Earnings Flash Some Green, Some Yellow

By Roger Conrad • June 3, 2011 • Portfolio Update

Dividend-paying stocks follow dividend growth. That’s why a payout increase doesn’t just mean more current income for investors. Sooner or later, it leads to a higher stock price as well.

Prior to Oct. 31, 2006, well-run Canadian income trusts routinely raised distributions, some several times a year. Just like every other stock, their unit prices often fluctuated wildly in the short term in response to events that seemed important at the time but later proved trivial. But, inexorably, every dividend increase pushed the trust’s market value higher.

The Halloween night trust tax announcement put the brakes on trusts’ dividend growth. Rather, management began wrestling with the question of how much dividend their companies would pay when they inevitably converted to corporations, or alternatively elected to stay trusts and absorbed the specified investment flow-through (SIFT) tax.

A handful of the very strongest business trusts managed dividend increases in 2007. Energy producers took advantage of higher oil and gas prices in early 2008 to boost payouts. By late 2008, however, they were cutting in earnest. And even trusts that were basically recession-proof were in full defensive mode, focusing on holding down debt.

By late 2009 Canada had emerged from the recession and at least a handful of companies had resumed growing dividends. Only here in 2011, though, are we starting to see the resumption of across-the-board, regular dividend increases circa pre-Halloween 2006, as companies have paid down and refinanced debt, economic growth is established and the former trusts have started to get used to paying taxes.

The good news is the return to dividend growth is only starting to unfold across the Canadian Edge How They Rate universe. And it promises to be a powerful catalyst for solid total returns in coming years, so long as our companies remain healthy and growing.

Earnings season is when we get a read on how well individual companies are doing. When it comes to dividend paying stocks this is a matter of how well they’re covering current payouts and how fast they’re setting the stage for dividend growth.

The better they stack up, the higher the share price they deserve, and the better holdings they are. Companies that show weakness aren’t necessarily sells right away. But we want to put them on a short leash very quickly, and be ready to unload.

Coming into this earnings season I was looking for several things. First, as always, is coverage of dividends by the relevant measure of profits. Contrary to popular opinion, the best metric for profits isn’t always earnings per share (EPS). In fact, most of the former income trusts are still using some variant of distributable cash flow (DCF) as their primary benchmark for how much in dividends they can pay.

Sometimes referred to as “cash available for distribution,” “funds from operations,” “cash earnings,” “adjusted earnings” or “free cash flow,” DCF is basically the operating cash flow generated by the business less any interest costs, taxes and maintenance capital spending, or cash needed to keep the business running at its current level. This excludes growth capital spending, which the company can turn on or off depending on opportunity and economic conditions. It also excludes any one-time items that may boost cash flow, such as an asset sale, or a one-time item that reduces it.

The greatest advantage of using EPS to measure profits is it’s a standardized measure of profits under Generally Accepted Accounting Principles (GAAP). You can use it to compare companies across industries because the tally is always based on the same factors.

The greatest disadvantage is one size rarely fits all when it comes to analyzing businesses. Standardized measures such as EPS can leave such a misleading impression that it’s better not to use them at all.

DCF’s greatest advantage is it can account for those differences. The biggest drawback is you have to check how a company calculates it to ensure they’re not taking the liberties afforded by using a non-GAAP accounting measure.

The good news about first-quarter results from virtually all CE Portfolio Holdings is payout ratios are almost universally under control.

The second factor I’ve looked for is the health of each recommendation’s key divisions, on which they’ll be basing future growth. We did have one company this earnings season fall short on this count, CML Healthcare Inc (TSX: CLC, OTC: CMHIF), which appears to have lost its way in the US. I sold it from the Portfolio last month. The rest, however, continue to progress.

The third factor is debt. During the 2008 credit crunch Canadian banks held their own, and credit lines stayed open for Canadian companies. But those forced to refinance debt or borrow more to fund growth were socked with hefty interest rates, in some cases suffering fatal blows.

If we should see European credit woes, a US government debt default or even higher inflation send interest rates higher, those forced to borrow would also fare poorly. Companies that have used the record-low corporate borrowing rates of the past year-plus to take care of their credit needs, however, will simply be able to wait out any trouble, no matter how severe it becomes.

Consequently, my third number of interest this earnings season has been companies’ refinancing needs. And here again our exposure in the CE Portfolio is minimal.

Here’s how Portfolio companies stack up on this criterion. The first number shows the total amount of debt–i.e. bank loans and maturing securities–that are due between now and Dec. 31, 2012. The second number shows that as a percentage of market capitalization.

In general, any company with outstanding maturities totaling 10 percent or less of market capitalization will be able to handle a refinance even under the worst of circumstances without any real pain. Those with maturing debt through 2012 between 10 and 20 percent are slightly more at risk, but should still have little difficulty as well.

Conservative Holdings

  • AltaGas Ltd (TSX: ALA, OTC: ATGFF)–CAD100 million, 4.7%
  • Artis REIT (TSX: AX-U, OTC: ARESF)–0, 0%
  • Atlantic Power Corp (TSX: ATP, NYSE: AT)–0, 0%
  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)–0, 0%
  • Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPUF)–CAD280 million, 11.6%
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–0, 0%
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–CAD70 million, 14.0%
  • Cineplex Inc (TSX: CGX, OTC: CGXPF)–CAD335 million, 21.9%
  • Colabor Group Inc (TSX: GCL, OTC: COLFF)–CAD14 million, 5.6%
  • Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–0, 0%
  • Extendicare REIT (TSX: EXE, OTC: EXETF)–0, 0%
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)–0, 0%
  • Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)–0, 0%
  • Just Energy Group Inc (TSX: JE, OTC: JSTEF)–CAD33 mil, 1.6%
  • Keyera Corp (TSX: KEY, OTC: KEYUF)–CAD2 mil, 0.1%
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–0, 0%
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–0, 0%
  • RioCan REIT (TSX: REI-U, OTC: RIOCF)–CAD220 mil, 3.4%
  • TransForce Inc (TSX: TFI, OTC: TFIFF)–0, 0%

Aggressive Holdings

  • Acadian Timber Corp (TSX: ADN, OTC: ACAZF)–0, 0%
  • Ag Growth International (TSX: AFN, OTC: AGGZF)–0, 0%
  • ARC Resources Ltd (TSX: ARX, OTC: AETUF)–0, 0%
  • Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)–CAD75 mil, 17.0%
  • Daylight Energy Ltd (TSX: DAY, OTC: DAYYF)–0, 0%
  • EnerCare Inc (TSX: ECI, OTC: CSWUF)–CAD60 mil, 14.4%
  • Enerplus Corp (TSX: ERF, NYSE: ERF)–0, 0%
  • Newalta Corp (TSX: NAL, OTC: NWLTF)–CAD115 mil, 18.2%
  • Parkland Fuel Corp (TSX: PKI, OTC: PKIUF)–CAD274 mil, 37.4%
  • Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE)–CAD224 mil, 1.9%
  • Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–CAD75 mil, 14.1%
  • Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)–0, 0%
  • PHX Energy Services Corp (TSX: PHX, OTC: PHXHF)–0, 0%
  • Provident Energy Ltd (TSX: PVE, NYSE: PVX)–0. 0%
  • Vermilion Energy Inc (TSX: VET, OTC: VETMF)–0, 0%
  • Yellow Media Inc (TSX: YLO, OTC: YLWPF)–0, 0%

The bottom line is debt isn’t a real problem for Canadian Edge Portfolio Holdings right now. Should interest rates spike up, as some fear, these companies would likely pull in their horns a bit as far as expansion and acquisitions go. But by and large they’re much better protected against a credit crunch than they were in 2008, an event they basically sailed through.

My strategy is basically the same as it’s been since CE’s inception in July 2004: to stick with positions in companies that have healthy, growing businesses, and to sell companies that weaken. I avoid leverage unless I can get it by owning a single stock. I avoid stop-losses, a technique that more often than not sells people out at bad prices. And I don’t pay more than my target price for any company.

The market right now is undergoing one of those inevitable gut checks, particularly for the stocks that have fared best since early 2009. That includes the vast majority of Canadian Edge Portfolio Holdings. But as long as my picks are stacking up on payout ratio, key growth areas and debt refinancing, we have little to fear from the ups and downs.

At this point the price of many Portfolio stocks is still above what I consider to be good entry prices. There are plenty, however, selling below buy targets that have just reported very strong first-quarter earnings and even dividend increases, the ultimate affirmation of a company’s underlying strength.

This is where you want to focus any new buying now. The longer this gut check goes on, the greater the chance that others will join them in bargain territory. That’s the nature of selloffs. The first key to taking advantage is to be disciplined and wait for those prices before you buy. The second is to stay focused on the numbers and to ignore the hype that always accompanies volatility.

Remember, we’re trying to buy healthy, growing companies at the best prices we can. And that means, more often than not, looking at stocks when they’re less than popular, and generally eschewing what’s popular.

The Numbers and the Takeaways

As of press time, only five the 33 companies represented in the Canadian Edge Portfolio have yet to report their first-quarter 2011 earnings. I’ve listed them below, along with announced reporting dates. All have confirmed a date and time. I’ll be featuring their numbers in upcoming Flash Alerts as they come in.

Conservative Holdings

  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–Jun. 9
  • Extendicare REIT (TSX: EXE, OTC: EXETF)–Jun. 8
  • Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)–Jun. 7
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Jun. 14

Aggressive Holdings

  • Ag Growth International Inc (TSX: AFN, OTC: AGGZF)–Jun. 9

As for the other 30, I’ve reported on them extensively over the past month. Five were highlighted in the May Portfolio Update. Two others are the June High Yield of the Month, Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) and IBI Group Inc (TSX: IBG, OTC: IBIBF). The other 21 are rounded up in Flash Alerts sent out May 13, May 18, May 20 and May 26. Bird Construction Inc (TSX: BDT, OTC: BIRDF) is profiled below for the first time this season.

I’ve listed where to find my analysis of each company’s earnings. For those reading Canadian Edge directly from the website, you can simply click on the document name to go directly to the stock in question. A shorter version of this list with links for some of these was included with the May 20 Flash Alert.

Those of you who are printing out and reading Canadian Edge can simply go to www.CanadianEdge.com to print out the appropriate Flash Alert or article. Flash Alerts are listed under “Alerts” on the top bar. The May Portfolio Update article can be accessed by clicking on “Articles” from that top bar and going to the article “Volatility, High Expectations and Earnings.”

Conservative Holdings

Aggressive Holdings

So what have we learned from first-quarter earnings season thus far? Takeaway No. 1 is that not all companies are rocking and rolling in the current environment.

Of the five Holdings  I highlighted in the May Portfolio Update, Acadian Timber Corp (TSX: ADN, OTC: ACAZF), AltaGas Ltd (TSX: ALA, OTC: ATGFF) and Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) posted unambiguously bullish numbers.

All were able to translate investment into higher cash flows and laid the groundwork for more growth for the rest of 2011 and beyond. Payout coverage and balance sheet metrics were strong. Acadian and AltaGas both earned higher buy target prices.

On the other hand, Colabor Group Inc’s (TSX: GCL, OTC: COLFF) results were disappointing, as its need to hold market share prevented the company from fully recovering its costs. The distributor of food and related products was able to continue executing its aggressive acquisition strategy, and management assured investors any shortfalls would be temporary. The subject of dividend safety never even came up in the first-quarter conference call, and the two analyst downgrades were related to tempered expectations of future growth.

That’s all promising, and it’s convinced me to stick with Colabor shares, as apparently most investors are doing, as the stock price has stabilized. On the other hand, I won’t restore its buy rating until the company’s numbers improve as management says they will. Colabor Group is a hold.

Conversely, I found Yellow Media Inc’s (TSX: YLO, OTC: YLWPF) report to be encouraging, and its announcement did stabilize the stock price temporarily. Shares even rallied toward USD5 a few days later, after management won Toronto Stock Exchange (TSX) approval to buy back up to 10 percent of the company’s shares.

Then came a series of negative developments, starting with a vote in San Francisco to ban distribution of print yellow pages, except upon request. A few days later the company’s Chief Marketing Officer Stephane Marceau resigned “to pursue other career interests.” Alarmingly, the resignation was immediate, leaving no time for management to arrange a replacement, as is customary for executives truly departing on good terms. Mr. Marceau is still a “special advisor to the organization” for an unspecified transition period.

That seemed to set off a swirl of rumors about the company’s potential final demise and the stock sank to a new all-time low this week, before management at the behest of the TSX finally answered back. As I reported in a Jun. 1 Flash Alert, the response included assurances that the sale of a portion of the Trader business for CAD745 million was on track and that the distribution of CAD0.0542 per month is safe.

The play here is simple. Management is still projecting it will be able to transition its traditional print directory business to the Internet without a significant drop off in cash flow.

If it can do that, it will not only hold the current dividend but the stock will almost surely score hefty capital gains. If it can’t there will be at least one more dividend cut and very likely more asset sales to cut debt.

At this point, anything short of outright business failure seems unlikely to drive the stock down much further from the current point of 42 percent of book value and yield of nearly 17 percent.

But this is not one to double-down on, either, and it’s certainly not the kind of stock conservative investors should be involved in. Yellow Media is a hold.

I further discuss Yellow’s prospects in the Dividend Watch List section of Tips on Trusts. In that article I also look at Perpetual Energy Inc (TSX: PMT, OTC: PMGYF), which cut its distribution by 50 percent last month to deploy capital to growing its output of oil and natural gas liquids.

Perpetual has been ground down by the relentless drop in natural gas prices over the past several years. The bet is that management has now proofed the balance sheet against any reasonable scenario for gas prices–including a plunge under USD3 per million British thermal units–and has kept the company’s earnings super-leveraged to natural gas prices, which sooner or later are headed much higher.

First-quarter earnings for sure were hardly inspiring. But I’m willing to keep playing this one as a leveraged speculation that still pays a modest dividend of around 5 percent. As I’ve written before–see the May 18 Flash Alert—this stock is not for the conservative. Buy Perpetual Energy up to USD5 if you’re patient and willing to take the risk of another drop in gas prices.

Finally, Bird Construction Inc (TSX: BDT, OTC: BIRDF) reported first-quarter adjusted earnings per share of just CAD0.10, well below last year’s CAD0.33 per share and good for distribution coverage of just 0.6-to-1 for the period. Construction revenue slipped 5.8 percent versus year-earlier levels, mainly because of reduced construction activity in the resurgent oil sands region of Alberta. The company also faced contracting profit margins, as it was forced to compete for lower-profit contracts. And it also absorbed corporate taxes for the first time.

The good news from the numbers and accompanying guidance is backlog remains extremely strong at CAD1.0714 billion. That’s still mostly focused on public-sector contracts, but oil sands action is starting to tilt the balance back to the typically much more profitable private sector. Alberta activity has been affected by wildfires in recent weeks and should rebound as that situation is brought under control.

Bird also has no debt to service, but rather by the nature of its business maintains a large cash hoard. As a result, the monthly dividend rate of CAD0.055 per share looks set to hold, regardless of the current shortfall.

I’m not particularly happy about these results, which are basically a continuation of the tough times faced by Bird in recent quarters. On the other hand, they’re hardly catastrophic and, more important, likely mark a nadir for this company’s results. Rather, my biggest problem with Bird remains price. The silver lining is that these results may take the stock below my target of USD12, where Bird Construction rates a buy for those who don’t already own it.

So much for the bad news about first-quarter 2010 earnings. Takeaway No. 2 is that the other 26 Canadian Edge Portfolio Holdings reporting actually turned in very robust numbers. That includes oil and gas producers, energy infrastructure companies, financials, power producers, energy services companies, transports and even consumer services companies like Cineplex Inc (TSX: CGX, OTC: CPXGF).

Cineplex’ numbers were particularly impressive in that they were accompanied by a 2.4 percent dividend increase, the company’s first since it converted to a corporation without cutting its dividend in January. The theater operator did suffer a drop-off in attendance, as there were no comparable blockbuster movies to last year’s Avatar to draw audiences.

The company did hold cash flow steady, however, thanks to successful up-selling and merchandizing.

This trend that will only boost profitability going forward, as the company completed the purchase of New Way Sales Games in late May. NWS is a supplier and distributor of arcade games in the amusement industry.

Cineplex is now somewhat above my buy target but a solid value any time it dips to USD23 or lower.

Also impressive were results at PHX Energy Services Corp (TSX: PHX, OTC: PHXHF). The company’s fourth-quarter profit took an unexpected hit from higher costs, as it lacked the rig and service capacity to meet surging demand and had to essentially rent others’ assets. That dropped the stock from a high of over USD16 to a low of USD11.50 by mid-March.

First-quarter earnings apparently weren’t enough to take the stock back to the old high in the current environment. But they’re certainly good enough to silence the company’s critics, as PHX was able to accelerate purchases and delivery of new equipment. Costs continued to rise, but at a pace much slower than revenue grew. And the result was a return to robust growth, with cash flows surging 46 percent. International revenue was particularly strong, reaching 9 percent of overall company sales from 5 percent last year.

As for the bottom line–distributable cash flow–it covered the dividend by a 2.63-to-1 margin. Funds from operations per share, meanwhile, surged 52 percent. Energy services is a volatile business, and it always will be. But PHX is in prime position in an extremely strong niche, directional drilling. At least for now, it looks set to grow profits as fast as it can provide services. Yielding about 4 percent, PHX Energy Services is a buy up to USD14.

Newalta Corp (TSX: NAL, OTC: NWLTF) probably hasn’t attracted many income investors since it converted to a corporation near the bottom of the 2008-09 market crash. But since that time the company has been far and away one of the CE Portfolio’s biggest winners, surging from a Mar. 27, 2009, low of barely USD2 to a range between USD13 and USD14 this spring.

First-quarter results showcased plenty of reasons why. Revenue grew another 16 percent, spurring a 20 percent jump in gross profit and a 31 percent leap in funds from operations. The company boosted capital expenditures for growth ventures by 94 percent and, coincident with the first-quarter earnings release, boosted its dividend by 23.1 percent.

To be sure, the current quarterly rate of CAD0.08 per share is still well below the monthly rate of CAD0.185 paid before Newalta’s conversion. And the stock price itself is less than half of its old high, reached in October 2006.

Ever since we’ve held Newalta in the Portfolio–dating back to April 2005–management has stayed true to its goal of consolidating Canada’s waste recovery and recycling business.

The stock price and dividend amount have been intensely volatile, just like the fortunes of the company’s economically sensitive industrial and natural resource producer customers.

But the company itself has kept on growing, even in its darkest times.

As a result, it’s arguably a much more valuable company now than it was in late 2006, when Finance Minister Jim Flaherty’s announcement of a 2011 tax on income trusts dealt the stock its first blow. That’s why I look for much more from Newalta, which remains a buy up to USD15 for those who don’t already own it.

It was also hard not to be impressed by results at fellow Aggressive Holding Parkland Fuel Corp (TSX: PKI, OTC: PKIUF), which I reviewed in a preliminary way in the May 13 Flash Alert. The company has had its work cut out for it over the past several months, as it’s had to absorb several major acquisitions that have improved reach and scope but also created complexity and forced management to demonstrate its skills.

Fuel volumes rose 25 percent and gross profit surged 61 percent, as the company enjoyed the benefit of both firming prices and cost controls. Distributable cash flow rose 145 percent, taking the dividend payout ratio down to just 43 percent, or 25 percent including the dividend reinvestment plan (available only to Canadians).

Further breaking down the numbers, revenue per liter sold rose 13 percent, gross margin surged 29 percent per liter, while marketing and administrative costs per liter dipped 21 percent. Earnings before income taxes exploded to CAD2.07 per share, up 445 percent from late year’s 38 cents.

These results demonstrate Parkland’s newfound earnings power and the spare cash will further shore up the balance sheet and promote efficiency and expansion. But are they repeatable the rest of the year?

To some extent fuel sales are seasonal. That’s less true of Parkland’s commercial fuels operation, which is more economically sensitive.

And fuel products in general are in demand year round for transport, with activity likely to be greatest in the summer months for some products.

Also, according to CEO Bob Espey speaking at the company’s first-quarter conference call, “Parkland currently touches 5 percent of the fuel that flows through the Canadian downstream market.” That leaves the door open for more acquisitions to further shift the revenue mix going forward.

Mr. Espey’s comment on earnings seasonality is that the first and fourth quarters as “our big commercial quarters” but that the purchase of Cango “will improve retail sales during (summer) quarters.” Meanwhile, management has looking for “another robust quarter” overall.

The bottom line: Dividend coverage may not be quite as deep as it was in the very robust first quarter. However, it’s set to once again be very strong and to point the way toward continued strong results going forward. Still yielding more than 8 percent, Parkland Fuel is a buy up to USD13 for those who don’t already own it.

Finally, in the oil and gas producer arena the standout by far was Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF). Again, based on what I’ve heard from some readers this stock isn’t getting much attention from yield-seekers. Nor should it, as it only pays about 3.4 percent at current levels.

But the company’s continued increases in production and reserves and cost cutting should certainly command the attention of anyone interested in total return. So should the fact that the company’s current stock price is still only about 60 cents per dollar of reserves in the ground, at conservative assumptions for natural gas prices.

Peyto is the most efficient producer of gas in Canada. It’s heavily held by insiders. And it’s small, with a market capitalization of just CAD2.9 billion and first-quarter daily production of 31,531 barrels of oil equivalent. That would seem to make it takeover target at some point. Meanwhile, the formula of boosting production and controlling costs (down 5 percent per barrel of oil equivalent in the first quarter) continues to produce strong profit growth.

Despite a 19 percent drop in realized selling prices for gas, funds from operations per share surged 10 percent. The company boosted capital spending by 109 percent over last year, ensuring further growth ahead. Buy Peyto Exploration & Development up to USD22 if you don’t own it.

See the Portfolio tables for buy targets for the rest of the Canadian Edge Portfolio picks.

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