Maple Leaf Memo
Editors’ Note: Earnings season is all about expectations. The results that companies report often have dramatic impacts on trading activity, but the reality is quarterly numbers are built over time. It’s important to understand the context when evaluating a particular company’s quarterly numbers.
To that end, we’ve turned over the Maple Leaf Memo space to our colleague Elliott Gue for a discussion of how to approach earnings; his commentary specifically addresses North American energy services, but there are larger points to be gleaned.
Enjoy.
Corporate earnings reports for the first quarter are just starting to roll in; a slew of energy companies are scheduled to report earnings between now and the end of April. Earnings season is always an important time for stocks. Several times in the past two years comments from the bigger firms in the energy industry have revealed key emerging trends.
But investors often interpret earnings reports and management commentary the wrong way. You can’t analyze a company’s results in a vacuum, nor can you simply compare results with analysts’ expectations and decide whether a release is positive or negative for the stock.
On countless occasions, I’ve seen companies show strong growth, handily beat estimates and make bullish comments on their conference calls, only to sell off in the wake of the release. The proper way to interpret earnings is to evaluate expectations and reactions.
This quarter, I’m not expecting to see many big surprises from the industry. The basic outlook has already been well telegraphed during the past few months: There’s a clear bifurcation in the industry between international activity and North American operations.
North America has experienced a marked slowdown in drilling, exploration and development activity since the mid-2006. There are a few reasons for that. The most obvious is that a good deal of North American drilling activity is focused on natural gas rather than oil; the weakness in natural gas prices for much of last year makes gas production less profitable.
The first areas to slow down were coal-bed methane and Canadian shallow gas drilling. These are some of the highest cost gas resources in North America. Now that weakness has spread to other drilling markets.
Canadian drilling activity has slowed particularly quickly. Check out the Canadian rig count chart below for a closer look.
Source: Baker Hughes, Bloomberg
The rig count is nothing more than a measure of how many rigs are actively drilling for oil or gas in a particular region. The chart depicts not the actual rig count but the year-over-year change in the count. All the numbers are in percentage terms.
Note for most of 2005 the Canadian rig count was sharply higher than in 2004. During the summer months in 2005, the rig count was, on average, more than 50 percent higher than during the same months of 2004. This was great news for oil and gas services companies and contract drillers with operations in Canada; all that activity spelled rising prices for services and rising day-rates for leasing drilling rigs.
The picture began changing around the mid-2006. As you can see, the rig count began to shrink year-over-year alongside natural gas prices. The first weeks of 2007 were particularly brutal; the rig count has fallen sharply over the past year.
As you might expect, this has had profound effects on companies with exposure to North America and, in particular, Canada. A host of companies have actually come out to warn their earnings wouldn’t meet estimates, guiding analyst expectations sharply lower. One of the more recent manifestations of this was a warning from oil services giant Halliburton on March 20.
Halliburton specifically cited weakness in North American activity as the driving force for its warning. I suspect that the company was particularly hard-hit by its exposure to North American pressure pumping.
To explain this business in brief, oil and gas exist in the pores and crevices of reservoir rocks, not in giant underground caverns or lakes. When an operator spuds a well, the oil and/or gas–under tremendous geologic pressure–flows through the rock into the well and then to the surface.
But if the pores in a rock aren’t well connected, there are few channels through which the hydrocarbons can travel. Although there may be plenty of gas in the ground, that gas is essentially locked in the pores of the rock and unrecoverable.
But there are ways to produce such reservoirs. In the fracturing process, operators pump a gel-like liquid under tremendous pressure into the ground. That gel actually enters the reservoir and cracks the reservoir rock. By cracking or fracturing the reservoir rock, the operator creates channels through which gas can flow. These services are typically broadly dubbed pressure pumping.
The problem with pressure pumping is twofold. First, North America remains the dominant market–though that’s starting to change. Second, because of huge demand for pressure pumping, services firms have added to their capacity at a rapid pace by building and purchasing new pressure pumping trucks and equipment.
This huge capacity growth was great when the market was going strong, but as demand slackened, a glut of pressure pumping capacity quickly developed. All this adds up to falling pricing power and lower profitability.
On the flip side, drilling activity outside North America has never been more robust. International projects tend to be larger-scale, multiyear affairs; such projects are far less sensitive to short-term commodity price gyrations.
And a good deal of international activity targets oil rather than natural gas. Oil prices are still off their 2006 highs but remain at high levels. In short, producers are making plenty of money on oil. Halliburton’s international business continues to look strong.
