Friday's analyst upgrades and downgrades

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Inside the Market's roundup of some of today's key analyst actions

Restaurant Brands International Inc.'s (QSR-N, QSR-T) performance has been "impressive," according to BMO Nesbitt Burns analyst Peter Sklar.

He initiated coverage of the parent company of Burger King and Tim Hortons with an "outperform" rating.

"We believe that RBI offers investors further opportunity through ongoing cost reductions, continued global development of Burger King, and potential upside from the global roll-out of Tim Hortons," said Mr. Sklar. "In addition, RBI generates substantial and consistent free cash flow through a 'capital light' model, which we believe will be highly valued by investors."

Mr. Sklar said the company has demonstrated "strong" earnings growth, pointing to several factors including: "notable" cost reductions; new restaurant openings; accelerated reimaging of Burger King sites and menu innovations.

"BK's adjusted EBITDA margin had already improved significantly since 3G took the company private in 2010," he said. "The margin expansion was achieved through notable reductions in SG&A expenses and a franchising of corporate-owned BK restaurants. Since the formation of RBI, BK has maintained this level of operating expenses.

"While TH's restaurant network was already largely franchise-operated, after the formation of RBI, we note a significant reduction in the brand's operating expenses. SG&A had been steadily creeping up since 2006 from high-$20-million to about $40-million per quarter by 2013-2014. However, since being part of RBI and under control of 3G, TH's SG&A has declined to about $20-million per quarter, or just over $4,000 per system-wide restaurant. This is a notable decline from $40-million per quarter, or $10,000 per system-wide location."

Mr. Sklar called the company's ability to cut costs "notable," and suggested further reductions are possible.

"Within about three quarters following the transaction, TH's SG&A has been reduced to about $25-million per quarter, and in the most recent quarter was down to below $20-million," he said. "In other words, TH's corporate overhead costs have been reduced 50 per cent within a relatively short period of time. The annualized impact is about $80-million on a business that was generating about $850-million of EBITDA prior to the transaction with BK, and at the same time we have not detected any discernible reduction of corporate services and function. Clearly, with the arrival of a new senior management team out of the 3G private equity firm, a substantial restructuring of corporate overheads has been orchestrated, something that previous TH senior management teams and board of directors were not able to effect on their own.

"We also noted that 3G orchestrated a similar reduction of SG&A expenses following its acquisition of BK in 2010, although the impact is more difficult to discern, as there would have been a significant amount of restaurant-level SG&A that would have been structurally eliminated by the conversion of corporate stores to franchises. However, the point is that the reduction of SG&A expenses at BK continued for quite a lengthy period, suggesting that there may be additional runway for further corporate overhead reductions at TH in future periods."

Suggesting Tim Hortons' international expansion may accelerate under the company's master franchise joint venture agreements, Mr. Sklar said RBI's "significant and stable" free cash flow should be valued by investors, given the current low interest rate environment.

"RBI's revenue stream is largely from rent and royalties, which provides a stable top line," he said.

"We also see potential value in the capital structure. RBI has expensive preferred shares that are redeemable after 2017, and we calculate a refinancing could be accretive to annual earnings by $0.30 per share, and is incorporated into our 2018 estimate."

Mr. Sklar set a target price for the stock of $52 (U.S.). The analyst consensus price target is $47.08, according to Thomson Reuters.

"In terms of valuation, the stock looks expensive, at [approximately] 16 times our 2017 EBITDA estimate, which is at a premium relative to the other major U.S. quick-service restaurant stocks (McDonald's, Dunkin Donuts, Wendy's, and Yum), and is at the high end of the range of the major Canadian consumer stocks, with only Dollarama (18x our calendar 2017 EBITDA estimate) attributed a higher multiple," he said. "However, we have argued that RBI generates substantial and consistent free cash flow due to its "capital light" model and we note that the company's free cash flow conversion ratio was a healthy 65% in 2015. When we look at valuation on an Enterprise Value to EBITDA (less capex) multiple basis, we find that RBI's multiple falls in line with the other major quick-service restaurant stocks. When we look at valuation on a free cash flow yield basis, we find that RBI is the least expensive stock among the major U.S. quick-service restaurant stocks.

"Our target price of $52 is based on an enterprise value that is about 15.5x our 2018 EBITDA estimate (which is essentially at the low end of RBI's historical range). We believe that RBI offers investors further opportunity through ongoing cost reductions, continued global development of the BK chain, and the potential for success with the global roll-out of the TH brand."

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Advantage Oil & Gas Ltd.'s (AAV-T, AAV-N) cost reductions have been "impressive," said Credit Suisse analyst David Phung.

Following the release of the energy company's third-quarter operational update on Thursday, Mr. Phung upgraded his rating for the stock to "outperform" from "neutral."

"We originally started with an Outperform rating for Advantage, owing to the company's strong balance sheet, self-funded growth profile, improving capital efficiencies and robust economic returns and scalability of its Montney Glacier asset. Those attributes still ring true," he said. "We subsequently downgraded the stock to Neutral following material price appreciation, coupled with our cautious view of dry gas in Western Canada and a material decrease to Credit Suisse's long term natural gas price outlook. While we maintained our positive view of the company as a preferred Neutral rated name, we recommended investors wait for either a share pullback, additional production data from the liquids rich Middle Montney for greater liquids optionality in an oil price recovery scenario or potential exploration success at Valhalla that could provide another leg of growth for us to justify assigning greater drilling inventory in our valuation. Those thoughts are also generally still applicable; however the cost reductions achieved since then have offset some of our concerns. In essence, we believe we should have kept it simple and stuck to the rule of thumb that good assets generally get better over time. We failed to appreciate the pace at which Advantage has been able to lower its costs, in particular well costs through efficiency gains, despite drilling relatively few wells (2016 budget had only 13 wells). We wonder what those efficiency gains and costs may look like if there were no infrastructure constraints and the drilling program was larger than it currently is and the company able to move forward on its learning curve even faster."

Advantage reported quarterly production of 215 mmcfe/d (million cubic feet equivalent per day), topping Mr. Phung's projection of 210 mmcfe/d. Cash flow of $45-million also exceeded his expectation ($42-million), due largely to lower operating costs (25 cents per mcfe versus 30 cents).

"Peyto has long been the benchmark of low costs among natural gas weighted producers in Western Canada, and at 25 cents per mcfe for operating costs and total cash costs of 58 cents per mcfe in Q3/16, Advantage is now roughly at that same level," said Mr. Phung. "With the next plant expansion the operating cost may further reduce to 20 cents/mcfe over time and could be sustainable and sheltered from cost inflation, given Advantage generates its own power and controls its water disposal.

"After factoring in the scalability of the Montney Glacier asset and improving capital efficiencies despite drilling relatively few wells, we wonder if Advantage is on the verge of, if not already, becoming one of the gold standards among dry gas producers in Western Canada. Of course, it may take a longer term track record of execution and consistency to be crowned such a distinction, but we believe the underlying assets and execution to date are supportive. We continue to believe some of the Montney Glacier wells to potentially recover upward of 10 bcfe EUR, however the company does caution that not all areas of their acreage may be that productive. Nonetheless, we continue to believe this is a top tier dry gas asset where costs may continue to come down."

He raised his target price for the stock to $11 from $9. Consensus is $10.50.

 "We continue to believe that longer term, structural constraints and competition from the United States will continue to challenge natural gas assets in Western Canada and that valuation gaps between lower cost gas producers are likely to further widen relative to higher cost producers," said Mr. Phung. "Following the company's recent operational update that confirmed lower operating and capital costs, we upgrade … as we believe that its Montney Glacier asset remains compelling at current valuations and near term catalysts could drive further stock outperformance relative to peers."

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DragonWave Inc.'s (DWI-T, DRWI-Q) second-quarter 2017 results indicate it continues to face significant liquidity challenges, said Desjardins Securities analyst Maher Yaghi.

On Thursday, the Kanata, Ont.-based tech company reported results that largely met Mr. Yaghi's forecasts with the exception of revenue, which fell 50.8 per cent year over year to $13.2-million (U.S.). That decline came as earnings before interest, taxes, depreciation and amortization rose to a $2.6-million loss from a $6-million loss in the 2016 fiscal year.

"We believe that recent indications on the state of the industry by Ericsson and others, coupled with a rise of NFV [network function virtualization] as a method to improve network functions, are trends that could continue to lower the value of fragmented non-commodity hardware for network operators, while software vendors gain more importance in the ecosystem," said Mr. Yaghi. "In our view, DWI is still in a difficult liquidity position. With $20-million (U.S.) of available credit and our estimate that the company still burns $3-million per quarter, we believe the renewal of the credit facility next April (end of fourth forbearance agreement) is crucial for the firm and its shareholders."

Mr. Yaghi did raise his 2017 and 2018 earnings per share projections to losses of $2.79 (U.S.) and $2.08, respectively, from losses of $4.51 and $4.34.

However, he lowered his target price for the stock to $3 (Canadian) from $5. The analyst average is $11.05, according to Bloomberg.

"We continue to recommend that investors wait for more clarity on DragonWave's future sales and profitability outlook, and we see potential downside risk until funding is secured by a new credit facility agreement," said Mr. Yaghi. "Revenue trends are heavily impacted by the Nokia relationship, which in turn affects the company's capacity to return to profitability. We believe the company requires a strategic transaction to resume growth."

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BMO Nesbitt Burns analyst Brian Quast believes Newmarket Gold Inc. (NMI-T) and Kirkland Lake Gold Inc. (KLG-T) will trade in tandem with each other and in line with peers given the coming merger of the companies.

In order to maintain the share ratio between the two, he lowered his target price for both.

Mr. Quast's target for Newmarket fell to $4.50 from $6, versus a consensus of $5.67. He kept his "market perform" rating.

"The Fosterville mine continues to deliver solid performance, and we expect high grade intercepts from the Eagle zone to be a driver of future growth for the company," he said. "However, we expect NMI shares to trade in line with the market as this transaction progresses."

With a "market perform" rating, Mr. Quast lowered his target for Kirkland to $9.50 from $12.50. Consensus is $14.23.

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With Lear Corp.'s (LEA-N) stock approaching his target price and seeing a "less attractive" risk-reward proposition for investors, RBC Dominion Securities analyst Joseph Spak downgraded it to "sector perform" from "outperform."

"To be clear, this is a 'no drama' downgrade as we approached our PT and not a call on the quarter," he said. "In fact, we see upside to 3Q16 consensus estimates. We just see a less favorable risk/reward at current levels."

Mr. Spak added: "Magnitude of beat-and-raise may be tougher in 2017. LEA has been able to guide to optically impressive growth while maintaining a reputation among investors of having that guidance be conservative. We actually continue to believe that will be the case this quarter. However in surveying 2017 (and 2018) consensus expectations, while they may be achievable, we see limited upside."

He said his 2017 earnings per share forecast of $13.25 (U.S.), down from $13.55, is almost 4 per cent below the consensus projection.

"Over the past 3 quarters, LEA's average EPS surprise was 15 per cent, but the average stock reaction was a decline of 2.2 per cent suggesting the market is already not willing to pay up for the beats," he said.

Mr. Spak did raise his target to $121 from $120. Consensus is $136.62.

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RBC Dominion Securities analyst David Palmer upgraded ConAgra Foods Inc. (CAG-N) to "reflect new pure-play focus, margin opportunity, and potential M&A upside."

Moving his rating to "outperform" from "sector perform," Mr. Palmer also raised his 2017 and 2018 earnings per share projections to $2.45 (U.S.) and $2.63 from $2.41 and $2.59.

"We believe ConAgra's trade promotion efficiency programs can leverage its below-average 27-per-cent gross margin (versus Big Food 36 per cent) into out-sized multi-year EPS growth," he said. "Assuming a 20-per-cent-plust rade rate (i.e. percentage of net sales spent on discounting, promotional displays, feature ads), our analysis suggests a 20-per-cent reduction in promotion spending could increase ConAgra EPS by over 50 per cent over time. While ConAgra has reduced unprofitable promotions and SKUs for its Banquet frozen entrée brand (volume down 20 per cent but margin up 200 basis points), we believe trade efficiency gains can continue—not necessarily driven by reduced trade dollars, but rather via smarter analytics and more targeted promotion construct."

Mr. Palmer said the next logical move for ConAgra is a major acquisition, suggesting Pinnacle Foods Inc. (PF-N) is a strong candidate.

"No other U.S. Food company has undergone a more significant strategic, financial, or cultural transformation than ConAgra over the past 18 months," he said. "The company 1) is ending its historical reliance on low-end consumers and deep discounting, 2) has divested its Private Brands and seasonings businesses, 3) spinning off Lamb Weston this fall, and 4) is moving its HQ from Omaha to talent-rich Chicago. While early results have been positive (e.g. promoted volume down 500bps and gross margin up 450bps since 2012), we believe diminishing deflation, sunsetting zero-based budgeting and restructuring savings, and accelerating share losses may intensify pressure on Big Food – ConAgra especially - to deliver EPS into '17. In our view, Conagra's lack of shareholder protection, peer-leading sales declines (down 6 per cent in latest 12 weeks), lack of a defining/growing brand franchise, concerted effort to become a pureplay consumer company, and a projected low level of leverage post-spin all point to a major acquisition in the near term - with Pinnacle the most likely candidate. ConAgra has not commented on a potential Pinnacle acquisition."

He raised his target price for ConAgra stock to $54 (U.S.) from $50. Consensus is $51.90.

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In other analyst actions:

Teck Resources Ltd. (TCK.B -T) was raised to "buy" from "neutral" by Dundee analyst Joseph Gallucci. He raised his target price to $31.50 per share from $21. The average is $23.91.

Mr. Gallucci downgraded First Quantum Minerals Ltd. (FM-T) to "neutral" from "buy" and lowered his target by a loonie to $13. The average is $12.88.

Yamana Gold Inc. (YRI-T) was upgraded to "neutral" from "sell" by Dundee analyst Josh Wolfson. He lowered his target to $6.50 from $6.75. The average is $8.23.