The Stock

What to Buy: FP Newspapers Inc (TSX: FP, OTC: FPUNF) < USD5.60/CAD

Why Now: FP Newspapers Inc’s sole asset is an ownership stake that entitles it to 49 percent of the distributable cash generated by FP Canadian Newspapers Limited Partnership (FPLP). FPLP owns the Winnipeg Free Press and Brandon Sun daily newspapers as well as Canstar Community News, which operates six weekly newspapers, a weekly entertainment newspaper and a twice-monthly newspaper aimed at age 50-plus readers. On Feb. 28, 2011, FPLP acquired a Steinbach, Manitoba-based printing and publishing business that operates a commercial web and sheet-fed printing business and publishes a regional paid weekly newspaper, The Carillon.

Like many print-oriented businesses, FPLP is struggling to find a place in an increasing digital world. Circulation and print advertising revenues continue to decline, as the company fights to make money on the web and through other uses of its print capabilities.

Now well off a Great Recession low below USD3 dollars, shares of FP Newspapers have responded well to first-quarter earnings. Readership numbers from its 20th century newspaper business are only relatively good–the Free Press, for example, trounced the other Winnipeg daily with 39 percent of the local market, actually the best rate for any major-city daily in Canada, compared to 19 percent for the Winnipeg Sun. But that figure was down from 41 percent in the 2009 survey.

So what’s to like? Although it still represents an all-too-small portion of the total, digital revenue grew by 45 percent in the first quarter. Online readership is also on the rise, up from 16 percent to 18 percent in 2010. The dividend appears safe, too, as FP Newspapers paid out 72 percent of distributable cash during the 12 months ended Mar. 31, 2011. Relatively cheap but also risky, FP Newspapers is a great way for highly risk-tolerant investors to speculate on a quick rebound from a soft patch for the North American economy while locking up an 11 percent-plus yield.

The Story

Before we get to June’s BIG target, a look at news impacting open positions is warranted, and it’s time to take a hard look at two positions, one that’s sure to frustrate, another that’s piled up a great record since November 2010.

Our picks illustrate what could be a maxim of this advisory: Go BIG, or don’t go at all, as we have winners that have trounced broader measures of market performance over comparable time periods, but we also have a few double-digit yielders that have turned into double-digit losers in terms of percentage price decline. It’s important to bear in mind that this is a risk-seeking, for lack of a better description, as opposed to a risk-averse project. A double-digit yield implies an extra-ordinary level of risk. All who join the hunt must understand this.

Roger: Before we get to this month’s recommendation, I think it’s time we revisited some of our prior picks.

David: Wait a minute. I think we’ve been pretty clear up front that we’re not running a portfolio here, just making higher-risk recommendations of companies that are already covered in our other advisories. Isn’t this sending the wrong signal to readers?

Roger: I have thought of that and before we get started I want to emphasize once again to anyone listening that we have a different approach in Big Yield Hunting. Mainly, we’re out looking for huge yields, and we’re willing to take on the risk that comes with them.

We’ve set a target of double-digits for recommendations that by its very nature means we’re taking on substantial risk. In fact, we’ve stated repeatedly that these are not safe, dividend-paying stocks but rather opportunities to score big gains. We’re also not running a portfolio here, and all of these companies are covered in our other advisories.

That being said, we now have 10 picks under our belt. Before we take on another we need to look at the record. After all, the best buys now may be something we’ve already covered.

David: OK, you convinced me. So let me start with a tough one. I’ve been particularly struck recently by the volatility in some of our recommendations. Some of that has to be due to what’s going on with the market as a whole. But several of these companies appear to have been hit harder than the average stock, and we’ve seen profits on several of our picks erode the past several weeks. A couple recommendations are even underwater.

Again, we’ve covered all this in Canadian Edge, Utility Forecaster, MLP Profits and even Personal Finance, and our BIG readers should be prepared to absorb the risks that come with shopping for double-digit yields.

But do you think anything is happening here that should change our approach in this advisory?

Roger: I don’t see a need for any change in strategy. As you may recall, when we started BIG risk aversion in the marketplace was running pretty strong. That’s one reason why there were so many opportunities to get a double-digit yield in what appeared to be strong companies.

