“You’re going to think this is weird…”

By David Dittman • March 23, 2012

What to Buy: Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)

Why Now: It can no longer be said that Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF) is a reliable, buy-and-lock-away wealth-builder, which is why it’s no longer a member of the Canadian Edge Portfolio. This change in status is relatively recent, which combined with the way management abruptly revealed an unsightly destiny for the company’s dividend in early December 2011 makes for strange circumstances indeed.

It can, however, provide a short-term pop for investors with risk capital to put to work–and who’d like to get paid a double-digit yield in the bargain. And that makes it a great target for Big Yield Hunting.

CE readers among the Hunting Party will be familiar with former Conservative Holding Capstone, which we first knew as Macquarie Power & Infrastructure Corp. A reasonable forecast suggests Capstone’s new rate would likely result in a double-digit yield based on current market pricing. Solid results for the parts of the business that will make up for a coming decline in cash flow from another key part in the fourth quarter and a positive outlook on early first-quarter results suggest a cut less than the market’s been anticipating.

Capstone Infrastructure Corp is a buy under USD4.50 for aggressive investors who understand that this is not a long-term investment, that a dividend cut is coming and that this company has a downside disappointment in its track record.

The Story

A little more than five years ago, in the early aftermath of the Canadian income trust tax debacle, what was then Macquarie Power & Infrastructure Income Fund was pushing an all-time high of nearly CAD12 on the Toronto Stock Exchange (TSX).

We added it to the CE Portfolio in May 2007 and were rewarded with a modest 2 percent dividend increase in February 2008. But the share price bounced around like a top, falling along with the broader market on signal events such as Lehman Brothers’ bankruptcy but then rallying from CAD4.47 on Mar. 6, 2009, to CAD8.47 by Feb. 11, 2011.

There is, however, a company-specific issue hanging over what’s now Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF): the renegotiation of the power-purchase agreement for its 156-megawatt Cardinal gas co-generation facility to supply the Ontario Power Authority (OPA).

We also have updates on two open trades that have posted notable performances in recent weeks, including our most recent pick, Australia-based OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY), which has nearly doubled since recommendation, and Data Group Inc (TSX: DGI, OTC: DGIPF), which has come back seemingly from the brink to approach our original entry price.

David: Let’s just clear this up right from the top: I already think you’re weird.

Roger: That’s not what I was saying.

David: OK, good; as for that, I actually kinda like it.

Roger: You know, a part of me thought you would.

David: How could I resist an idea the introduction of which begins, “You’re going to think this is weird…”

Roger: Exactly. Enough of this; let’s get started.

What should we make of OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY)?

David: It’s safe to say the market was pleased with its fiscal 2012 first-half results, even though the company will pay only AUD0.03 per share for its interim dividend, down from AUD0.06 a year ago.

The exciting thing is that OneSteel is making a shift from its steelmaking past to a future focused on iron ore mining operations. Management is even thinking about changing the company name.

What really drove the share price were results from mining operations for the first half of the year laid the foundation for what management says will be “significant improvement” in the second half of fiscal 2012.

Roger: So those who got in early and under our USD0.80 target have seen something on the order of a 70 percent gain for OneSteel, in about five weeks.

David: I think we should recommend booking part of the gain, as we did when PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) when it popped. We’ll find out about the second half of the fiscal year on Aug. 21, 2012, and hopefully see more progress with debt reduction, balance-sheet repair and asset focus.

As far as getting what we want out of it, of course the early pop is literally a jackpot, particularly for a service called Big Yield Hunting. I say we have our cake and eat it, too, by selling half of the original position and holding on to see what August brings.

I also think we need to talk about Data Group Inc (TSX: DGI, OTC: DGPIF). I really enjoyed your update in the March Dividend Watch List for CE.

Roger: I’m quoting now: “Conventional wisdom is that a dividend cut is all but inevitable when a stock trades at a high-teens yield. By this measure this stock has been pricing in a huge dividend cut for months. But management has continued to maintain the same rate, even after converting from an income trust structure to a corporation earlier this year.”

David: I’m smiling now.

Roger: Remember, however, where the market took this stock when fear was high, and remember what can happen to high-yielders when the fear rolls back in. This was a CAD2.50 stock and a pothole in the Open Positions table as recently as October.

And–recalling again Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Data Group’s longer-term challenge is evolving from a paper-based business into a digital business while keeping its customers.

David: Yellow Media, by the way, is your new hair shirt.

Roger: Everybody needs one of those, particularly in this business.

