Fitch Affirms TransAlta's IDR at 'BBB-'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed TransAlta Corp.'s (TransAlta) 'BBB-' Issuer Default Ratings (IDR) following its announcement to sell economic interest in a number of contracted assets to its publicly traded subsidiary, TransAlta Renewable, Inc. (TRI, not rated by Fitch). The Rating Outlook is Stable. A full list of ratings follows at the end of this release.

The rating affirmation reflects Fitch's expectation that TransAlta will use cash proceeds to reduce leverage and maintain Fitch's previously expected leverage measures.

TransaAlta will receive $220 million of cash and approximately $1.1 billion of stock. In addition, TRI will fund the remaining $490 million of development costs of the South Hedland project through a combination of cash and debt. After the transaction, TransAlta will own approximately 76% in TRI and receive its proportional share of dividends. Fitch expects a series of future transactions in which TransAlta will transfer additional contracted assets to TRI. This strategy to use TRI as a source of capital will also transfer a large portion of contracted EBITDA to TRI, one of the key rating factors for TransAlta's IDR. Going forward, Fitch will use proportional consolidation to reflect increased subordination of TransAlta's cash flows to that of TRI's debt holders and equity investors. Currently, Fitch's ratings are based on fully consolidated financial statements. TRI currently accounts for about 17% of consolidated EBITDA. TRI will grow to about 35% of TransAlta's consolidated EBITDA by the end of 2017 (once the gas-fired plant is complete and placed in service in Australia) and could grow to about 50%-55% of TransAlta's consolidated EBITDA with the additional projects that TransAlta has identified for drop downs to TRI.

KEY RATING DRIVERS

Drop down of Assets to TRI: TRI is a publicly listed, yield driven and growth oriented vehicle of which TransAlta currently owns about 70%. Asset drop downs provide the company an alternate source of capital. Management estimates it will ultimately be able to transfer about $3 billion of assets into TRI. TRI plans to fund the drop downs with equity units with TransAlta maintaining at least a 70% equity interest in TRI.

Fitch recognizes the enhanced financial flexibility that TRI provides to TransAlta, but at the same time, a steady pace of transfer of TransAlta's portfolio of contracted assets compromises the quality of assets left at TransAlta. Fitch expects TransAlta to use proceeds from the transfer of contracted assets for debt reduction. Fitch will continue to monitor management's acquisition and financial strategy and rising conflict of interest between TransAlta and TRI. A predominantly shareholder focused use of proceeds from the transfer of assets will have negative implications for TransAlta's credit.

Hedged Profile in Transition: TransAlta's generation portfolio is highly contracted, at present (~80%), and will remain so through 2018, thus providing a high degree of visibility to cash flows. The hedge profile will materially change beyond 2018 as the long-term power purchase agreements (PPAs) for its Alberta based coal-fired fleet start rolling-off. Currently, the Alberta assets provide about 40% of TransAlta's consolidated EBITDA.

Fitch expects the expiration of PPAs at the Alberta coal fleet by 2020 to materially increase the commodity sensitivity at TransAlta, thus, inducing greater volatility in cash flow generation. Fitch expects 50% of TransAlta's EBITDA to be generated by long-term contracted assets post 2020 while the rest is generated by assets under short duration contracts and/or open merchant sales. Fitch recognizes that the current market construct in Alberta does not allow TransAlta to hedge its resources on a long-term basis given that the buyers in the wholesale electricity market are primarily commercial and industrial users that prefer short-term contracts.

On the positive side, Fitch expects considerable improvement in TransAlta's cash flows post the expiry of the PPAs. The weighted average PPA prices are currently below market. Fitch expects wholesale electricity prices in Alberta to trend at approximately $50 - $55/MWH in 2020 and beyond.

Constructive Outlook for Alberta Wholesale Electricity Market: Alberta's wholesale market follows an economic dispatch model favoring low-cost generators and is a real-time energy market with a single price for the entire market. Even though Alberta's wholesale electricity market is the smallest wholesale electricity market in North America (between 14,000 - 15,000 MWs), it offers a robust load growth outlook through 2030. Strong electricity demand that can outpace the annual capacity additions, lack of transmission rights, and high barriers to investment in inter-market ties are positive for the outlook for electricity prices in Alberta. Fitch has assumed that these features in Alberta's electricity market will continue, at least, through 2030.

