What to Buy: WesternOne Inc (TSX: WEQ)

Why to Buy Now: WesternOne is a Vancouver, Canada-based buyout firm that specializes in acquiring predominantly privately owned small and mid-market businesses that operate in the construction and infrastructure industries.

Since the high-yield equity space is dominated by master limited partnerships (MLP), mortgage REITs and other specialty financials, this name gives us a rare opportunity to diversify the portfolio into other areas.

And with a market capitalization of just CAD251.0 million, this micro-cap company has ample room for long-term growth. In fact, the incoming CEO, who takes the helm in September, led his previous company from a similar size roughly 10 years ago to a market cap of CAD2.5 billion today.

Meanwhile, the company’s stable, well-supported payout of CAD0.05 per month, or CAD0.60 annualized, is nice compensation while we wait for the firm to enter its next stage of growth.

Although WesternOne does trade on the US over-the-counter (OTC) market, because it’s a Canadian micro-cap, trading volume on the OTC is virtually non-existent, hence the reason we’re not listing that ticker symbol.

Investors should only purchase the TSX-listed shares, for which daily trading volume has averaged around 74,000 shares over the past three months–reasonable liquidity for a stock of this size.

Even so, investors should still use limits both when purchasing a new position or selling an existing position, to avoid moving the market while mitigating the cost of the bid/ask spread.

With a current yield of 7.6 percent, WesternOne is a buy below CAD8.50. Set your limit order slightly below the market price to ensure you don’t overpay for your position.

Ari: WesternOne Inc (TSX: WEQ) is a Vancouver, Canada-based buyout firm that specializes in acquiring predominantly privately owned small and mid-market businesses that operate in the construction and infrastructure industries.

The company primarily focuses on firms domiciled in resource-rich Western Canada, though portfolio companies also operate in the US and Australia.

WesternOne currently has two major operating divisions.

Its modular building and construction business operates under the Britco brand, and is one of the largest designers and manufacturers of commercial custom built mobile and modular buildings in North America. In early 2013, this unit expanded into Australia by acquiring one of the largest modular building manufacturers there.

Britco also boasts one of the largest fleet of modular rental units in Western Canada, with a customer base that ranges from the commercial, residential, government and infrastructure sectors, to the resource, energy and mining industries.

The Britco division accounted for nearly 75 percent of first-quarter revenue, or CAD87.4 million.

WesternOne’s Infrastructure Services division is comprised of two business lines, which collectively accounted for CAD29.2 million in first-quarter revenue, or 25 percent of the firm’s total revenue.

Its construction heat and fuel services business specializes in renting, selling and servicing construction heat-related equipment (i.e., torches, heaters, and generators, among other items) and providing fuel-distribution services at customers’ sites.

And its aerial equipment business specializes in renting, selling and servicing high-reach and material-handling equipment (such as work platforms that rise via scissor lifts) and provides logistical support to its customers. Interestingly, this unit’s equipment is not only used in construction, but also in Canada’s film industry.

Khoa: How does the firm select new businesses to acquire?

Ari: On the acquisition front, WesternOne looks for companies in early to middle growth stages situated in markets benefitting from strong secular growth trends. These companies should be market leaders in their respective niche, and have strong management teams with a history of generating stable and growing cash flows.

Additionally, I like the fact that WesternOne takes a more conservative approach to debt than the usual private equity firm by avoiding the use of excessive financial leverage in its acquisitions.

Khoa: And how does it manage these firms after they’re acquired?

Ari: Similar to Warren Buffett’s approach, WesternOne takes a hands-off approach to portfolio companies, leaving day-to-day operations under the control of existing management teams, whose prowess was presumably a key factor in attracting investment in the first place.

However, WesternOne oversees all major strategic and capital allocation decisions. That’s where the firm hopes to generate organic growth, by providing the financial resources for growth that these tiny firms lacked as standalone entities.

Khoa: You mentioned that the incoming CEO has an interesting story.

Ari: I don’t normally like buying companies that are in the midst of a management transition, however, I believe the one that’s slated to happen in September could take the company to the next level over the medium to long term

In September, former Ritchie Bros Auctioneers Inc (NYSE: RBA, TSX: RBA) CEO Peter Blake will take the helm from acting CEO Robert W. King, whose been in the position since last September and will continue on as chairman of the board.

Blake’s announcement last October that he would be stepping down from the Canada-based global auctioneer of industrial equipment was certainly a surprise. Blake had been with the firm since 1991, starting as the controller and eventually rising to CEO in 2004.

Under his leadership, Ritchie Bros grew from a company with a market capitalization of CAD250 million to a market cap of CAD2.5 billion.

