Canadian Edge began life in a still-expanding world of income trusts. Much has changed since July 2004: our understanding of Canada’s politics, what it means for the business climate and the economic fundamentals that underlie it all.

The Oct. 31, 2006, announcement that Canada would begin taxing specified investment flow-throughs (SIFT) at the entity level–effectively eliminating the advantage that allowed trusts to pass cash flow on to unitholders to be taxed in their hands–obviously had significant implications for CE and our readers. CE is essentially an income-focused investment advisory, but as Warren Buffett famously said and as has always been the fundamental underpinning of what we do here, when you invest in a company, you’re buying a business. A steady dividend stream is a reliable route to building wealth–but first and foremost is what’s happening at the operational level.

Canada’s political dialogue in superficial ways mirrors the one in the US: You have “liberals” and “conservatives,” seemingly intractable policy differences at the headline level, apparently irreconcilable regional priorities. What you don’t have, however, and crucially, is a vocal, powerful segment of the ruling class seriously advocating for a government you could drown in a bathtub. There’s a broad recognition that government can and should reconcile the inevitable inefficiencies a robust but imperfect market economy creates.

The bottom line is the Canadian economy is fundamentally sound, anchored by a solid balance sheet and ample natural resources. The federal government was running a CAD12.9 billion surplus for the 11 months ended Feb. 29, 2008. (That number will come down after CAD2.5 billion in year-end adjustments based on allocation of funds for public transit and a project to demonstrate how companies may be able to capture and store carbon emissions.)

Canada’s minority Conservative government also pushed through a five-year, CAD60 billion tax-cut package last year to help shield the world’s eighth-largest economy from a slowdown in the US. The plan included immediate reductions in personal income taxes and a 1 percentage point cut in the federal sales tax as of Jan. 1. In the end, the 2007-08 surplus will come in about 16 percent below the CAD15.29 billion posted for 2006-07.

Employment in Canada is not only growing, but the proportion of the adult population with jobs has reached a record high of 63.9 percent. In the US, this ratio has been dropping sharply, down 0.6 to 62.7 percent so far.

Retail sales are up 6.8 percent in Canada over this time last year. In the US, sales are up just 2.9 percent and growth is still slowing. Housing construction, a major creator of employment in recent years, has collapsed in the US to roughly half its peak level, down 29 percent just in the past year. It’s still rising in Canada, up 3.9 percent over the past year.

Home prices, a crucial indicator of household wealth because a home is the most valuable asset for most families, have plunged nearly 13 percent on average in the US over the past year, and the rate of decline has accelerated in recent months. By contrast, Canadian home prices are up by more than 5 percent over the past year. Auto sales, a useful index of consumers’ willingness and ability to make a big purchase, are down 7.7 percent in the US this year to a 10-year low. They’re up 6.1 percent in Canada to a new record high.

And Canada, unusual among developed countries in the importance of natural resources and raw materials, now ranks with the world’s top five producers of 14 mineral commodities. Overall, commodities account for about half of Canada’s exports.    

With all that in mind, we’ve broadened our coverage of investment opportunities in the Great White North.

The original approach to Canada-based companies outside the income and royalty trust space centered on dividend payers. But we ignored that loose construct in our first discussion (see CE, April 2007, “Canadian Currents: Northern Exposure”), recommending alternative power generator Canadian Hydro Developers (TSX: KHD, OTC: CHDVF), a long-term growth play on increasing awareness of and demand for cleaner sources of electricity.

We’ve added our non-trust recommendations to How They Rate coverage, grouped at the bottom of the table. The plan is to expand the Canadian Edge universe, slowly, over time, building on the same principles that frame our trust coverage: Buy good businesses at value-based levels, and stick around for the long term.

Today we’ll take a deeper look at another original non-trust recommendation, one of the Big Six Canadian banks, and briefly update the other seven companies we’ve introduced. Going forward, we’ll include companies we cover outside the income trust space in our weekly roundup in Maple Leaf Memo.

The Deal You Don’t

It says a lot about Bank of Nova Scotia’s (NYSE: BNS, TSX: BNS) relative strength among North American financials that it was named as a contender to rescue National City Corp (NYSE: NCC) from the US home mortgage monster.

It says more that it didn’t buy the regional bank.

Scotiabank is reputed to be a shrewd acquirer, taking long, slow looks at its prey before gradually consuming it; the bank has a reputation among analysts for its surgical approach to acquisitions. Its current strategy is oriented around small acquisitions in familiar markets, mainly in South America, the Caribbean and Mexico, but it’s now expanding into Asia as well.

Prolonged weakness in the financial sector has led to talk of buying opportunities, and Scotiabank was rumored to be sniffing around National City Corp in the days leading up to the troubled US regional’s first quarter earnings announcement. Clobbered by the home mortgage monster, National City found one more lifeline–a USD7 billion capital infusion from equity investors–that stopped talk of an immediate takeover.

Scotiabank was reportedly willing to go in for as much as USD4 billion, about a year’s worth of earnings, for National City. But the acquisition of National City would have been a significant departure from the Canadian financial’s current strategy. It has operations in more than 50 countries but has no retail presence in the US.

Scotiabank has always shunned opportunities to invest in the US market, unlike Bank of Montreal (NYSE: BMO, TSX: BMO), Toronto-Dominion Bank (NYSE: TD, TSX: TD) and Royal Bank of Canada (NYSE: RY, TSX: RY), all which have spent years and billions of dollars trying to build worthwhile franchises down south. Scotiabank could have done with one deal what its peers have been unable to accomplish: establish a strong regional retail presence in the US.
 
Up to the National City discussion, Scotiabank found acquisitions were too expensive, the US banking market was too competitive, building scale would take too long, and there were opportunities to make better returns in other countries.

Scotiabank has historically mitigated the risk of new acquisitions in the Caribbean, Mexico and Latin America by taking an investment position at first and gradually increasing the size of its position after learning the market, an approach that’s served it well. That Scotiabank passed up National City–forgoing a cheap opportunity, however alluring–is further testament to management’s discipline.

Bank of Nova Scotia is a buy up to USD58.

Canadian Hydro Developers has plans to double its current 365 megawatts (MW) of installed capacity during 2008. About 360 MW of wind/hydro projects should be under construction, and a further 225 MW of price purchasing agreements (PPA) could be signed.

Within two years, less than 10 percent of the company’s revenues will be exposed to the spot hydro market, with the rest coming from long-term PPAs. Long-term PPAs would insulate Canadian Hydro from economic cycles, and the company’s growth prospects are substantial relative to most utilities.

Venterre, a joint venture between Canadian Hydro and TCI Renewables, was recently awarded two 20-year PPAs from Hydro-Quebec Distribution for the supply of 116 MW from two wind projects. The power will come from the 66 MW New Richmond Wind Project and the 50 MW St. Valentin Wind Project. Canadian Hydro Developers is a buy up to USD5.95.

First Quantum Minerals (TSX: FM, OTC: FQVLF) reported a 63 percent increase in copper production to 75,600 tons, a record quarterly output for the company.

First Quantum is focused on the copper and cobalt sector in Africa and has interests in associated gold and cobalt production. It’s benefited from rising copper prices, linked to global demand from rapidly growing economies in India and China. Its main operations are the Kansanshi open-pit copper-gold mine in Zambia, the Guelb Moghrein copper mine in Mauritania, the Frontier open-pit copper project in the Democratic Republic of Congo and the Bwana Mkubwa development in Zambia and Congo.

In April, First Quantum offered CAD9.90 a share (CAD265 million) for Scandinavian Minerals (TSX: SGL, OTC: SCANF); Scandinavian Minerals’ main asset is the Kevitsa nickel, copper and platinum group elements project in northern Finland, which contains 831 million tons of ore.
 
A bidding war among First Quantum and mining giants Norilsk Nickel and Xstrata could happen, the anticipation of which pushed Scandinavian Minerals’ share price north of CAD10 in the aftermath of First Quantum’s friendly offer. Barring an auction, the acquisition is expected to close before the end of the second quarter.