David: I think we can make use of Data Group without getting into the question of whether this is another Yellow or another Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF), which has gone from basically printing checks for Canada’s Big Six banks to handling all sorts of data-warehousing, record-keeping and transaction-processing functions. And now it’s expanding into Internet marketing as well.

Roger: I think we should point out how well Data Group is doing financially and on the ground–the foundation for its share-price rebound and the ability to maintain the dividend.

The full-year payout ratio was 82.6 percent, while the fourth-quarter’s was 77.6 percent. In the fourth quarter revenue, gross profit, adjusted EBITDA and net income all grew compared to the fourth quarter of 2010. For the full year revenue stabilized, gross profit increased and adjusted EBITDA was only slightly lower.

David: I thought management’s outlook was encouraging, particularly the emphasis on the immediate contribution to revenue and the ability to attract new customers posted by new digital initiatives introduced during the year.

Roger: A November 2011 acquisition will help attract new customers as well, it fits with the web-based gift card, direct mail and other marketing services, and it was immediately accretive.

As I noted in CE, “The answer to whether it succeeds or not lies in the numbers we see from Data Group in coming quarters.” I still like it up to USD4.

David: I do, too. The thing it it’s traded as high as USD5.90, as recently as this week, more than double its bottom and extremely close to where we recommended it. I think selling now and booking a short-term capital loss would help offset the tax impact of the short-term gain we’re recommending readers to book on OneSteel.

And we avoid the risk of a broader market selloff wiping out the ground we’ve gained back.

Roger: I think that makes sense, provided, of course, that readers consult their own tax attorney or tax specialist regarding the tax implications of these and any other transactions.

David: Now, returning to this fantastic e-mail: “You’re going to think this is weird…”

The more I read about Capstone, the more I like this idea.

First of all, the one thing that the Q4/FY 2011 call did for me was clear up a major nag, and that was that Cardinal won’t generate “zero” revenue after 2014–in other words, in CEO Michael Bernstein’s words, in fact, “Cardinal is part of the future mix of the Ontario supply chain.”

Roger: I’m not sure that management has been this explicit on this topic previously, but in early March they did state pretty unequivocally that Cardinal will have a contract with the Ontario Power Authority (OPA) come 2015. According to Mr. Bernstein there’s an offer on the table, but Capstone is trying to negotiate better terms.

We know Cardinal’s contribution to the overall cash flow pie will be reduced and that the dividend will be reduced, too. But the trend has been clear for awhile now: It’s down to 32 percent of cash flow in 2011 from 50 percent in 2010 and headed to 20 percent in 2012.

There will be some contribution, albeit a lesser one, from Cardinal when the current power-purchase agreement expires, yes. Losing it entirely would leave a lot of cash flow. But that’s not going to be the case.

David: The essence of the problem here is that Cardinal generates–for lack of a better word–a disproportionate share of free cash flow because its CAPEX costs are low and there’s little debt attached to it.

Capstone’s mission seems similar enough to other transition plays that investors are scared–or were scared–about its ability to execute.

Roger: There’s a major distinction for Capstone from Yellow Media, which was competing in what is essentially a service industry on terms it had little experience negotiating. It was a print company trying to go digital.

Capstone is still an infrastructure company running major power-generation and utility assets. It’s already added the pieces that will help mitigate the impact of the inevitable loss of cash flow from Cardinal post-2014, and those three pieces–and the rest of the portfolio–performed well in the fourth quarter of 2011 and the year, for that matter.

David: The other thing management noted during the call you reference is that the pace of negotiations with the Ontario Power Authority has picked up considerably since that doomsday Dec. 6 announcement.

When Capstone revealed this shift in focus so abruptly, management had only met with the OPA once in the preceding five months. But since Dec. 6 the parties have met five times.

Roger: That gives me more confidence that management’s guidance for a decision in the first half of 2012 may be realistic. In fact the early June first-quarter earnings announcement will probably include more details about the new payout level.

Bloomberg’s forecast for the new dividend is CAD0.035 per share per month, about CAD0.42 on an annual basis, down from CAD0.66, or CAD0.055 per share per month.

That’s about a 36 percent cut. The market had been pricing in something more drastic, along the lines of 50 percent.

David: Management could have made a cut to a level that assumed no contribution from Cardinal, before it knew the exact terms of the post-2014 arrangement, which would have been the ultra-conservative move.

But it also would have removed some uncertainty and provided a lot of room for some up-side surprise.

Capstone paid CAD.0875 per share per month from February 2008 until January 2010. At that point it cut to CAD0.055 per share per month and has maintained that level–through conversion–ever since.