Though he helped build Ritchie Bros from a micro-cap to a mid-cap, the stock had fallen about 36 percent from its all-time high in early 2011 at the time of the announcement.

While it’s possible that Blake was encouraged to leave the firm, he remained in place as CEO for another nine months following the initial announcement, so it sounds like a relatively amicable split, all things considered.

And his unusually candid rationale for why he chose to leave lends further credence to the notion.

By his own admission, Blake is a bean counter, whose accounting background (he’s a chartered accountant who served as the firm’s CFO before he became CEO) doesn’t lend itself to the sales and marketing strategy needed to take Ritchie Bros to its next stage of growth. As he put it, at this point in its growth story, Ritchie Bros needed a “rock-star” leader with a strategic marketing vision.

Though it sounds like it was the right move for him to step down from Ritchie Bros, I also believe he has the expertise and the rolodex to help WesternOne begin its own next growth stage.

After all, WesternOne has roughly the same market cap now as Ritchie Bros did when Blake took the helm there.

And while he may not have the sales and marketing chops for a firm like Ritchie Bros, a bean counter seems ideally suited to evaluating potential takeover candidates, while helping wring greater efficiencies from existing portfolio companies.

In addition to Blake, WesternOne’s management team includes executives with extensive experience in corporate finance, private equity and asset management.

Khoa: What about the payout? It seems unusual for a company of this size to offer such a high yield.

Ari: Although WesternOne converted from an income trust to a corporation at the end of 2012, it continued to maintain its high payout.

The company has been paying a regularly monthly dividend since late 2006, with the current payout of CAD0.05 per month in effect since mid-2007.

At current prices, the annualized payout of CAD0.60 translates into a yield of 7.6 percent.

The first-quarter distribution had a payout ratio of 69.2 percent, based on adjusted EBITDA (earnings before interest, taxation, depreciation and amortization). For full-year 2013, it was a very conservative 41.2 percent.

Khoa: How has the stock performed?

Ari: In the nearly eight years since WesternOne’s initial public offering (IPO) in mid-August 2006, the stock has gained 121.4 percent on a price basis in local currency terms compared to 26.8 percent for the S&P/TSX Composite Index (SPTSX).

But the compounding effect from the reinvestment of its high-yielding payout is where its performance truly shines. Over that same period, WesternOne has produced a total return of 489.3 percent on a dividend-reinvested basis compared to just 59 percent for the SPTSX.

That performance also compares quite favorably to the S&P 500, which returned 80 percent (including dividends) during that time.

And with a market capitalization of just CAD251.0 million, which puts the stock firmly in the middle of micro-cap territory, there’s still plenty of growth ahead, assuming management executes effectively on their growth strategy.

Despite enviable long-term gains, the stock has had little to show in terms of price appreciation over the trailing two-year period, with several run-ups in price, including an all-time high of CAD8.96 in March 2013, eventually coming undone.

Over the trailing 12-month period, the stock has gained just 0.9 percent in local currency terms compared to nearly 22 percent for the SPTSX. That performance improves considerably on a dividend-reinvested basis, to 9.1 percent, though it’s still well short of the 25.7 percent dividend-reinvested return of the SPTSX.

However, that doesn’t mean actual trading activity has been mellow. In late March, the stock hit a two-year low of CAD6.83 before rebounding nearly 23 percent, to CAD8.39. The stock swooned again more recently and currently trades near CAD7.90, which is 5.8 percent below its 52-week high.

Khoa: How does analyst sentiment stack up?

Ari: The stock enjoys solidly bullish sentiment on Bay Street, at five “buys,” no “holds,” and no “sells.” In fact, the stock hasn’t been rated anything less than a buy since last September.

Although that’s relatively thin analyst coverage compared to a larger stock, it’s rare to have even five analysts rate a micro-cap stock.

Analysts forecast sales will rise 12 percent this year, to CAD425.2 million, with adjusted earnings per share jumping 259 percent, to CAD0.29.

The consensus 12-month target price is CAD8.90, which suggests potential appreciation of 12.7 percent above the current share price.

Khoa: Anything else worth noting?

Ari: Insiders currently own 2.9 percent of shares outstanding, which is not all that remarkable in and of itself, but these holdings have risen by 19.3 percent over the past six months.

The company does make periodic secondary equity issuances, with a total of five in the past eight years. The most recent offering totaled CAD51.5 million and occurred in two parts, in mid-December of last year and mid-January earlier this year.

Khoa: What about taxation?

