Last week Atlantic Power Corp (TSX: ATP, NYSE: AT) announced fourth-quarter and full-year 2012 results generally in line with previous guidance. Revenue and cash flow growth reflected the successful addition of new assets, and distributable cash flow covered the payout by roughly 1-to-1.

But management also revised downward, sharply, its guidance for 2013 earnings, citing previously unmentioned challenges such as the Ontario power market.

And in a real punch to the gut for longtime holders including us, the company slashed the monthly dividend by 65 percent to a new rate of CAD0.03333 per share effective with the April 30 payment.

Since then the stock has skidded as far as USD5.57 per share as of Tuesday, a loss of more than 50 percent year to date. And more than a few investors are wondering if the next stop isn’t outright oblivion.

On Friday, March 1, we alerted readers to Atlantic Power’s news and management’s stated reasons for its move, following the company’s conference call. I took our research a step further by directly questioning CEO Barry Welch and his staff on Tuesday, March 5.

My first purpose is to provide answers for what to do now with Atlantic Power’s greatly deflated shares, which I rated “hold” immediately following the news. The second objective is to discern any lessons to avoid blow-ups in the future.

Not This Time

Investing for the long term means you often have to be patient with stocks when they take hits. Nine times out of 10 a company that’s performed well in the past will pull through a current challenge, and its share price will recover and then some.

We’d gotten used to seeing that drop and recovery pattern from Atlantic Power time and again. During the depths of the 2008 crash, for example, the company proved its business plan’s underlying strength by raising its dividend, even as its stock was making an all-time low.

Unfortunately, this time the challenges appear to have been considerably more than management was expecting. And the result is arguably the worst setback in the company’s 10-year history.

My questions to Mr. Welch and his staff focused on trying to get a sense of the odds of whether management can recover from this shock to the system–which, at a minimum, will hit its near-term ability to raise equity capital.

I’ve paraphrased and melded Mr. Welch’s answers in most cases with responses from others on his staff. Following the q-and-a I have some conclusions.

The Interview

Question: First, thank you, Barry, for your time.

A little over a year ago you raised Atlantic’s dividend, and at least some of us had the impression we could expect fairly regular raises.

Briefly, what changed in the past year that caused you to reverse strategy? Was the dividend cut this drastic so it would be the last?

Answer: The purpose of this move was to give Atlantic stock both a sustainable dividend and a growth component at a challenging time for independent power companies.

We made a number of these points in our slide presentation, which your readers can access on our website. But basically it was several things that induced us to shift.

First, as you have already told your readers, conditions got worse in Florida, which had been an important market for us. During the third-quarter conference call in November, we conveyed we were still hoping to re-contract the Lake Project at a price that made sense to run it. Unfortunately, by December it was clear that wasn’t going to happen.

TECO Energy Inc (NYSE: TE) announced a self-build on a large, new and highly efficient plant, which really shut down the possibility of decent economics in Florida. It was starting to look like we might have to run the plants at a loss for a time.

The selling price looked good, and when it’s completed the transaction is going to get us out of a very tough market that’s not liquid.

The second thing that happened relates to developments in the Ontario power market. We noticed that a number of companies had gone in to re-contract plants as their “power purchase agreements,” or PPAs, expired, and they still hadn’t come out.

That got us thinking about what kind of deal we would get when the first of five plants we have in the province goes into negotiations upon its December 2014 expiration. And our decision was basically to reset our assumptions downward.

Ontario, unlike other markets, has only one buyer, the provincial authority. So the process there is very opaque.

Our assumptions were further clouded by the fact that TransCanada Corp (NYSE: TRP) is shipping less natural gas to the east and–due primarily to US shale gas production–is charging a higher tariff. And our plants are set up to benefit from waste heat from their compressors, which is now more scarce in winter.

All that taken together has made us a good deal more cautious on what kind of profit we can expect to get from these plants.

The third thing was the eventual expiration of the power sales contract for the Selkirk power plant, which comes up for renewal September 2014 in New York.

As in Ontario and Florida, we’ve seen a continued slow recovery in wholesale power prices as demand continues to drag. Unlike Florida and Ontario, this is a liquid market, and we can see real prices on which to base assumptions.

But in view of how things are going, we again decided the best idea was to be much more conservative, and that again reduced our assumptions for future cash flow from Selkirk.

