What to Buy: The Big Yield Hunting Field Bet

Why Now: After two weeks of market turbulence it’s time to assess stocks already on our target list before we seek out new prey. We’ve weeded out two picks–one, for a double-digit gain, because a recent capital raise and dividend cut portend weak quarterly results, the other because an overbearing government has eviscerated existing players in an entire industry, including a company highly admired by its customers for its quality service, in the name of “competition.”

What we have this week is a detailed look at eight high-yielding stocks that have been tested through tough times, operationally and in the equity market. We’ve adjusted buy targets for a couple, though that’s for new money only. It’s tempting to “double down” on open positions, particularly on selloffs such as Thursday’s. However, you never want a single position to come to occupy a dominant position in your portfolio, even if we are talking about your speculative, higher-risk ventures.

The Story

It’s been an incredible couple of weeks, a fortnight worthy of some reflection. Rather than rush into a new position, we’re going to evaluate all of our open recommendations for suitability in an obviously ever-shifting short-term market environment.

Roger: Quite a couple of weeks we’ve seen in the stock market. But what impresses me most is how little really changed, if anything. We’re still in that slow and jagged growth environment for the economy that we’ve been in since the 2008 crash. There’s little or no inflation. Investors buy US Treasury bonds and sell everything else on days when they’re worried about the economy. And they buy everything else and sell Treasuries when they’re less worried. Standard & Poor’s credit rating downgrade actually triggered a sharp rally in Treasuries, as all it did was increase worries about the economy.

What we really need to comment on to our readers is how these economic worries have affected Big Yield Hunting recommendations. As I hope we’ve made clear to everyone, we haven’t been picking safe yields here, as we do in our other advisories’ portfolios, such as Utility Forecaster, Canadian Edge, MLP Profits and Personal Finance. Instead, the mission of Big Yield Hunting is to pick stocks yielding at least 10 percent because investors are undervaluing the prospects of the underlying companies. We win as the companies prove their businesses are stronger than their stock prices currently reflect. And optimally, we get both a high dividend and some capital gains.

That type of recommendation doesn’t usually fare well when people are worried about the economy. Rather, investors run away from risk, perceived or otherwise. The silver lining is that these fears have created some outstanding bargains in Big Yield Hunting recommendations we’ve made so far. In fact, some of the values are truly outstanding given that second-quarter earnings have shown them once again to be backed by good businesses.

Prices have bounced a bit from last week, but I think this is truly an outstanding opportunity for our readers to pick up shares in our prior recommendations.

I’ll give you an example, Superior Plus Corp (TSX: SPB, OTC: SUUIF) came in with a 50 percent boost in adjusted operating cash flow (AOCF) in its second quarter. AOCF is the primary measure from which the company pays dividends. The second quarter is traditionally a seasonally weak one for Superior, as its propane sales are a lot lower than in the colder first and fourth quarters. But I was very impressed by the continued solid showing of the specialty chemicals operation as well as the energy services business. Both are tied into an industrial recovery in North America that looks pretty resilient at this juncture.

Even the construction products distribution operation, which has been absolutely shellacked by the weak US housing market, got about a 7 percent lift in cash flow. So management stuck with its profit forecast–again, using AOCF–of CAD1.55 to CAD1.90 per unit. That’s coverage of between 1.29-to-1 and 1.58-to-1 for the dividend this year.

And management seems to be expecting even better in 2012. All of this is better than it looked when we first recommended Superior back in April, yet the stock is about a buck below where we initially entered the position. That’s a super opportunity to buy this company-on-the-mend. In fact I’m reiterating my buy recommendation on Superior Plus up to USD11.60.

David: Superior is one that jumped out at me last week when all hell was breaking loose. That one closed at USD9.24 on Aug. 8, the Monday after the S&P downgrade. Wow, to have set a “dream buy” limit order on that one.

I think you’re right about our approach this month. What service do we provide if we simply pluck double-digit yielders from a Bloomberg stock screen? The universe of undervalued high dividend payers is limited as it is.

