Hello, Old Friend

By David Dittman • June 22, 2012

What to Buy: Data Group Inc (TSX: DGI, OTC: DGPIF)

Why Now: Data Group Inc (TSX: DGI, OTC: DGPIF) is a former Big Yield Hunting recommendation that we advised exiting in March 2012. Since then the stock has dropped roughly 20 percent, even as the underlying company reported very strong first-quarter earnings and affirmed the strength of its dividend.

Data Group yields nearly 14 percent at its current price, with dividends paid monthly on or about the 15th of the month. The next ex-dividend date is expected to be on or about Jul. 17 for payment in August.

We’re looking for a return trip to a range of USD8 to USD9, just as we were when we entered Data the first time in May 2011. The timing for achieving that will depend much on market conditions, which are likely to remain jagged and volatile this summer.

But so long as Data continues to execute its business plan, hold its dividend and avoid running up debt burdens, it looks set to get there for patient investors. Buy under USD5.

The Story

Before we revisit an old pick that looks even more attractive now than it did when we made our initial run at it, circumstances compel a wide-ranging overview of all of our “Open Positions.”

Times have been tough in equity markets this spring and early summer, particularly for the high-yielding prey that comprise our set of picks. For some it’s time to cut bait, though for others–whose underlying businesses and operating results provide reason for optimism–it’s time for a fresh look.

That’s what’s driving this month’s “new” selection, and it’s a perspective that could pay significant returns for all those we’re sticking with as well.

Roger: I’ve got to tell you, David, this is really one of the tougher months for finding stocks yielding more than 10 percent that I have a level of confidence in.

True, there are a number of stocks that are caught up in negative momentum. And I still don’t see the market this summer as being any worse than what we saw in 2010 and 2011.

But it’s also a fact that even the major economies in Europe appear to be moving into recession and weak companies can’t count on growth in the US to bail them out, either.

Before we recommend anything else, I think we really ought to talk about what our readers should do with the 13 “Open Positions” we have right now.

David: I’ve thought the same thing. This isn’t a pretty economy. There are some very real problems, and these high yielders always seem to be the first to get smashed.

Roger: Well, that’s not a big surprise. These aren’t the riskiest picks in the super-high-yield universe of stocks. But they are the highest risk in the three advisories you and I do, Utility Forecaster, Australian Edge, Canadian Edge and of course MLP Profits that I co-write with Elliott Gue.

David: Oh yeah, Elliott wrote a pretty cautionary piece on the stock market in Personal Finance recently. And he’s paring through that portfolio to cull out underperformers.

Is some of that bearishness rubbing off on all that sunshine you seem to always carry around?

Roger: Ha.

I prefer to think of it as an ounce of prevention being worth a pound of cure.

But you raise a good question: Is this a time for investors to unload some of these high-yield picks that we haven’t yet closed out, or should we just hunker down and ride out the summer?

I still don’t think a 2008-style market crisis is likely or even possible now. There’s almost a universal consensus that bad things are happening, and investors and corporations alike are really hunkered down. That’s just 180 degrees different from the market mood prior to what happened in 2008.

I fully expect news to stay bad and keep the market mood negative for a while. But there’s just not enough leverage in the system to get to those 10 percent down days we saw then.

That being said, things could get a lot uglier over the summer, and there will be more dividend cuts. That’s what happened in 2010 and 2011 and to some extent we’re already seeing it in 2012.

David: Well, we do publish our “Open” and “Closed” positions at the bottom of each issue of Big Yield Hunting. I see a lot of energy and telecom trades still open.

Roger: It should be pointed out that both of these are essential-services sectors, so there’s a certain amount of stability in their business. People need what they sell and the services they provide.

Where these companies get in trouble is with leverage, either by taking on a lot of debt relative to their size or by getting too exposed to changes in commodity prices.

David: And we’ve had some successes, such as last year’s PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) trade. Hopefully some of our readers took a partial profit on that one as we suggested.

Roger: That’s one I think is definitely worth sticking with at this point.

The stock has taken a hit since late March, basically because of falling oil prices. But they have a really nice reserve and are finally executing on their production. And I really see this oil slide as a temporary reaction to these global growth worries.

Once it becomes clear this is more like 2011 than 2008, we’ll see a solid recovery.

David: Readers should be prepared for more volatility though.

Roger: Absolutely, and the same is true for the other energy positions we have. The two master limited partnerships (MLP), BreitBurn Energy Partners LP (NSDQ: BBEP) and QR Energy Partners LP (NYSE: QRE), have done a good job managing their near-term exposure to energy prices with hedging future sales, just like most of their peers.