Capstone certainly isn’t the same company it was when we added it to the CE Portfolio five years ago. And when it revealed, suddenly, the drastic shift in early December 2011 it was time to cut our losses.

What we’re betting on now is that management’s coming cut will come as a pleasant surprise to the market.

From its closing bottom on Dec. 13 the stock has generated a total return of more than 40 percent in US dollar terms. It’s trading around CAD4.30 midday Friday, Mar. 23. It bounced from CAD3.26 to CAD3.80 within days of the bottom it made after its crushing announcement.

Average daily volume is about 25.5 percent higher to date in 2012 than it was for 2011, suggesting there’s still a lot of respect for this company among investors.

More evidence, of the institutional variety, can be found on Bay Street, where CIBC World Markets recently upgraded the stock to “sector outperform” with a CAD4.50 target; the stock closed at CAD3.99 the day of the upgrade.

The full buy-hold-sell line on Bay Street is six-two-two, suggesting a split but still strongly in favor of the company’s long-term performance.

This was an $8 stock less than a year ago, and back when we first recommended it the price on the TSX approached CAD12.

Roger: I still think conservative investors should avoid this thing, and let’s be clear again that it’s not an income stock. But as of Friday morning it’s yielding more than 15 percent, which means it’s pricing in a hefty dividend cut, something that will leave the payout closer to 50 percent of the current level.

Working from Bloomberg’s estimated new rate–which would make for a cut short of 40 percent–and today’s pricing we’re looking at a yield of around 9.8 percent.

There is some debt coming due this year, but it’s relatively inconsequential relative to the OPA-Cardinal contract.

The bottom line is this is a predictable business, but the specific situation with Capstone is clouded by unpredictable circumstances, mainly a contract renegotiation with a government authority. That’s what we’re betting on.

David: And there has been progress on fronts that will allow the new assets to contribute more to distributable cash flow, particularly the recapitalization of the Varmevarden facility in Sweden that will result in immediate savings.

Roger: The key for me is that revenue increased by 36 percent over 2010, primarily on the strong contribution from Bristol Water, which wasn’t part of the portfolio in 2010. And the Amherstburg Solar Park was an important driver of growth. But we also saw steady production from the balance of the power portfolio, where power-purchase agreements provide price-certainty for 98.7 percent of the power Capstone generates.

On a quarterly and an annual basis power generation was up, 0.7 percent and 2 percent, respectively. Total expenses in 2011 increased by 50.7 percent including about CAD19.7 million related to the internalization of management in April. But these costs won’t recur.

As of Dec. 31 the company had cash and cash equivalents of CAD57.6 million.

Total long-term debt at year’s end was approximately CAD935 million, and the company is meeting all covenants.

The recapitalization of Varmevarden, with its parent company issuing approximately CAD138 million in senior secured bonds, allowed Capstone to repatriate approximately CAD46 million in capital that it used to repay a portion of a senior credit facility, leaving about CAD33 million outstanding.

David: That brought Capstone’s debt-to-capitalization ratio to 69 percent from 71 percent as of Dec. 31, 2011, another promising trend.

Management’s guidance was solid: “Overall in 2012, we expect stable operating performance from our businesses and will benefit from a full year of contribution from Amherstburg Solar Park, Bristol Water and Vrmevrden.” Steady performance here will offset lower revenue from Cardinal due to previous provincial government decisions that will reduce revenue, but management is contesting these amendments and could claw some back. Cardinal will also see higher costs in 2012 due to higher gas tolls.

The adjusted EBITDA forecast for 2012 is CAD120 million.

Bristol Water should generate CAD8 million to CAD9 million in dividends in 2012, continuing its stable performance and higher rates. Bristol should complete about CAD110 million to CAD120 million in capital expenditures in 2012, which is currently tracking on schedule. Varmevarden, though Capstone’s investment has been reduced following the recapitalization, should provide about CAD4 million in cash flow in 2012.

Roger: In other words, operations were solid in the fourth quarter, the start of the year has been in line with expectations and results for 2012 should continue to show that the company will be able to offset a loss of Cardinal cash flow come 2015.

This sounds like a buy under CAD4.50 to me. But again this is not something for conservative investors. There’s also the chance they surprise us again on the downside.

David: Alright, then.

Capstone Infrastructure is a buy under USD4.50–but only for investors who appreciate the fact that a destabilizing transition is under way against the backdrop of a still-recovering economy; a dividend cut is coming; the company has let us down before and that are confirmed risk-seekers.

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