The Goods Up North

By David Dittman • June 6, 2014 • In Brief

Editor’s Note: What follows is the executive summary of the June 2014 issue of Canadian Edge. Thanks for reading.

The Conference Board of Canada introduced its Composite Leading Index (CLI) in December 2013. The index is designed to track short-term indicators of the economy.

The latest reading, for April 2014, showed an increase of 0.4 percent, driven by export demand for commodities. We take an in-depth look 11 companies, including four CE Portfolio Aggressive Holdings, tied into the rebound for Canada’s non-energy resource economy.

The CLI includes 10 components that track the short-term course of the economy. A leading indicator signals changes in the business cycle (notably, the approach of turning points that see the economy move into recession or recovery) and periods of faster and slower economic growth.

The Conference Board introduced its CLI to pick after Statistics Canada discontinued work in this area. The CLI retains 6 of the 10 components from the Statistics Canada index, including the housing index; the US leading indicator; the money supply; the stock market; the average workweek in manufacturing; and new orders for durable goods.

It added four new components, including The Conference Board of Canada’s Index of Consumer Confidence; commodity prices; claims received for employment insurance; and the spread between the interest rate for private versus government short-term borrowing.

Together, the 10 components in the current index cover all the major cyclical parts of the economy, including financial markets, the labour market, exports, housing, and the manufacturing sector.

The picture emerging from April is more promising for exporters, less so for the labor market and the housing sector. The CLI suggests a shift in drivers of growth from domestic spending to exports, with little change in the overall rate of growth.

Five of the ten components increased, and those were mostly related to export demand for Canada’s commodities. Higher resource prices contributed to an eighth consecutive month of growth for the Toronto Stock Exchange.

The Bank of Canada’s Commodity Price Index posted the largest increase of any component, 2.4 percent, its fastest advance in three years.

Agricultural prices have led the latest gains for commodities. Wheat prices in particular received a boost from the uncertain outlook for exports as a result of political turmoil in the Ukraine.

Both manufacturing components–new orders and the average workweek in factories–were unchanged in April, while the housing and labor markets remained a source of weakness.

Claims received for employment insurance rose 1.8 percent, the largest jump in almost three years and the third consecutive monthly increase. The housing index, meanwhile, retreated for the sixth consecutive month.

Big Profits

Business investment and stronger exports are the two key ingredients in the Bank of Canada’s (BoC) recipe for sustained growth in Canada.

They’ve both proven somewhat elusive in the last few months, but rising corporate profits could bolster business investment.

Statistics Canada reported May 27, 2014, that Canadian corporations generated CAD88.6 billion in operating profits during the first quarter, up 7.4 percent from the previous quarter and the biggest sequential gain in three years. The year-over-year increase was 12.3 percent.

The increase followed a 0.5 percent drop in the fourth quarter of 2013 from the third quarter.

The improved profit performance is an encouraging sign for business investment.

And it reinforces the BoC’s conclusion in the Business Outlook Survey for spring 2014 that sentiment on future investment in machinery and equipment is improving among Canadian businesses.

Some of the gains in the first quarter, a period when North American economies were coping with extreme winter weather, came from commodity price increases.

But stronger demand from the US in coming months should help improve the bottom line for Canadian exporters and eventually help spur stronger business investment in Canada, as some of the challenges that have hemmed in corporate profits–weak global growth, stagnant commodity prices, retail competition and a lofty loonie–are diminishing.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

The Canadian Edge model Portfolio is broken into two parts. The Conservative Holdings are chosen for their ability to pay consistent and rising dividends over time, thanks to healthy and growing underlying businesses that have proven they can prosper even in the most volatile and dangerous environments.

The Aggressive Holdings represent outsized total return potential, either because of strong positions in key natural resource sectors or a special situation with big upside. Here we take on more risk for greater potential reward.

One way to build a portfolio of CE stocks this way is simply to buy the two Best Buys in each issue.

These are typically drawn one from the Conservative Holdings and one from the Aggressive Holdings.

If you have new money to put to work now, you could do much worse than to start with this month’s Best Buys.

In addition, the last 12 Portfolio Holdings have posted results for recently concluded reporting periods. Eight of them are summarized here, while we look at four in this month’s In Focus feature.

Portfolio Update has details from eight Portfolio Holdings that reported financial and operating results over the past month, including an update on our REIT holdings and a breakdown of how to build a portfolio the CE way.

Best Buys

One is rapidly gaining share in its key markets. The other already dominates its realm.

Our Aggressive choice as one of June’s “Best Buys” for new money is an Energy Services firm that’s making a return to the CE Portfolio based on the quality of its technical offering, its strong presence in North America and expanding international profile and its solid operating and financial performance.

Our Conservative selection has occupied a place in the Portfolio since June 2010, boosting its dividend every year since, diversifying and augmenting its revenue streams via innovative uses of its key assets and early adaptation of new technologies, ensuring its continuing dominance through facilities upgrades and acquisitions.

Both are well placed to build wealth for the long term.

PHX Energy Services Corp (TSX: PHX, OTC: PHXHF) joined the CE Portfolio Aggressive Holdings in September 2010. We sold it in October 2012 after a gain of 10.3 percent in favor of Poseidon Concepts Corp, a move that turned out about as well as the 1972 disaster epic The Poseidon Adventure.

Poseidon Concepts tried to get too big too fast and foundered, eventually going bust in early 2013. It was a complete loss.

From Oct. 5, 2012, through June 5, 2014, PHX generated a total return in US dollar terms of 87.5 percent. We can’t get that back.

But we can participate in PHX’ promising future. PHX Energy Services is a buy under USD16.

As of this writing Cineplex Inc (TSX: CGX, OTC: CPXGF), Canada’s dominant owner/operator of movie theaters, is trading just below our recommended buy-under target of USD38, having closed at CAD41.11 on the Toronto Stock Exchange (TSX) on June 5, 2014, equivalent to USD37.59 based on the prevailing Canadian dollar-US dollar exchange rate.

The share price dipped from an all-time high of CAD44.31 registered on Dec. 24, 2013, early in the new year and has traded in a tight range thus far in 2014.

The opportunity now lies in the box office upside that’s likely to be driven by another string of strong, tent-pole-type offerings from Hollywood over the balance of 2014 and into 2015.

Next year, in particular, looks likely to be a record-breaking year for box-office sales. Cineplex is a buy under USD38.

Best Buys has more on the Portfolio Holdings that represent our top ideas for new money in June.

In Focus

As go commodities prices, so goes the Canadian economy.

The good news–which apparently is having a hard time finding acceptance-is that prices for the commodities Canada exports have reached their highest levels since the recession

The Bank of Canada’s Commodity Price Index shows that prices for Canadian commodity exports are at their highest level since peaking in the commodities boom before the Global Financial Crisis/Great Recession.

The BoC CPI covers 24 commodities produced in Canada and sold in world markets, including .

This is more than an energy story. Non-energy commodities, which account for 37 percent of the index, are also reaching new heights.

Included in the index are minerals and metals, such as potash, gold and nickel; forestry products, including pulp and newsprint; agricultural commodities such as cattle, canola, wheat and hogs; and fishery products.

Share prices for major producers have varied in their reaction, based of course on the fact that there is some significant variation in price performance among commodities.

There’s still considerable upside for those that enjoyed solid market performance, based largely on long-term fundamentals such as rising demand.

And for those that have languished there are opportunities to find value.

In Focus takes a look at 11 members of the Natural Resources segment of the How They Rate coverage universe, including four Portfolio Holdings, still poised to benefit from Canada’s rebounding resource economy.

Dividend Watch List

Just Energy Group Inc (TSX: JE, NYSE: JE), as we forecast in the May 2014 edition of the monthly Canadian Edge web chat, announced another dividend cut, making it the sold member of the How They Rate coverage universe to reduce its payout over the past month.

Just Energy announced this the sale of National Home Services, its waterheater and HVAC home services business to Reliance Comfort LP for CAD505 million.

Upon closing of the transaction Just Energy will repay CAD400 million in debt, shoring up its balance sheet.
Due to the reduction in earnings before interest, taxation, depreciation and amortization (EBITDA) and base funds from operations, Just Energy will also cut its dividend, moving from monthly payments of CAD0.07 per share, which will remain in effect in June, to quarterly payments of CAD0.125 per share beginning in September.

The new annualized rate of CAD0.50 per share is 40.5 percent lower than the old rate of CAD0.84 per share per year.

Dividend Watch List has the details on members of the How They Rate coverage universe whose current dividend rates are in jeopardy.

Canadian Currents

After a strong start to the year despite the unusually harsh winter, Canada’s economy finally succumbed to the inevitable, with first-quarter growth falling short of expectations, notes CE Associate Editor Ari Charney in this month’s Canadian Currents.

Bay Street Beat–First-quarter reporting season is over for the Canadian Edge Portfolio.

Here’s how Bay Street has reacted to financial and operating numbers and how it sees our Portfolio Holdings as we near the end of the second quarter of 2014.

How They Rate Update

Coverage Changes

We have no additions to or subtractions from the How They Rate coverage universe this month.

Our evaluation of the coverage universe is ongoing, as we streamline our focus to companies with realistic opportunities to build wealth for investors for the long term, keeping in mind too that part of the rationale for building a coverage universe is to provide context and comparison.

Advice Changes

Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV–From Hold to Buy < 7. Results for the first quarter of 2014 suggest management’s plan to reorient operations around the Montney Shale formation is a wise one. Funds from operations per share were up 108 percent, as management cut operating costs by 68 percent and administrative costs by 57 percent, the latter largely via the sale of the Longview Oil Corp stake.

Debt reduction continues apace, with another CAD111 million cut during the quarter, bringing the total outstanding down to CAD188 million.

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–From Hold to Buy < 16. Management reported a 38 percent jump in first-quarter production revenue, as funds from operations per share grew by 40 percent to CAD0.80. Output was up 2 percent to 73,936 barrels of oil equivalent per day (boe/d), and operating netback rose by 39 percent to CAD27.01 per boe.

The payout ratio for the period was 26.3 percent.

Management’s longer-term efforts to control costs and reduce debt are beginning to pay off. Recent asset sales mean the company has exited heavy-oil production, with proceeds used to add approximately 1,000 barrels of oil equivalent per day of liquids-rich natural gas assets in the Glauconite formation. Management is evaluating additional transactions of this size and type.

Empire Company Ltd (TSX: EMP/A, OTC: EMLAF)–From Hold to Buy < 65. A selloff that’s taken the share price from CAD83.24 on Sept. 9, 2013, to CAD65.44 as of June 5, 2014, is well overdone for this diversified services company with food retailing operations, including the Sobeys grocery chain, and real estate investments, including a 41.6 percent stake in Crombie REIT (TSX: CRR-U, OTC: CROMF).

Empire has never cut its dividend; in fact it’s announced a dividend increase every June since 2002 and will likely do so again on June 30, 2014. The yield is modest at 1.6 percent, but it’s solid.

And there seems to be compelling value as well, with the stock trading at just 1.06 times book value at 14.15 times estimated fiscal 2014 earnings.

Fiscal 2014 fourth-quarter results will likely be impacted by the severe winter. But for the long term Empire, at these levels, looks attractive.

Liquor Stores NA Ltd (TSX: LIQ, OTC: LQSIF)–From Buy < 14 to Hold. A turnaround strategy is driving up administrative costs at the same time management is trying to grow the business via the addition of new stores. Same-store sales growth in Canada and the US, meanwhile, was negative in the first quarter, suggesting the business model is not immune to the economic cycle.

And the payout ratio for the three months ended March 31, 2014, was negative.

There are no debt maturities before the end of 2015, though there are significant rollovers looming in 2016 and 2018, amounting to 70.3 percent of current market capitalization.

Liquor Stores earns Safety Rating points for its debt as a percentage of assets and its operation in a sector traditionally viewed as recession-resistant, alcohol. But there are serious signs of weakness here.

Rating Changes

We have many Safety Rating changes this month in the aftermath of first-quarter reporting season.

Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV)–From 0 to 1. The company earns a single point because overall debt as a percentage of assets is less than 30 percent.

Algonquin Power & Utilities Corp (TSX: AQN, OTC: AQUNF)–From 5 to 6. The renewable power producer’s last dividend cut came in October 2008, so it has no cuts within the last five years. It operates in a relatively stable industry, with generation assets covered by long-term power purchase agreements that provide predictable cash flows. The payout ratio is below the “Very Safe” threshold, with visibility over the next 18 to 24 months. Overall debt as a percentage of assets is also “Very Safe,” and obligations coming due before Dec. 31, 2015, amount to just 6.3 percent of market capitalization.

Atlantic Power Corp (TSX: ATP, NYSE: AT)–From 2 to 0. The struggling owner/operator of North American power generating assets posted a negative payout ratio for the first quarter. Its exposure to a volatile merchant power market is the source of much of its problems over the past 20 months, while overall debt and obligations coming due before Dec. 31, 2015, both are outside of our comfort zones.

ARC Resources Ltd (TSX: ARX, OTC: AETUF)–From 3 to 5. The oil and gas producer has a trailing-12-month payout ratio well below the 50 percent threshold below which it’s considered “Very Safe” under the Safety Rating System, and it’s likely to remain so for the next 18 to 24 months based on forecast production growth and management’s focus on reinvesting cash into the business.

Debt as a percentage of total assets is low for its sector, and there are minimal obligations coming due between now and Dec. 31, 2015.

In addition to earning four points on the payout ratio and debt criteria, ARC earns another point because its last dividend cut was more than five years ago, in May 2009.

Athabasca Oil Corp (TSX: ATH, OTC: ATHOF)–From 0 to 2. The company gets a point because overall debt as a percentage of assets is well below the threshold considered “Very Safe” under the Safety Rating System and another because it has no obligations coming due before 2017, implying low credit risk.

Bellatrix Exploration Ltd (TSX: BXE, NYSE: BXE)–From 2 to 1. Bellatrix loses a point because debt coming due before Dec. 31, 2015, as a percentage of market capitalization now exceeds 20 percent, above our comfort threshold of 10 percent. Overall debt as a percentage of assets remains in the “Very Safe” range.

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–From 2 to 4. Bonavista’s trailing-12-month payout ratio is well below the “Very Safe” threshold and is likely to remain there.

There are no maturities coming due until 2016, and total debt as a percentage of assets is less than 30 percent. And recent production results have been solid. This all suggests the current dividend rate of CAD0.07 per month is safe for the medium term.

Cameco Corp (TSX: CCO, NYSE: CCJ)–From 3 to 4. The uranium producer has never cut its dividend, not even during the last, highly stressful five-and-a-half years. The trailing-12-month payout ratio is 34.8 percent, well below the 50 percent “Very Safe” threshold for Natural Resources companies, though whether it will remain so for the next 18 to 24 months is in question due to the delayed recovery for uranium prices in the aftermath of the March 2011 Fukushima Dai-ichi nuclear disaster in Japan.

Total debt as a percentage of assets is likewise “Very Safe,” and there are minimal maturities between now and the end of 2015.

Canadian Natural Resources Ltd (TSX: CNQ, NYSE: CNQ)–From 4 to 5. Canadian Natural has never cut its dividend, not even during the Great Recession/Global Financial Crisis. A consistently low payout ratio earns it another two points under the Safety Rating System. A well-managed balance-sheet, with low overall debt as a percentage of assets and minimal obligations coming due before Dec. 31, 2015, earn it another two points.

Canadian Utilities (TSX: CU, OTC: CDUAF)–From 4 to 6. This diversified electric and gas utility has never cut its dividend, earning it a Safety Rating System point. Its utility operations generate stable cash flow, earning it another point. Overall debt and debt coming due by the end of 2015 are both well within our comfort zones, as is the payout ratio, which is also on a stable track for the medium term.

EnCana Corp (TSX: ECA, NYSE: ECA)–From 2 to 3. Total debt as a percentage of assets is high, but obligations coming due before Dec. 31, 2015, are more than manageable. And the trailing-12-month payout ratio, in the aftermath of the 65 percent dividend cut announced in November 2013, is just 26.5 percent. The first-quarter payout ratio was just 18.4 percent.

IBI Group Inc (TSX: IBG, OTC: IBIBF)–From 1 to 0. IBI’s current financial and operating profiles offer no supportive evidence satisfying any of the Safety Rating System criteria at present, as it eliminated its dividend just a year and therefore has no payout ratio and its overall and short-term debt situations are potentially debilitating. And its business is not resilient enough to endure through the cycle.

Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)–From 5 to 4. The CE Portfolio Conservative Holding loses a Safety Rating point because its trailing-12-month payout ratio ticked up to 111.9 percent as of March 31, 2014, above the 110 percent threshold that marks entry to “At Risk” territory.

Just Energy Group Inc (TSX: JE, NYSE: JE)–From 3 to 1. The fiscal 2014 payout ratio based on “base” funds from operations was 112.3 percent, well into the “At Risk” zone for Gas/Propane companies.

Fiscal 2015 base earnings before interest, taxation, depreciation and amortization (EBITDA) guidance of CAD220 million to CAD220 million and base FFO “in excess of” the dividend (approximately CAD125 million) suggest very little room for error. Overall debt as a percentage of assets is also high, as are maturities coming due before the end of 2015.

Management cut the dividend in March 2013, and another reduction, as it attempts to pay down debt while growing the business, is very possible.

Leisureworld Senior Care Corp (TSX: LW, OTC: LWSCF)–From 3 to 4. The long-term care and retirement facility operator has maintained its current dividend level for more than five years, supported by the relatively predictable cash flow generated from its health care niche. The payout ratio is below our “Very Safe” threshold, and it has minimal debt coming due before the end of 2015.

Liquor Stores NA Ltd (TSX: LIQ, OTC: LQSIF)–From 4 to 2. A turnaround strategy is driving up administrative costs at the same time management is trying to grow the business via the addition of new stores.

Same-store sales growth in Canada and the US, meanwhile, was negative in the first quarter, suggesting the business model is not immune to the economic cycle.

And the payout ratio for the three months ended March 31, 2014, was negative.

There are no debt maturities before the end of 2015, though there are significant rollovers looming in 2016 and 2018, amounting to 70.3 percent of current market capitalization.

Northland Power Inc (TSX: NPI, OTC: NPIFF)–From 5 to 4. Northland fails to earn any of the two points available under the Safety Rating System based on debt metrics, as its overall debt is more than 60 percent of total assets and its obligations coming due before the end of 2015 represent 14.1 percent of market capitalization, above our favored threshold of 10 percent.

Primary Energy Recycling Inc (TSX: PRI, OTC: PENGF)–From 2 to 3. Primary Energy is entitled to another point because its payout ratio is low relative to its peers, though its reliance on steelmaking operations to produce its power opens it up to more market-based forces than is typical for a power generator, its overall debt is low and so are maturities before Dec. 31, 2015.

Suncor Energy Inc (TSX: SU, NYSE: SU)–From 4 to 5. Like Canadian Natural, Suncor has never cut its dividend, not even during the Great Recession/Global Financial Crisis. It too maintains a consistently low payout ratio, while low overall debt as a percentage of assets and minimal obligations coming due before Dec. 31, 2015, earn it another two points.

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.