Deleveraging is Critical: Fitch acknowledges the steps that management has taken to rein in leverage such as a dividend cut along with equity issuance through its dividend reinvestment plan (DRIP) in 2014. However, further deleveraging is needed to appropriately align the capital structure to a higher business risk profile post 2020. In this regard, management's stated goal of $300 - 500 million of senior debt reduction and predominantly equity funded new growth investments over 2015 - 2017 will be key. Fitch has assumed total capex, including growth capex, of about $2 billion through 2018 will be funded through issuance of preferred capital, internally generated funds, and proceeds from the transfer of contracted assets to its renewable subsidiary TRI.

Consolidated adjusted debt/EBITDAR at the end of 2014 was 4.4x. Fitch expects the ratio to improve to 3.5x by 2018 mainly driven by decline in proportionally adjusted debt and modest EBITDA growth. Beyond 2018, Fitch expects TransAlta to maintain proportionally adjusted debt/EBITDAR between 3.0x and 3.25x and proportional FFO/Debt of approximately 28% in order to maintain the investment grade ratings. While Fitch expects proportionally consolidated EBITDA to improve with the completion of projects in Australia; incremental debt reduction could be needed over 2018 - 2020 to achieve this target if power prices in Alberta fall below Fitch's expectations. Fitch believes this level of incremental debt reduction is achievable.

In maintaining the assigned ratings, Fitch will continuously monitor TransAlta's cash flow profile, level of sales to industrial and commercial customers in Alberta, and its strategy to drop-down contracted assets in TRI without affecting TransAlta's cash flow profile and asset quality.

Adequate Liquidity: As of Dec. 31, 2014, TransAlta had about $1.6 billion in total liquidity, including $43 million in cash on hand. Available liquidity is sufficient to meet funding needs over next 18 - 24 months. Total committed credit facilities at the end of Dec. 2014 were about $2.1 billion, including $1.5 billion in bank facilities maturing in 2018. 2015 debt maturities of $751 million are manageable.

KEY RATING ASSUMPTIONS:

Fitch's key assumptions within our rating case for the issuer include:

--A flat electricity sales through 2018;

--Operating costs are expected to increase by 2% through 2018 over 2014 actual costs;

--Trading income will decline by about 30% in 2015 over 2014 levels and by 20% between 2016 - 2018;

--Fitch has assumed debt financing of negative cash flow and interest rate of 6.5%.

RATING SENSITIVITIES

Ratings Upgrade Unlikely: Given the uncertainty associated with the changing business profile and management's stated deleveraging targets, a positive rating action is unlikely over the next 12 - 24 months. Proportionally adjusted debt to proportional EBIDTAR would need to sustain at 2.5x before Fitch would consider an upgrade.

Negative Rating Action: Future developments that either individually or combined could lead to negative rating actions include:

--Proportionally adjusted debt/proportional EBITDAR greater than 3.25x on a sustainable basis;

Change in growth investments strategy such that the proportion of EBITDA from long-term contracted assets falls to below 50% beyond 2020; and

--A change in TransAlta's strategy to support its renewable business that will transfer contracted assets to TRI without a commensurate decrease in holding company debt and increased volatility in TransAlta's cash flows due to wholesale electricity price volatility.

Fitch Rates TransAlta Corporation as follows:

--Long-term IDR 'BBB-';

--Senior unsecured debt 'BBB-'.

The Rating Outlook is Stable.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=981806

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Contacts

Fitch Ratings
Primary Analyst
Roshan Bains
Director
+1 212-908-0211
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Shalini Mahajan
Managing Director
+1 212-908-0351
or
Committee Chairperson
Robert Hornick
Senior Director
+1 212-908-0523
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Roshan Bains
Director
+1 212-908-0211
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst
Shalini Mahajan
Managing Director
+1 212-908-0351
or
Committee Chairperson
Robert Hornick
Senior Director
+1 212-908-0523
or
Media Relations:
Alyssa Castelli, +1 212-908-0540
alyssa.castelli@fitchratings.com
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com