Both of them raised dividends back in April to reflect production gains. Both have pretty strong coverage ratios as well.

But they’re still producers of energy, and what they can pay as dividends in the long haul is going to be determined in a big way by energy prices. If oil falls far enough, there are going to eventually be dividend cuts.

That possibility is what’s driven them down recently.

David: At what point for oil should we be worried?

Roger: Energy executives are used to seeing oil and natural gas prices all over the place.

Keep in mind that oil actually got a bit lower twice in 2011, in early August and again in early October. And in early 2010, oil actually got under USD65 a barrel for a while. That was about the time when BreitBurn started paying dividends again, and it’s consistently raised them since.

QR Energy hasn’t been around that long but also maintained dividends last year, and PetroBakken has paid the same thing since it came into being in late 2009.

The point is management isn’t going to cut dividends unless it’s convinced significantly lower energy prices are here to stay. That, in my view, would be a breakdown to somewhere around USD60 a barrel accompanied by some really bad economic news that suggested no hope of recovery anytime soon.

I don’t see that as very likely, particularly now that China has tamed its inflation and we’re seeing things there like accelerating demand for electricity and steel production.

But it’s the risk you take buying very-high-yield energy.

David: So we stick with those three.

What about Avenex Energy Corp (TSX: AVF, OTC: AVNDF)? They cut their dividend in March and have basically been sinking ever since.

Is it that they’re just too small to measure up to market pressures?

Roger: I think that has a lot to do with it.

The market is definitely pricing in another dividend cut, with a 14 percent-plus yield, and my sense is they’re going to take another hit to earnings from the drop in oil prices. I think we probably should finally cut our losses in this one.

Yes, they’re substantial. But I’d much rather have people in the other three energy picks, where the only flaw is falling energy prices. It’s just a lot easier to see a recovery.

David: OK, so sell Avenex Energy.

What about Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)? They also cut their dividend this spring. We of course knew they would when we entered the trade back in late March. But they did wind up cutting a bit more than we expected, to a new quarterly rate of CAD0.075 rather than the CAD0.035 per month we were talking about.

Roger: Which as it turns out was about what was priced into the stock. It hasn’t moved much since.

I think management has set a very conservative payout rate. They still haven’t gotten a new contract for the Cardinal power plant. But there seems to be enough going right at this owner of power plants to keep things moving in the right direction, even if the eventual Cardinal deal disappoints. That being said, I think Capstone is now back to being a conservative stock again. I’m going to keep covering it in Canadian Edge and I may even make it a buy again there. But for Big Yield Hunting purposes, we’ve had our shot and I would consider this position closed.

David: OK, sell Capstone Infrastructure too. I assume you also want to stick with Capital Product Partners LP (NSDQ: CPLP)?

Roger: This tankers group still looks really cheap to me.

Yes, the spot market is weak, but Capital’s bread and butter is long-term contracts, so their revenue isn’t suffering.

They don’t even seem to be having any trouble raising capital to pay off higher-cost debt, as last month’s USD140 million convertible preferred issue and USD149.6 million debt payoff demonstrated.

The analyst community also seems to be coming around, with two upgrades in the past month. Management was also at the 2012 MLP Conference in Greenwich last month and gave a nice presentation.

Capital Product Partners is still a buy up to USD9.

David: What about Superior Plus Corp (TSX: SPB, OTC: SUUIF) and Inergy LP (NSDQ: NRGY)?

Propane has been a horrible business with the mild winter in North America. Superior did cover its distribution pretty comfortably in the first quarter despite that, and management is sticking to guidance, which allows for considerable debt reduction as well.

Inergy, meanwhile, is making my head spin with all of its strategic moves. Do they still own anything?

Roger: Only the general partner interest and a lot of limit partner units in Inergy Midstream LP (NSDQ: NRGM), which they partially spun off just a few months ago.

Management is in the process of selling off the propane distribution operations to Suburban Propane Partners LP (NYSE: SPH).

I have to say, Elliott and I attended the Inergy presentation at the MLP conference and came away fairly confused about just what management’s end game was. So was pretty much everyone else there, including, it appeared, Inergy’s management team.

David: Time to sell?

Roger: The only reason to hang on would be if the spinoff Inergy Midstream bought out the general partner Inergy LP.

That’s essentially what Inergy LP did a year or so ago to what was then its general partner Inergy GP. One of the analysts at the conference actually asked whether that was in the plan but got some pretty evasive answers.