At any rate, Halliburton’s warning wasn’t good news. Looking at the numbers and guidance, you’d probably have expected the stock to get slaughtered. And the rig count picture for North America—where Halliburton still derives most of its revenues—doesn’t exactly look bullish for the company. But that simplistic take would be largely incorrect.
Halliburton’s stock did fall on the day of the announcement. But look at what’s happened over the past month:
Source: StockCharts.com
The lows on March 20 held, and the stock has actually been rallying since that time. By early April, Halliburton was actually trading above its pre-announcement levels. In fact, Halliburton set a new high for 2007 in April–hardly a drastically negative reaction to an ugly announcement and earnings warning.
Even more interesting was the action in BJ Services. I won’t belabor the point by explaining all of BJ’s operations; suffice it to say that the company is the most-heavily exposed to North American pressure pumping of any services firms I cover.
You may have expected BJ’s stock to get hit hard in the wake of Halliburton’s announcement. Unlike Halliburton, BJ doesn’t have a large international presence to bail the company out.
But that didn’t happen. Since Halliburton’s March 20 warning, BJ Services is actually up just shy of 8.5 percent–a nice return in just the past few weeks. That’s despite the fact that BJ Services’ April 24 earnings release is almost certain to be replete with bad news about North America. In my view, the company may even miss its current consensus earnings estimates.
The positive reaction to negative news flow in BJ Services and Halliburton stocks is a far more valuable bit of information than the news itself. This reaction tells us an important fact about the industry: These stocks are already pricing some bad news about North America.
Although the underlying business in North America has deteriorated, the stocks are currently trading at a level that’s attracting buyers on any dip. The bar of expectations has already been lowered enough for these stocks; they’re now in an excellent position to rally through the upcoming earnings season.
A year ago, the market seemed to be totally ignoring the possibility that there would be a slowdown in the North American drilling market. Although there were certainly some early signs of trouble brewing, analysts weren’t really factoring those problems into their numbers and estimates. But the sharp decline in activity I outlined above is no secret now; the market knows and expects these companies to report some negative numbers.
For the record, I’m currently recommending neither Halliburton nor BJ Services in The Energy Strategist (www.energystrategist.com). That said, I tempered my long-held bearish outlook for both stocks back in February. I already recommend a few stocks levered to activity in the region; now I’m looking at more ways of playing washed-out North America-focused stocks.
For those with a more-speculative bent, there should be some shorter-term trading opportunities in the next few weeks ahead of corporate earnings releases. I see very limited downside in North American services and drilling companies.
Meanwhile, if any of these companies unveil a sliver of good news, the stock would shoot higher. The extraordinarily strong options buying activity in a slew of North American services names suggests that some bigger players are already jumping into the group.
The Roundup
Oil & Gas
Canadian Oil Sands Trust (COS.UN, COSWF) reported a 188 percent increase in net income for the first quarter of 2007 to CD262 million (55 cents Canadian per unit) from CD91 million (20 cents Canadian per unit) a year ago. The quarter-over-quarter boost is tied to the August 2006 completion of Stage 3 of the Syncrude project, a larger Syncrude working interest based on the acquisition of Talisman Energy’s stake and lower maintenance costs.
Canadian Oil Sands also raised its distribution 33 percent to 40 cents Canadian per unit from 33 cents Canadian, effective with the distribution payable May 31 to unitholders of record on May 8. First quarter 2007 cash from operating activities was CD202 million (42 cents Canadian per unit), compared to CD187 million (40 cents Canadian per unit) in 2006. Net income and cash from operating activities benefited from a 41 percent reduction in per-barrel operating costs quarter over quarter, offset somewhat by a higher royalty expense.
Sales volumes increased 46 percent, averaging about 109,000 barrels per day, in the first quarter of 2007 compared to the same 2006 period. Operating costs averaged CD23.56 per barrel in 2007, down from CD40.26 per barrel in the first quarter of 2006. Quarterly capital expenditures in 2007 declined to CD33 million from CD137 million in 2006 with the completion of the Stage 3 project.
On March 13, 2007, the trust announced a reduction to the upper end of its production range by 5 million barrels, with the current range now between 105 million and 115 million barrels, 39 million to 42 million barrels net to Canadian Oil Sands. The change reflects constrained production rates from Coker 8-3 since late 2006. Syncrude plans to perform maintenance on Coker 8-3 during the second quarter of 2007 to restore production throughput. Canadian Oil Sands Trust is a buy up to USD27.
Enterra Energy Trust (ENT.UN, NYSE: ENT) has acquired Trigger Resources for CD63.2 million. Trigger produced an average of approximately 2,400 barrels of oil equivalent per day (BOE/d) from its oil and gas exploration and development operations in western Saskatchewan.