One of our primary goals at Atlantic the past several years, as North America’s power market has floundered, has been to move our portfolio away from projects that are most exposed to the weakness.

And that’s the fourth major reason for this change.

As a small company, we have a fairly high cost of capital. That makes it harder for us to compete to buy operating power plants that already have long-term contracts. So in order to shift, we’ve had to move to earlier-stage projects.

Fortunately, we’re seeing a large number of these, particularly in renewable energy. But doing these means we have to put up more capital at first for a later payoff than we would if, for example, we were buying a plant that was already operating.

Following our announcement of the sale of the Florida plants, our stock price began to decline, raising our cost of equity capital.

Our preferred method of financing is 50 percent equity–which is from issuing stock or spending cash–and 50 percent debt. Our cost of debt capital had risen. We made the decision we needed in order to apply more cash generation to do the kind of strategic moves we must do and lower the cost of equity capital to make our growth more accretive. And the easiest way to do that is to bring down the payout ratio.

All put together, the reset dividend and proceeds from asset sales should leave us with $140 million to $150 million in capital to invest by the middle of this year beyond our normal $50 million cushion and revolver liquidity. This will eliminate any need to issue equity this year as we execute our plans to grow us over the long haul.

As for the current dividend rate, we ran a number of adverse scenarios to stress test it. Hopefully, we will do better on a lot of these fronts I’ve mentioned.

But we’re comfortable that even if we don’t, we’re going to meet our guidance for cash flow and therefore the new dividend.

Question: Your statements above, as well the earnings release and conference call, revealed exposure to power-market weakness in several areas of North America.

How stress tested is the lower dividend against these challenges? What if power prices stay weak two to three more years?

Would you consider going back to the old dividend guidance, where you would say a certain dividend level could be maintained through a set date if there were no new sources of revenue?

Answer: As I said, we’re comfortable we’ve run the reasonable scenarios here that enable us to maintain our two goals of executing our growth plans and maintaining the reset dividend, even with the power market remaining weak.

There are actually a few other pockets of power-price weakness we mention that have already been impacting results. One is the cash flow from the Chambers plant, a portion of which depends on pricing in the PJM (Pennsylvania, New Jersey, Maryland) hub. This plant is already suffering from low prices. A smaller, 80-megawatt portion of Selkirk’s output is already selling into the spot market.

The expiration of the large part of the Selkirk plant contract in New York with Consolidated Edison Inc (NYSE: ED), as I mentioned above, is also a concern and an unknown. But we have tried to take the potential weakness in these areas into account as well.

I don’t think we would go back to the old way of giving dividend guidance, mainly because we think setting a range of likely payout ratios is a better way to show probabilities.

This is a fairly complex portfolio, I admit. And these payout ratio bands we’ve set as guidance could well be upset by factors we don’t now foresee, such as extended plant outages.

But they’re the best we can do now, and again we are comfortable they’re stress tested against anything we’re likely to see.

Question: You reached a deal to buy renewable energy assets from Veolia Environnement SA (France: VIE, NYSE: VE) before wind-power tax credits were extended in January.

Is there now additional value in these assets, and was the desire to develop them a factor in cutting the dividend?

Answer: The primary attraction of the Ridgeline acquisition was 150 megawatts of operating wind power. But we also really liked the development pipeline and the organization that had a great record of getting these projects done.

Of course, we didn’t know that the wind-power tax credits would be extended in the US. We were hearing from people that a number of Republicans wanted to make it happen, which made it possible. But it’s been a nice development for us, certainly.

Our highest priority with Ridgeline’s development pipeline now is to get power purchase agreements in advance of construction. There are state renewable power mandates across the country, and we’re talking to a lot of people.

Our ideal would be something that looked like our Canadian Hills deal, which has become a lightly levered project thanks to some effective use of tax rules on financing. And our goal would be start something this year for wind.

Incidentally, we did not consider current Ridgeline revenue as a replacement for the sold Florida plants, mainly because we wanted to keep reinvesting it. That’s why when we did the deal we said that it would be cash-flow neutral initially but with a substantial payoff coming in later years.

What’s really encouraging about our renewables presence now is we have the organization in place to dial up more projects when we get the opportunity. It all depends on how successful we are with new contracts, and we’re very hopeful. We have a very good team.

Question: The new strategy of the company seems to bring the dividend policy in line with that of a traditional corporation.

