Canada’s Proof Is in Its Dividends

By David Dittman • September 6, 2011 • Canadian Edge Weekly

Last week was not a good one in terms of US economic data. A revised gross domestic product (GDP) growth rate for the second quarter reinforced a lot of negativity that’s accrued during the third. News that the US economy added literally zero jobs in August made this rotten feeling more concrete. Another wave of European sovereign debt worry washed over global markets Monday while American and Canadian stock exchanges were closed in observance of Labor Day (Labour Day, of course, in the Great White North).

Trading action early Tuesday was generally driven by Friday’s Bureau of Labor Statistics report; later on, however, after the Institute of Supply Management’s report on activity in the services sector in August had time to settle in, buyers stepped in and the S&P 500 and the S&P/TSX Composite Index bounced back to close at session highs. Down on more weak jobs data, back up on a better-than-expected ISM reading: This now-familiar pattern of bad news/good news–or good news/bad news–has defined what remains an insufficient recovery.

The market continues to change its mind about the value of the companies that comprise it from one day to the next. Despite the fact that the bond market is telling the US government that it can borrow at the cheapest rates it’s ever borrowed, and that other sovereigns have similar room to access capital more cheaply than businesses, the political class continues to focus almost exclusively on austerity measures. Perhaps this weekend’s meeting of Group of Seven (G7) leaders will result in steps that ease all this fear-based irrationality. We won’t count on it.

The new president of the International Monetary Fund, Christine Lagarde, may have sketched the outline of a new concerted effort by the G7 that stresses short-term fiscal and monetary stimulus coupled with medium- and long-term cost cutting in a speech to a meeting of central bankers in Jackson Hole, Wyo. Not only are many developed economies constrained by past policy decisions. But the unity of purpose that drew leaders together in late 2008 and early 2009 no longer exists.

The good news is the companies that make up the Canadian Edge Portfolio have proved once again with their second-quarter numbers that they’re build to last.

Cineplex Inc (TSX: CGX, OTC: CPXGF), Canada’s biggest movie theater operator and a lynchpin of the CE Conservative Holdings, reported in mid-August that second-quarter revenue rose 6.6 percent on the strength of a 17 percent increase in “value added revenue” combined with a 3.8 percent jump in attendance. That’s particularly encouraging given a generally lackluster spring movie lineup and the more exciting summer bill, which should contribute to a strong third quarter. Cash flow margin rose to 17.2 percent from 17.1 percent a year ago. Free cash flow per unit was off slightly, but dividend coverage was still strong with a 64 percent payout ratio.

Management continues to have success controlling costs and reducing dependence on Hollywood’s ups and downs with ancillary sales. In late August the company set a single-day ticket sales record for its “The Met: Live in HD” series of performances, an example of the innovative ways Cineplex management is monetizing its screens.

Combined with conservative financial policies, that should ensure the safety of the dividend, even as the theater owner expands its presence in Canada’s fastest-growing markets. Cineplex has rallied strongly following the post-S&P downgrade selloff and is yielding 5 percent as of Tuesday’s close. The next large-scale selloff may provide another entry point for new money.

Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) is our favorite way to play the Canadian oil sands. The company recently finished work on the Nipisi and Mitsue pipelines–both ahead of schedule, both on budget. Nipisi is a heavy oil pipeline, while Mitsue will transport diluent. Completing this CAD400 million project is a major milestone for Pembina and its strategy of growing by building and buying needed Canadian energy infrastructure assets.

Asset growth was the key to Pembina’s robust second-quarter results. The company’s adjusted cash flow per share–the key account for dividend safety and growth–rose 43 percent to CAD0.50 per share. That produced dividend coverage of roughly 1.28-to-1 for the quarter, or a payout ratio of 78 percent.

Revenue rose 19 percent, driven by solid results at conventional pipelines and marketing operations. Operating expenses were roughly flat, due to higher labor and power costs as well as maintenance work. Operating margin, meanwhile, rose 26.3 percent.

Continued progress on the company’s construction of new midstream energy infrastructure is critical to future growth. Encouragingly, Pembina is still having no problems pre-contracting new assets before they’re built. A planned CAD75 million plant to expand ethane extraction and processing has already been 80 percent contracted for a planned startup in October. The company is on track to line up the rest for an expected CAD12 million to CAD15 million increase in annual operating margin. The company also has planned CAD40 million investment by mid-2012 in additional pipeline projects.