To pay for the acquisition, Enterra initially issued 4.3 million trust units at CD5.90 per unit and CD40 million of 8.25 percent unsecured subordinated debentures convertible into trust units at a price of CD6.80 per unit; the underwriters fully exercised the overallotment option granted as part of the bought deal financing, resulting in the issuance of an additional 645,000 units at CD5.90 per unit. Sell Enterra Energy Trust.
Thunder Energy Trust (THY.UN, THYFF) has agreed to a CD4 per unit offer by the Public Sector Pension Investment Board and Overlord Financial. Calgary-based Overlord will own about 2 percent of the trust and will assume management responsibility. The Public Sector Pension Investment Board manages assets for the federal public service, the Canadian Forces and the Royal Canadian Mounted Police pension funds.
The offer represents a 5.3 percent premium over the trailing 20-day average trading price of CD3.80. Thunder units traded above the offer price, reflecting anticipation of a superior offer. Thunder will pay a CD10 million breakup fee if a higher offer is accepted. The deal is subject to a vote of unitholders scheduled for June 22. Sell Thunder Energy Trust.
Electric Power
Countryside Power Income Fund’s (COU.UN, COUUF) revenues from two California cogeneration facilities could suffer during certain periods if a proposed decision by an administrative law judge (ALJ) is adopted by the California Public Utilities Commission (CPUC). The ALJ has proposed modifications to the short-run avoided cost pricing formula, including the adoption of a new energy pricing formula based on market-based pricing indexes.
Capacity payments would remain fixed, as designated in Countryside’s purchase agreements. The ALJ’s nonbinding judgment must be ratified by a majority of the CPUC’s members. The earliest a final, binding decision could be made by the CPUC is May 24, 2007. Hold Countryside Power Income Fund.
Primary Energy Recycling (PRI.UN, PYGYF) reported a 35 percent drop in first quarter revenue to USD16.7 million and a USD2.7 operating loss. Primary Energy took a writedown for a negative inventory adjustment at its Harbor Coal operation, and that factor was exacerbated by unfavorable commodity prices, lower blast-furnace production and narrow price spreads between the coal used and the natural gas and coke it displaced.
Earnings before interest, taxes, depreciation and amortization (EBITDA) fell to USD7.5 million from USD13.3 million in the first quarter of 2006. Distributable cash of USD4.2 million resulted in an effective payout ratio of 216.5 percent for the quarter. Hold Primary Energy Recycling.
Gas/Propane
Keyera Facilities Income Fund (KEY.UN, KEYUF) has adopted a unitholder rights plan effective April 30, 2007. The plan was adopted “to provide fair treatment for all unitholders, and to provide Keyera’s board of directors and unitholders with sufficient time to explore and develop alternatives for maximizing unitholder value, in the event of a takeover bid for the fund or other acquisition of control of the fund.”
The move isn’t a response to any specific proposal. Buy Keyera Facilities Income Fund up to USD18.
Precision Drilling Trust (PD.UN, NYSE: PDS) reported a 29 percent drop in its first quarter profit on a slowdown in the natural gas space. Precision reported net income of CD158.1 million (CD1.26 per unit), down from CD224.2 (CD1.79 per unit) in the first quarter of 2006. Revenue was off 23 percent at CD411 million, revenue in the contract drilling services segment dropped 27 percent, and the completion and production services segment decreased 15 percent.
Canadian drilling rig operating days declined 29 percent to 11,785 days from 16,694 during the first quarter of 2006. Service rig operating hours dropped 20 percent from the first quarter of 2006 to 132,411 hours. With its assets still solid enough to attract takeover interest, Precision Drilling is a buy up to USD30.
Business Trusts
Chemtrade Logistics Income Fund (CHE.UN, CGIFF) is buying Olin Corp’s liquid sodium hydrosulphite business for USD7.3 million. The deal doesn’t include Olin’s manufacturing assets, and Olin will produce the chemical–used in dye processes, water treatment, gas purification, cleaning and other industrial applications–for Chemtrade at its plants in Charleston, Tenn., and Augusta, Ga. Chemtrade Logistics Income Fund is a buy up to USD9.
Contrans Income Fund (CSS.UN, CSIUF) reported solid revenue growth in its core transportation services operations for the first quarter of 2007, generating CD106.4 million for the period, up 12.5 percent from a year ago. Net income was off 16.5 percent to CD8.1 million, but Contrans realized a significant one-time gain from a land sale during the first quarter of 2006. Excluding the land sale, net income per unit rose 12 percent to 28 cents Canadian per unit from 25 cents Canadian per unit. Contrans Income Fund is a hold.
Custom Direct Income Fund (CDI.UN, CUDFF) reported sales of USD30.8 million in the first quarter of 2007, down from USD31.6 million a year ago. The fund reported a gross profit of USD22.8 million (73.9 percent of sales) compared to USD22.8 million (72 percent of sales) for the same period in 2006.
Operating income was USD8.6 million, up from USD6.4 million on decreased advertising expenses and labor cost reductions. A first quarter net income of USD6.1 million was up from USD4 million. Distributable cash was USD7.2 million for the quarter, up USD2.4 million compared to the same period in 2006.
EdgeStone Capital Partners, a unit of GMP Securities, has offered CD10.20 a unit (CD199 million) for Custom Direct. Edgestone has experience buying companies in old, out-of-the-way industries (waste disposal, hair care) and guiding management teams through acquisition-driven growth. Edgestone’s focus could now turn to Deluxe Corp, M&F Worldwide and Bradford Exchange, the other three players in the check-printing game.
Edgestone will get a CD7.9 million free if another company tops its bid. If you own Custom Direct Income Fund units, hold on through the bid process.
Oceanex Income Fund (OAX.UN, OCNXF) generated operating income of CD600,000 for the first quarter of 2007, up from an operating loss of CD800,000 a year ago. Net income was CD1.2 million (14 cents Canadian per unit), up from a net loss of CD200,000 (3 cents Canadian per unit) a year earlier.
Revenue was up 4 percent to CD25.2 million from CD24.3 million. Cash flow from operations was CD2.1 million compared to a negative cash flow of CD3.6 million for the first quarter of 2006. The fund distributed CD2.5 million during the first quarter and expects to continue at that level for the remainder of 2007. Oceanex Income Fund rates a buy up to USD13.
Priszm Income Fund (QSR.UN, PSZMF) reported sales for the first quarter of CD100.7 million, a 0.5 percent decrease compared to the same period in 2006. Priszm’s business is seasonal, with sales for the three-month period of January, February and March typically accounting for 20 percent of annual sales. Bad weather early in the quarter contributed to the decline.
Same-store sales from KFC/Taco Bell locations continued to outperform standalone KFC locations, posting sales growth of 2.1 percent. Cost of restaurant sales, as a percentage of sales, for the first quarter was 61 percent, up from 60 percent in the first quarter of 2006 on increased food and labor expenses.
Net income came in at CD3 million, down from CD5.2 million last year. Distributable cash was CD1 million, down from CD3.7 million in the comparable period. Priszm Income Fund is a buy up to USD11.
Specialty Foods Group Income Fund’s (HAM.UN, SFGUF) units are being reviewed for continued listing eligibility by the Toronto Stock Exchange (TSX). The fund won’t meet the TSX listing requirements by the May 8, 2007, deadline imposed under the TSX listing review process. The fund has been in discussions with the TSX Venture Exchange and the NEX regarding its ability to meet the listing requirements for the Venture Exchange or the NEX.
The Venture Exchange has informed Specialty Foods that it doesn’t meet its listing requirements, and the fund doesn’t expect that it will meet the Venture Exchange requirements prior to being delisted from the TSX. However, the fund is continuing to work to have its units listed on the NEX in order to ensure uninterrupted trading. Sell Specialty Foods Group Income Fund.
The Keg Royalties Income Fund (KEG.UN, KRIUF) reported a 12 percent rise in gross sales to CD105.2 million for the first quarter of 2007. Same-store sales increased by 8.1 percent in Canada and by 3.8 percent in the US. Total consolidated same-store sales increased by 7.6 percent for the quarter.
Royalty income increased 13.3 percent to CD4.3 million. Earnings increased by 6.1 percent to 33 cents Canadian per unit from 31 cents Canadian per unit. Distributable cash was up 6.1 percent to 33 cents Canadian per unit from 31 cents Canadian. The Keg Royalties Income Fund is a hold.
TransForce Income Fund (TIF.UN, TIFUF) boosted quarterly revenue by 7 percent to CD464.8 million, up from CD433.8 million during the first quarter of 2006. Operating income was CD52.7 million for the quarter, an increase of 7 percent. Cash flow from operating activities was CD45 million in the first quarter, compared with CD41 million in the first quarter of 2006. TransForce increased its regular monthly distributions during the first quarter to 13.25 cents Canadian per unit. The fund’s normal distribution payout ratio was 102.2 percent for the first quarter, up from 87.8 percent for the same period last year. Hold TransForce Income Fund.
Pipeline Trusts
Pembina Pipeline Income Fund (PIF.UN, PMBIF) reported net earnings for the first quarter of 2007 of CD29.4 million, up 46 percent from CD20.2 million a year ago. The fund distributed 33 cents Canadian per unit during the quarter for total cash distributions of CD42.1 million, up 16 percent from a year ago.
Total throughput, including both the conventional pipelines and the Syncrude Pipeline, averaged 761,200 barrels per day during the first quarter of 2007. The conventional pipelines transported an average of 459,400 barrels per day during the quarter, up slightly from year-ago levels. The conventional pipelines contributed CD62 million in revenue and CD37.9 million in operating income, up 10 percent and 13 percent, respectively, over the same period last year.
The oil sands segment contributed CD14.5 million in revenue, down 2 percent, and CD9.5 million in operating income, up 4 percent from the CD9.1 million recorded in the first quarter of 2006. Pembina’s midstream operations generated CD19.9 million in revenue and CD17.8 million in net operating income, a 93 percent increase for both revenue and net operating income. Buy Pembina Pipeline Income Fund up to USD16.
Real Estate Trusts
H&R REIT (HR.UN, HRREF) is selling 8 million units at CD25.30 per unit to a syndicate of underwriters led by CIBC World Markets and RBC Capital Markets for total proceeds of CD202 million. H&R has granted the underwriters an overallotment option, exercisable in whole or in part up to 30 days after closing, to purchase an additional 1.2 million units at the same offering price. Should the over-allotment option be fully exercised, the total gross proceeds of the financing will be approximately CD233 million.
Closing is expected to occur on or about May 9, 2007, subject to regulatory approval. The proceeds of the offering will be used to fund the acquisition of additional properties and future development commitments. Any proceeds not initially used for such purposes will be used to reduce H&R’s indebtedness. H&R REIT is a buy up to USD22.
Morguard REIT (MRT.UN, MGRUF) reported a 7 percent increase in net operating income for the first quarter of 2007 to CD26.4 million from CD247 million a year ago. Net income for the period was CD7.8 million (13 cents Canadian per unit), up from CD4.9 million (11 cents Canadian per unit).
Distributable income was CD14.2 million (24 cents Canadian per unit), compared to CD11.3 million (24 cents Canadian per unit) a year ago. Funds from operations (FFO) for the first quarter of 2007 amounted to CD16.2 million (27 cents Canadian per unit); FFO for the first quarter of 2006 was CD13 million (27 cents Canadian per unit). Occupancy levels increased to 95 percent at March 31, 2007, up from 93 percent at March 31, 2006. Hold Morguard REIT.
Natural Resources Trusts
Fording Canadian Coal Trust (FDG.UN, NYSE: FDG) reported lower first quarter net income as a harsh winter hurt its sales and output but anticipates improved conditions for the balance of the year. Fording has negotiated agreements for the sale of approximately 90 percent of its expected sales for fiscal 2007, which began April 1, and it expects rail service to improve during the rest of the year.
Fording reported net income of CD77 million (52 cents Canadian per unit) for the first quarter, down from CD165.3 million (CD1.12 per unit) a year ago. Coal sales sagged 10 percent to 2.8 million tons from 3.1 million a year earlier.
Revenue for the quarter fell by about 25 percent to CD350.5 million from CD473.3 million. Distributable cash was CD77 (53 cents Canadian per unit), down from CD202 million (CD1.37 per unit) a year ago. Fording Canadian Coal remains a buy up to USD24.
Labrador Iron Ore Royalty Income Fund (LIF.UN, LBRYF) units got a boost after workers at its Labrador City operations ratified a new five-year contract that management and the union agreed on April 22. Iron Ore expects production, which has been disrupted by a strike since March 9, to resume as soon as all employees can be recalled. Buy Labrador Iron Ore Royalty Income Fund up to USD24.
TimberWest Forest Corp (TWF.UN, TWTUF) generated distributable cash of CD26.9 million (35 cents Canadian per unit) during the first quarter of 2007, down from CD31.5 million (41 cents Canadian per unit) a year ago; the 2006 figure reflects an additional CD5.5 million because of real estate sales.
Log sales volumes fell to 823,100 meters from 889,200 meters during the first quarter of 2006 because of weakness in the US housing market; TimberWest realized CD95 per meter, compared to CD96 per meter a year ago, a relatively strong result in light of the weak market south of the border. Domestic sales continued to be strong.
EBITDA for the three months ended March 31, 2007, were CD30.3
million (39 cents Canadian per unit), compared to CD27.5 million (35
cents Canadian per unit) a year earlier. TimberWest generated net
earnings for quarter of CD3.7 million (5 cents Canadian per unit), up
from CD2.9 million (4 cents Canadian per unit) during the same period
in 2006. Buy TimberWest Forest Corp up to USD14.