11/15/12: Strong Earnings, Negative Reactions

By Roger Conrad • November 15, 2012

Let’s start with some basic facts: All Canadian Edge Portfolio recommendations have now reported their third-quarter results, and each posted numbers that affirmed the safety of dividends while management teams continued to offer encouraging guidance.

The numbers weren’t perfect, and several companies continue to face challenges. But given what in many cases proved to be a less-than-optimal macro environment, performance was impressive nonetheless, including for energy producers affected by lower realized selling prices for oil and natural gas liquids.

Reaction to the numbers, however, was a somewhat different story. As I’ve pointed out in recent Flash Alerts as well as the November CE Portfolio Update, companies that reported results during the earlier part of the earnings season generally received a favorable reception.

Since the US presidential election, however, we’ve seen several stocks sell off sharply despite reporting what were robust third-quarter results. In the case of Just Energy (TSX: JE, NYSE: JE), the catalyst was a downgrade by an analyst who questioned the company’s dividend-focused strategy.

Such selloffs are disconcerting, particularly in the current momentum-led market. Mainly, when a stock starts to sell off for whatever reason, many investors seem to assume the worst and unload at any price.

In particular, high-dividend stocks are in the crosshairs these days for two big reasons. First, the prospective increase in US dividend taxes for top earners has triggered selling in dividend-paying stocks across the board. Second, the prospect of the US going over the fiscal cliff and plunging the world into another recession has raised fears about many companies’ ability to maintain dividends going forward.

The stock market always prices in expectations for the future, never what happened in the past. So in this context, it’s not surprising that dividend-paying stocks are weakening, particularly the high-yielding names that investors tend to try out when they’re upbeat about the economy.

The logic of this selloff, however, only goes so far. For one thing, Canadian stocks are primarily owned by Canadians–and their tax burden remains the same regardless of what results from the negotiations between the US president and Congress to bring the US back into fiscal balance. US investors who hold Canadian stocks in IRAs won’t see any change in rates either, nor will US institutions such as mutual funds.

Judging from the action in the US market, many investors have bought into the idea that a crash in dividend-paying stocks is imminent because of higher tax rates on investors in the top tax brackets. But in 2003 when the tax rate on dividends was initially cut, there was no commensurate rally to reflect the benefit.

Rather, any increase in dividend-paying stocks’ prices since then has been due to solid operational performance and rising dividends. And again, with so many investors unaffected by the likely increase in rates, buyers should step up to the plate as bargains appear. Consequently, there should be no permanent loss of value in dividend-paying stocks from a change in tax rates.

As we’ve learned time and again during the bull market that began in March 2009, stocks will recover from damage sustained even in the worst market debacles, provided the underlying business stays strong. We saw that in the recovery from the 2008 crash. We saw it again in late 2010, as the markets recovered from the Flash Crash that year. And we saw it yet again in late 2011, when Uncle Sam reached a deal on the debt ceiling and confidence returned.

The economy and stock market do face challenges at present, starting with the battle over the US fiscal cliff. But nothing has changed about any stock’s ability to recover so long as underlying companies retain their strength. And if anything, our companies are now better prepared to weather market turmoil than ever.

The bottom line: Despite the scary market action we’ve seen in recent days, we’re sticking with all of our positions in the expectation that recent losses will be more than offset by future gains. Note that I am switching IBI Group (TSX: IBG, OTC: IBIBF) to the Aggressive Holdings for reasons highlighted below. Here’s a look at the results for the last seven CE companies to report third-quarter earnings.

The Numbers

Ag Growth International (TSX: AFN, OTC: AGGZF) is that rare stock to rally following a post-US election release of calendar third-quarter 2012 results. That seems more related to the hit the stock took in the weeks prior to the announcement. But despite very challenging conditions related to a weak corn harvest in the US, the company still maintained its dividend and a generally upbeat outlook for the coming year. Sales ticked up 2 percent, as the company continued to expand its reach outside North America. Cash flow was lower, however, as the US drought reduced demand for the company’s higher-margin, on-farm grain handling equipment. North American weather variation has historically contributed considerable volatility to Ag’s results. The good news is one year’s setback tends to be reversed the next, and 54 percent growth in offshore sales over the past year is steadily reducing dependence on the US market. The company has also advanced product development initiatives, for example, as US farmers are expected to ramp up planting next year to take advantage of robust grain markets. The re-election of President Obama is also likely to keep ethanol a healthy portion of the US fuel mix, stabilizing underlying demand. The bottom line is despite guidance for a weak fourth quarter, Ag’s underlying business is still quite solid, growth is on track, the balance sheet strong and the dividend secure. Now yielding nearly 8 percent, Ag is a buy up to USD45 for aggressive investors who don’t already own it.