Early last week I thought we’d have chance to put together a double-digit-yield “field bet,”  made up of high-quality companies trading at bargain-basement prices, but the end-of-week rally scotched that idea. After the four-by-four-hundred-point seesaw and another triple-digit day on Friday we’re just about where we were before it all began.

There are a couple sore thumbs to talk about, too, starting off with The Data Group Income Fund (TSX: DGI-U, OTC: DGPIF). The market’s pricing it at just 88 percent of book value; granted, that’s not exactly Bank of America (NYSE: BAC), which is trading for less than 40 percent of the value it places on its assets, which include, of course, the highest proportion of mortgage among major US banks. It is well below where we entered, at about USD6.43 per share in May.

The stock traded as low as CAD3.29 last week but, like just about everything else, has bounced back. I’m not as sanguine on this one as I am on Superior, and I found the company’s second-quarter results a mixed bag. But management continues to stick with its distribution policy. Here’s what CEO Michael Suksi had to say in his opening statement: “We continue to do what we say we will do. We continue to execute on our plan to position the Data Group for long-term growth while also maintaining a healthy balance sheet, stabilizing our financial results in 2011 and, most importantly, maintaining our annual distribution to unitholders at CAD0.65 per unit.”

It’s that last part I’m most interested in, though of course the stuff that comes before determines whether it happens or not.

A couple numbers look good, such as gross profit, which improved to 25.2 percent of revenue from 24 percent in the second quarter of 2010. But the revenue figure was down 1.2 percent for the quarter, 1.4 percent for the six months ended Jun. 30. Net income was off compared to a year ago, but that’s distorted by the impact of new taxes–Data Group hasn’t converted yet, remember, and is paying the SIFT tax.

Cash available for distribution for the quarter was CAD4.3 million (CAD0.18 per unit), while total distributions were CAD3.8 million (CAD0.16 per unit). The second-quarter payout ratio was 88.7 percent, while for the first half of the year it’s 81.9 percent. Both are substantially better than a year ago. And the entire distribution was funded from cash generated by the business.

Management noted a pick-up in May and June sales after a less-than-stellar April, which is a good harbinger for third-quarter results. Positive trends in lottery-roll sales from 2010 to 2011 are also healthy. The company added document management customers during the quarter without shedding customers. New initiatives in the third quarter include a digital photo-book product that management describes as unique in the space.

The company added CAD10 million in new business in the first six months of the year, which will begin to show up over coming weeks, months and quarters, depending on what type of services and products the new clients have engaged. It’s a good thing that the company is adding customers and presumably market share.

Consider too that the year-over-year revenue decline last year compared to 2009 was 5 percent; this year it’s 1.4 percent. Far from strong, but it seems things are at least beginning to stabilize. And it’s likely a healthier economy will help maintain average revenue per customer.

Data Group Income Fund–paying an annual dividend of CAD0.65 per unit, a yield of 14 percent at these levels–is a buy for new money up to 6.

Roger: I actually disagree with you on the “field bet” idea. For one thing, most of our picks are still selling below where we initially advised people to buy up to–not by much in most cases, but they’re still in a range where I think they make good high-yield bets. Take AvenEx Energy Corp (TSX: AVF, OTC: AVNDF), which used to be known as Avenir Diversified Income Fund. That stock still yields right around 10 percent. But looking at the second-quarter numbers, there’s no way investors should be pricing in so much risk.

Revenue more than doubled, funds from continuing operations per share were up 35 percent from last year, and the payout ratio was just 59 percent. Not only that, but the company cut its long-term debt by 65 percent. And second-quarter results are traditionally its weakest seasonally.

Yes, it’s now primarily an oil and gas producer, with most of the rest coming from energy services, and some people are worried a new recession will take down oil and gas prices the way 2008 did. But this company has increased production by 47 percent over the past year and even held output pretty steady in the second quarter versus the first quarter, despite all those wildfires in Alberta. Management has hedged a lot of production going forward as well, and the realized selling price for its natural gas appears to have bottomed, too. We might even see debt come down even more if they can sell some more of those non-core assets.

