8/15/11: Canada: Still on Sale

By Roger Conrad • August 15, 2011

It was just a week ago that S&P’s downgrade of the US government sent global markets into virtual freefall. Now, after several days of bull-versus-bear tug of war, the mood seems suddenly tranquil.

Stocks investors couldn’t wait to dump a few days ago have suddenly returned to the upside. Many are virtually back where they were before the selling began in earnest.

That’s true of the vast majority of Canadian Edge Portfolio recommendations. My oil and gas producers were particularly volatile early last week, with most following crude prices sharply lower. Since the middle of last week, however, even they have moved higher. Enerplus Corp (TSX: ERF, NYSE: ERF), for example, crashed to barely USD24 at one point but is now back pushing toward USD30.

As I pointed out in the August issue of CE as well as in several Flash Alerts last week, stocks of companies with strong underlying businesses always recover bear market losses. The key is to ensure your picks are still strong fundamentally.

Odd are, unless you’re very lucky, some of your companies will stumble when times get tough. That happened with Yellow Media Inc (TSX: YLO, OTC: YLWPF), which I advised swapping for Student Transportation Inc (TSX: STB, OTC: STUXF) in the August issue.

Student Transport is up about 10 percent from last Monday’s close. The only real news last week was the company has received approval to list its common stock on the Nasdaq and expects to begin trading under the symbol “STB” on Sept. 6, at which time it’s possible we’ll see another solid round of earnings. My buy target for Student Transportation remains USD7.

As for Yellow Media, as I wrote in the “sell” recommendation, it’s not uncommon for a particularly beaten-up stock to bounce. That may be happening now. But my reason for riding the stock down all that time no longer exists (see the August Dividend Watch List), so I’m out. I’ll  continue to monitor the company in How They Rate.

The good news is the rest of the nearly three-dozen CE Portfolio companies did post solid second-quarter 2011 earnings. Even better, they indicated results would also be solid the rest of the year, even as managements maintained generally cautious outlooks for the broad economy.

As the Portfolio tables on the Canadian Edge website show, many of my favorites have rebounded on the strength of their numbers. In fact several, such as Cineplex Inc (TSX: CGX, OTC: CPXGF), have surged back above my buy targets after spending several days below them.

If you didn’t get in at the lower prices, just remember there’s nothing fixed about stock prices in the near term. There’s also no guarantee another market event such as we saw last week will carry prices back below target again anytime soon. But as of this writing at least, there are still plenty of strong companies available at low prices.

That’s true of Extendicare REIT (TSX: EXE-U, OTC: EXETF), which I featured along with Student Transportation as a High Yield of the Month in August. The company’s second-quarter earnings call included an extensive analysis of the impact of the recently announced 11.1 percent reduction in Medicare rates, which I touched on briefly in last week’s Flash Alert.

Fleshing out the numbers, management now projects an “annualized reduction” in revenue and cash flow for USD57 million, including the effect on both Medicare and managed care rates. In addition, the company expect cash flow to be hit a further USD13 million to USD23 million by policy changes for “group therapy and assessment policy.”

That’s a combined impact of USD70 million to USD80 million per year. In comparison, second-quarter revenue was CAD520 million (USD530 million), while cash flow was CAD65.1 million (USD67 million). Annualized, that’s a maximum impact of about 3.8 percent of revenue, but about 30 percent of cash flow.

The key to dealing with it will obviously be cost controls. In my August High Yield of the Month write-up of Extendicare, I noted that management had commented on a proposed 11.3 percent reduction in Medicare payments during its first-quarter conference call, and that it was almost certain to have formulated plans to cut costs, were the final reductions to be of that magnitude.

That view appears to have been vindicated. Management used its second-quarter call to detail plans to reduce the impact on annual cash flow between USD15 million and USD20 million. That’s in addition to anticipated interest savings of USD14 million from the refinancing plan announced earlier.

Assuming it’s successful, that will effectively reduce the annualized impact on cash flow to a range of between USD36 million and USD51 million, or 13 to 19 percent of annualized cash flow. As a result, CEO Timothy Lukenda reaffirmed in the second-quarter conference that the board of directors feels the “distribution is at a supportable level now going forward.” And that’s not including the accretive impact of buying back stock or expansion opportunities that may arise from the demise of less-well-capitalized rivals in the wake the Medicare cuts.

The stock has basically stabilized since last week’s conference call and remains cheap, yielding more than 11 percent. Given that dividend growth is now unlikely, I’m taking my buy target down to USD10 for now. Investors, however, should have no problem buying Extendicare REIT under USD8 for the time being.

All four CE Portfolio picks announcing second-quarter profits since Friday’s Flash Alert are also still on the bargain counter. Starting with the Conservative Holdings, Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–formerly Macquarie Power & Infrastructure–saw its cash flow and funds from operations rise 23.3 percent and 39.7 percent, respectively, from year-earlier levels.

Both figures exclude one-time items related to company restructuring and were backed by a 4.3 percent increase in revenue. Sales will get a further lift going forward from ongoing distributions from Scandinavian district heating investments as well as the Jun. 30 startup of the Amherstburg Solar Park in Ontario. The latter is operated under a 20-year sales contract to the provincial power authority at a preferential green energy rate.

As expected, the payout ratio for the first six months of the year came in a bit above 100 percent, with the seasonally weak second-quarter tally at 203.7 percent–slightly better than last year’s 214.4 percent. Hydro power production and higher rates at the Cardinal gas cogeneration plant were partly offset by lower wind output at the Erie Shore facility and maintenance outages.

