A New Way to Look at the Loonie

By David Dittman • September 13, 2011 • Canadian Edge Weekly

It’s yet another measure of how much has changed already in the 21st century that the Canadian dollar’s decline toward parity is a headline-worthy event. The loonie has been trading at a premium to the buck since the end of January but has recently come off due to heightening fear of European sovereign debt and other threats to global growth.

The Canadian dollar declines along with equities when it’s “risk off,” maintaining its historical correlation with economically sensitive crude oil prices. At the same time, however, foreign investors are snapping up Canadian government bonds at an unprecedented pace. This suggests the loonie is taking on “safe haven” characteristics.

The chart below shows the Canadian dollar-US dollar exchange rate (a rising white line indicates loonie strength, a falling line weakness) and the price of the generic front-month crude oil futures contract traded on the New York Mercantile Exchange over the last five years. The trough in the middle is the March 2009 bottom. Before, the loonie traded basically right along with oil; after, it’s been a different story.

Source: Bloomberg

Foreign investors bought CAD8.5 billion worth of Canadian government bonds in the second quarter, pushing the 12-month increase in foreign ownership to CAD25 billion. Non-Canadian holdings of Canadian government bonds are now CAD137 billion, an all-time high. This new demand for loonie-backed bonds has kept interest rates low in the Great White North; the yield on the 10-year Government of Canada bond closed at 2.19 percent on Tuesday, near a record low and down sharply from a near-term high of 3.5 percent in mid-April. The yield is significantly lower today than it was during the depths of the 2008-09 financial/credit crisis.

Bungled and Botched

Nineteen of the 165 companies and funds currently tracked in the Canadian Edge How They Rate coverage universe have suspended or eliminated distributions since 2007. We took a look at all 19 in the September issue of Canadian Edge; here we’ve pulled the three that stand out for their still-significant potential.

The general rule is that a dividend cut is a sell sign; this discipline has been tested during an historically tumultuous period for the global economy. But time and again, sticking to it has helped us avoid a lot of down-the-line trouble.

That’s not to say we’ve been hard-and-fast with this rule; we saw enough promise in Yellow Media Inc’s (TSX: YLO, OTC: YLWPF) quarterly reports on its migration from print to the Internet to stick with it long enough to see it fall below CAD2 per share. What ultimately led us to sell it from the Canadian Edge model portfolio were terrible second-quarter operating results that seriously undermine management’s case that Yellow will survive as a web-based advertiser.

We do follow quarterly results closely, looking for signs of breakdowns in the businesses that support our regular dividend checks, with the idea that we’ll be in front of any cuts. A combination of policy choices that basically killed the tax-advantaged Canadian income trust sector and an historic global economic meltdown forced management teams to cope with multiple aggressive and unpredictable demands and threats to cash flow, in addition to normal operating challenges, in recent years.

As we’ve seen over the past several quarters, the businesses that comprise the Canadian Edge Portfolio rode out the Great Recession and the dawn of 2011–when Finance Minister Jim Flaherty’s 2006 Halloween Nightmare became reality–with dividends intact. Historically low interest rates have allowed them to lock in new financing or refinance old debt, freeing up cash flow to reinvest in the business or share with investors. For the most part businesses that survived the experience entered the Great Recession on sound footing, were operating in industries where cash flows were easy to identify and sustain, and were committed to paying dividends over the long term.

But some cuts had to be made to preserve the long-term viability of the underlying business. These three companies are worthy of a little more scrutiny–from investors with higher-than-average risk tolerance–than run-of-the-mill dividend-slashers.

Advantage Oil & Gas (TSX: AAV, NYSE: AAV) eliminated its distribution entirely in March 2009 as part of an early move to convert to a corporation. At the time CEO Andy Mah explained that Advantage wanted to focus as much of its resources as possible on its huge find at the Glacier prospect in the Montney Shale formation in Alberta. Low natural gas prices made it virtually impossible to imagine Advantage being able to exploit the resource in the manner it hoped while still paying a dividend.

The unit price bottomed around CAD2.60, right around the time the whole market was making its post-Lehman Brothers low. Since then it’s rallied to north of CAD5, validating Mr. Mah’s ambition. Proactive Advantage is the model of a rational transition from a growth-and-income orientation to growth only. In the second quarter of 2011 output–which is now more than 90 percent gas–rose 22 percent despite difficult drilling conditions. Management forecast 24 percent production growth by the summer of 2012. It trimmed operating expenses by 17 percent year over year as well.

Bellatrix Exploration (TSX: BXE, OTC: BLLXF), at the time known as True Energy Trust, stopped paying a distribution in February 2009 after a series of capital-spending cutbacks and corresponding production declines. Management got a grip on the company’s debt issues, and production is back up above 11,000 barrels of oil equivalent per day, weighted 62 percent gas, 38 percent oil. A successful foray into shale gas has fueled Bellatrix’s turnaround.

