On with the Execution

By David Dittman • June 7, 2013 • In Brief

Editor’s Note: What follows is the executive summary of the June 2013 issue of Canadian Edge. Thanks for reading.

Last month in this space I articulated the approach I and Associate Editor Ari Charney will take as the newly anointed helmsmen of the good ship Canadian Edge.

We will rely on the analytical framework provided by the CE Safety Rating System. There are times, however, when the objective criteria teased out via application of the System are not sufficient to totally inform a buy-hold-sell decision.

There are circumstances where a company can satisfy enough criteria to earn a high Safety Rating, though financial and operating numbers have only begun to reveal underlying weakness.

In December 2012, for example, Atlantic Power Corp (TSX: ATP, NYSE: AT) had a “5” Safety Rating and was counted among the CE Portfolio’s Conservative Holdings. Meanwhile, the deterioration of the North American wholesale power market and the difficulty of re-contracting projects in Florida were only just beginning to manifest in the company’s numbers.

It wasn’t until March, after management announced a drastic dividend reduction and a shift in the way it would go about adding new projects and cash flow, that we shaved three points off the company’s Safety Rating and moved it to the Aggressive Holdings.

Had we a crystal ball we would have closed out our position in Atlantic Power last fall, when it was trading above CAD15 and had through October 2012 generated a total return of nearly 200 percent since we added it to the Portfolio in October 2006.

Or we might have been more sensitive to management’s discussion of its Florida issues as well as the broader context of the troubled wholesale power market during the late fall and early winter, when the stock was still trading in a band around CAD12.

We did cut the Safety Rating to “4” in the January 2013 issue, a sign that we knew there was some trouble, specifically that the payout ratio, based on management guidance, wasn’t likely to remain within the range considered safe for Electric Power companies over the ensuing 18 to 24 months.

There was, of course, a lot more going on with Atlantic Power, but we didn’t know conclusively until management’s Feb. 28, 2013, announcement of fourth-quarter and full-year numbers.

What we have now, new to management of the CE Portfolio, is an opportunity to establish a more rigorous sell discipline, to be more sensitive to emerging underlying weakness in the businesses we cover so that we can avoid steep and painful capital losses.

That’s not to say we won’t make mistakes, or that we’ll never enter a position that we eventually close out for a loss. It does mean we’ll be quick to admit mistakes and to close them out before losses become irreparable.

The Safety Rating System establishes an objective framework. But exercising this more rigorous sell discipline requires a bit of subjective judgment. In other words, there is no trigger for a sell decision.

In many cases, for example, companies that cut dividends–which event would make for a simple sell sign–use the saved cash to shore up healthy-for-the-long-term-but-struggling-in-the-short-term operations and push on for greater growth–for shareholders, too–down the road.

But this–greater sell discipline–in addition to sticking with the analytical framework established by the Safety Rating System is the mandate we’ve established at the outset of our tenure in charge of Canadian Edge.

Beginning, actually, with the May 17, 2013, Flash Alert wherein we advised readers to sell IBI Group Inc (TSX: IBG, OTC: IBIBF), we’ve begun to execute on our self-imposed mandate. In this issue, in this month’s Portfolio Update, we continue the work with two more dispositions of Portfolio Holdings that we feel no longer merit notice as high-quality companies.

Of course this takes place against the backdrop of a renewed period of equity market volatility.

Dividend-paying stocks, in particular, have been hard hit over the past month-plus, as fears of rising interest rates and an anticipated concomitant reversal of what had been a virtuous confluence–their relatively high yields attracted traditional bond investors, low benchmark rates allowed them to borrow and refinance at historically attractive costs and repair and strengthen balance sheets, thus boosting financial and operating performance and attracting even more investor attention–have inspired indiscriminate selling.

The factors driving interest rates higher–specifically, signs of an improving US labor market and the sense that what’s still the world’s biggest economy is now getting firmly back on its own two feet–could actually benefit sectors and industries known traditionally for their dividend-paying stocks.

Electric utilities, for example, will generally benefit from improved economic health, as that implies rising power usage at the industrial as well as the consumer level. Similarly, select real estate investment trusts (REIT) on both sides of the border will enjoy the rising consumer foot traffic, increased apartment rental rates and higher demand for office space that should accompany economic growth at long-term trend rates.