Bird Construction (TSX: BDT, OTC: BIRDF) came in with record revenue that was 61 percent higher than last year’s, fueling a near double in net income. Order backlog of CAD1.162 billion was more than twice year-earlier levels, as the company continues to win construction business in both the public and private sectors. CEO Tim Talbott expects CAD400 million of current backlog to “be put into place through the remainder of 2012” with the result of “very respectable net income results for the year.” The key catalyst for growth is still the acquisition of O’Connell last year, which continues to provide new opportunities, particularly in the burgeoning oil sands region of northern Alberta. Adjusted net income per share covered the 6 cents per share monthly payout by a 2.5-to-1 margin, auguring another dividend increase in the coming months. Backing off recently, the stock’s again a solid buy up to CAD14.50 for those who don’t already own it.

Brookfield Real Estate Services (TSX: BRE, OTC: BREUF) posted rolling 12-month cash flow from operations of CAD1.98, a slight uptick from last year’s CAD1.97 in its primary measure of profitability. Three months’ results were 55 cents per unit, a slight decline from last year’s 57 cents. The numbers again demonstrate the steadiness of Brookfield’s revenue, more than two-thirds of which come from fixed fees paid by its member real estate agents. The results were also very much in line with management’s expectations laid out earlier in the year, with market transactional value slipping 7 percent from last year on a decrease in home sale activity. That was in large part due to changes in mortgage regulations, as the Canadian authorities attempt to slow momentum in the housing market, offset by higher selling prices. Importantly, the numbers and current guidance continue to support Brookfield’s dividend, with the current payout ratio just 50.2 percent. Given the company’s reliance on the health of the housing market and management’s cautious outlook, I’m not expecting a dividend boost soon, but the yield of 9 percent-plus is attractive without one. Brookfield is a buy up to USD14.

Chemtrade Logistics Income Fund’s (TSX: CHE, OTC: CGIFF) third-quarter distributable cash flow per unit was a solid 58 cents Canadian, covering the 30 cents paid during the period by nearly a 2-to-1 margin. The dividend is not likely to be increased this year, given management’s ultra-conservative financial policies and cautious outlook for the global economy. But CEO Mark Davis nonetheless notes “firm” demand for “most of our products,” which should keep cash surpluses coming even if demand and pricing for sulphuric acid–Chemtrade’s key product–should weaken in coming months. Ultimately, the driver of growth is the company’s capital spending on expanding capabilities, and that remains on track as well, even as management continues to shave debt off the balance sheet. Guidance is for ChemTrade to generate distributable cash in 2013 well in excess of the distribution rate, and these results certainly back that up. Chemtrade is a buy so long as it trades at less than USD16.

IBI Group’s (TSX: IBG, OTC: IBIBF) third-quarter 2012 numbers were far from ideal. The global architectural and design firm continued to face headwinds from the slowdown of building in US educational markets, particularly in California. And it took lesser hits from a slowdown in social infrastructure spending in the UK, less building activity in its Chinese markets and the suspension of a major toll project in Greece. The market reaction to its numbers was, however, well out of proportion to that news. Mainly, overall revenue still actually rose year over year, as IBI added new relationships around the world. Meanwhile, distributable cash flow once again covered the dividend with a payout ratio of 94.5 percent. Management also affirmed it expects improvement in both revenue and costs, as well as its intention to keep paying dividends at the current rate. The company is sticking to its plans for growth via expansion outside North America, with such operations now accounting for 14 percent of fee volume. That still leaves 24 percent in the US and 62 percent in Canada, making the company somewhat vulnerable to another North American recession–and it explains a lot about why there were five downgrades by analysts following these results. The current count is two buys, six holds and three sells for those analysts covering IBI. Even the most bearish analysts, however, are still setting 12-month price targets above the stock’s current level, which was only reached because momentum created panic. Why keep holding this stock now? Because IBI’s current yield of nearly 18 percent is clearly pricing as much as a two-thirds reduction in the dividend, which management just as clearly doesn’t need to do. In fact, even the bears concede the company is under no pressure to cut the payout in the near term and that management is likely to keep paying at the current rate–if for no other reason than IBI’s parent and affiliates control nearly 75 percent of the stock. I never recommend overloading on a single company. And in my view, IBI’s results this quarter have demonstrated it’s somewhat more cyclical than I had anticipated. As a result, I’m moving the stock to the Aggressive Holdings to better reflect that risk and am cutting its safety rating a notch to reflect less visibility for future earnings. But in my view, this stock offers deep value and is a buy up to USD10 for aggressive investors who don’t yet own it.

Noranda Income Fund (TSX: NIF-U, OTC: NNDIF) had a more difficult third quarter than a year ago, as zinc sales and byproduct revenues fell. That was only partly offset by higher zinc premiums and lower finance costs, as management continues to devote almost all available excess cash flow to cutting debt. Earnings before interest and taxes–the primary measure of profitability for the company, which derives all income from royalties paid by a zinc processing facility–fell by 16.5 percent from year-ago levels. The payout ratio, however, came in at a manageable 76 percent. That number is likely sufficient to maintain the current level of distributions for the income trust, which has decided not to convert to a corporation and to instead eliminate the tax-inducing “in kind” distribution. But coupled with the drama of the takeover of parent Xstrata Plc (London: XTA, OTC: XSRAY) and worries about the North American economy, these results are likely to rule out distribution increases in the near term. Indeed, management’s non-mention of the dividend during the conference call should be taken as a sign that investors are going to have to be patient with this speculation. That said, the nearly 11 percent yield does pay us to wait. My buy target for Noranda is USD6 for those who don’t already own it.

Poseidon Concepts Corp’s (TSX: PSN, OTC: POOSF) market action following its release of third-quarter numbers is the most extreme of this reporting season. Despite management’s statement that its 9 cents per share monthly dividend remains “unchanged,” the stock fell by more than 50 percent. On their face, third-quarter numbers were solid. Revenue rose 71.5 percent, pushing up cash flow 32.1 percent. Per-share cash flow was flat, after a 29.5 percent increase in outstanding shares to finance growth. The company added to its tank fleet, which reached 500 rental pieces by the end of the third quarter. And management reported the successful rollout of multiple new products and services, including tank heating and monitoring systems. The company also noted a pickup in activity in western Canada from the second quarter. What apparently set off the selling was the impact of a sharp drop in well completions that triggered discounting of up to 75 percent on tank rentals reported by competitors. For its part, Poseidon is still holding discounting to 15 percent to 30 percent of what management calls “historical norms.” But with drilling activity reduced due to price worries, particularly in the Bakken region in the US, the company announced lower cash flow estimates and capital spending for the rest of 2012. According to one still bullish analyst, the company had been previously known in its brief history for low-balling projections. The extreme reaction in the market is directly attributable to issuing disappointing results and guiding lower, with six of the 11 analysts covering the stock reducing ratings. The current count is 3 buys, 4 holds and 4 sells. Interestingly, even the lowest 12-month price estimate is still CAD7, well above the current price–but in a market like this one, it’s hard to gauge a floor for any stock caught up in selling momentum. My view is with the stock now yielding north of 18 percent–and the company still supporting that dividend with profits and forward guidance–now is not the time to give up on Poseidon. The only pending debt maturity is a CAD100 million credit line maturing in June 2014, on which just CAD34.54 million is drawn. And the company has considerable ability to adjust capital spending to match increases and decreases in actual orders, so financial risks are low. Rather, this stock appears to already be pricing in a slowdown in the energy sector equivalent to what happened during 2008–that hasn’t happened yet and it remains unlikely. I don’t recommend loading up on any one stock. But after this one-day disaster, Poseidon is still a buy up to USD10 for those who don’t already own it.

All the Numbers Fit to Print

Here’s the summary of where to find my analysis on all Canadian Edge Portfolio companies reporting calendar third-quarter earnings, including those featured above.

Conservative Holdings

Aggressive Holdings

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