Is this by design, and can we expect some kind of regular dividend growth now as others in your sector have done, such as Brookfield Renewable Energy Partners LP (TSX: BEP, OTC: BRPFF)?

Answer: Let me be clear with you that we’re not likely to grow our dividend for the foreseeable future. That’s in part because we want to be able to grow our business in a market where cash flow is tight but opportunity still abounds.

But it’s also because we’ve made deleveraging our portfolio a priority, and raising the dividend even if cash flows rise would distract from that goal.

As I said, we have no need to access the capital market at this time, and barring a major transaction we won’t until July 2014. At that point, however, we need to refinance a USD190 million bond attached to the Curtis Palmer hydro facility.

As I said, we prefer to refinance using half debt and half equity. We do have several pathways to do this with Curtis Palmer given its long-term PPA.

Mainly, if we couldn’t issue debt and equity at a reasonable cost, we will be able to refinance at the project level.

We would not get the benefit from deleveraging immediately. But the cost would be amortized over the life of the contract. Again, that’s not preferable but certainly doable if market conditions don’t cooperate. And we do have some time to make this happen.

We should from here on be considered a dividend-paying corporation. But our goal at this point is to keep the dividend stable and realize growth for shareholders as we grow the business. That means for now the dividend is going to be a relatively constant component.

Question: How has taking on the operation of assets affected the initial mission of the company as some of us understood it–acquiring ownership in power assets and hedging out volatility to cash flow for paying dividends?

Answer: We think the impact has been very positive. That’s despite some of the challenges in individual markets that we entered with the Capital Power purchase as well as the fact that we had to pay more than we had hoped to finance the debt portion of the acquisition.

Even back when we were only an owner, and not an operator, we were always proactive about trying to improve performance of assets and contracts.

Now that we have real operations capability, we have our hands on the wheel. We can go in and optimize assets directly and keep them running well over the long term.

We also have the people in place now to kick the tires on projects, which improves our expansion capability as well.

Whether you’re an owner/operator or just an investor in a power plant, the market is the primary factor determining how profitable you’ll be. But there are some key advantages to being an operator that I really think are going to help us over the long pull.

I’ve mentioned the fact that we have a team in place for growth as the biggest benefit from the Capital Power deal and becoming an operator/owner. But we’re also seeing our improved scale boost us a bit on the margin in other areas, such as spare parts and insurance costs.

The large equipment suppliers generally aren’t that price-responsive unless you’re very big. But even here we’re seeing improvement.

And being bigger also gives us the ability to provide plant managers with career development. I think it’s made us a more sustainable company, though I do love that model of an investment with locked in cash flow, however it’s realized.

Question: What should we expect Atlantic to look like in 12 to 18 months? Two to three years?

Will it be mostly an operating company? Will there still be owned assets?

Answer: I think you’ll see a company that owns and operates a lot more power plants, still under long-term contracts, than it does now.

One area of growth is going to be renewable energy. We believe we have a team that will be able to support the growth side of the business and find interesting deals in a competitive market that’s going to have good support for awhile.

The Canadian Hills plant is a good example of what we’d like to do more of. The Ridgeline track is another way we’ll likely grow. This relationship started with us buying a small interest in a wind plant in Idaho but has now expanded to where we can do a lot more.

And we could also partner on projects, as we’ve done with the Rollcast team at the Piedmont biomass plant.

The point is we have the personnel that can analyze, finance and execute these deals. When we buy or build a new asset, we have the infrastructure to integrate it well. We have the people.

And state mandates, the ability to do long-term contracts and tax credits give renewable energy all the elements we need for favorable economics.

I would also like to do another gas deal at some time, and we’re looking around for that.

We are going to miss a quarter of revenue from the Piedmont biomass plant due to startup issues. And we won’t get the prices for renewable energy credits from this deal, either, that we’d hoped to get.

But I like the business proposition here too, and the tax features are still interesting, particularly if we bring in a tax equity player.

I don’t think at this point we’ll do another transmission project. I had originally hoped to grow this business. But our Path 15 asset in California is now in middle of a sale process. We’ve found building new transmission is really tough to get up and running, and the potential delays are ruinous.

We’ll leave the business to bigger companies, and in the meantime selling Path 15 is one way we can significantly deleverage.

So overall, investors can expect us to keep growing and keep on the theme of paying a stable dividend as we grow the business.

We hope after the initial shock of this move that the competitive advantages of our business model and team and what we’re doing will shine through, even relative to other independent power producers.