Not a lot of people follow this stock, but those who do certainly still like it. And I’ve got to say, I think the market has it all wrong on this one. I think AvenEx Energy is a great buy here up to USD6.

Otelco (NYSE: OTT) is another one. Here you have a company that’s making a great deal of money in the wireline communications business that it’s happy to dish out to shareholders. But it still gets little respect from investors. Everyone seems to look at losses of local phone connections–that’s not rocket science. Americans are using cell phones and broadband connections more and more, the old wireline connections less and less. But operating income was up 4.5 percent in the second quarter, and the company ramped up capital expenditures by 50.4 percent. Those aren’t exactly the actions of a dying company.

Yeah, Otelco lost some voice access lines, but just 1.5 percent over the past year. Meanwhile, it’s adding Internet and satellite television customers that are way more profitable and don’t turn over. And management cut operating expenses 6.8 percent, even though product costs rose. Again, Otelco isn’t exactly a household name. But that kind of yield is usually associated with very risky companies and this one just doesn’t fit into that category. Otelco is a buy up to USD20.

And neither does France Telecom (NYSE: FTE), for that matter. Like we pointed out last month, there’s a lot of moving parts here, not all of them well-oiled. But it certainly looks like the dividend is well protected, and “Orange” did add 7 percent more customers over the past 12 months. Second-quarter earnings weren’t spectacular, but I see management just confirmed its operating cash flow target for 2011, and revenue was actually up a bit overall.

Forty-one percent of the French wireless market isn’t a bad position, and the company’s spending more than USD4 billion a quarter to upgrade its networks. That’s a financial advantage its rivals don’t have–and France Telecom is cutting debt at the same time. It’s even apparently growing in Spain, which is pretty hard in a country with 20 percent-plus unemployment.

Again, this isn’t exactly a popular stock. But I’m reminded of that old baseball adage “hit ’em where they ain’t.” I like France Telecom up to USD23, the target we set back in July before all the turmoil in the market.

David: My “field bet” hope was about new names, but now I see that we have an existing “field bet” with some of our open recommendations.

AvenEx, the second pick we made, in September 2010, is basically flat in price-only terms from our entry point to now. But if you count dividends it’s returned more than 13 percent, against an 8 percent-plus return for the S&P. I was equally impressed with recent operating results, particularly how acquisitions have fed into funds from operations and increased the sustainability of–and the long-term growth potential for–the dividend.

I’m with you on AvenEx, Otelco and France Telecom. Now let’s take a look at Cellcom Israel Ltd (Israel: CEL, NYSE: CEL). It’s safe to say we underestimated the impact of government efforts to increase competition in the domestic mobile phone industry.

Management reported a 6 percent decline in overall revenue, based largely on a 24.5 percent reduction in service revenue that resulted from new regulatory changes. The most significant of these changes reduced interconnect fees–fees mobile service providers are allowed to charge other providers to carry and/or continue calls on their network equipment.

So, despite the fact that Cellcom added 32,000 net new subscribers in the quarter, and that minutes of use rose 1.2 percent, the top line figure was ugly on a comparable basis. It shows up most prominently in the average revenue per user metric, which was off 26 percent. Free cash flow was off 46 percent, down to USD51 million.

Equipment sales–new smartphones and upgrades to 3G handsets–rose an impressive 173 percent, offsetting some of this erosion. But it’s pretty clear that the government is getting its way. And it doesn’t look like Netanyahu is done, as the public continues to demonstrate and pressure the government on rising costs across the board.

I think it’s time we cut our losses on Cellcom.

Duet Group (ASX: DUE, OTC: DUETF) has beaten the S&P 500 by 12 percent in total return terms since Feb. 23, 2011. Duet, which invests in energy utility assets in Australia and the US, is going to announce earnings on Friday, Aug. 19, in Australia, which means we’ll have numbers Thursday night in the US.

