11/14/11: Ag Growth and Atlantic Power: “A” OK

By Roger Conrad • November 14, 2011

Sometime after the markets close today Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF) will release its third-quarter earnings. That will be followed by a conference call Tuesday morning, concluding third-quarter earnings reporting season for Canadian Edge Portfolio recommendations.

Up to now the numbers have universally supported companies’ current dividends, balance sheet strength and growth plans. That goes for the two most recent reporters, Ag Growth International Inc (TSX: AFN, OTC: AGGZF) and Atlantic Power Corp (TSX: ATP, NYSE: AT).

During an early October conference call Ag Growth CEO Gary Anderson warned that the third quarter had been a challenging one for the company. The call was held to answer questions about the USD11 million purchase of Airlanco, a US-based provider of aeration and filtration equipment sold to the commercial grain-handling and processing sectors. The deal expands Ag’s manufacturing capabilities and customer reach and is expected to be accretive in both the short and long term.

Questions from analysts, however, quickly turned to expectations for third-quarter results, which had hurt the stock since summer. Management largely affirmed that weather-related factors had impacted sales and margins, including a speeded-up harvest in western Canada that hurt demand for grain-handling equipment. But Mr. Anderson also restated Ag’s view that its markets remain healthy and that this year’s woes would reverse in 2012.

Both of those assertions were clear in third-quarter results released today. Mr. Anderson started off this conference call by saying the results “didn’t meet the plan.” The company’s year-to-date sales hit a record, due to acquisitions and strong global demand for commercial grain-handling equipment. Sales for the third quarter, however, were 5.8 percent lower than a year ago, due to a weather-depressed harvest in North America and to some extent the stronger Canadian dollar. Cash flow after one-time items sank 35.2 percent.

Funds from operations–the account from which dividends are paid–fell 38.5 percent. Even with that, however, Ag’s third-quarter payout ratio still came in at just 57 percent, while the nine-month payout ratio is only 63 percent. That’s extremely good dividend coverage for what was clearly an off quarter.

Historically, demand for portable grain-handling equipment is seasonal, with the fourth quarter relatively light. Management expects that to be the case this year in North America, which is still the biggest source of sales (82.7 percent in the third quarter). Commercial sales in Russia, Ukraine and Latin America, however, continue to be robust. That should push commercial sales overall above last year’s pace.

Based on its conversations with it customers, Ag expects another large corn planting in the US for 2012, along with a return to normal historical activity patterns in western Canada. That’s of course subject to the weather. The company also expects to get its Twister storage bin plant up and generating cash flow by the end of the year, ending a cash drain as it starts 2012. It also anticipates a return to profit in Europe, which was hurt by a drought in Northern Europe and a spike in steel costs.

European results are seasonal, with losses typically in the first and fourth quarters of the fiscal year, so real improvement won’t be felt until spring. But with order backlogs high, acquisitions producing revenue and the company getting a further handle on costs–even as its asset base grows–management expects strong growth to return organization-wide in 2012.

As for the dividend, management is likely to wait for the numbers to improve before raising it again. But these numbers show once again that payout policy is conservative enough to absorb the shocks in a business that’s exposed to commodity price swings both for sales and costs. Steel, for example, is 29 percent of production costs, and the ability to pass those costs through is a key variable for margins.

In my view the weakness in Ag Growth’s stock this year has been largely due to worries that the global boom in agriculture would fizzle in a worldwide recession, caused in large part by European credit problems. That’s basically the same bear argument that has driven down the prices of many commodity-price-sensitive stocks since summer, with only a partial recovery since.

The good news is these results show there’s no such trend yet. Moreover, despite several adverse events in the third quarter that should be non-recurring, the now nearly 8 percent dividend is well covered with profits. And to the extent there is weakness in its industry, the company also has CAD75.5 million in largely undrawn credit lines from which to fund more expansion at rivals’ expense.

The bottom line: Despite a loss of nearly 40 percent in its stock this year, Ag is still on very solid ground. Investors should also note that this has historically been a volatile stock, with big drops routinely followed by large jumps depending on the market mood. That’s why it’s  an Aggressive Holding. But for those who can handle that, Ag Growth is a buy up to USD40, for a potential ride to a new high in the USD55 range in coming months.

As for Atlantic, the biggest news this month was the close of its acquisition of Capital Power LP, and the subsequent boost in the monthly dividend to an annualized rate of CAD1.15 per share. Third-quarter results released Friday afternoon don’t include the impact of either move. Nonetheless, they are encouraging.

First and foremost, management is maintaining 2011 project cash flow and payout ratio guidance. That’s the underpinning for this month’s dividend increase, and it’s apparently not affected by the cost of permanently financing the Capital purchase. The payout ratio for the quarter was 93 percent of distributable cash flow, down from 96 percent last year.

Project cash flows were basically flat, as contributions from the Cadillac biofuels facility and Idaho Wind plant largely offset higher maintenance costs at the Chambers plant and lower capacity payments at the Badger Creek facility. Such offsets are likely to be more common going forward with the addition of the Capital Power assets, adding more stability to overall results. So will enhanced diversification by geography and fuel type.

The biggest uncertainty for the company is integrating Capital Power personnel, a process that’s been ongoing for the past four months-plus. There’s also the need to roll over power sales contracts for a natural gas fired facility in Florida, though that’s much less important after the Capital merger. And Atlantic also must select a new chief financial officer in the coming weeks.

The good news is Atlantic has thus far retained virtually all operating personnel for facilities acquired in the deal. But successful execution on integration plans will be key to meeting management’s projection of improvements in cash flow and the payout ratio in 2012. The full-year 2011 payout ratio is currently expected to be between 100 and 105 percent, including this month’s dividend boost.

My biggest question going into this announcement was whether the cost of financing the Capital Power deal would significantly affect the economics. The details given in the conference call appear to answer that as a “no.” CEO Barry Welsh did state “the interest rate on the bonds was higher than originally anticipated.” But he also assured that “the transaction overall is still accretive and in fact in 2012,” despite “the obvious that paying more on financing takes away from some of the potential accretion.”

Atlantic does have the option to call the bonds after three years if conditions merit. If has extended its credit revolver agreement from CAD100 million to CAD300 million, while adding banks to the deal and extending the maturity to 2014. That’s a huge plus for future financing.

Moreover, integration risk and a lot worse is already priced into Atlantic at its current yield of nearly 8.5 percent. If you haven’t bought Atlantic Power yet, now’s a great time to jump in. My buy-up-to target remains USD16.

Where the Numbers Are

Here’s where to find my analysis and the numbers for Canadian Edge companies that have now reported third-quarter results.

Conservative Holdings

Aggressive Holdings

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