We kind of went through a period earlier this year where some that risk aversion seemed to wear off and people started bidding many of these stocks up. Now that seems to be unwinding–people are again worrying about the economy, the sovereign debt crisis in Europe, inflation and what have you.

These stocks yield a lot because they do have question marks, and when investors worry their tolerance for uncertainty goes by the boards. That’s what’s behind the pullback in these stocks as a group.

David: Is there any merit to cashing out of any of these positions? What if this market continues to trend lower or the economy really does slow?

Roger: As you know, my philosophy generally is to hold dividend-paying companies so long as their underlying businesses are in good shape–that is they can maintain their dividends and even increase them over time.

The model portfolios in all of my advisories are anchored in the strongest companies around, which aren’t necessarily the highest-yielding stocks. In fact, most of the time I’m giving up the really big yields in return for security and growth, which ultimately produces a bigger total return if I’m right on the underlying business.

When you’re dealing with this type of stock, however, you’ve got to be somewhat more flexible. That’s again because of the question marks surrounding their underlying businesses. Mainly, odds of something going wrong are greater than they are, say, for a Utility Forecaster Growth Portfolio Core Holding or a Canadian Edge Conservative Holding. And if something does go wrong, we do have to move.

That’s what’s really important to our return, not the latest shift in market sentiment.

David: Most of our picks seem to have lost a little ground in recent weeks, but three of them stand out in my opinion: Capital Products Partners LP (NSDQ: CPLP), New Flyer Industries (TSX: NFI-U, OTC: NFYIF) and Cellcom Israel Ltd (NYSE: CEL).

Have any of these really weakened enough as businesses to merit selling?

Roger: Let’s take them one at a time. The action at Capital Products Partners appears related to two things. First, it’s a master limited partnership (MLP), and we’ve seen selling of this group across the board over the past month, in part due to trial balloon floated by the US Treasury Dept regarding a possible tax on MLPs. In my view, that’s not really a cause for concern, as this appears to have been shot down.

Second, it’s a tanker company, and we’ve seen a tremendous negative shift in sentiment on this group the past several months. That’s mostly due to concerns about the global economy and spot-market rates for tankers. As you know, we’ve recommended tankers that rely almost entirely on long-term contracts in our MLP Profits advisory.

I picked Capital Products for BIG precisely because it’s more aggressive–which is, of course, what we do in BIG. And management proved that once again with the merger it announced with Crude Carriers Corp. That deal does create greater exposure to the spot market for Capital. But management is still convinced the dividend is sustainable at its current level and it’s working to reduce its exposure by locking in rates and contracts. Again, we have safer stuff in MLP Profits, but this one is doing exactly what we want it to. As long as that’s the case, we want to stick with it.

David: I feel the same way about Cellcom. What strikes me most about this one is that results were largely stable in the face of stiff competition and steep regulatory changes: EBITDA as a percent of revenue, for example, was 40.3 percent, roughly flat with the first quarter of 2010’s 40.4 percent. And although monthly average revenue per user (ARPU) was down 17.2 percent–basically because of the Israeli government’s drastic reduction in interconnect fees that took effect Jan. 1–the subscriber base did grow by 2.5 percent to 3.395 million as of Mar. 31.

Some of the impacts of new competition and government efforts to stimulate same will linger into the next couple quarters, but I think the market has overreacted to the threats posed by smaller operators. Once the ground underneath it stabilizes a bit Cellcom will be able to capitalize on its dominant position in a market that features one of the highest wireless penetration rates in the world.

Regulatory changes have resulted in lower interconnect fees and lower early termination fees. Churn is up because customers looking for bargains are shopping around–and there are more competitors. Sales of handsets, which more than doubled, and increased use of high-value content such as video streaming and texting (up 13.5 percent) made up for a lot of the decline, so total revenue actually grew by 0.4 percent to USD455.9 million.

Cellcom continues to do well responding to rapidly changing customer demands, reflected in the fact that it added 48,000 3G subscribers to reach a total of 1.188 million as of Mar. 31. That’s 35 percent of the total; Cellcom is also selling more smartphones, which enable access to higher-value-added content.