Other than that, the company has reduced its distribution almost by half from our entry point, so it’s less attractive on that front as well. I would say there are better places to invest right now.

David: So sell Inergy LP. And Superior?

Roger: Superior Plus has a range of other businesses besides propane distribution.

But yeah, I think this one is worth hanging onto. In fact, I would rate it a buy up to 7 for anyone who doesn’t own it.

They’ve tackled their debt problem, and their businesses are performing well enough to make the payout ratio very conservative indeed. Insiders have increased positions recently, and even some of the brokerages appear to be warming up to them.

It only yields about 9 percent, but let’s keep Superior Plus in our “Open Positions.”

David: What about the telecoms?

We kind of went right into the maelstrom last year by recommending France Telecom SA (France: FTE, NYSE: FTE) and Telefónica SA (Spain: TEF, NYSE: TEF) last year, and things really haven’t gotten better for either one.

Then there’s Otelco (NYSE: OTT), which actually cuts its dividend back to the debt interest portion of its income deposit security.

Is this really an industry where people should be investing?

 

Roger: I don’t know if you want to condemn the entire industry, but these are definitely not stocks for anyone who’s can’t stomach share-price volatility and possibly further dividend cuts.

But on the other hand, this is an essential service, and I think it’s about as close to a sure thing as is possible in Europe now that France Telecom and Telefónica are going to survive this crisis, no matter how it comes out.

The real problem for these companies isn’t really revenue. Telefónica is losing it in Spain, but at this point its Latin American operations are more than picking up the slack.

The problem for these companies is debt they have to roll over the next couple years, at a time when credit raters are slashing sovereign debt ratings on a daily basis. They’re doing it with asset sales and dividend cuts.

But we’re still seeing what I would consider a lot of pretty lame credit rater moves to bring corporate ratings in line with sovereign debt ratings, such as Moody’s downgrade of Telefónica this week supposedly over concerns about the Spanish economy.

It’s hard to imagine a more useless gesture. I would like to lower the buy target to USD15 for Telefónica’s American Depositary Receipt.

France Telecom’s CEO is now saying the company will probably cut its dividend next year but only modestly. That’s worth a hold at least from the current price, given the yield is well in double digits.

Meanwhile, both of these companies are still borrowing at pretty low rates.

The market’s not fooled; these companies are going to be around at the end of the day, and at that point these stocks are headed a lot higher.

It’s going to take patience though.

David: So Telefónica is still a buy, up to USD15, and France Telecom is a hold.

What about Otelco?

Roger: It’s definitely more of a crapshoot, mainly because it’s a much smaller company.

Keep in mind that Otelco isn’t a traditional common stock but an income deposit security (IDS), combining debt and equity. The IDS now trades for less than the USD7.50 face value of the bond portion. That’s negative equity value, and it implies a market expectation of bankruptcy.

They will lose about 12 percent of revenue when the Time Warner Cable Inc (NYSE: TWC) contract expires at the end of 2012. But by eliminating the equity portion of the dividend, management did save a bunch of cash to pay off debt.

And I just don’t see the bankruptcy argument at this time. That alone is enough reason to keep Otelco as a hold.

My main problem is management has been pretty lax communicating with shareholders.

Why didn’t we know in advance the Time contract was at risk? There certainly wasn’t anything in the 10-K to suggest anything was amiss, beyond the usual disclaimer under “Risk Factors.” That’s why the stock cratered on the news of the contract loss and dividend cut.

I don’t like that lack of communication. But it’s also hard to see any reason to sell a security yielding nearly 14 percent that can’t be cut, barring a very unlikely bankruptcy.

In fact, so long as we’re in for a dollar, let’s pony up another dime. Let’s make Otelco a buy up to USD7.

David: So no more Avenex or Capstone, but stick with everything else.

That leaves us with the two picks from Down Under.

Roger: It’s a little early to assess last month’s pick Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF). But our decision to sell half the OneSteel Ltd (ASX: OST, OTC: OSTLF) was a good one.

How do you feel about the company now?

David: Management announced a change in strategic focus in mid-February from steelmaking to iron ore production. This move and successful initial efforts to reshape and repair the balance sheet gave the stock the huge lift we saw shortly after our recommendation.

Management continues to roll over debt at favorable rates, typified by a mid-June refinancing of a AUD295 million syndicated loan that was scheduled to mature in August 2013. It’s also “well progressed” on its next maturity, a AUD250 million facility due in October 2013. The new arrangement maintains the company’s average interest rate at about 5 percent and lengthens the average maturity.

