Oil and gas exploration and production stocks have led the CE Portfolio to an outstanding, benchmark-beating performance over the first half of 2014. Energy, for better and worse, is a huge part of the Canadian economy.

We’re in the midst of an energy production and infrastructure super-spending cycle, and there’s a long ways to go, with fundamentals in place for robust growth through the end of the decade.

According to the Canadian Association of Petroleum Producers, Canadian crude output is expected to rise to 4.9 million barrels per day by 2020 from 3.2 million barrels per day in 2012.

Oil sands and liquids-rich natural gas are driving growth in the Western Canadian Sedimentary Basin. Going forward further development of the Montney, increasing development of the Duvernay and drilling in anticipation of liquefied natural gas (LNG) export projects in British Columbia will be major catalysts.

More than a dozen of LNG projects have been proposed for the province as Canadian natural gas producers seek new export markets in Asia.

AltaGas Ltd (TSX: ALA, OTC: ATGFF) recently signed a letter of intent with the British Columbia government regarding regional LNG development. Its portfolio of energy export projects in British Columbia alone could total CAD2 billion to CAD5 billion of net capital investment. Opportunities span multiple jurisdictions and all business segments, including midstream and power projects. The diversity of projects is notable and reduces risk to its growth profile.

Newalta Corp (TSX: NAL, OTC: NWLTF), with a network of more than 85 facilities across North America, is one of the established leaders in the niche market of providing waste processing and management services to the oil and gas sector in Western Canada and increasingly in the US.

Demand for such services has increased and is likely to continue so as a result of increasingly stringent environmental regulations relating to the production and drilling activities in the sector.

AltaGas is also part of a consortium bidding for an LNG asset that’s part of the Douglas Channel LNG project bankruptcy proceeding.

Although a modest investment at approximately CAD100 million, this initiative could accelerate AltaGas’ LNG development plans, including its Triton LNG project, and possible PNG pipeline expansion. The ability to leverage existing assets and the stakeholder relationships it’s established as part of Northwest projects are strategic to its British Columbia growth plans.

AltaGas operates in three business segments, Power, Utilities and Gas, including extraction and transmission, field gathering and processing and energy services, establishing diversified sources of revenue. The latter is its largest segment, accounting for approximately 33 percent of 2013 total revenue.

Almost 80 percent of the company’s earnings are supported by either stable regulated returns or long-term contacts.

Earnings quality has improved since the addition to its Utilities business of SEMCO Energy Inc and Pacific Northern Gas Ltd and cleaner power-generation assets via Blythe Energy LLC to the company’s Power portfolio. These new assets are primarily underpinned by long-term take-or-pay commitments, resulting in no incremental direct exposure to commodity-price risk.

Power provides exposure to strong long-term electricity demand in Alberta, British Columbia, California and Arizona, with regulated earnings underpinned by long-term take-or-pay contracts. The acquisition of Blythe during the second quarter of 2013, together with projects under development, is expected to expand installed power generation capacity to over 1,300 megawatts and into cleaner fuel types.

Utilities generates low-risk, regulated natural gas distribution earnings in Canada and the US via interests in several regulated natural gas distribution businesses that deliver 135 billion cubic feet (bcf) of gas to 550,000 customers, with a rate base of $1.3 billion.

Gas is composed of Extraction & Transmission; Field Gathering & Processing, which provides exposure to demand for natural gas processing capacity and natural gas liquids (NGLs); and Energy Services, which entails services related to both gas and power demand.

Two-thirds of the company’s processing capacity serves areas with liquids-rich gas in Western Canada. A large portion of the Gas segment earnings are supported by long-term, cost-of-service or fixed-fee contracts and annual escalation clauses, with no commodity-price risk, resulting in stable, predictable cash flow.  

AltaGas’s large organic growth plans are focused in the Power and Utilities segments.

With the construction of the Northwest Transmission Line now complete and commissioning underway, the Forrest Kerr run-of-river hydro project is now expected to be generating power this month. Executing this major project, essentially on time and on budget, is an important accomplishment for the company and enhances its project execution reputation.
AltaGas reported company-record first-quarter normalized earnings of CAD73.7 million, or CAD0.60 per share, up from CAD55.5 million, or CAD0.53 per share, a year ago.

Normalized earnings before interest, taxation, depreciation and amortization (EBITDA) grew by 22.8 percent to CAD179.2 million.

Normalized funds from operations were CAD129.8 million, or CAD1.06 per share, up 6 percent from CAD122.4 million, or CAD1.16 per share, for the prior corresponding period. The payout ratio for the first quarter was 36.2 percent. 