During a recent analyst presentation CEO Robert Michaleski responded to a question about future dividend policy by forecasting annual growth of 3 to 5 percent after 2012. He also stated a target payout ratio of 75 to 85 percent, with an eye to being a fully taxable corporation starting in 2015. Those expectations are certainly backed by strong second-quarter numbers. Pembina is another stock to watch when the market loses its mind.

Not every Portfolio Holding reported world-beating results for the second quarter. But even those that struggled, such as Bird Construction Inc (TSX: BDT, OTC: BIRDF), took steps to ensure the sustainability of their dividends for the long term.

Bird is working through several quarters of backlog based on lower-margin contracts that make its comparables difficult to measure up to. Dividends, however, remain solidly covered by cash, and the company has no debt. Moreover, management cites strong growth in order backlog and the recently announced merger with HJ O’Connell as reasons to expect a strong boost in profitability in the second half of 2011. The company’s future is still bright, and recent action has left it trading at bargain levels.

The Roundup

The last two of Canada’s Big Six banks to report fiscal third-quarter earnings both raised their dividends, Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) to CAD0.90 per share per quarter from CAD0.87, Toronto-Dominion Bank (TSX: TD, NYSE: TD) to CAD0.68 from CAD0.66. Both banks remain holds at current levels.

CIBC’s third-quarter net income was up 26 percent on higher investment-banking fees, driving the bank’s first dividend increase since August 2007. Net income for the period ended Jul. 31 was CAD808 million (CAD1.89 per share), up from CAD640 million (CAD1.53 per share) a year ago. Cash earnings were CAD1.91 a share, beating a CAD1.81 consensus estimate. Like its Big Six peers, CIBC’s domestic personal and consumer operations were solid, posting better-than-expected results even as margins shrink amid a softening economy. The retail and business banking segment earned CAD539 million, up from CAD526 million a year ago. Revenue rose 3 percent to CAD2 billion on volume growth in personal banking and higher fees, offsetting the fact that net interest margin–the difference between what it charges for loans and its funding costs–shrank. Revenue in personal banking rose 3.8 percent, while business banking revenue rose 1.4 percent.

Provisions for credit losses were CAD195 million, down 12 percent from a year ago. Net interest income rose 3.8 percent to CAD1.61 billion. Non-interest income jumped 11 percent to CAD1.45 billion, primarily from higher merchant-banking gains and higher advisory revenue. Wealth management earned CAD68 million, up from CAD53 million a year ago.

Wholesale banking net income surged almost six-fold to CAD145 million from CAD25 million a year earlier, mainly from lower losses in its structured credit run-off business, lower credit-loss provisions and higher corporate and investment banking revenue. Corporate and investment banking revenue jumped 44 percent to CAD232 million, while capital-markets revenue slipped 2 percent mostly from charges against credit exposures to derivative counterparties.

Toronto-Dominion, which boosted its dividend for the second time in fiscal 2011, posted third-quarter profit growth of 23 percent. TD earned CAD1.45 billion (CAD1.58 per share), up from CAD1.18 billion (CAD1.29 per share) during the three months ended Jul. 31, 2010. Cash earnings were CAD1.72 per share, well ahead of a consensus estimate of CAD1.62.

Credit-loss provisions rose 10 percent to CAD374 million, as management set aside more money for potentially bad loans acquired in the US.

TD’s Canadian personal and commercial banking division earned CAD954 million, up 13 percent from a year earlier, while US personal and commercial banking profit rose 21 percent to USD328 million. Net income in its global wealth-management division, excluding TD Ameritrade, jumped 26 percent to CAD195 million on higher fee revenue. Expenses rose 9 percent mainly from higher compensation. TD added 216 employees, up 3 percent from a year ago. Wholesale banking earnings dropped to CAD105 million, as revenue fell 20 percent to CAD458 million. As with other Canadian banks, TD’s fixed-income and currency trading revenue dropped on lower volume driven by risk aversion.

Here are links to analyses of second-quarter earnings for all Portfolio Holdings except Student Transportation Inc (TSX: STB, NSDQ: STB), which will report fiscal fourth-quarter and year-end 2011 results on or about Sept. 23, followed by reporting dates for the third quarter.

Conservative Holdings

Aggressive Holdings

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