAC’s bondholders.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Rating Companies in the Independent Power Producer Industry (August 2014) and Preferred Share and Hybrid Criteria for Corporate Issuers (January 2015), which can be found on our website under Methodologies.