Mainly, we don’t have the same levels of exposure to coal power or to selling wholesale power into the spot market. That’s the kind of vulnerability that hurt companies like Dynegy Inc (NYSE: DYN), and we don’t have it.

Question: What’s the reception been on Bay Street and Wall Street to your change in strategy?

Answer: We’ve been talking to them, and they’ve been asking many of the same questions you have.

I think first we’re just going to have to wait for things to settle down for the stock, and that means waiting for the reaction to the dividend cut to go through.

We made a big shift, and now it’s going to be up to us to prove ourselves. There’s no doubt we’ve turned off a lot of investors with this switch, and we’ve heard from many of them directly.

What’s going to have to happen for a recovery is for other investors, with objectives consistent with what we’re trying to provide now, to come and kick the tires and take a look.

As you know, most of the analysts covering us have been on the bearish side for some time. They’re now adjusting their view with what we’re saying, and we’re trying to help them understand our assets and our plan.

But let’s face it. They’re going to want to see some milestones met before they’re going to stick their necks out.

Some important ones in the near term I think are going to be our ability to complete the sale of the Florida assets, our ability to syndicate the Canadian Hills financing, our ability to invest the proceeds from asset sales that are going to show up about mid-year and, of course, how we stack up against our payout ratio guidance.

We’re clearly a show-me story now. And we have to execute.

Question: What’s the company’s exposure to a potential tightening of credit conditions? What’s the capacity to cut debt with the reduced payout? What’s the company’s goal?

Answer: As I said before, the Curtis Palmer loan refinance in mid-2014 is the next maturity.

The cash-flow saving from this dividend reset doesn’t immediately allow us to pay off debt, but it will help because we literally don’t have to access the capital markets until mid-2014, which gives us time to show we can execute our strategy. I’d rather do so with a 50 percent debt, 50 percent equity split, but we could do a project finance deal if needed.

That’s protection against a near-term tightening of credit. After that, the focus is on de-levering the balance sheet gradually over time. Lots of things can help this, tax-equity financing for Piedmont for one. So will meaningful acquisition and development efforts that add cash-generating assets at lower leverage.

Our big maturity is obviously when the high-yield debt we issued in late 2012 comes due. We have a call in November 2014. We paid more for this than we wanted to, and it’s traded in by 200 basis points, so this is really an opportunity to not only deleverage but also to cut interest costs potentially.

We have the flexibility to call it in over time. But the key is we now have time to get this done right.

We’re obviously going to tailor our debt reduction goals to keep in line with our other objectives, mainly to grow the company. But we believe we are both protected against near-term tightening of credit conditions as well as positioned to bring down leverage over time.

Question: How are you hedging currency risk, interest-rate risk, fuel-cost risk and wholesale-selling-price risk now as an operating company?

Answer: There’s really no change here from past policy. We watch all three components very carefully and try to absorb as little direct impact from them as possible.

We will continue to pay our dividends in Canadian dollars and to hedge the portion of cash flow needed that we don’t generate from Canadian operations. After the dividend cut we’re actually a bit over-hedged, or long, on the Canadian dollar and will probably unwind some of the position. But our strategy of factoring out the currency risk remains very much in place.

As for the rest of the business, we’re going to continue to extend contract lives. That’s something that’s going to continue to happen swiftly in the coming months.

All of our new projects are targeted to longer-term deals, and the near-term contracts such as in Florida are dropping off. And we will continue, of course, to manage the input risk within those contracts as effectively as we can as well.

Question: Any closing words for Canadian Edge and Utility Forecaster readers?

Answer: This was not an easy thing to do. But it was something we felt like we needed to address now for the long term, particularly in view of the pressures of our market.

We realize fully that we have made a lot of investors unhappy. And we are going to have to show everyone that our strategy can work.

Thank you for this opportunity to address your readers.

Conclusions

We can’t erase the losses we already have in this stock. And, conversely, the worst mindset we can have about this or any losing position is to double down in hopes of making it back.

Here are my takeaways from this interview, which support my current “hold” rating in this stock.

First, there’s absolutely no question that Atlantic management is going to have a credibility problem for some time.

This has always been a more complicated company than most. Cutting the dividend so dramatically leaves very little level for comfort. And judging from the massive volume in the stock, a lot of investors can’t get out soon enough.

Encouragingly, one place we haven’t seen carnage is in the company’s bonds. These in fact have scarcely moved since the fourth-quarter announcement, which is a nice affirmation of the company’s odds of staying solvent.

But it’s going to be very tough for Atlantic to raise any equity capital anytime soon without raising some real questions about dilution–that is until it executes on certain benchmarks.

Here’s what I’ll be looking for by mid-2013:

• Successful completion of the sale of the Florida plants at the stated price.
• Successful syndication of the Canadian Hills financing.
• At least one new project announcement.
• Successful completion of the Path 15 power line sale.
• Payout ratio in line with guidance.

In my opinion, Mr. Welch has given us enough reason with these answers–as well as the others given to the general public and analyst community last week–that Atlantic can execute on these goals. And it also appears the company has turned itself into a very hard target. If the power market stays chronically weak, it can still survive.

More important, I’m still satisfied that management’s long-term plans to build a business–though obviously set back recently–still have a potential pathway to success.

In Canadian Edge over the years we’ve had the good fortune to hold several companies that have taken heavy blows, including dividend cuts, but have later gone on to produce great wealth for shareholders.

TransForce Inc (TSX: TFI, OTC: TFIFF) is one that’s recently flowered. And fourth-quarter earnings–which we’ll detail in the March issue, which will be published on Friday, March 8–point the way to much more ahead.

We’ve seen the same thing happen with several Utility Forecaster recommendations as well. CMS Energy Corp (NYSE: CMS) and NV Energy Inc (NYSE: NVE), for example, were one false step from bankruptcy in 2002 but have multiplied investors’ money many times since.

Despite this week’s events my view is still that Atlantic is much more likely to follow that route, rather than go down the proverbial rat hole, a la Yellow Media Inc (TSX: Y, OTC: YLWDF).

But this is fundamentally a much different investment than it was a week ago, and we can’t afford to blithely ignore what we now know.

So here it is. Despite the red ink, my advice on Atlantic Power remains to hold the stock, with the following caveats.

First, this is not a suitable investment for conservative investors at this time. We didn’t know it wasn’t before this week. But based on the facts as presented, there are challenges and unknowns here. If you can’t take the risk of another 50 percent drop from here, sell this stock.

Second, I do not recommend investing new money in Atlantic at this time, especially if it’s an attempt to average down the price. I truly appreciate management’s answers to us in this interview and believe they are sincere. But they’re going to have to execute their plan before this stock is again a buy.

I’ve heard from many readers over the past week, and I’m fully aware many own or have owned Atlantic stock. But at this point it’s just one losing stock in a year where even most of our Canadian Edge Holdings are doing well, and our utilities are hitting new highs.

The surest way to turn this loss into a full-fledged portfolio disaster is to really load up on it, i.e. build a position that’s out of balance to the rest of your portfolio.

Third, to reflect the changed nature of Atlantic Power–again, based on what we now know–I’m moving the stock to the Aggressive Holdings in Canadian Edge and the Growth Portfolio Aggressive Holdings in Utility Forecaster. This is where I put all of my most aggressive recommendations that are suitable only for those willing to take on the risks. Note that Atlantic Power’s Safety Ratings are also down several notches in both CE and UF, again based on the information we now have.

As I noted above, I’ve received a great deal of feedback from readers regarding Atlantic Power, many asking why-oh-why didn’t we get out before this news broke. I will strive to get back to each and every one of you in the coming weeks, though I hope this bulletin will answer what you want to ask.

But for now it’s important to know that I based decisions for Atlantic the same way I do every stock in our portfolios. That is, I only respond to what we know, not rumor.

True, using a stop-loss at some point the past couple weeks would have sold you out at a higher price than Atlantic is trading for now. Equally, however, Atlantic isn’t the only stock that’s been volatile or down-trending in recent months.

And a clear-headed look at the price action of the past few years shows clearly that most of these downward price breaks were short-lived, hurting only those who were whipsawed out with stops or who sold on momentum.

Obviously, we continue to try to pick stocks that are performing well as businesses, just so we can avoid a souring situation like this. But the only real way to protect yourself when I’m wrong–and this won’t be the last time, I promise you–is to diversify and balance your portfolio.

In other words, don’t let any one holding come to be such a large part of your portfolio that it can do serious damage. This won’t ensure you never have a losing position. But no matter what happens to an individual stock you’ll still be in good shape.