Second-quarter production rose 51.8 percent, as operating expenses per barrel of oil equivalent declined 11.5 percent. That combination triggered 90.9 percent growth in funds from operations per share.

Noranda Income Fund (TSX: NIF-U, OTC: NNDIF) paid a final CAD0.04 per unit distribution on Jul. 27, 2009. That payment, declared the preceding Jun. 19, came just a week after management discontinued the distribution because of depressed demand and prices for its processed zinc and byproducts amid the Great Recession.

During the second quarter of 2011 Noranda closed a CAD90 million private placement of 6.875 percent senior secured notes due in 2016 and also negotiated a five-year revolving credit facility that provides CAD150 million of financing. These moves eliminate near-term refinancing risk that had been overhanging the stock. Also on the plus side, cash flow from operating activities in the second quarter rose 16 percent to CAD21.4 million. Zinc metal production was 4 percent higher than in the year-ago quarter, and Noranda was able to realize higher prices for its output. Copper in cake sales more than doubled, while sulfuric acid production was up 13 percent.

With long-term financing in place and restrictions on its uses of cash eased, management is now considering the reinstatement of a dividend

Buy Canada: Build Keystone XL

The official Canadian Edge/Maple Leaf Memo position is that TransCanada Corp’s (TSX: TRP, NYSE: TRP) Keystone XL pipeline should be built. The 1,980-mile extension to the existing Keystone Pipeline will connect Hardisty, Alberta, to refineries in the US Midwest and on the Gulf Coast.

Or it won’t. Whether it happens or not is in the hands of President Obama, who may have been too busy preparing his “jobs” speech last week to notice that TransCanada is ready to sink private capital into a significant infrastructure project that will employ Americans and generate tax revenue for several jurisdictions well into the future. And all it requires is a signature.

Well, Canadian Natural Resources Minister Joe Oliver visited California Tuesday to meet with Asia-Pacific ministers, and it’s a lead-pipe certainty that the oil sands will be produced. As Mr. Oliver said to the Toronto Globe and Mail, “The overarching strategic need to diversify our energy customers is an important issue for this government.”

The bottom line is Canada is happy to ship its oil sands output west to British Columbia for eventual export to China.

The Roundup

Canadian Edge Conservative Portfolio Holding Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPUF) is being merged with parent Brookfield Asset Management’s (TSX: BAM, NYSE: BAM) South American and US renewable power assets to form Brookfield Renewable Energy Partners LP. According to a press release announcing the transaction, the result will be a “global pure-play renewable power business” with CAD13 billion in assets, including 4,400 megawattsw of installed capacity and 17,000 gigawatt hours of annual generation, with an additional 400 megawatts of capacity and over 1,000 gigawatts of generation under construction and expected to be operational over the next two years.

Management anticipates the arrangement will be immediately accretive to cash flow and has already boosted the payout Brookfield Renewable Power Fund unitholders will receive from the new entity; following the transaction’s close Brookfield Renewable Energy Partners’ annualized distribution will be CAD1.35 per unit, up from CAD1.30 per fund unit.

Distributable cash flow per unit is forecast to increase by more than 10 percent on average over the next five years. The weighted average contract term for the new entity’s assets represents an increase to 24 years, and the limited partnership is likely to maintain investment-grade ratings from S&P and DBRS.

Under the proposed transaction announced by Brookfield Asset Management on Tuesday, Brookfield Renewable Power Fund unitholders will receive one unit of the new publicly traded partnership for each unit of the fund they currently own. After adjustments for its contribution of assets in addition to those held by Brookfield Renewable Power Inc, Brookfield Asset Management will own 73 percent of Brookfield Renewable Energy Partners, while current Brookfield Renewable Power Fund unitholders will own the remaining 27 percent.

The partnership will assume CAD1.1 billion of unsecured public bonds issued by Brookfield Power Inc as well as a CAD250 million preferred shares issued by a subsidiary of the fund.

All the assets in the combined portfolio are contracted to high-credit-quality customers; negotiations are under way for certain projects that should lead to CAD45 million in new revenue in 2012, and Brookfield will transfer all of its development portfolio–approximately 2,000 megawatts–to the new entity for no up-front payment.

The transaction requires approval by two-thirds of Brookfield Renewable Power Fund unitholders as well as two-thirds of the fund’s preferred-share owners and bondholders. Meetings to obtain these approvals will be held in October and November 2011.

The bottom line is this is positive development that will create a cash-generating renewable-power behemoth with the scale and financial backing to undertake large-scale projects. Brookfield Renewable Power Fund has already jumped well past its USD23 buy target on the news. It’s a buy if it dips below that price.

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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