Management noted “strong asset performance” across all of AltaGas’ operating segments, with revenue and earnings growth driven mainly by energy infrastructure assets added over the past two years. A five-year, CAD2.5 billion growth plan promises more revenue, earnings, funds flow and dividend growth to come.

During the quarter AltaGas sanctioned the Alton natural gas storage project in Nova Scotia and the regional liquefied natural gas (LNG) project in Dawson Creek, British Columbia, for approximately CAD125 million, bringing total secured growth capital to over CAD1 billion.

Higher natural gas volumes processed, the partial ownership of Petrogas, the addition of Blythe, colder weather in Michigan, Alberta and Nova Scotia and favorable exchange rates positively influenced first-quarter numbers.

These factors were partially offset by lower earnings from Power in Alberta and higher costs in Gas related to natural gas storage and extraction premiums. And the Blythe facility was on major turnaround during March.

AltaGas is now a buy under USD50.

Newalta, which provides environmental solutions to the oil and gas, petrochemical, refining and mining industries, is well positioned to benefit from the capital being invested in these markets.

The Canadian Energy Research Institute (CERI) forecasts heavy oil mining to grow at a 3.9 percent compound annual rate from approximately 800,000 barrels per day (bbl/d) to 1.7 million bbl/d from 2012 to 2030.

Over the same period steam-assisted gravity drainage (SAGD) oil production is expected to grow at a 6.9 percent compound annual rate from about 1 million bbl/d to 3.5 million bbl/d.

Newalta has proven its ability to compete in the heavy oil and oil mining sectors, and its ability to locate its operations on the customer’s site means that it’s also created an effective barrier to entry for its competitors.

Management has guided to 20 percent annual earnings before interest, taxation, depreciation and amortization (EBITDA) growth, but Newalth is trading at just 7.8 times estimated 2015 enterprise value-to-EBITDA. The peer-group average is 9.7 times.

AltaGas, for example, is trading at 14.1 times estimated 2015 EV/EBITDA, while Secure Energy Services Inc (TSX: SES, OTC: SECYF), which provides a similar set of oilfield clean-up services, is trading at 12 times.

Newalta posted 10 percent year-over-year revenue growth to CAD187.8 million for the first quarter of 2014, driven by growth capital investments and improved commodity prices, partially offset by the impact of an unusually cold winter on operations. Adjusted EBITDA grew by 16 percent to CAD32.1 million.

Funds from operations for the quarter were CAD24.1 million, or CAD0.43 per share, basically flat year over year. The first-quarter payout ratio was 25.6 percent.

New Markets revenue and gross profit increased 37 percent and 17 percent, respectively, to CAD56.1 million and CAD14.6 million, driven by strong growth in Heavy Oil supported by investments in onsite contracts and contributions from Newalta’s Heavy Oil facilities.

Oilfield revenue and gross profit were up 12 percent and 5 percent, respectively, to CAD54.3 million and CAD20.6 million on contributions from investments, higher waste processing volumes and improved commodity prices, offset by the impact of extreme weather on operating
costs.

Industrial revenue decreased by 6 percent to CAD77.3 million, while gross profit grew by 14 percent to CAD6.4 million.

Onsite services posted strong results, and management’s Rationalization Plan helped drive down costs. These positive factors were offset by lower contributions from oil recycling services and the timing of waste receipts at Newalta’s Stoney Creek Landfill.

First-quarter adjusted selling, general and administrative expenses declined from 12.3 percent of revenue a year ago to 11.1 percent, primarily due to overhead reductions as part of the Rationalization Plan.

CAPEX for the three months ended March 31, 2014, were CAD27.1 million, focused primarily on growth capital projects in New Markets and Oilfield.

As part of the aforementioned Rationalization Plan management closed four facilities, reduced overhead in associated support functions and began redirecting lines of business.

In March 2014 Newalta announced that it had retained RBC Capital Markets to conduct a strategic review of the Industrial division, assessing a full range of alternatives, including a potential sale, initial public offering (IPO) or spin-off of the division, in whole or in parts.

Relative to its New Markets and Oilfield divisions, Newalta’s Industrial division has lower growth and profitability and greater exposure to commodity-price volatility. A sale of the underperforming division could generate proceeds of CAD400 million and CAD500 million that could be redeployed into the higher-growth businesses.

A sale of this magnitude would leave Newalta virtually net debt-free and could also potentially allow for the payment of a special dividend. It would drive growth, improve an already sound financial position and catalyze the next leg up for the stock price.

Given Newalta’s competitive positioning and its valuation discount relative to its peers, an apparent delay in the marketing of the Industrial assets could be due to a potential buyer expressing an interest in acquiring not just the Industrial assets but all of Newalta.

A sale of the Industrial business would generate funds for deployment into the New Market or Oilfield divisions, driving substantial EBITDA growth. And if Newalta is the target of a takeover bid, it would clearly be at a significant premium.

Our recommendation is not, however, based on Newalta’s viability as a takeover target. We’re in it for the long haul, for two basic reasons.

An aggressive capital expenditure plan should drive above-average growth. Management has committed to CAD180 million off total CAPEX in 2014 and CAD150 million to CAD200 million annually through 2017.

The 2014 capital program consists of CAD145 million of growth spending and CAD35 million of sustaining expenditures. Approximately 90 percent of the 2014 growth spending is for expanding the New Markets and Oilfield businesses.

Management expects that from 2014 to 2017 New Markets revenue will grow 20 percent annually, while Oilfield revenue will grow 15 percent. Over this period EBITDA, including management’s plan to control costs and boost margins, is forecast to grow 20 percent per year.

Second, as we note above the sale of its low-growth industrial business should provide additional capital to fund Newalta’s higher-growth operations.

Newalta is a strong buy under USD20.

For more information on AltaGas, go to How They Rate under Energy Infrastructure. Click here to go to the company website.

Click here to go to AltaGas’ Yahoo! Finance page for its Toronto Stock Exchange (TSX) symbol and here for its US over-the-counter (OTC) listing. Both links include a wealth of information and data, and both include links to Yahoo! Finance’s very useful “Key Statistics” page.

Newalta is tracked under Energy Services. Click here to go to the company website. Click here to go to its Yahoo! Finance page for its TSX listing, and here’s the link to the Yahoo! Finance page for TransForce’s US OTC listing. Both links include access to the “Key Statistics” page.

AltaGas has a market capitalization of CAD6 billion versus an Energy Infrastructure average of approximately CAD14 billion, which skews higher due to Enbridge Inc (TSX: ENB, NYSE: ENB) and its CAD43 billion market cap and TransCanada Corp’s (TSX: TRP, NYSE: TRP) CAD37 billion.

Newalta has a market capitalization of CAD1 billion versus an Energy Services average of approximately CAD2 billion.

Both AltaGas and Newalta have plenty of liquidity on both sides of the border, both in TSX and US-listed symbols.

AltaGas trades on the TSX under the symbol ALA and on the US OTC market under the symbol ATGFF. Newalta trades on the TSX under the symbol NAL and on the US OTC market under the symbol NWLTF.

AltaGas is covered by nine Bay Street and Wall Street analysts. Five analysts rate the stock a “buy,” while three rate it a “hold.” One analyst rates the stock a “sell.”

The average 12-month price target among the eight analysts who provide such a figure is CAD51.50, with a high of CAD54 and a low of CAD47, implying a 12-month total return of 9.2 percent from a CAD48.77 closing price on July 10, including an annual dividend rate of CAD1.77 per share.

Newalta is covered by 11 analysts, six of whom rate it a “buy” and four of whom rate it a “hold.” There is one “sell” rating on the stock.

The average 12-month price target among the 10 analysts who provide such a figure is CAD22.65, with a high of CAD26.50 and a low of CAD20.

Newalta closed at CAD20.43 on July 10 on the TSX. Including a current annualized dividend rate of CAD1.50 per share, Newalta would post a total return of 18.2 percent based on analysts’ consensus forecast.

As is the case with all stocks in the Canadian Edge coverage universe, you get the same ownership whether you buy in the US or Canada. These stocks are priced in and pay dividends in Canadian dollars. Appreciation in the loonie will raise dividends as well as the value of your shares.

Dividends paid by AltaGas and Newalta are 100 percent qualified for US income tax purposes. Dividends paid by both companies are taxed at the now-permanent Bush-era rates of 5 percent to 15 percent for investors’ first USD450,000 a year of income for couples and USD400,000 for single filers. Above that the maximum tax rate is 20 percent.

Canadian investors enjoy favorable tax status for AltaGas and Newalta. For US investors, dividends paid into IRAs aren’t subject to 15 percent Canadian withholding tax, though they are withheld at a 15 percent rate if held outside of an IRA.

Dividend taxes withheld from US non-IRA accounts can be recovered as a credit by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation.