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Thursday’s analyst upgrades and downgrades

A Dollarama store in Toronto.

Fred Lum/Fred Lum/The Globe and Mail

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

Raymond James analyst Chris Cox sees the strategic merit in Cenovus Energy Inc.'s (CVE-T, CVE-N) $17.7-billion acquisition of 50-per-cent interest in the Foster Creek and Christina Lake oil sands projects owned by ConocoPhillips Co. (COP-N).

However, Mr. Cox said he struggles with Cenovus' "noticeably" higher risk profile following the deal, announced Wednesday after market close, as well as its decision to deploy capital toward acquisitions rather than share buybacks.

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The analyst said he has a "fairly neutral" stance on the transaction, maintaining that the projects are "best-in-class" and consolidating its working interest makes sense if an "attractive" price can be garnered later.

"We like the idea of adding more depth to the company's inventory of short-cycle development opportunities as we saw the company's inherently long-cycle focused capital program as somewhat incongruent with the new realities of the commodity landscape," said Mr. Cox. "This is not to say that expansions of the existing oil sands assets don't make sense – we believe they do – but rather, greater flexibility was needed in the company's capital program to reflect an ever more volatile commodity landscape. Cenovus' recent emphasis on the Palliser block and the opportunities available in the Mannville there were the first step in this direction, but clearly the acquisition here of the Deep Basin assets further bolsters the company's depth of shorter-cycle development opportunities and broadens the company's development opportunities to include a large inventory of natural gas and liquids-rich drilling locations.

"Asset quality will be one question mark, in our view. With 3 million net acres and 1.4 billion cubic feet per day (Bcf/d) of processing infrastructure, there are certainly some pockets that look quite compelling; in particular, we think there are some attractive opportunities relating to the company's lands in the Elmworth region, especially with the significant processing capacity acquired; this should allow the company to pursue a 'drill to fill' strategy and focus on attractive half cycle economics for some of the emerging liquids-rich opportunities in this region. That said, there is a reason why the former owner was not deploying capital aggressively to these assets, and we believe it will take some time before Cenovus can convince the market of the quality it sees in the broader Deep Basin package."

Mr. Cox said his biggest concern is a "noticeable increase" in the company's risk profile, despite expecting a "fairly seamless" integration with consolidation being "done on day 1" and seeing "limited risks" in the Deep Basin assets.

He believes investor perception of the altering risk profile for Cenovus stock will "change noticeably."

"First, from a financial standpoint, we see the company's pro-forma leverage increasing materially," the analyst said. "At strip pricing, we estimate that our 2018 net debt to EBITDA metrics increase from [approximately ] 1.0 times in 2018 to 2.5x–3.0x. Notably, this is prior to planned divestments, with the company already marketing its Pelican Lake and Suffield properties. However, even taking a more optimistic perspective on the potential value of these packages, we still see leverage increasing to more than 2.0x at strip pricing. Notably, this transaction effectively moves the company from one of the lowest leverage profiles in the peer group to the highest following the deal. Furthermore, not only does the company's leverage profile move to the top-end of its peer group, but this is relative to an asset base that has already demonstrated greater sensitivity to oil prices through this downturn. While we do not expect oil prices to revert back to the lows seen in 2016, we do believe the market will take a less constructive view on the combination of above-average financial leverage, coupled with an asset base exhibiting above-average operational leverage. Making matters worse, roughly 15–20 per cent of the upside from higher oil prices is lost due to contingency payments the company must pay to ConocoPhillips, if oil prices post a more durable recovery from current levels. Overall, we do not believe the market will appreciate the balance of higher downside risk, with limitations on the upside benefit.

"Finally, with Cenovus' legacy oil sands production already outpacing the company's net share of heavy oil processing capacity in the downstream, we note that the company will now be fully exposed to swings in heavy oil differentials for effectively 100 per cent of the acquired oil sands production. Undoubtedly, this has significant impacts with respect to the company's level of integration and we suspect, the perceived risk profile amongst investors. In particular, we believe market sentiment with respect to the deal could sour over the balance of the year, as we expect growing heavy oil supplies from projects currently under construction to gradually outpace available pipeline capacity, potentially causing widening heavy oil discounts. While Cenovus' acquisition of the Bruderheim rail terminal can help mitigate the impact of this to a degree, the net effect is nevertheless negative."

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With a "market perform" rating (unchanged), Mr. Cox lowered his target price for Cenovus stock to $18 from $23. The analyst average price target is $22.10, according to Bloomberg.

"We do believe one of the more important considerations relates to valuation, and whether this was a value-maximizing decision by management," he said. "Undoubtedly, the bulk of the value relating to this deal pertains to the additional 50-per-cent interest in the FCCL partnership – just as was true of the shares prior to this announcement. As such, perspectives on the overall value of this transaction will largely reflect an investor's previous view on the stock; those who thought the stock was inexpensive prior to the deal will likely see good value in the transaction, while those who thought the stock was overpriced will inevitably have a different view."

Elsewhere, the stock was upgraded to "neutral" from "underperform" by Macquarie analyst Brian Bagnell. His target remains $16.

UBS analyst William Featherston upgraded his rating for ConocoPhillips stock to "buy" from "neutral" and raised his target to $55 from $41. The average is $58.80.

"COP is divesting a low growth, low margin asset that will enable it to immediately reduce its debt load by [about] $7-billion (or 9 per cent of its enterprise value) and double its share repurchase program," he said. "Thus, assuming COP trades to its pre-deal 2018 multiple under our price deck of 6.1 times implies a stock price of $51 per share. We'd also note the deal improves COP's production mix with its percentage of lower margin bitumen decreasing from 15 per cent to 5 per cent and higher margin oil increasing from 35 per cent to 40 per cent."

"While COP's asset base makes it a challenge to generate absolute production growth competitive with E&Ps, the combination of its low depletion rate, high leverage to oil prices, and constrained capex should enable it to generate FCF with Brent at less-than $50 per barrel. Moreover, we believe COP will re-rate up from current levels given its improved production mix and balance sheet. Assuming a 2018 normalized DACF multiple of 6.2x (a half turn below the peer target multiple) implies a price of $55."

Credit Suisse analyst Edward Westlake raised his  ConocoPhillips target for ConocoPhillips stock to $60 (U.S.) from $55. He kept a "neutral" rating.

"There were three challenges with COP's investor proposition – leverage, the lower 2.3-per-cent dividend yield versus the Majors, the lower growth relative to the E&P's," said Mr. Westlake. "This transaction will address the debt. After the deal, the shares trade at the cheaper end of the Majors on free cash yield – indeed COP may deliver a higher TSR than CVX or XOM. We will have to see whether modest growth + a modest dividend + buybacks will work over time. Management credibility should help. However, there are pure plays delivering 15-per-cent-plus pa multiyear cash flow growth from a deep shale inventory that have also sold off unfairly. The competition is fierce."

He added: "We expect a strong response at the open [Thursday]. The shares look cheap relative to the Russell 1000 which offers a FCF yield of 4.8%. At $55 per barrell Brent (real), COP could generate a 7.2-per-cent free cash yield in 2019. At our deck it could be 9.2-per-cent using COP's sensitivities. A $60/sh TP is easy to justify in absolute terms."

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Lululemon Athletica Inc.'s (LULU-Q) weak first-quarter guidance was "tainted" by sluggish trends in both its direct-to-consumer and bricks and mortar channels, according to BMO Nesbitt Burns analyst John Morris.

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On Wednesday after market closed, the retailer reported "solid" fourth-quarter financial results with what Mr. Morris deemed to be "strong" performance across both its men's and women's divisions.

However, its guidance for the first quarter, including weaker-than-expected earnings per share of 25 to 27 cents (U.S.) that fell 9 cents below the Street's projection, drew concern from both Mr. Morris and investors, causing the stock to plummet in premarket trading.

"The negative low-single-digit comp expectations reflect the company's reads on lower conversion in the DTC channel and slow traffic trends in the brick & mortar channel—despite positive performance across other key comp drivers," said Mr. Morris. "While we think the weak traffic was likely already priced into the stock due to the broader industry commentary, the worse conversion trends in DTC were likely more of a surprise. Further, we estimate that the comp in physical stores could be as low as negative MSD, given that e-comm is still expected to come out positive."

He added: "Deleveraging effect from weak sales should outweigh product margin expansion in 1Q. Although, currently, the company is seeing product margin improvement similar to 4Q, the company's deleverage on fixed costs should more than offset this in 1Q. Gross margin will likely be pressured by B&O costs, while SG&A will likely be pressured from ongoing investments."

Mr. Morris said the company's full-year guidance, with EPS of $2.26 to $2.36, hints at a second-half recover. The Street had expected $2.56.

"Like many others in the retail industry, the recovery is primarily based on transaction trends reverting back to the mean," he said.

"Eyes should be on traffic/conversion-driving initiatives. We believe LULU's 2017 rebound will be dependent on its ability to re-ignite traffic across both channels. Hence, successful execution of the new brand campaign, product initiatives, and CRM [customer relationship management] capabilities will be critical to FY2017 earnings, given the overbearing effect that weak conversion and traffic trends are expected to have in 1Q."

Based on the guidance changes, Mr. Cox's full-year EPS estimate fell to $2.29 from $2.49.

"This assumes that the company will be able to recoup some traffic and conversion in the second half of the year given the new product initiatives and brand campaign," he said.

He kept a "market perform" rating for the stock and lowered his target to $55 (U.S.) from $66. The analyst average target is $62.86.

Meanwhile, Citi analyst Paul Lejuez said Lululemon now has a "muddier path" and downgraded the stock to "neutral" from "buy." His target  fell to $59 from $85.

"LULU capped off a great year with a strong 4Q, but trends have slowed significantly in 1Q17 both online and in stores," he said. "The slowdown is being attributed to a correctable fashion miss and the company is looking for an acceleration in comp trends following 1Q. We believe they may be setting the bar too high to expect an acceleration, particularly as the company faces difficult productivity comparisons. Beyond F17, we believe LULU has significant room to grow the brand. However, the path to long-term growth is not as visible against the backdrop of the current weakness."

"We continue to believe LULU is a strong brand with great long-term growth potential. But the path to achieve that growth is not so simple. In the U.S., we believe the company may want to slow growth ... In fact the company is opening more stores in F17 (vs F16), and may be pushing growth too far by expanding existing stores and opening stores in smaller markets. While international stores should provide another leg of growth, it is likely to weigh on margins in the near/medium term as the company ramps up (particularly as they open some flagships in high profile locations)."

The stock was also downgraded by Susquehanna analyst Sam Poser to "neutral" from "positive" with a target of $57 (down from $82).

Credit Suisse analyst Christian Buss kept a "neutral" rating with a target of $56, down from $64.

"While the company has done an impressive job recapturing lost productivity (sales per square foot up to $1,520/s.f. in 2016 from trough levels of $1,320/s.f.) and improving gross margin (up to 51.2 per cent from 48.4 per cent at trough), it appears to be more challenging to come by incremental operational improvements," he said. "We had expected store comps of 2-3 per cent in FY17, but we now believe that store comps are likely flat to up 1 per cent year over year as visibility into product drivers is less clear. The company also continues to deleverage occupancy as store openings are weighted to lower productivity international regions, suggesting limited margin expansion for the year. Our lowered target price ... reflects the risk that underlying productivity gains have hit a peak.

Canaccord Genuity analyst Camilo Lyon dropped his target to $41 from $45 with an unchanged "sell" rating.

"At issue is the product assortment that lacks depth and colour, exacerbated by store traffic declines and weakening e-commerce conversion metrics," he said. "This assortment failure is particularly surprising given all the hype and expectations surrounding the appointment of Chief Product Officer Lee Holman last year. While LULU is taking corrective action to remedy the situation by adding more color into the line, we see a larger issue brewing, specifically that the LULU customer was so quick to leave the brand and go elsewhere. This suggests to us that pricing, competition, and/or fashion alternatives were a strong enough force to drive the consumer away and thus will make it that much more difficult to recapture her. To this point, comps are expected to see only a modest improvement in later quarters; however, we continue to believe trend shifts away from athleisure to denim will present stiffening headwinds to LULU and thus result in flat to negative 2H comps. As we feared, this sharp deceleration in comps is eroding any remaining benefit to gross margin as occupancy deleverage is overwhelming the last remaining supply chain benefits."

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Industrial Alliance securities analyst Neil Linsdell raised his target price for shares of Dollarama Inc. (DOL-T) in reaction to the retailer's "strong" fourth-quarter fiscal 2017 results.

On Thursday morning, the Quebec-based company reported earnings per share of $1.24, exceeding Mr. Linsdell's estimate of $1.04 and representing a 20-cent increase year over year. Revenue grew 11.5 per cent to $854.5-million, also topping his projection ($848.8-million).

"Q4 results were stronger than expected, even against difficult Q4/F16 comps," he said. "Management also raised guidance for F2018 and revised its long-term store target to 1,700 over the next 8-10 years (as we expected), all of which provided further confidence in the company's continuing growth opportunities. Continuation of profitability improvements, the rollout of higher price points, and our recently increased estimate of the potential for dollar stores in Canada, further support our thesis."

Mr. Linsdell bumped his target to $120 from $110. The analyst consensus price target is $113.06.

"Dollarama has an industry leading EBITDA margin," he said. "Given the market potential of dollar stores in Canada, we have confidence in Dollarama's ability to sustain these margins. As such, we reiterate our 17 times EV/EBITDA [enterprise value to earnings before interest, taxes, depreciation and amortization] multiple. As we roll forward our valuation period to F2019, and adjust our forecasts to reflect the strong Q4 results and positive guidance, we derive a higher target price."

"Our 17-times multiple remains at a justifiable premium to the 7-12-times range for other comparable Canadian and U.S. retailers. With an 11.6-per-cent potential return to our target price, we maintain our buy recommendation."

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Calling Ensign Energy Services Inc. (ESI-T) "a high quality land driller positioned for a recovery," RBC Dominion Securities analyst Benjamin Owens initiated coverage with an "outperform" rating.

"Ensign's attractive FCF [free cash flow] profile and well-structured balance sheet provide a solid footing as North American activity levels continue to accelerate out of the trough," said Mr. Owens. "We think the company's high quality rig fleet is well positioned to capitalize on an improving market for contract drillers.

Mr. Owens pointed to a trio of factors in justifying his rating for the Calgary-based company:

1. The outperformance of land drillings stocks historically during the early stages of a sector recovery.

"The land drillers have led OFS [oilfield services] stocks off the bottom (low for crude) in every cycle recovery since the early-1990s," he said. "Outperformance has historically carried over into year two. The first incremental E&P spend typically goes into drilling and we expect this cycle to be no different. We are one year into the current cycle recovery."

2 . The company is "well positioned" to participate in the "evolving" growth market for high-spec land rigs south of the border.

"The company has developed advanced drilling technologies that are now being deployed to the field and that we believe are highly competitive with best-in-class offerings from other well positioned land drilling contractors," said Mr. Owens.

3. Its fleet of rigs are "well suited" for all Western Canadian Sedimentary Basin hydrocarbon plays, which he said "gives Ensign strong leverage to the ongoing recovery in Canadian oilfield activity levels. We believe this will allow the company to maintain or grow its market share in the basin if activity levels continue to accelerate."

Mr. Owens also believes the company's current valuation does not fully reflect is growth outlook.

"ESI currently trades at 6.0 times our 2018 EDITDA estimate of $317-million," he said. "The 5-year historical average multiple is 5.8x with a one standard deviation band of 4.8 times to 6.7 times. We do not view this as an overly rich valuation, given that cyclical stocks tend to trade closer to the high end of the historical standard deviation band in early phases of cycle recovery. As the current cycle recovery in oilfield drilling activity is still less than one year old, we think the stock could trade closer to the high end of the historical range over the course of the next twelve months."

Mr. Owens set a target price for the stock of $10. Consensus is currently $10.08.

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CIBC World Markets analyst Todd Coupland downgraded EXFO Inc. (EXFO-Q, EXF-T) to "neutral" from "outperformer" in reaction to lower-than-expected second quarter financial results.

"While demand for optical testing systems was strong, its service assurance products suffered from order delays," he said. "We expect the share price to fall on these results."

On Wednesday, the Quebec-based company, which builds equipment to test fibre optic networks, reported adjusted earnings per share of 2 cents (U.S.), versus Mr. Coupland's estimate of 7 cents. Its third-quarter EPS guidance was a 2-cent loss to a 2-cent profit, while the analyst had anticipated a 10-cent gain.

"EXFO's reiterated that it is benefiting from 'optical testing and the 100G investment cycle,'" said Mr. Coupland. "Physical layer sales were up 17 per cent year over year in fiscal Q2 and up 12 per cent quarter over quarter. This is consistent with many carriers shifting spending to fibre optics. The slower Service Assurance demand yielded flat revenue."

Adding revenue mix remains a "concern," he added: "Margins were 8.1 per cent due to the negative mix (LQ was 10.2 per cent). The book-to-bill is also negative at 0.93, which says to us it will take at least a couple of quarters to recover the delayed orders. While management confirmed 2017 EBITDA is still expected to grow by 18 per cent, they admitted achieving the goal would be more difficult."

Citing a "less attractive" valuation, Mr. Coupland lowered his target to $5.50 from $6. Consensus is $5.21.

"While the trend of increasing fibre optic spending in 100G metro networks and overall fibre-optic test spending is expected to continue, the company suffered from a drag in margins due to negative revenue mix," he said. "While this thesis might work longer term, we expect investors will get a chance at a more attractive entry point."

Elsewhere, RBC Dominion Securities analyst Steve Arthur raised his target to $5.50 from $4.75 with a "sector perform" rating (unchanged).

Mr. Arthur said: "We believe EXFO is a strong technology player in a robust niche with an interesting risk/reward proposition. At this stage, however, we remain on the sidelines given recent execution challenges, limited near-term visibility, and earnings growth further out. We will revisit as we see improving indications of ongoing order flow from leading service providers, together with a visible path to sustainable growth. Global broadband demand continues to grow aggressively, driven by HD video streaming, higher quality websites, mobile data applications, etc. Network capacities as a result continue to be constrained and significant capital investments are needed to maintain network integrity. EXFO offers a solid and differentiated network testing and monitoring product portfolio and stands to benefit from increased capital expenditures and constrained network environments, in our view. We wait for evidence of sustained revenue and earnings growth before becoming more aggressive with the stock."

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The current oil price environment does not support incremental oil sands development, said RBC Dominion Securities analyst Benjamin Owens.

Accordingly, Mr. Owens expects shares of Black Diamond Group Ltd. (BDI-T) to perform in line with peers over the next 12 months.

He initiated coverage of the Calgary-based company, which rents and sells modular workforce accommodation and space rental solutions, with a "sector perform" rating.

"The primary stock driver for BDI has historically been revenue and EBITDA generation from its remote accommodations business, which primarily serves the oil sand region of Canada," said Mr. Owens. "Due to large upfront capital costs, oil sands projects typically require significantly higher oil prices in order to be economically viable than other North American resource plays - we estimate $65-70 for SAGD [Steam Assisted Gravity Drainage] projects and $100-plus for mining projects."

Mr. Owens said Canadian LNG exports should be seen to investors as a potential growth driver moving forward. However, he cautioned that the "timing is uncertain and pricing will be competitive."

"Two LNG export projects could potentially impact BDI's operations in the near-to-medium term," he said. "These are Pacific Northwest LNG led by Petronas, and LNG Canada led by Shell. The timing associated with these projects is highly uncertain at this point. However, should development move forward, we expect the associated construction will create demand for several thousand remote accommodation beds."

He added: "Outside of significantly higher oil prices and oil sands activity, Canadian LNG exports represent the greatest near-term catalyst for demand growth for BDI's remote accommodation business. However, most Canadian LNG projects have been cancelled or postponed indefinitely due to the recent downturn in commodity prices. The two projects closest to final investment decision (FID) are Pacific Northwest LNG and LNG Canada. The timing of both of these projects remains highly uncertain. Based on our recent investor survey, consensus appears to be that FID for these projects is likely a 2018+ event. Our estimates do not include any contribution from incremental demand for BDI services in Canada related to LNG export development. We view Canadian LNG exports as a potential positive catalyst for the stock longer-term. Should LNG proceed in Canada, we expect the associated construction of export facilities and pipelines will create demand for several thousand remote accommodation beds (up to 10-15k)."

Mr. Owens set a target price for the stock of $4.25. The analyst average is currently $5.45.

"We view the barriers to entry as modest in many of BDI's core businesses, particularly in the modular workspace solutions and small accommodations manufacturing and rentals," he said. "However, we believe the company does have strong differentiators in terms of scale of operations (allowing logistical synergies), location of workforce (i.e., strong presence in local communities in remote areas) through numerous long-term customer relationships and through partnerships with First Nations groups in Canada. While a wide range of competitors could enter the market with relative ease, few would find it easy to scale up to a size in which they could compete with BDI for large-sized projects and major customers, in our view."

At the same time, Raymond James analyst Andrew Bradford lowered his target price by a loonie to $5.50 with an "outperform" rating (unchanged).

"Black Diamond is down materially from its late-January highs, much of which is understandable given the one-two punch from crude prices ducking below $50 (U.S.) and its below-consensus guidance range for 2017, though we feel the correction was likely overdone," said Mr. Bradford. "Notwithstanding, BDI persevered with its capital plans, raising $32-million via an equity issue (at $3.75) and acquiring Britco's British Columbia rental assets for $41-million. BDI also quietly amended it credit facility, reducing its size to $100-million plus a $50-million accordion feature, thereby reducing standby fees. As an offset, its interest rate increased, but still remains below 6 per cent on its senior notes and is approximately 5 per cent on its credit facility. Covenants are relaxed to well beyond what we expect will be required for the next two years. Given this fact pattern, we characterize this as a very good level at which buy Black Diamond, both for its income stream and its growth potential within the confines of its existing asset base. We cannot identify any specific catalysts beyond the wellworn pipeline developments and LNG facilities, nevertheless, this is when investments are typically at their most attractive."

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In other analyst actions:

FedEx Corp. (FDX-N) was raised to "positive" from "neutral" at Susquehanna by analyst Bascome Majors with a target of $237 (U.S.), up from $203. The average is $214.52.

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About the Author
Globe Investor Content Editor

David Leeder is a content editor in the Report on Business. He was previously Deputy Sports Editor and Weekend Digital Editor at The Globe.  He holds an undergraduate degree from McMaster University and a graduate degree from Ryerson University. More

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