First Quantum Minerals is a buy up to USD102.
 
Manitoba Telecom Services (MTS, TSX: MBT, OTC: MOBAF), anchoring a consortium that plans a national rollout of service, and Shaw Communications (TSX: SJR.B, NYSE: SJR), Canada’s No. 2 cable and satellite TV company, are among the potential challengers to enter Canada’s national wireless communication market.

MTS stock took a hit after it made its wireless desire public; investors were wary of the costs associated with the build-out of a new network. MTS has financial backing from the Canada Pension Plan Investment Board and US-based Blackstone Group but hasn’t announced partnerships with global or US-based carriers.

MTS would face many challenges to a national service rollout, but its existing business communications services would help it compete. Its ambition may actually be to buy spectrum cheaply in the May 27 auction and flip it at a premium down the road.

And Shaw may elect to wait several years before rolling out a network, until the debut of fourth-generation wireless equipment; the company may want to hold off investing until it can spend on the newest technology. Shaw could use bundling strategies to help boost a wireless offering.

Shaw’s interest may also be as a potential buy-and-flip wireless player. The cable company cautioned investors not to read too much into its decision to put up a CAD400 million deposit ahead of the auction.

Manitoba Telecom Services is a buy up to USD50; Shaw Communications is a buy up to USD24.

Norbord (TSX: NBD, OTC: NBDFF) has been placed under review “with negative implications” by credit rating agency Dominion Bond Rating Service (DBRS). Norbord is one of world’s largest producers of wood-based oriented strand board (OSB), a building material used widely in housing construction.

Significantly softer demand for OSB south of the border has taken a toll on the company, driving Norbord’s stock price to a 52-week low in mid-April. We recommended it in April 2007 as play on a recovery in the US construction cycle; that’s not going to happen within the time frame we originally anticipated.

Norbord had experienced strong demand from European markets in 2007, offsetting some of the impact of the US slowdown, but the global credit crisis has slowed European Union demand as well. Norbord also settled US litigation over allegations of price fixing, agreeing to pay USD30 million to purchasers of OSB. Norbord was one of nine forest products companies sued in US District Court in Philadelphia in June 2002 over a complaint brought on behalf of direct purchasers of OSB.

This is now a long-term recovery story. Hold Norbord.

Russel Metals (TSX: RUS, OTC: RUSMF) has boosted its dividend nine times in the last five years and now pays 45 cents Canadian per share per quarter. It paid out CAD1.75 per share in 2007, nearly 100 percent of its CAD1.77 annual earnings per share, but it’s operated that close to the razor’s edge before–in 2001, for example. Encouraging, free cash flow per share was CAD3.09 for 2007.

Bay Street analysts have also identified Russel as a potential takeover target, so there’s a possibility for a onetime windfall on top of the company’s consistent dividend performance.

Net earnings for the fourth quarter 2007 were CAD25.3 million, down 22.5 percent from CAD30.6 million in the same period of 2006. Net earnings for the year were CAD111.2 million, a decrease of 30 percent from fiscal 2006 net earnings of CAD158.7 million.

In the metals service center segment, steel prices and margins remained under pressure throughout 2007, but announced steel mill price increases in the first quarter of 2008 are expected to increase both selling prices and margins. The energy tubular products segment, a leading provider in the oil sands of northern Alberta, helped offset the decline in volume of western Canadian operations that distribute pipe primarily to gas-drilling customers. Lower active drilling rigs and excess pipe availability pressured volumes and margins.

Russel Metals is a buy up to USD35.

Our colleague Elliott Gue, editor of The Energy Strategist, has an interesting take, from the April 23 issue of TES, on Talisman Energy (NYSE: TLM, TSX: TLM):

Talisman isn’t a pure play on natural gas or the North American market. However, the company is making the shift from a conventional oil and gas producer to targeting fast-growing unconventional plays.

Under a new CEO, I expect Talisman to see a significant uptick in production growth over the next few years. This will propel the stock.

For 2007, roughly 42 percent of Talisman’s production came from North America, with another 33 percent from the North Sea. North American production is weighted in favor of natural gas, which accounted for more than three-quarters of 2007 production. In contrast, North Sea production is close to 90 percent crude oil, mainly the most valuable light crude oil.

In North America, Talisman has traditionally focused its attention on the Western Canada Sedimentary Basin (WCSB), the prime conventional natural gas play in Canada. As I explained the Feb. 20 issue [of The Energy Strategist], conventional gas production in North America is declining, and such reserves generally simply don’t offer the growth potential of unconventional plays.  

Unconventional oil and gas plays are simply reservoirs that can’t be produced using traditional technologies. Through a combination of horizontal drilling techniques and fracturing, these reserves are prolific. Because of the company’s less-than-stellar production growth and relatively high costs, Talisman has lagged most of its peer group focused on unconventional North American plays.

Last September, Talisman hired new CEO John Manzoni and is in the middle of a strategic review of its acreage. We should hear more concerning the outcome of that strategic review at the upcoming earnings release at the end of this month and an in-depth analyst meeting scheduled for May 21-23.

Most likely, the company will announce its plans to develop several unconventional plays it owns but hasn’t fully exploited. The list of plays includes about 800,000 acres of land in the Appalachian Basin of the US. This region includes an area known as the Marcellus Shale.

Readers will recognize that XTO purchased acreage in this exact same region from Linn Energy last week. So far, only a few producers have drilled wells in the region. But early results are positive, and the area also benefits from close to consuming markets such as New York. Talisman already has plans to drill six test wells in the region for 2008, but that development plan could easily be accelerated.

I’ve highlighted the potential of the Bakken Shale oil play before in TES. This shale play is primarily in the US; however, part of the play extends into southeastern Saskatchewan. Talisman has about 100,000 acres in this area. Oil production growth from Bakken has been impressive for other producers in the region.

The Montney gas field in Alberta and British Columbia, the Utica Shale of Quebec, and the Outer Foothills of British Columbia and Alberta are three more promising gas plays where Talisman owns significant acreage and likely plans significant drilling activity.

And there’s another catalyst for Talisman in Canada near term: The producer owns significant acreage in an Alberta deep gas play. Producers are drilling wells as long as 6,000 meters (18,000 feet) to produce this gas effectively.

Although this is a highly promising reserve, Talisman, along with other producers, cut back capital spending plans sharply in the region after the Alberta government made changes to its royalty regime. These changes hiked the royalty rates producers were required to pay on deep gas fields, rendering production from such fields uneconomic.

But on April 11, Alberta backtracked on those planned changes, set to go into effect Jan. 1, 2009. The government announced it was making changes to the new royalty framework to offset unintended consequences. Basically, drilling activity dropped off so quickly in Alberta the regional government realized higher royalty rates meant lower royalties for their coffers.

Deep gas plays such as those owned by Talisman where a specific area in which the government is altering its royalty structure to encourage development and capital spending. I suspect that, in light of these changes, Talisman will boost its capital spending plans in the region. This would be a positive move for the stock.

And although North American unconventional reserves are perhaps Talisman’s most exciting prospects, don’t ignore international growth potential. The firm has $2 billion in capital spending planned for the North Sea, about $1.14 billion for the UK and the remainder for Norway.

The list of projects includes some exploration spending, redevelopments of older fields, and appraisals and tests for wells Talisman has already identified. Five projects came online in 2007, and Talisman has plans for six more in 2008 and 2009.

Talisman believes that fields in the region remain underdeveloped. The company has the opportunity to re-enter existing fields and increase production. And because there’s significant oil and gas processing, storage and pipeline capacity in the region, expenses are relatively low. Overall, Talisman is looking for 45 percent production growth between 2007 and 2009.

And the company is increasing its capital spending in Southeast Asia to $765 million from $585 million last year. Exciting, high-growth potential projects are underway in Vietnam, Malaysia and Indonesia. Buy Talisman Energy under USD24.