The new AUD295 million facility was actually oversubscribed, which I think demonstrates that institutions are also pretty bullish about the new mining-and-consumables focus.

Management is in the process of awarding contracts to expand its mining output, which should reach 50 percent by fiscal 2013 with the completion of projects already underway.

The company, which will become Arrium Ltd to reflect its new orientation as of Jul. 2, 2012, isn’t abandoning entirely is steelmaking history; in fact management says the unit should return to profitability this fiscal year.

We’ll know more about that as well as initial results from ramped-up iron ore operations when the company announces full-year fiscal 2012 results in late August.

The stock has come well back from the post-shift-announcement high of USD1.40 it reach in early May, likely because investors were selling off a profitable position. I’d be very comfortable buying the stock again if more bad news from abroad takes it below USD0.80 again. But I wouldn’t chase it.

Let’s keep OneSteel a buy under USD0.80, and we’ll remove the addendum to “sell half of position.”

Roger: Which brings us to whatever new recommendation we want to make.

I think we’ve given readers enough high-yield telecom and energy. And like I said before, I’m not seeing a lot out there I like outside those areas.

I have been pretty impressed with one of the former Big Yield Hunting picks we cashed out of in March, Data Group Inc (TSX: DGI, OTC: DGPIF).

We recommended it initially last May, right before the market really started to crack, so we were down a bunch early. We sold it after a parabolic rise early this spring, but it’s now down more than a buck from those highs.

And we’ve since seen first-quarter earnings, which covered the payout as management accelerated its “strategic plan.” That’s basically moving away from paper documents and into digital products.

David: That does sound a bit like what Yellow Media Inc (TSX: YLO, OTC: YLWPF) tried to do.

Roger: And of course you’re 100 percent right on that.

But there are some huge differences in what these companies have done. One is the entire concept of print directories has become obsolete, but documents are a bigger business than ever.

And the more litigious our society becomes, the more documents we’re going to have to deal with, both print and digital. In fact, I’d argue the Internet age has probably increased the number of documents exponentially as well as the need to manage them.

Data Group’s strategic focus is to be the leading document manager in Canada. Also unlike Yellow, Data Group didn’t build its business on debt.

The only obligation on the books is a CAD45 million issue of a convertible bond that will have to be either converted to stock, rolled over or paid off in cash on Jun. 30, 2017. The security is well out of the money, but that’s nearly five years away–plenty of time for the company to get ready.

David: Still looking for a return trip to the USD8 to USD9 area as we laid out last year?

Roger: I think that’s reasonable, since the company has now converted to a corporation and is still covering its payout comfortably.

Management’s intention is certainly to continue to cover that payout. During the first-quarter conference call CEO Michael Suksi stated the company is “focused on achieving our growth plan” but that “we’d like to be able to maintain the dividend as it is right now.”

That’s no guarantee they will. And the stock certainly does look like it carries the burden of Yellow Media’s failure. But a nearly 14 percent yield is pricing in an awful lot of bad news.

And if management is successful executing its growth plans without running up debt and while maintaining its dividend, sooner or later investors are going to come around to the fact that it is not another Yellow, and we’re going to see a much, much higher valuation for the stock.

That’s really what we’re after with these trades after all.

David: Can it do that in this market, where investors are really shunning risk?

Roger: Honestly, I doubt a stock like this will make much headway in the near term, or at least until the market psychology improves significantly. This is going to be one to be patient with.

But a buy below USD5 I think is going to really pay dividends down the road. And again, we are re-entering Data at a significantly lower price than we exited earlier this year.

David: So buy Data Group up to USD5.

Anything else to tell our readers this month?

Roger: Just to stay focused on business health of companies we own.

By the time we do another one of these, earnings reporting season is going to be coming on us quickly. That will give us another window on how these very high-risk companies are doing. Until then we’re going to see a lot of volatility in these stocks. That’s pretty much a guarantee. But it will all be meaningless for how these trades eventually turn out, provided the companies we’ve chosen stay on track.

We don’t do Big Yield Hunting updates in between issues. All of these stocks are also covered in our higher-priced advisories, including Canadian Edge, Australian Edge, Utility Forecaster and MLP Profits.

David: A shameless plug. But it does bear saying that we do provide a great deal of analysis on a wide range of investment areas.

Roger: And are always looking for more opportunity.

Thanks, David, and here’s to better times ahead.

David: Amen, brother. And thank you.

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