Looking ahead, management still expects higher cash flow the rest of the year and states the current distribution is sustainable in a worst-case through 2014. That’s the same kind of guidance fellow Conservative Holding Atlantic Power Corp (TSX: ATP, NYSE: AT) gives investors, and it’s based on the extremely unlikely possibility the company doesn’t add any new projects to generate cash flow between now and then.

That guidance will also almost surely improve once the company has a new contract for power sales from the Cardinal plant. Management is currently in advanced, confidential negotiations with the Ontario Power Authority. During the second-quarter conference call CEO Michael Bernstein noted that “the negotiation process would take several months.” That means this issue will likely continue to hang over the stock for a while longer. The good news is the dividend of 9 percent-plus is solid, and new buyers have an opportunity to get in on Capstone Infrastructure well below my buy target of USD9.

Fellow power generation company Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF) saw even bigger boosts in output and revenue of 61 percent and 72.4 percent, respectively. That’s the result of solid performance at existing facilities, successful progress on asset additions and the company’s merger with its parent as part of its conversion to a corporation last year. Cash flow was up more than 80 percent and the payout ratio based on cash flows ex-one time items was just 36.4 percent.

The Cloudworks acquisition, completed last year, has proven to be a major plus for profits. Looking ahead, the company expects the Montagne-Seche and Gros-Morne Phase I wind plants to meet its target for Dec. 1, 2011, startup dates. Gros-Morne Phase II in target for a Dec. 1, 2012, startup date. Meanwhile, the Stardale solar project is set for a first-quarter 2012 startup.

All of these projects will immediately begin adding to cash flow under long-term contracts with provincial power authorities under favorable terms. And the company’s pipeline extends for years beyond. During the second-quarter conference call CFO Jean Trudel reaffirmed management’s long-term target of generating more than CAD250 million in annual cash flow by 2017. That’s roughly twice current levels and allows plenty of room for a return to dividend growth as well. My target remains USD10 for those who haven’t bought Innergex Renewable, a very strong, low-risk power play.

IBI Group Inc (TSX: IBG, OTC: IBIGF) shares took a big hit in the days leading up to its announcement of second-quarter results but have since recovered sharply. That’s no great surprise, given the very strong numbers.

Revenue surged 17.9 percent to a new quarterly record, while cash flow and distributable cash flow rose 29.6 percent and 7.1 percent, respectively. The payout ratio came in at just 77.3 percent, down from 101.6 percent a year ago and 85.5 percent in the first quarter of 2011.

Encouragingly, management reports both strong progress in gaining new orders for its contract design services as well as collecting on existing accounts. That’s the result of recent global expansion both organically and via acquisitions, which has been profitably integrated into the overall company. Recent initiatives include the acquisition of a Massachusetts-based firm with extensive ties in China, a huge market for IBI’s entire range of businesses and expertise.

During the company’s second-quarter conference call CEO Philip Beinhaker affirmed a long-term cash flow growth target of 15 percent a year, stating IBI is now “back where we should be.” That’s impressive, given the world economy is still not running on all cylinders and the fact that governments and businesses have been slow to commit to both big and small infrastructure-related design contracts. And management’s conservative assessment of markets is good reason to expect more solid numbers the rest of the year and beyond.

The stock still trades with a yield well north of 8 percent. That’s a number likely to grow going forward, as cash flows continue to expand and drive down the payout ratio. And because management generally finances growth with equity and cash flow, there’s little concern about debt. Buy IBI Group up to my target of USD15 if you haven’t yet.

Turning to the Aggressive Holdings, Ag Growth International Inc (TSX: AFN, OTC: AGGZF) is the last recommendation besides Student Transportation to report numbers. The stock has been all over the map this year, tumbling from more than USD55 earlier in February to barely USD37 in early August. It’s since rebounded into the low 40s.

The catalyst for the volatility is clearly that concerns about a slowing global economy will crimp the company’s grain handling business. That didn’t show up in second-quarter numbers. Rather, earnings per share of 91 cents were 5.8 percent above very robust year-earlier tallies. Revenue in the quarter and first half of 2011 were both at records, as strength in commercial grain handling trumped weather-related weakness in demand in western Canada and the negative impact of a stronger Canadian dollar.

The payout ratio came in at 65.9 percent of earnings, likely setting the stage for at least a modest dividend increase at the end of the year. As CEO Gary Anderson pointed out in the second-quarter call, sales growth is the “result primarily of 2010 acquisitions” which haven’t been “fully reflected yet on our bottom line.”

A second consecutive wet spring in Canada–which cut sales 14 percent there–is one reason that’s likely to be reversed going forward. And the company has also experienced some delays in expansion, particularly its initiatives in Eastern Europe. Here too, however, management is looking at improvements in the second half of 2011 and beyond, as Mr. Anderson noted that “demand is strong in both North America and overseas.”

Order backlog is strong, and growth appears set to soar along with global food demand. That’s a formula for a much higher stock price going forward. Now selling in the low 40s, Ag Growth is a solid bet for new buyers.

Here’s where I’ve updated second quarter numbers for Canadian Edge Portfolio picks. For buy targets, please refer to the Portfolio tables on the website, which include live quotes and dividend information as well.

Conservative Holdings

Aggressive Holdings

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