The company did, however, announce that it’s raising AUD277 million through the issue of new shares, and management said it will trim the distribution for fiscal 2012 by 20 percent. That seems to be a fair indication that recent results haven’t been stellar.

On a positive note, Chorus Aviation Inc’s (TSX: CHR/B, OTC: CHRVF) operating revenue for the second quarter was up 12 percent to CAD402 million. A lot of the increase was tied to pass-through costs received as a result of higher fuel prices. Passenger revenue, which excludes pass-through costs, increased 3.6 percent, or CAD8.4 million on a 4.3 percent increase in billable block hours and a 0.4 percent increase in departures.

Total operating expense increased 13.5 percent to CAD378.1 million from CAD333.1 million, though controllable costs–which excludes fuel–increased by CAD10.4 million, or 5 percent, and that was mostly because of capacity expansion. Free cash flow–where distributions come from–was CAD23.9 million, down CAD4.8 million, or 16.8 percent, from CAD28.7 million a year ago.

Management is sticking to a projected 70 percent to 80 percent payout ratio based on free cash flow for 2011. Management plans to declare a CAD0.15 per share dividend on Sept. 21 for shareholders of record on Sept. 30, which will be payable Oct. 18. And management is also holding to a forecast of 385,000 to 395,000 billable block hours for 2011. The company’s agreement with Air Canada has some protection should an economic downturn cut into total block hours, so management is confident the dividend will withstand anything that comes down the pike.

Management was confident–CEO Joe Randell said he didn’t see anything that would lead him to expect “any significant or even minimal” decrease in billable hours–that Chorus will be able to cover its distribution. And the company continues to replace part of its fleet with new, more fuel efficient planes.

Currently trading around USD4.70 and yielding 12.9 percent, Chorus Aviation is a buy for new money up to USD5.50.

Roger: All right, so recapping our discussion thus far, we still like AvenEx, Otelco, France Telecom, Superior, Data Group and Chorus, and you believe we should get cut losses on Cellcom. I think that’s probably a good idea. We’re not marrying these stocks, and, again, readers need to realize sometimes we’re going to have to cut losses.

Cellcom’s rival in Israel, Partner Communications (NSDQ: PTNR), certainly isn’t doing any better and, while we’re down in this trade, there are all too many examples of regulators taking good companies down in this business. Israeli regulators may come to their senses and start supporting these companies, but then again they pull a New Zealand and really squash them. Sell Cellcom.

I’m also going to suggest readers get rid of Duet Group. Here we’re just about flat from the entry point. But I think we have to stick to the discipline of getting out of any stock that cuts its dividend. As you point out, that’s never a good sign for the underlying business. And while there’s no doubt the stock was already pricing in a cut before it was announced, I prefer to stand clear when I hear that kind of news.

Pretty much every stock I’ve ever really been burned in was a dividend cutter that I didn’t sell immediately. I still like the company’s story, but let’s just watch from the sidelines. Sell Duet Group.

The last two picks on our list have also been victims of the recent selling. FP Newspapers Inc (TSX: FP, OTC: FPNUF) management was reasonably upbeat in its second-quarter conference call about a week ago. It looks like the company’s still able to generate enough cash to cover distributions, despite a weak environment for newspapers.

I was a little disturbed by the 7.6 percent decline in revenue from classified advertising, though display advertising was a bright spot. Management has done a good job making acquisitions to replace lost revenue, but you have to wonder how long they can keep that up, even in a place like Winnipeg, where they really don’t face a lot of competition. Flyer distribution revenues were another bright spot, rising 3.2 percent on both better rates and volumes. I frankly throw those things right in the recycling bin. But the fact that businesses are paying them for distribution is again a big plus. I also don’t like the fact that circulation revenue dipped in the second quarter, but that really is a long-term trend all newspapers are facing.

I will say that this company is benefitting from Internet applications. But the bread and butter is paper and print–again, still very profitable but no guarantees FP can keep that up. The payout ratio was again solid at about 71 percent, based on the current monthly rate of 5 cents Canadian per share and distributable cash flow (DCF) of 21.1 cents. And once you factor in the taxes FP now has to pay as a corporation–it was an income trust last year–and a reserve for its pension plan, that number is pretty steady with last year’s DCF.