Ari: Before proceeding, it should be noted that we’re not tax professionals, and that subscribers should consult their accountant or tax advisor to confirm the treatment of these dividends.

Our understanding is that thanks to the tax treaty between the US and Canada, the Canadian government withholds just 15 percent of the payout (as opposed to the 25 percent rate that would prevail without the agreement). Depending on their individual tax situation, investors should be able to offset some or all of that amount in the form of a credit at tax time by filing Form 1116.

The Canada Revenue Agency (CRA) implemented a new rule in early 2013 that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

It appears that the form must be filed for each company for which you’d like to receive the more favorable withholding rate. The forms expire after three years from the end of the calendar year in which the form is signed and dated, so if you’re still holding the security at that juncture, then you’ll have to renew the filing.

Finally, since WesternOne is organized as a corporation, individual retirement accounts (IRA) and other tax-advantaged retirement accounts should be exempt from the Canadian government’s withholding. It’s not entirely clear whether filing form NR301 is sufficient to qualify for this treatment or whether a letter of exemption must be obtained.

If the latter, the page at this link instructs you on how to proceed, and also provides a searchable database for entities that have already received the exemption (in case your tax-advantaged account happens to fall under one of those entities).

Although WesternOne does trade on the US over-the-counter (OTC) market, because it’s a Canadian micro-cap, trading volume on the OTC is virtually non-existent, hence the reason we’re not listing that ticker symbol.

Investors should only purchase the TSX-listed shares, for which daily trading volume has averaged around 74,000 shares over the past three months–reasonable liquidity for a stock of this size.

Even so, investors should still use limits both when purchasing a new position or selling an existing position, to avoid moving the market while mitigating the cost of the bid/ask spread.

Portfolio Updates

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) announced it acquired natural gas assets in the Ansell area of its Deep Basin Core Area. The acquired assets are comprised of a 49 percent working interest in the Bonavista-operated Wilrich plays and minor lands in the immediate area. The CAD141 million deal closed on July 10.

Total proved reserves plus probable working interest of the area stand at 34.6 million barrels of oil equivalent. Bonavista plans to develop 34 wells in the area with average production of 6,000 barrels of oil equivalent per day by the end of 2015.

Bonavista will report second-quarter earnings on Aug. 1.

Bonavista is a hold.

On July 1, BreitBurn Energy Partners LP (NSDQ: BBEP) announced it boosted its monthly distribution by 1 percent, to $0.1675 per unit, or $2.01 per unit annualized. The new distribution represents an increase of  6 percent from a year ago.

BreitBurn’s units currently yield 8.7 percent. The partnership will report second-quarter earnings on Aug. 6.

BreitBurn is a buy below 21.

Capital Product Partners LP (NSDQ: CPLP) reported second-quarter net income came in at $7.8 million, compared to $34 million in the same quarter in 2013, which was due to a one-time $32 million gain related to claims against Overseas Shipping Group. Excluding that one-time gain, second-quarter net income was up 281 percent versus the prior year.

Adjusted net income attributed to unitholders came in at $0.04 per limited partnership unit, compared to $0.08 per unit the previous quarter and $0.07 per unit in the second quarter of 2013.

Revenues for the second-quarter increased 13.4 percent, to $47.4 million, thanks to the partnership’s expanded fleet and higher day rates. Total expenses came in at $35.5 million, up 15.3 percent from last year. The higher costs were the result of the increased fleet size and repairs related to the redelivery of two vessels.

Capital Product Partners also announced that it has agreed with Capital Maritime & Trading Corp to purchase three containerships and two product tankers for a total of $311.5 million.

These new vessels are expected to be delivered between March and November of 2015. The partnership was able to buy these at prices below market value, with each containership priced at $81.5 million and each product tanker at $33.5 million.

Capital Maritime will also allow Capital Products the first choice on additional product tankers expected to be delivered to Capital Maritime between September 2015 and December 2016.

CPLP is a buy below 11.50.

Shares of Exchange Income Corp (TSX: EIF, OTC: EIFZF) climbed as high as CAD23.19 in late June, but then subsequently fell as low as CAD18.36. They currently trade near CAD18.64.

The selloff appears to have been precipitated by the company’s announcement that current CFO Adam Terwin would be shifting to the role of chief corporate development officer, where he’ll oversee acquisitions and strategic growth initiatives for existing portfolio companies.

Meanwhile, the firm hired Ted Mahood as its new CFO. Mahood has previously served as a CFO at a number of different manufacturing firms, so he should be a good fit.

While investors usually take it as an ominous sign when there’s turnover at the CFO level, if Terwin had posed a problem in this position, then presumably he would have been ousted, instead of moving into a new prominent position.

For now, we’re going to assume that panicked investors who dumped this stock have simply overreacted, as there doesn’t appear to be any other news beyond this development.

And analyst sentiment remains strongly bullish, at seven “buys,” one “hold,” and two “sells.” The consensus 12-month target price is CAD25.78, suggesting potential appreciation of 38.3 percent.

We don’t advise doubling down in this name, but if you don’t already have a position and are willing to give management the benefit of the doubt about these personnel changes, then this stock is certainly attractive at this level.

Exchange Income Corp is a buy below 22.

Legacy Reserves LP (NSDQ: LGCY) continues to gain favor among analysts, with Oppenheimer & Co boosting its price target recently to $33, from $29. Units of Legacy have gained 17 percent since we recommended it two months ago, as oil prices remain high.

In July, insiders picked up a heavy amount of shares. Chairman Cary D. Brown and Director Dale A. Brown each bought 200,000 units at $25 per unit.

On July 22, Legacy announced its 15th straight quarterly distribution increase, to $0.61 per unit, up 5.2 percent from last year. This equates to an annual payout of $2.44 per unit and a yield of 7.6 percent at current prices. The new cash distribution will be payable on Aug. 14 for unitholders on record as of Aug. 1.

Legacy is a buy below 28.

Shares of Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) hit a trailing-year high of CAD9.03 in late June before falling in sympathy with an energy sector selloff.

Lightstream has divested CA600 million in assets since its dividend cut last November. The company continues to receive interest for its East Pembina and southeast Saskatchewan assets, but has mentioned that it does not need to divest these assets immediately and will look for the right valuation.

Lightstream currently has CAD850 million drawn on its CAD1.3 billion credit facility but the amount drawn would drop to CAD300 million once these asset sales have been completed.

On July 15, the company provided an update on its production for the second quarter, which averaged 42,500 barrels of oil equivalent per day.

Though production for the quarter fell 3 percent compared to the first quarter, this is must less than the average seasonal drop of 11 percent it’s seen for the past three years due to the spring break-up period.

Lightstream plans to ramp up production for the second half of the year, with about 45 percent of its drilling program left to execute, as the company expects to drill an additional 41 wells.

Lightstream remains a hold.

LRR Energy LP (NYSE: LRE) shares are up 7.7 percent in the past month.

The master limited partnership (MLP) boosted its cash distribution to $0.4950 per unit, or $1.98 per unit annualized.

The new distribution is 0.5 percent higher than its previous quarterly distribution and 2 percent higher than a year ago.

The distribution will be payable on Aug. 14 for unitholders on record as of July 31. This latest move marks the partnership’s eighth consecutive distribution increase.

LRR Energy will report second-quarter earnings on July 31.

LRR is a buy below 18.

Memorial Production Partners LP (NSDQ: MEMP) announced it closed on the acquisition of oil-producing assets in Wyoming for approximately $915 million.

The assets have estimated proved reserves of about 84 million barrels and will be immediately accretive to distributable cash flow. The acquisition was funded through borrowings from its credit facility.

Memorial reported that it also amended its $2 billion revolving credit facility, increasing its borrowing base to $1.44 billion from $870 million. It also increased the number of lenders under its credit facility to 28 from 23.

On July 14, Memorial announced a public offering of $500 million in 6.875 percent senior unsecured notes due 2022. Memorial intends to use the proceeds to repay part of its credit revolver.

Memorial is a buy below 20.50.

Unfortunately, last month’s recommendation, Norbord Inc (TSX: NBD, OTC: NBRXF), has already demonstrated how susceptible it is to monthly volatility in US housing data. The stock has fallen from our entry price of USD25.21 to USD21.30, as housing data weakened.

US housing starts plunged 9.3 percent to an annualized 893,000 in June, a nine-month low and well short of market expectations of an increase to 1,020,000 units.

Building permits also fell by 4.2 percent, to 963,000 annualized, also well short of forecasts for an increase to 1,035,000 units.

However, as economists with RBC noted, even with the recent pullback, housing starts still averaged 980,000 annualized units during the second quarter, which was a 26.2 percent annualized improvement compared to the first quarter.

Furthermore, RBC notes that homebuilder confidence rose to a six-month high in July, while building permits have sustained robust levels in recent months. The firm’s economists anticipate that overall homebuilding activity will resume an upward trend and that starts will return to levels above the million-unit mark in the months ahead.

Although we’re extremely disappointed in the stock’s near-term performance, we expect the shares to recover as housing data improve.

Norbord is a buy below USD26.