5/20/11: Buyer’s Market

By Roger Conrad • May 20, 2011

We’re not quite back to bear market prices for Canadian Edge Portfolio recommendations. In fact, though many investors seem to be in a selling mood, we’re not likely to go that far anytime soon.

A rising number of recommended stocks, however, are now dipping below my long-standing buy targets, including several without any near-term “numbers risk”–i.e., they’ve have already announced first-quarter earnings.

Here are the Portfolio stocks that have already reported, along with where I analyzed the details. Investors should consult the buy targets and current prices in the Portfolio tables before leaping in.

Buying after earnings have been released is my preferred strategy in this market for two reasons. First, it’s the best way to ensure the dividend is still being well covered by earnings and that no problems have emerged since the prior quarter’s report. You’re buying in on the most complete and timely information available regarding the strength of the underlying business, which is the guarantor of dividend safety and growth potential.

Second, even strong numbers in this market are being met with selling in many cases. Consequently, you’re likely to get a better price for waiting as well. That means a higher yield that you’ll have greater confidence in. And a stock that’s sold off a bit isn’t as vulnerable to the missed expectations of what appears to be an increasingly fickle and demanding investing public.

Below I highlight the numbers from nine more Portfolio recommendations. The rest will follow by the schedule listed at the end of the Alert, though several companies have yet to announce specific dates, indicated by “estimate.”

These companies, like all but two of the Portfolio recommendations announcing before them, reported robust numbers that support strong dividend coverage, balance sheet strength and future growth plans. I’m sticking with all of them and have raised buy targets for several.

To review, the exceptions to this bullishness were Colabor Group (TSX: GCL, OTC: COLFF) and Perpetual Energy Inc (TSX: PMT, OTC: PMGYF).

Colabor is currently a hold pending a read on its ability to pass through costs in the second quarter.

Perpetual is a buy up to USD5, but only for those willing to bet very aggressively on management’s skill navigating a very tough environment, as well as on an eventual recovery in natural gas prices.

The company reported first quarter numbers basically in line with management guidance. But it cut its monthly distribution in half in order to deploy capital to increasing production of light oil and natural gas liquids. The payoff could be great for the patient here. But anyone who does stick with Perpetual needs to be prepared to suffer even another dividend cut while they wait.

Finally, I recommended selling CML Healthcare Inc (TSX: CLC, OTC: CMHIF) in the May issue of CE, as the sudden firing of the CEO and COO seemed to signal worse news ahead and a potential change in direction as well. This week’s report confirms operations in the US are still a mighty drain on the company’s financial strength, despite its still solid position in Canada.

Sales dropped 8.3 percent overall, as a 30.6 percent drop in US revenue more than offset a slight gain in Canada. Cash flow did improve, reflecting cost cutting measures. But it looks like there’s more bloodletting to come, particularly with the company suddenly bereft of its long-time top bosses.

The market, which continued to sell off CML following my recommendation, is apparently taking the first-quarter earnings announcement as a sign the worst is behind the company. That’s far from clear in my view, particularly given the US operations’ dependence on an increasingly unclear long-term US health care policy. Equally murky is just what the proper metric is for measuring the safety of the dividend. Consequently, I continue to advise investors steer clear of CML Healthcare.

The Nine

ARC Resources Ltd (TSX: ARX, OTC: AETUF) reported a 16 percent increase in funds from operations (FFO) in the first quarter of 2011, or 1.5 percent per share after a 13 percent increase in outstanding shares. The company also increased capital expenditures by 23 percent and boosted overall production 10 percent, notably with higher output of 50 and 41 percent in condensate and natural gas liquids, respectively. Natural gas production rose 13 percent.

Offsetting these positives was a 25 percent drop in realized selling prices for natural gas, which tilted the company’s overall price per barrel of oil equivalent downward 6 percent. Operating costs also rose 9 percent, reversing recent quarterly drops in large part because of one-time operating problems at Dawson gas plant, which were mostly because of adverse winter weather.

The good news is first-quarter FFO still covered the monthly distribution by more than a 2-to-1 margin (payout ratio 44.1 percent). Debt-to-annualized cash flow, meanwhile, remained at a very well behaved 0.9-to-1 ratio, with net debt representing just 9 percent of total capitalization. The company also expects to finance all capital spending and dividends in 2011 with free cash flow plus proceeds from the dividend reinvestment plan (available to Canadian investors). That eliminates any potential reliance on outside funding, and it’s an extremely comfortable cushion for ARC as it continues to shift production to higher-priced liquids and low-cost shale gas.

The company is being negatively impacted by the wildfires and flooding hitting several areas of operation. That’s caused management to estimate average 2011 output of 80,000 to 85,000 barrels of oil equivalent per day (boe/d), but it’s sticking to an exit production rate of 90,000 boe/d, per initial estimates.

The upshot is these results prove conclusively that ARC has successfully absorbed corporate taxation and is dealing with a weak environment for natural gas, even as it realizes its goals of ramping up low-cost output. Also, Dawson is now ramping up to normal levels. That leaves the impact of fires and floods to overcome. Now back from its highs, ARC Resources is again a buy for those who don’t already own it, up to my target of USD25.

Artis REIT (TSX: AX-U, OTC: ARESF) announced first-quarter revenue 87.4 percent above year-ago levels, while same property net operating income–a well-worn measure of real estate investment trusts’ profitability–surged 76.4 percent. Funds from operations (FFO), the account from which dividends are paid, moved up 83.6 percent.

FFO per unit of 28 cents was 3.7 percent higher than year-earlier levels and 12 percent above the fourth quarter 2010 reading. Interest coverage rose to 2.23-to-1 from 2.15-to-1 at the end of last year and mortgage debt to gross book value was reduced to 51.3 percent from 52.6 percent. The payout ratio for the quarter–which is traditionally weak due to heating costs–came down to 96.4 percent, a good portent for the rest of the year.

The REIT acquired 13 properties during the first quarter, ranging from Alberta industrial parks to a Minneapolis office building, continuing the past few years’ torrid pace of expansion and geographic diversification. It completed CAD60.3 million of these deals, while announcing CAD242.3 million more.

Rents portfolio-wide are still 2.4 percent below market, while occupancy is robust at 95.3 percent. Newly acquired properties meet this high-quality profile as well, ensuring they’ll be accretive to cash flow as absorbed. And Artis’ low cost of capital, both debt and equity, ensure even the least risky propositions are very profitable.

Though it’s recently shown signs of life, the REIT’s once core Alberta market remains relatively soft. These results show Artis has the financial power and portfolio quality to continue weathering that, while laying the groundwork for much larger cash flows down the road with its acquisitions. That plus a generous yield of 7.7 percent, paid monthly, make Artis REIT a buy up to USD15 for those who don’t already own it.

Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRBMF) posted total first quarter generation of approximately 1,500 gigawatt hours. That was about 5 percent below the power plant fleet’s long-term average, as lower hydro inflows in Ontario offset solid wind output.

Overall revenue was off 11.7 percent and operating cash flow per share was 12 percent lower. The income trust, however, still covered its distribution by a 1.33-to-1 margin, or a payout ratio of 75 percent. The average price per megawatt hour was flat with year-earlier levels. The year ago was characterized by hydroelectric generation that was well above long-term averages, thanks to above-average water flows.

Brookfield invested $3.7 million in major maintenance and sustaining capital expenditures during the quarter out of a total of $39.8 million expected for all of 2011. That includes work that should increase potential output at plants in British Columbia, New England, Ontario and Quebec. Management also reported substantial progress at the Comber wind farm for a fall 2011 commissioning.

Revenue collected from wind power plants is generally on a capacity basis and is therefore more stable than hydro power revenue. The company has spent about CAD130 million to date on the project, which is expected to generate substantial accretive cash flow after startup. That’s also true of major expansions at the Prince and Gosfield wind farms, set to come on line in 2012 and 2013, respectively. The company’s plants and projects overall are 99 percent contracted, with a contract duration of approximately 20 years.

Looking ahead, Brookfield Renewable’s growth will depend on winning more contracts, which, in turn means a continuation of supportive federal and provincial policies for wind and hydro. The good news is, despite Conservative Party pushback on some subsidy issues, Canadian wind and hydro remain very price competitive and enjoy considerable support. That means more construction projects are likely, even as existing business is locked in by enforceable contracts.

Management offered no fresh details on its corporate conversion plans in its first-quarter announcement and earnings call. But with no taxes owed until at least late 2014 even as an income trust, there’s no great rush to make a move. Brookfield Renewable Power Fund trades above my buy target of USD22 but remains a solid value up to that price.

Daylight Energy Ltd (TSX: DAY, OTC: DAYYF) had a lot of good news for investors in its first-quarter earnings report.

First, the payout ratio came in at a very steady 32 percent, proving again the company’s ability to produce superior results despite corporate taxation and sliding natural gas prices. In the May Portfolio Update, I noted the company’s operating highlights report indicated strong progress with its development of light oil properties in the Pembina Cardium region. The first-quarter report further elaborates on the effort as well as the rest of the Deep Basin properties, which now comprise more than 95 percent of Daylight’s output.

The focus on the Deep Basin is part of a long evolution at the company, which began with management’s novel approach of acquiring land adjacent to property under development by major oil producers. So doing, the company was able to learn what technologies and strategies would best serve its purposes, and it’s since focused on these while divesting the rest of its holdings–usually for cash at a substantial profit to plough back into the operation.

One area of particular importance is the Rock Creek liquids-rich gas wells, which continue to perform above expectation at liquids rates of well over 50 barrels per thousand cubic feet. Natural gas liquids (NGL) are in hot demand throughout North America as substitutes for much higher priced oil. The company has now increased its capital budget for the year to CAD350 million, with a focus on Pembina Cardium light oil and Rock Creek NGLs and on “de-bottlenecking” production infrastructure in the region to allow a future ramping up of output in both areas.

That should also help the company maintain low operating costs, which it’s now projecting between CAD9.50 and CAD9.90 per barrel of oil equivalent (boe) for full-year 2011. The disruption of a gas plant temporarily shut in about 8,500 barrels of oil equivalent per day (boe/d) of the company’s NGLs-rich gas (85 percent gas, 15 percent NGLs). That took average first-quarter output down about 3 percent to 39,257 boe/d, and it will have some impact on second-quarter results as well. Nonetheless, work is proceeding on improving needed infrastructure, and the company still expects to achieve its projected exit rate of 43,000 boe/d at the end of 2011. The impact on cash flow is expected to be less than 1 percent.

Meanwhile, funds from operations were actually 22.2 percent higher in the first quarter of 2011 than they were a year ago and were slightly higher than the fourth quarter tally as well. That’s a testament to the success of the company’s move to liquids, which were 38 percent of first-quarter 2011 output despite the plant outage. Realized selling prices for natural gas were off 26.5 percent from last year, while oil and liquids prices were up about 10 percent.

All in all, it was a very solid quarter. My buy target for Daylight Energy remains USD11 for those who don’t already own it.

Enerplus Corp’s (TSX: ERF, NYSE: ERF) combined oil and gas production averaged 75,483 barrels of oil equivalent a day (boe/d), in line with management’s projections despite the one-time effects of unplanned plant outages and extreme weather in some areas. That’s a sound testament to management’s financial and operating flexibility to weather the ups and downs of its often-volatile business.

Importantly, oil and natural gas liquids (NGL)–which enjoy a favorable pricing environment–have now been increased to 44 percent of total output, with a target of near 50 percent as the company continues to execute its development program. Enerplus’ three major new development initiatives in the US Bakken, “waterflood” Canadian properties and the Marcellus Shale in the US continue to proceed successfully. Waterflood properties are chiefly light oil properties in the Cardium and Ratcliffe regions, where the company has been able to deploy cutting edge technology to revive older lands. Development in Bakken has been “slowed” according to management because of high industry levels of activity in the region. That’s now been remedied by long-term agreements to secure drilling rigs and fractionation services in North Dakota and Montana.

Impressively, Enerplus slashed its operating costs to CAD8.40 per barrel of oil equivalent, an 8.7 percent cut from last year’s levels due to a refocus on richer properties and moves to cut electricity costs. The payout ratio came in at a solid 60 percent of distributable cash flow. Including capital spending (estimated at CAD650 million for all of 2011), the ratio came in at 169 percent, reflecting the outside capital needed to develop Bakken, Marcellus and the “waterflood” resource. That, in turn, has increased debt-to-annualized cash flow to approximately 1.2-to-1, but is expected to decline in 2012 and beyond as the production ramps up at these developments.

In the meantime, the ratio is among the lowest in the industry, reflecting Enerplus’ conservative financial strategies. Coincident with the earnings report, the company reported the sale of a portion of its Marcellus assets for USD575 million, primarily 91,000 non-operating acres with current production of 5.4 thousand cubic feet of gas equivalent per day. The cash will further focus the company’s efforts on its most promising assets by concentrating the remaining acreage, a key to keeping costs under control for the entire project. It’s the kind of move management has executed to great benefit in the past, and it’s strongly bullish for the company going forward as well.

The stock has backed off slightly in the face of falling oil prices, but Enerplus is superbly positioned for long-term growth. Selling with a yield of 7.5 percent (monthly dividend), Enerplus is still a solid buy up to USD33.

Just Energy Group Inc (TSX: JE, OTC: JSTEF) has made a habit of reporting record quarterly results recently. And fiscal fourth quarter 2011, announced this week, was no exception.

The key once again was adding new customers to its retail electricity and gas profitably. Acquisitions in Canada and the US boosted customer additions 462 percent above last year’s adds, with 77 percent growth in additions from the company’s own marketing efforts. That lifted sales 16 percent, even as productivity and efficiency measures lifted gross margin per unit by 18 percent.

Distributable cash flow after all marketing expenditures–essentially Just Energy’s capital spending–was up 21 percent. That took the payout ratio after all marketing expenditures down to 63 percent from 72 percent a year ago. Turning to full-year results, the customer base grew 45 percent, spurring a 28 percent jump in sales and 6 percent increase in gross margin per unit. The payout ratio came in at 88 percent after all marketing expenditures. The company’s customer base is now about 3,314,000, well represented on both sides of the border.

The JustGreen product continues to attract attention, with 36 percent of residential customers now taking an average of 90 percent or better of green supply. Fundamentally, the retail electric and gas business is about continuing to reach new customers and retaining enough existing ones to combat the inevitable attrition, as tire kickers and bargain hunters move on to try something else.

The good news is Just Energy in fiscal 2011 held “customer attrition rates at or below target levels in all markets for the first time in several years,” according to management. That’s a good sign the overall industry is maturing a bit, particularly since currently low wholesale electricity prices increase the competition and make it more difficult for companies like Just Energy to differentiate themselves. So does the fact that fourth-quarter earnings showed generally improved metrics versus the rest of the year’s numbers, allowing full-year numbers to best fiscal 2010 results despite a record mild winter and US dollar weakness.

The company also enjoyed success in the waterheater rental business, scoring a 154 percent jump in sales and a 123 percent increase in margins. This business, added as part of a recent acquisition, both stabilizes overall revenue and gets the company into more people’s homes from which it can sell other services. Management’s growth goals for fiscal 2012 appear modest at first glance: a 5 percent boost in per-share growth of gross margins and cash flow. That reflects and expectation voiced by Executive Chair Rebecca MacDonald that this is “a low inflation environment and the growth (will be) driven by expected customer growth rather than increased margins per customer.” Ms. MacDonald also believes customer attrition “trends will continue to decline in the US in the coming periods given that all new customers signed over the past three years are at rates consistent with current commodity rates.” She sees a 70 percent renewal rate, with bad debt in the target range of 2 to 3 percent.

That will be more than adequate to sustain and eventually grow the monthly dividend, which currently equates to a yield of 8.3 percent. Buy Just Energy Group up to USD16.

PHX Energy Services Corp’s (TSX: PHX, OTC: PHXHF) first-quarter revenue surged 46 percent, spurring a 79 percent jump in cash flow from 2010 levels. The catalyst: Rising drilling activity that continues to dramatically increase demand for the company’s equipment and related services.

PHX added CAD10.2 million of equipment in its first quarter and has another CAD20.7 million scheduled for delivery by late summer. Management also announced it will increase its full-year capital budget by CAD10 million to CAD47.8 million, a move that induced it to boost its short-term borrowing facility to CAD70 million. Growing the business is what makes a company more valuable. PHX’ problem in the previous quarter was its rapid pace of order growth seemed to have outpaced its ability to meet it, resulting in much higher costs and lower profits. My concern going into this quarter was we’d see more of the same. The company’s 52.4 percent boost in funds from operations per share, however, has largely laid those worries to rest in my view.

The payout ratio, for example, has settled back to a modest 37.5 percent, while debt has been cut 10 percent from Dec. 31, 2010, levels, even as capital spending has been ramped up. Operations outside North America, meanwhile, have expanded to 9 percent of consolidated revenue in the first quarter, up from 5 percent for all of 2010. And with Russian operations starting to contribute, that figure will continue to rise throughout the year. That makes the company progressively less dependent on the ups and downs of North American drilling, a big plus with natural gas prices still very depressed here.

US revenue is currently 31 percent of the company-wide total. Canadian operations (60 percent) are benefitting from exceptionally strong growth in oil drilling. Horizontal and directional drilling are PHX’ specialty, and now comprise a growing 70 percent of total drilling activity in North America. That puts the company squarely in the sweet spot to benefit. And, unlike most rivals, it has no real exposure to conventional drilling, which continues to decline.

On the negative side, we did see a 45 percent jump in direct costs at the company in the first quarter from year-earlier levels. Gross profit as a percentage of revenue–which puts these costs into the context of the company’s growth–actually rose to 27 percent from 26 percent a year ago. And that percentage should rise further in coming quarters, as PHX adds new equipment and slashes exposure to the third-party rentals that drove up costs in the prior quarter.

In short, the company looks back on track and ready to profit from the most profitable segments of the drilling industry. Buy PHX Energy Services up to USD14 if you haven’t yet.

RioCan REIT (TSX: REI-U, OTC: RIOCF) posted a 9 percent increase in operating funds from operations per share for first-quarter 2011. The CAD0.35 per share produced a distribution coverage ratio of 1.02-to-1, continuing a trend of steady improvement that should lead to a return to dividend growth in the next 12 months.

Portfolio occupancy rose to 97.4 percent, and the real estate investment trust expanded its portfolio as well, adding a dozen properties (11 Canada, one US) since the start of the year. The company also continued to cut its cost of capital, redeeming an issue due April 2014 with an interest rate of 8.3 percent by issuing debt paying out at just 4.5 percent. A newly inked joint venture with Tanger Outlet Centers to develop a string of outlet malls in Canada promises a new revenue stream in coming years, with a high percentage payoff. And same-store growth was 0.6 percent, demonstrating the company is still enjoying success getting more from its existing portfolio.

The average rent increase for lease renewals was a robust 8.7 percent. Improvement was especially evident in the US, where same-store net operating income surged 6 percent over year-earlier levels in US dollar terms. In addition, the sequential gain of 4 percent from the fourth quarter shows the trend is accelerating, a sure sign management has chosen its US acquisition targets well and is reaping the benefit of sharply improving performance.

That, in effect, is what RioCan has been known for in Canada, and proved again during the 2008-09 downturn. The fact that it’s doing the same in the US is again a testament to its management team’s skill running properties as well as finding opportunity for growth. National and anchor tenants–the kind that don’t vacate and have staying power in a tough environment–now contribute 86.8 percent of annual revenue, up from 85.4 percent a year ago. And no single tenant contributed more than 4.6 percent of overall revenue. Debt, meanwhile, is just 47.1 percent of assets, with no major maturities this year. That’s solid insurance against an economic relapse.

If I have a problem with RioCan, it’s the relentless rise in its unit price, which has made a new all-time high this month in US dollar terms. The yield of 5.3 percent (paid monthly), however, is percentage points above that of US REITs of far lesser quality and growth potential. New investors should wait for a dip to USD25 or lower to buy, but RioCan REIT remains a cornerstone holding for those who own it.

TransForce Inc (TSX: TFI, OTC: TFIFF) enjoyed a 20 percent increase in first-quarter revenue, spurring a 35 percent jump in cash flow. Adjusted profit–the key metric on which dividend safety is based–more than doubled to CAD0.12  per share. That gave management room for its first-ever dividend increase since converting to a corporation in 2008, a 15 percent boost to a new quarterly rate of CAD0.1156 per share.

Dividend coverage was 1.06-to-1 based on adjusted profit, a strong number given that the first quarter is seasonally weak for the transport/logistics business in Canada. And it portends more payout growth ahead as the company continues to profitably consolidate its industry. The acquisition of Dynamex Inc is one such deal that’s only beginning to show up in profit. The new unit is the company’s initial foray into the also fragmented US transport/logistics market. CEO Alain Bedard states TransForce intends to double its revenue south of the border in the oil rig moving business and is likely to acquire other competitors as well. This from a recent interview: “There’s a market for us in Texas, Louisiana. Oklahoma (where) we’re not present today…If you look at the energy (sector) I can’t do anything in Canada because I’m number three behind two good companies, so this is why to me, the growth has to be in the US.”

A strong Canadian dollar and the company’s abundant cash flow should speed its entry, though realizing profit will depend on reducing the impact of negative currency swings.” All in all, this company is doing exactly what I hoped when I added it to the CE Portfolio in November 2009. Coupled with the dividend increase, TransForce is now a buy up to a higher target of USD15.

Here are announced dates for the rest of the Portfolio for earnings releases. Note dates can change so stay tuned to my Flash Alerts, when I’ll be updating numbers.

Aggressive Holdings

  • Ag Growth International (TSX: AFN, OTC: AGGZF)–Jun. 9 (confirmed)
  • Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)–May 30 (confirmed)

Conservative Holdings

  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)–May 25 (estimate)
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–Jun. 9 (confirmed)
  • Extendicare REIT (TSX: EXE-U, OTC: EXETF)–Jun. 7 (confirmed)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)–Jun. 1 (confirmed)
  • Innergex Renewable Energy (TSX: INE, OTC: INGXF)– Jun. 7 (confirmed)
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Jun. 14 (confirmed)
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–May 25 (confirmed)

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