Roger: The Israeli credit rating agency, S&P Maalot reaffirmed the company’s A (stable) rating when it issued debentures in the first quarter, and that debt bears the lowest interest rate of Cellcom’s debentures.  Inflation pushed up interest expenses on Israeli shekel denominated debt, but otherwise the company has access to capital on favorable terms.

David: The payout ratio in net income terms reached 95 percent for the first quarter, quite a departure from management’s prior target of 75 percent. But during the conference call to discuss results CFO Yaacov Heen reiterated the position that Cellcom can continue with its present dividend policy.

With an indicated yield of 11.7 percent Cellcom looks attractive for new BIG subscribers up to 32.50 on the New York Stock Exchange. But I think folks who picked up shares on our initial recommendation should sit tight.

Roger: I agree. That’s a tough market, but it appears to be doing well. Unfortunately, New Flyer has had a tougher time. There was some good news in the first-quarter numbers. The deliveries-to-new orders ratio was steady at 1-to-1, meaning they’re replacing their business.

On the other hand, this is an extremely tough environment for selling buses to the municipalities that are their main customers. Cash flow didn’t cover the distribution in that quarter, which is always a sign of weakness. Management, to its credit, did alert investors to these risks and this week it made its move: The company will convert from an income participating security (IPS)–combining debt with equity–to a pure common stock.

As part of the move, it’s anticipating it will cut its dividend roughly in half, a point where it will be able to cover capital costs and preserve financial flexibility. It’s also going to pay a special dividend somewhere between CAD0.18 and CAD0.33 per share sometime before Aug. 2012, when it expects to complete the conversion from an IPS. That’s a dividend rate of between 10 and 12 percent over the next 12 months and about 7.5 thereafter.

I think the rate will hold, and in any case the cut was priced in beforehand. I also thought it was interesting that no Bay Street analysts changed their opinion on the stock following the announcement. That’s two buys and four holds, no sells.

David: So should we stick with New Flyer?

Roger: I think the company has hit bottom. The numbers appear to be improving, and the new dividend rate looks very conservative. On the other hand, whenever there’s a dividend cut you have to be wary of more bad news to come. The bottom line is there are a lot of other companies out there with better numbers and prospects, like Capital Products Partners, as I mentioned above.

I’m going to keep covering New Flyer in Canadian Edge, and if management guidance holds I may upgrade it to buy again. But at the lower dividend rate, it really doesn’t meet our BIG criteria. So I recommend a sell on New Flyer Industries.

That does give us an opportunity to take a profit on a pick that’s done very well, Telstra Corp Ltd (ASE: TLS, OTC: TLSYY). We’re still covering it in Utility Forecaster. But it would take a long time for dividends paid to add up to the capital gain we’ll be locking in.

David: In price-only terms Telstra’s US over-the-counter (OTC) American Depositary Receipt (ADR) is up 26 percent; including the one dividend paid–worth about USD0.70 per ADR–we’re almost 32 percent to the positive on this one. The S&P 500 from our Nov. 18, 2010, recommendation to date is up about 6 percent.

I agree; within the context of our goals for BIG now’s a good time to lock in a handsome gain and sell Telstra Corp. We’re looking at about a 15 percent loss on New Flyer. Absent the 11 dividend payments we’ve collected we’d be down 25 percent.

Now, since we’ve covered that ground, how about a new recommendation? I’ve been taking a hard look at FP Newspapers Inc (TSX: FP, OTC: FPNUF). Again, within the context of what we’re doing here, I think it makes sense to roll the net proceeds from the New Flyer and Telstra sales into this one.

Roger: The variables here are simple, another thing that we hope is a hallmark of BIG recommendations–in other words, the risks are easily understood: Digital revenue growth has to accelerate fast enough to offset declining print advertising and circulation revenue

David: Comparable advertising revenue–excluding the several weeks’ worth contributed by the Steinbach assets–declined 2.9 percent in the first quarter from the first quarter of 2010. But management has context: Same-store ad sales for April and May were showing decline rates of less than 0.5 percent from year-earlier levels. Still eroding, and more slowly, but enough so that management cast some doubt on its previous forecast for full-year revenue growth of 2 percent, which didn’t take account of the potential of the recent acquisition.

