Sell TransAlta Corp: its earnings and dividend are in decline

This investment advisory’s Investment Planning Committee has removed TransAlta Corp. from its list of Key stocks and advised shareholders to sell their shares in favour of other buy-rated utilities. The Investment Reporter formerly rated the stock a hold for investors seeking high current income.

But this year, TransAlta cut its dividend by 38 per cent—from $1.16 a share to 72 cents a share. It could cut its dividend again at some point. That’s because the company’s earnings have declined.

In 2014, TransAlta is expected to earn 41 cents a share. This is significantly less than the dividend. Next year, it’s expected to earn a marginally-lower 40 cents a share. Unless TransAlta can find a way to earn substantially more, it may find itself forced to cut the dividend again–particularly since it wants to retain its ‘investment grade’ credit rating.

TransAlta’s low profits make it overpriced

Based on these earnings estimates, TransAlta is overpriced. Indeed, it trades at an excessive price-to-earnings ratio of 31.8 times this year’s expected earnings. It trades at a slightly worse 32.6 times next year’s expected earnings of 40 cents a share. Also, its share price is back to where it was in the early 1990s.

Companies may maintain their dividends even when their earnings per share fall short. This can happen when a company expects it earnings to rebound. But this seems unlikely in TransAlta’s case. Companies may also keep their dividends if their cash flow is high enough or they hold lots of cash.

Looking at the last full year, TransAlta generated cash flow of $691 million. This fell far short of its net capital spending of $625 million, acquisitions of $30 million, other investments of $31 million and dividend payments of over $311 million. Yes, TransAlta’s dividends on the common shares will fall in 2014, but its cash flow is still likely to fall short of its needs.

At the end of the first quarter of 2014, TransAlta held cash of $37 million. Subtract this from total debt of $4.312 billion and its net debt was $4.275 billion. Divide this by the cash flow of $750 million over the latest four quarters and you find a ratio of 5.7 times. True, utilities can carry more debt than most companies. But 5.7 times is far above our comfort zone of two times or less. If TransAlta borrows a lot more, it could lose its investment-grade credit rating.

TransAlta trades above its book value

We also calculated the book value of TransAlta’s shares. At the end of the first quarter, the common shareholders’ equity stood at $2.655 billion. This excludes the preferred shares’ equity. Divide that by 270.3 million common shares and you come up with a book value of $9.82 a share. The shares trade almost a third higher that that.

We can think of three potential pluses for the company:

■ First, its dividend of 72 cents yields over 5.5 per cent. That’s high. But that’s because its share price has fallen and it could cut its dividend again.
■ Second, TransAlta’s net debt-to-cash-flow ratio is only 4.7 times. This is below the five times we look for. But in this case that could reflect TransAlta’s difficulties.
■ A third point in TransAlta’s favor is that the long cold winter drove up natural gas prices. This makes its coal-fired generation plants relatively more cost competitive.

But on balance, TransAlta Corp. (TSX—TA) is no longer a Key stock and is therefore a ‘sell’.


The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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