It’s never a good time to throw the baby out with the bath water. This is the essential, fundamental discipline the CE Safety Rating System enforces. As we prepare each issue, particularly those that coincide with earnings reporting season, including this one, we’re evaluating each company in the context of the six basic criteria that comprise the System.

Our approach is all about the “bottom-up” view, which helps establish whether present dividend rates are supportable and whether we’ll see dividend growth in the future.

In addition to our heightened focus on sell discipline, we want to reemphasize the importance of buy discipline as well.

Buy-under targets are based on two things, quality and prospective return. The first is established by the Safety Rating System. The second is basically the dividend plus prospective growth, preferably in the dividend rate.

One reason dividend growth is important for a stock is it sets a new baseline price. The more a company can pay out consistently, the higher its stock will trade, particularly if investors have been buying it because it pays dividends.

Dividend growth is also the best possible indicator of dividend safety. It’s the most powerful statement the company’s management and board can make that earnings are rising and stable, and that there’s a lot more to come.

Whatever’s happening at the macro level–and as of today the picture remains mixed, more positive than it was a year ago at this time but nevertheless mixed–there’s reliability in a growing payout.

We’re clearing out positions that no longer merit inclusion in a Portfolio we consider to be comprised of high-quality stocks. This selloff in dividend-paying fare presents a compelling opportunity to establish positions in other Portfolio Holdings that have come down from above our recommended buy-under targets.

This is no time to panic. It is a time to proceed with a clear plan for the long term.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

First-quarter earnings reporting season has concluded. In a departure from past practice, we’re focusing this month on specific Portfolio Holdings that have underperformed.

Brief, key details on results for Portfolio Holdings as well as the rest of the coverage universe can be found in this month’s How They Rate table.

If a Holding isn’t discussed in Portfolio Update, take it as a sign that financial and operating results continue to support the current dividend rate and that the underlying business remains relatively healthy.

If a Holding is discussed in Portfolio Update, it’s a sign of trouble.

We take at what you might describe as a “hit list,” including Atlantic Power Corp (TSX: ATP, NYSE: AT), Colabor Group Inc (TSX: GCL, OTC: COLFF), Extendicare Inc (TSX: EXE, OTC: EXETF), IBI Group Inc (TSX: IBG, OTC: IBIBF), Just Energy Group Inc (TSX: JE, NYSE: JE) and Wajax Corp (TSX: WJX, OTC: WJXFF), with an eye on cutting losses.

We also review Bird Construction Inc’s (TSX: BDT, OTC: BIRDF) first-quarter performance, taking account of what appears to some “selling in sympathy” because it looks somewhat like IBI Group.

We have two new “sells” in this month’s Portfolio Update following the May 17 Flash Alert wherein we disposed of IBI Group.

But we remain fans of Bird Construction.

Portfolio Update has an in-depth look at the CE Portfolio’s “trouble spots” in the wake of first-quarter 2013 reporting season.

Best Buys

This month’s Best Buy selections include Conservative Holding Brookfield Renewable Energy Partners LP (TSX: BEP-U, OTC: BRPFF), which owns a high-quality portfolio of renewable power generation assets in the US, Canada and Brazil, and Aggressive Holding Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), an oil and gas producer that’s boosting conventional production through the use of innovative technologies.

As of Dec. 31, 2012, 98 percent of Brookfield Renewable’s expected 2013 generation was under contract, at an average price of CAD83 per megawatt hour and a weighted-average remaining duration of 18 years. These power purchase agreements (PPA) provide cash flow stability and protection against wholesale power price risk.

The diversified generation portfolio is 85 percent hydro, 12 percent wind and 3 percent natural gas-fired generation.

A true invest-to-grow story, Brookfield Renewable boosts cash flow every time it adds a project. During the first quarter management completed a deal for 19 hydroelectric facilities in New England, totaling 351 megawatts, from NextEra Energy Inc (NYSE: NEE). That adds to 103 megawatts of low-cost generation Brookfield Renewable already had in the region, all contracted through 2025.

It also expanded its operating wind portfolio in California to 430 megawatts with the acquisition of Western Wind Energy Corp, which was completed in late May.

In total Brookfield Renewable deployed CAD600 million of equity to acquire over 560 megawatts of hydroelectric and wind facilities. It also achieved commercial operations for a 29 megawatt hydroelectric project in Brazil, which brings the in-country total to 14 stations and 314 megawatts constructed since 2003.

Brookfield Renewable’s CE Safety Rating of “6” and growing dividend are compelling long-term attractions. A New York Stock Exchange (NYSE) listing this year could offer a near-term boost as well. Buy Brookfield Renewable Energy on dips to USD32.

Crescent Point’s monthly dividend rate has been stable since July 2008. That’s nearly five years without an increase. But that’s also five years without a cut. And this timeframe encompasses one of the most volatile periods for commodity prices in recent memory.

Based on solid first-quarter results management boosted its 2013 production guidance and capital expenditure plans. Average daily production is now forecast to increase to 114,000 boe/d from 112,000 boe/d in 2012, and the company’s 2013 exit production rate is expected to increase to 117,000 boe/d from 114,000 boe/d. CAPEX is expected to increase by CAD150 million to CAD1.5 billion.

Shipping oil via rail has allowed Crescent Point to reduce its exposure to volatility in oil-price differentials. Throughout the first quarter the company continued to increase oil deliveries through its three rail terminals in Saskatchewan and Alberta, providing access to diversified refining markets and more stable price differentials to West Texas Intermediate (WTI) crude.

Its ability to grow production, exploit new ways of getting it to market and sustain its dividend well tested, Crescent Point is a strong buy all the way up to USD48.

Best Buys–which features the top two candidates for purchase in June–is the place to start if you have money to put to work right now.

In Focus

The low interest rate environment that’s prevailed in the aftermath of the 2008-09 global meltdown variously known as “The Great Recession” and/or “The Great Financial Crisis” has allowed North American real estate investment trusts (REIT) to fix and strengthen their balance sheets.

Unit prices for US and Canadian REITs have rallied strongly over the past half-decade, as they attracted traditional bond investors because of their relatively high yields while financial and operating metrics benefitted from their ability to raise low-cost capital.

A series of events–unfortunate, if you’re a REIT investor–has raised the important question of whether this party is over.

In Focus addresses speculation that higher interest rates will kill what have been golden geese during the last half-decade as investors run from Canadian real estate investment trusts.

Dividend Watch List

Four members of the How They Rate coverage universe, including one recent and one current Portfolio Holding, announced dividend cuts last month.

Former CE Portfolio Aggressive Holding IBI Group Inc (TSX: IBG, OTC: IBIBF) on May 23 announced the immediate suspension of its dividend.

We recommended investors sell IBI in a May 17, 2013, Flash Alert.

In addition to ongoing operational challenges, management acknowledged, if only in a roundabout way, other pressures on its payout policy when it discussed first-quarter 2013 results.

In addition, Wajax Corp (TSX: WJX, OTC: WJXFF) announced a 25.9 percent reduction in its monthly dividend rate on May 10.

Wajax had been on the Dividend Watch List because of weak fourth-quarter earnings and due to management’s oft-expressed willingness to trim the payout as it copes with ongoing difficulties associated with reduced drilling in the Canadian energy patch.

Also among the cutters: Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF), which cut its dividend in half on May 10 as a direct consequence of its ongoing dispute with Air Canada (TSX: AC/A, OTC: AIDIF).

Chorus reduced the quarterly rate from CAD0.15 to CAD0.075 effective with the payment due in July in order to conserve cash.

And Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) announced a 48.1 percent cut in its quarterly dividend rate, from CAD0.27 to CAD0.14 effective with the third-quarter payment due in October.

In a June 4, 2013, statement that covered much more than the new dividend policy, Penn West also announced the retirement of CEO Murray Nunns, a commitment to “focus on operating the business in a more efficient manner” and the formation of a special committee of the board of directors to explore strategic alternatives.

Dividend Watch List has more on this quartet as well as the latest on other members of the How They Rate coverage universe with payout rates under pressure.

Canadian Currents

Canada’s economic recovery has largely been driven by domestic demand. Now it’s time for growth in exports to take over.

Canadian Currents takes a look at the current state of the economy in the Great White North, including the perspective of recently installed successor to Mark Carney as governor of the Bank of Canada Stephen Poloz.

Bay Street Beat–The vast majority of Canadian Edge Portfolio Holdings reported first-quarter 2013 earnings after the May issue was published. Here’s how Bay Street responded.

How They Rate Update

Coverage Changes

H&R REIT (TSX: HR-U, OTC: HRUFF) has completed its takeover of Primaris Retail REIT. Primaris has been removed from How They Rate coverage.

PetroBakken Energy Ltd has completed a name change and is now known as Lightstream Resources Ltd (TSX: LTS, OTC: PBKEF). PetroBakken/Lightstream is now trading under the symbol LTS on the Toronto Stock Exchange. The US over-the-counter (OTC) symbol for the stock remains PBKEF.

Poseidon Concepts Corp has de-listed from the TSX. Management has entered an agreement to sell its assets to Rockwater Energy Solutions. Poseidon is now operating under bankruptcy protection in the US and Canada.

There are a number of shareholder suits ongoing against the company. One US law firm participating is Howard G. Smith of Bensalem, Pennsylvania (888-638-4847).

Given how fast this one imploded, no one should get their hopes up for much restitution. But by the same token shareholders have little to lose, either.

Advice Changes

Canadian REIT (TSX: REF-U, OTC: CRXIF)–To Buy @ 44 from Hold. Management announced a 6.4 percent dividend increase, the fourth payout boost in the last 12 months. First-quarter funds from operations per unit were up 6.3 percent.

Cominar REIT (TSX: CUF-U, OTC: CMLEF)–To Hold from Buy @ 26. The diversified real estate investment trust reported that first-quarter recurring funds from operations per unit declined 4.4 percent to CAD0.43 and that occupancy declined to 93.9 percent from 94.6 percent a year ago.

Essential Energy Services Inc (TSX: ESN, OTC: EEYUF)–To Buy @ 2.50 from Hold. The Energy Services outfit reported a 2 percent increase in first-quarter revenue, as gross margins held steady at 31 percent and funds from operations per share were flat at CAD0.24. Utilization for deep coil tubing rigs and service rigs was also steady.

Inter Pipeline Fund (TSX: IPL-U, OTC: IPPLF)–To Buy @ 24 from Hold. Management reported solid first-quarter funds from operations of CAD109.4 million (CAD0.40 per unit), in line with year-ago levels, and announced a plan to convert to a corporation. The company also boosted its dividend by 2.7 percent.

InterRent REIT (TSX: IIP-U, OTC: IIPZF)–To Buy @ 6 from Hold. The residential REIT with properties in Toronto boosted its distribution by 25.5 percent, and financial, operating and leverage metrics for the first quarter were all positive.

Suncor Energy Inc (TSX: SU, NYSE: SU)–To Buy @ 35 from Hold. The major Canadian oil and gas producer announced a new quarterly dividend rate of CAD0.20 per share, up from CAD0.13, taking effect with the June 25, 2013, payment to shareholders of record as of June 4, 2013.

Ratings Changes

Essential Energy Services Inc (TSX: ESN, OTC: EEYUF)–To 2 from 1. The company earns an additional point for having a low payout ratio, on top of low overall debt burden.

Wajax Corp (TSX: WJX, OTC: WJXFF)–To 1 from 2. Management slashed the dividend by 25.9 percent. The first-quarter payout ratio soared to 131 percent, as revenue declined by 6.1 percent to CAD336.3 million, gross profit shrank and expenses rose.

Safety Ratings

The core of my selection process is the six-point CE Safety Rating System, which awards one point for each of the following. A rating of “6” is the safest:

Payout Ratio–A ratio below our proprietary industry baseline.
Earnings Visibility–Earnings are predictable enough to forecast a payout ratio below our proprietary industry baseline.
Debt-to-Assets Ratio–A ratio below our proprietary industry baseline.
Short-Term Debt Ratio–Debt due in next two years is less than 10 percent of market capitalization.
Business Stability–Companies that can sustain revenues during recessions are favored over more cyclical ones.
Dividend History–No dividend cuts over the preceding five years.

Resources

The following Resources may be found in the top navigation menu at www.CanadianEdge.com:

Ask the Editor–We will reply to your queries via email or in an upcoming article.
Broker Guide–Comparison of brokers for purchasing Canadian investments.
Getting Started–Tour of the Canadian Edge website and service.
Cross-Border Tax Guide–What you need to know about taxes and Canadian investments.
Other Websites–Links to other websites to help you get the most out of your Canadian stocks.
Promo Stocks–Guide to the mystery stocks we tease in our promotional messages.
CE Safety Rating System–In-depth explanation of the proprietary ratings system and how to use it effectively.
Special Reports–The most recent reports for new subscribers. The most current advice is always in your regular issue.
Tips on DRIPs–Details for any dividend reinvestment plan offered by Canadian Edge Portfolio Holdings.