That’s all to the good, and it’s enough for me to keep our buy target for FP Newspapers at USD5.60. But this is one I want to watch every single quarter.

The other pick is Capital Product Partners LP (NSDQ: CPLP), which we entered last December. Things were pretty stable for this one up until last month, when it fell from around our initial entry point of about USD9 to less than USD5 in a few trading days. That’s the kind of drop that usually has a dividend cut attached, and Capital did cut its payout pretty drastically back in May 2010, when industry conditions weakened.

One of the reasons we got into this master limited partnership, however, was it boosted its payout in November 2010, as its fortunes seemed to improve. And the good news is there’s nothing in the second-quarter numbers to indicate that recovery isn’t still ongoing.

Operating surplus–which is Capital’s primary measure of profitability, like many shipping companies–was lower in the second quarter. But the difference appears to be a one-time event, consisting of expenses related to the company’s merger with Crude Carriers and the purchase of the dry-bulk vessel Cape Agamemnon. Being able to do these acquisitions in a weak industry environment for tankers and shippers is really a sign of strength. And it’s going to pump up Capital’s profits going forward as industry conditions improve.

It’s undeniable that there’s a glut of shipping capacity in the world and that shipping rates are down. Some tankers’ customers are refusing to pay legally contracted rates, and when shippers have to find new contracts the rates are generally far below what they were getting under older ones. That’s a tough environment that’s not likely to change soon, though there were some signs of recovery in the second quarter.

The important thing, however, is where this company stands and how well it covers the distribution. And here I think Capital’s unit price dramatically undervalues its prospects. That’s not surprising, considering the fear level in the market and the conventional “wisdom” that all tankers/shippers should be sold or shorted. But Capital has spread out its contracts and controlled its expenses. Distribution coverage by operating surplus is 1.1-to-1, excluding one-time items. And the company has also improved its debt coverage ratios in recent months.

This industry is economically sensitive and overbuilt, and profits are being squeezed, even at Capital. But unit-price volatility notwithstanding, the dividend looks covered, and the business is still meeting management’s clearly stated expectations. In short, Capital Product Partners is the kind of high reward with risk play we specialize in here. And it’s still a buy up to USD9.

I’d also like to add a final word about two positions we closed out previously, Telstra Corp Ltd (OTC: TLSYY) and New Flyer Industries Inc (TSX: NFI-U, OTC: NFYIF). I don’t want to get in the habit of revisiting closed positions. Once we’re done with a stock we’re done–and no looking back. And both of these stocks are covered in other advisories, Telstra in Utility Forecaster and New Flyer in Canadian Edge. But given how volatile the market is and the number of questions we seem to keep getting, I have a couple of comments.

First, New Flyer’s second-quarter earnings pretty clearly indicate that the planned conversion to a corporation and anticipated 50 percent dividend cut when it does are out of necessity. Units delivered were off by 20.9 percent, and the average bus selling price also fell, by 2.7 percent. With so many state and local governments in financial trouble, the orders just aren’t flowing as they have in past years.

Management believes the business is stabilizing and that restructuring will provide the cash it needs to stay a major player. But with second-quarter cash flow off 39.8 percent, I’m happy to be out of this one. The payout ratio was 81.2 percent for the second quarter, so the company should be able to pay out at half its current rate even after paying full taxes as an ordinary corporation. But the business is weak, and my rule is to sell and cut losses following dividend cuts.

As for Telstra, it’s really been on a rollercoaster ride since we closed out the position. In retrospect, we could have reentered at a very good price last week and would already be looking at a sizable profit. There are no real problems here, as solid fiscal second-quarter (end Jun. 30) earnings attest and the dividend looks solid. But we are, at this point, out of this position.

David: That’s a wrap, Rog. I think we’ve covered a lot of ground here. Details on open positions, including buy targets, are below.

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
• 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
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.60
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)