Roger: OK, let’s take a look at some other numbers, starting with the fact that the Winnipeg Free Press boosted what it charges for home delivery by 5 percent–the first increase in more than two years. That should mitigate revenue losses due to declining overall subscriptions.

And new advertising and commercial printing revenue will come from the acquisition of The Carillon and Derksen Printers, which closed Feb. 28. And FP won the printing contract for the Winnipeg edition of the Metro free daily. All this should add up to CAD4.5 million over the final three quarters of 2011.

It’s enough to make you believe in management’s forecast that “additional EBITDA” from Derksen and the Metro contract will “considerably offset” the lost EBITDA if/when advertising revenues slide.

David: Because of the persistent threats to its core business FP management always has to be cutting costs where it can, and more employees lost their jobs in the first quarter. At the same time, however, the realities of survival in the 21st century mean that it has to keep up investment: Management spent CAD1.2 million to add web printing units and boost capacity at the new Steinbach facility.

Roger: Hold on a minute. Why so glum?

David: I don’t get to go to the Nats game with you tonight, and this reminds me of the scene in the kids’ movie Ratatouille when the food critic tastes the dish of the title, only the opposite: I still have newsprint stains on my elbows and forearms from leaning on the LA Times to read Jim Murray. My wife still harasses me about the newspaper collection I kept in my law school apartment. I only got through law school because of crossword puzzles, from the Philadelphia Inquirer and the Times. I know you love newspapers, too, and it’s a bummer to witness their demise.

I’m feeling some optimism at the prospect of making money on this one, though, so it feels better.

Roger: This ought to lift your spirit, too, and it applies to the broader Canadian story. From the company’s first-quarter earnings press release: “Despite the reported softness in advertising revenues, there is much going on in-and-around Winnipeg that is likely to fuel future economic growth. Significant infrastructure and other capital investments are being made at unprecedented levels.”

Among these projects are a CAD585 million upgrade to Winnipeg’s James A. Richardson International Airport and a new stadium in 2012 for the Canadian Football League’s Winnipeg Blue Bombers. The provincial government has committed CAD4 billion over 10 years to develop “Centreport Canada,” an “inland port” adjacent to the airport to make it easier to “efficiently move goods throughout North America and across the world.”

David: I see that. And I like this:

The planned investment is intended to reroute North American trade through the middle of the country. Centreport recently announced agreements with Chinese partners including China’s largest private shipping company to create a new container-based rail system that will quickly move crops from the Canadian prairies into the Chinese market.

Roger: A new, CAD310 million human rights museum is opening soon. And Winnipeg just got a National Hockey League team back. Those are all important for identity and emotional reasons, but the key will be FP’s ability to translate that into revenue.

David: Of course, but that’s the risk, and it’s pretty easy to see. It’s also nice to see management’s forecast that cash from operating activities and cash on hand will fund operations, CAPEX, principal payments on its credit facility and distributions if ad revenue remains within its current expectations. That’s a sign of management’s discipline. And there are no debt concerns; FP is well within the coverage ratio requirements established in its credit facility.

Roger: Only one Bay Street analysts covers it; National Bank Financial has a “sector perform” rating on the stock, which Bloomberg reduces to “hold,” and a CAD5 price target. The analysts had been as high as CAD7 with his target as recently as Mar. 2 of this year. Seems like signs of second-quarter slowdown and potential for a corresponding backup in advertising activity may have scared him a bit, as he dropped to CAD6.25 on Mar. 21 then CAD5 on Jun. 9, just after the company announced first-quarter results

David: I think I have a little more confidence in our thesis than to be so shifty. FP Newspapers, yielding 11.3 percent and trading for 59 percent of book value, is a speculative buy up to USD5.90 on the US over-the-counter (OTC) exchange or CAD5.45 on the Toronto Stock Exchange (TSX).

Roger: Keep in mind, however, that this is another print media company trying to adapt to a digital/Internet age and so faces a huge amount of investor skepticism. The stock trades ex-dividend after Jun. 28; the CAD0.05 dividend declared Jun. 16 is payable on Jul. 29 to shareholders of record on Jun. 30.

Open Positions

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9.50
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–Buy < USD32.50
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–Buy < USD1.70
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6.70
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.90

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL