Thursday’s analyst upgrades and downgrades

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

Canadian banks have experienced a "slowdown, not a bust" thus far in 2017, said Citi analyst Ian Sealey.

In a research note ahead of second-quarter earnings season, which begins May 24, Mr. Sealey called the start "tough" with share prices down 1 per cent on average.

"This is being driven by a string of negative news flow; a potential mis-selling scandal, Home Capital Group's liquidity issues, house price slow down (and Government intervention), volatile oil prices, a Moody's downgrade, and negative read across from Australia where the housing boom appears to be at the beginning of a protracted unwinding," he said. "While these events should make investors more cautious, we believe the Canadian Banks are well protected from the slowdown through their low LTV mortgage books, strong geographical diversification, and high profitability. We therefore expect a slowdown in domestic loan volumes, but little impact to asset quality or returns."

"We would expect investors to be focused on margin outlook (and interest rate sensitivity) and for any further update on the low oil price and heated housing markets feeding into the underlying economy (particularly in retail). We would also expect some commentary on the impact of recent government initiatives in the housing market, and any read across from HCG."

Mr. Sealey said the sector has been plagued by margin pressures brought on by sensitivity to interest rates. However, he expects that begin to subside in this quarter, pointing to BMO economists' forecast of two U.S. rate hikes in fiscal 2017 and a Canadian increase in the first quarter of 2018.

He said: "We see the main themes in Canadian banking as 1) the property price slowdown particularly in Toronto, 2) rising rates stabilizing margins, 3) capital allocation decisions between organic growth, inorganic growth, and capital return, 4) digital and cost cutting as the banks become more efficient (see here), and 5) regulation driven by Basel IV, IFRS 9 and mortgage insurance changes."

Citing a recent pullback in bank share prices and attractive valuation, Mr. Sealey upgraded Bank of Montreal (BMO-T, BMO-N) to "buy" from "neutral," calling it a "leading business bank in Canada."

"BMO has a leading market share in Canadian corporate lending (c19%) and we believe it is well placed to capture volume benefits from a re-levering of Canadian corporates," he said. "As the cost of bank loans becomes more competitive we expect more corporates to choose bank loans over capital markets debt. The recovery in the oil price is likely to spur further lending by businesses either directly operating in the energy industry, or operating in the oil dependent regions (particularly Alberta)."

He maintained a target price of $110. Consensus is $105.41.

On the sector as a whole, Mr. Sealey said: "Highly efficient (and profitable) Canadian businesses combined with organic and inorganic growth opportunities outside of Canada, are driving strong book value and dividend growth over the longer term. Our top pick is RBC (BUY, $112), then TD (BUY, $76) and BMO ... We remain Neutral on BNS ($82)."

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Fiscal 2018 is expected to be a "transition" year for Just Energy Group Inc. (JE-T, JE-N), according to Canaccord Genuity analyst Raveel Afzaal.

Also citing a recent run-up in share price and a reduction in his target in reaction to its fourth-quarter 2017 financial results, Mr. Afzaal downgraded the Mississauga-based energy management solutions provider to "hold from "buy."

On Wednesday, Just Energy reported quarterly earnings before interest, taxes, depreciation and amortization of $75-million, ahead of Mr. Afzaal's projection of $72-million though slightly beneath the Street's expectation of $77-million. At the same time, it introduced 2018 EBITDA guidance of $210-million to $220-million, compared to the analyst's estimate of $222-million and the consensus of $234-million.

"We would have been concerned if JE expects continued net customer decline and gross margin per RCE [residential customer equivalent] (which have been increasing) to flatten out resulting in year-over-year EBITDA decline," said Mr. Afzaal. "However, according to management, it is focused on turning net customer growth back into positive territory and expects to see increased costs associated with this in F2018. Management stated its F2018 EBITDA guidance is lower than F2017 EBITDA as it is making significant investments to facilitate geographical and product suite expansion as well as in the form of up-front commissions to drive customer growth. JE realizes 50-per-cent upfront commissions and 50 per cent in residual commissions to acquire residential customers in North America, but the percentage is skewed more in favour of upfront commissions in Europe. It expects residential customer growth in Europe to play a significant role in improving net customer growth. It expects EBITDA growth to turn positive again in F2019 as upfront costs associated with these F2018 initiatives are removed."

Noting the company's residential customer base declined by 4 per cent in fiscal 2016 and 5 per cent in 2017, Mr. Afzaal thinks management has taken appropriate steps to reverse the trend. However, he also emphasized the magnitude of net customer growth is "difficult to predict."

"First, it shed unprofitable customers, resulting in improved margins, and more recently has been focused on expanding its geographical presence in Europe (Germany and Ireland following success in UK) and sales channels (on-line, telemarketing and retail kiosks) as well as introducing new products (flat bill product) and loyalty programs," he said. "However, many of these initiatives are in early days, require significant de-risking and will take time before they make a material impact on JE's financial performance given its large customer base. We believe the current low and stable energy price environment also makes it more challenging to convince complacent customers to switch service providers. This makes it difficult to estimate F2019 EBITDA with a high degree of confidence until we see a few quarters of net customer growth in F2018."

After lowering his 2018 EBITDA estimate to $212.9-million (from $222.4-million), he reduced his target price for the stock to $8.25 from $9. The analyst average target price is $9.31, according to Bloomberg data.

"We initiated coverage of JE in November 2016 when it was trading at enterprise value/F2017 EBITDA of 7.2 times well below its historical average of 8.5 times," the analyst said. "Given the steps taken by management to improve its balance sheet and payout and given the recent share price appreciation, EV/2018E EBITDA has expanded to 8.3 times. JE's net debt to EBITDA, which averaged 6.3 times between F2013 and F2015, declined to 1.8 times in F2017. Similarly, its payout ratio, which averaged over 100% during F2013 and F2015, was reduced to 60 per cent in F2017."

Elsewhere, CIBC World Markets analyst Kevin Chiang lowered his target to $8.50 from $9.

"JE reported Q4/F17 results in line with expectations, while the company's leverage ratio is now within its target range," he said. "That said, JE is guiding to  fiscal 2018 EBITDA that is below expectations as it invests in growth. While the long-term outlook is unchanged, we expect the knee-jerk reaction to F2018 guidance will be for the market to be disappointed. We maintain a Neutral rating as we wait for greater visibility on the earnings contribution from JE's growth initiatives, but could see a more compelling entry point at the $7.25- $7.50 level."

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The first-quarter earnings season for Canadian large-cap energy producers was "relatively quiet," said Canaccord Genuity analyst Dennis Fong.

"We remain focused on a modest and improving commodity price environment through the end of 2017 with the projected oil price averaging $55 (U.S.) per barrel in 2018 and $60 longer-term," he said. "Given the oil price volatility, we continue to favour Suncor Energy as a defensive way to gain energy exposure with a pipeline of catalysts including first production at its Fort Hills oil sands mining project and Hebron. We believe some of the major themes investors will focus on include exposure to heavy oil (in light of current differentials), improving cost structures and further oil supply concerns on the back of impressive Permian well results and other takeaways from U.S. E&P Q1/17 earnings."

However, in a research note on the sector, he said there is potential for a "positive trading opportunity" for Cenovus Energy Inc. (CVE-T) around its investor day on June 20.

"We expect the close of the final of two significant acquisitions within the oil sands space to occur within the next month, providing step changes in production for both CNQ and CVE," he said. "For CNQ we believe a majority of the synergies are understood by the market in terms of improving operating cost structure and lower G&A costs with running a geographically concentrated operation at AOSP and Horizon. In addition, CNQ has a history of acquiring assets and showing a step change in cost efficiencies. For CVE, we believe investors have a 'show me' attitude towards the Deep Basin assets. In addition, we see the completion of asset sales being paramount to helping improve balance sheet strength. Looking forward, we expect significant commentary around the investor day on the resource potential from the Deep Basin and where the company can show incremental oil sands growth with the application of solvent technology which could be positive catalysts for the share price."

He maintained a "hold" rating for Cenovus shares and lowered his target to $15 from $16.50. The analyst consensus price target is $18.91, according to data from Thomson Reuters.

"In 2017, we estimate IMO and CVE as having relatively higher corporate exposure to heavy oil with 58 per cent and 43 per cent stemming from unhedged/un-integrated production, respectively," said Mr. Fong. "We highlight ECA and SU as the two companies with the least naked (heavy) oil exposure. Given a modestly improving oil price environment, CNQ, IMO and CVE could see the largest expansion in 2017E cash flows. We remain focused on improving cost structures across both the oil sands players as well as ECA. Companies have looked to shed higher cost assets over the past few years and have improved operating efficiencies to increase profitability in the current volatile commodity price environment. In aggregate, oil sands companies have shown significant operating cost improvements since 2014 of ~26% to $33.29 per barrel ($25.01 U.S.) for synthetic light crude and $10.02 per barrel ($7.52 U.S.) for bitumen in 2017. Encana has continued to manage its operating and capex structure through its centralized supply chain management and shedding non-core assets."

Heading into the second half of the fiscal year, Mr. Fong said his top pick in group remains Suncor Corp. (SU-T), which he has given a "buy" rating and $52 target (versus $48.50 consensus). He also maintained "buy" ratings for Encana Corp. (ECA-N, ECA-T) and Canadian Natural Resources Ltd. (CNQ-T, CNQ-N).

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Saying "let the beauty parade commence," RBC Dominion Securities analyst Richard Hatch believes the current valuation metrics for Dominion Diamond Corp. (DDC-N, DDC-T) are "attractive."

However, he said they require belief in its Jay Project in its majority-owned Ekati mine in the Northwest Territories, which he questions the viability of.

"Dominion hosts an exploration workshop and site visit to the Ekati mine in Canada next week for sell-side and buy side investors," said Mr. Hatch. "Given the emergence of Washington Corporation's interest in the company and an indicative expression of interest at $13.50 U.S. per share, DDC has been subject to continued bid anticipation, with the Canadian Pension Plan Investment Board (CPPIB) linked to a potential bid for the company and peer Stornoway Diamond Corp also linked to a potential merger. None of the companies have commented … We expect the company to use this trip as an opportunity to highlight the value within DDC that it thinks the market is missing. We believe that while DDC has the potential to present an attractive investment, this is, in our view, predicated on (i) the success of the Jay pipe and (ii) a robust rough diamond market. Further upside, for example through exploration, opportunistic M&A and exploitation of other ore bodies on the Ekati property (such as Fox Deep and Misery Deep) is possible, with the latter likely to be a focal point of the trip."

Mr. Hatch expressed concern about the economics of the Jay projecting, noting the company's trading discount is driven "predominantly" by the market's perception that it is not as robust as Dominion believes.

"Jay‎ is‎ likely‎ to be a focal point of the site visit as the market seeks further colour on the economic viability of the project and how dependent it is on rising prices and a favourable CAD (we think a lot)," he said.

"We remain cautious on the Jay project and believe that it is dependent upon better prices and robust demand. As we have previously flagged, we see potential for rough diamond supply increasing in the near-term as new mines ramp up and existing producers either increase production or hold steady (with De Beers and ALROSA seeking to maintain market share). This could, in our view, result in a surplus of supply over demand (particularly in smaller goods) and weigh on Jay prices. Our Ekati NAV [net asset value] reduces to $141-million (U.S.) from $355-million if we hold Jay prices flat."

With a "sector perform" rating (unchanged), Mr. Hatch raised his target price for Dominion Diamond stock to $12 (U.S.) from $10. Consensus is $15.36.

"We have gone back over time to look at how DDC has traded on a P/NAV [price to net asset value] basis and on an EV/EBITDA [enterprise value to earnings before interest, taxes, depreciation and amortization] basis," he said. "The company has tended to trade at a discount to NAV due to a mixture of a shorter mine life, a complicated reporting structure (which is improving) and concerns over Jay. While the company reiterates its belief that Jay is the future of Dominion, we believe the market still has its concerns, particularly given relatively tight project economics and lacklustre pricing for these goods. Further, the EV/EBITDA multiple has reduced over time as the market factors in the reducing mine lives of both Diavik and Ekati. We think that while DDC now has the Jay project which can extend its Ekati life of mine to 2033, pushing out the rehabilitation liability, concerns over the viability of the Jay project continue to weigh on sentiment and are driving the subdued EV/EBITDA; this is likely to remain until the company can convince the market of the merits and financial viability of the project."

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Painted Pony Petroleum Ltd. (PPY-T) is "bigger, better, stronger" from its acquisition of UGR Blair Creek Ltd, said TD Securities analyst Juan Jarrah upon resuming coverage of the stock.

"At 84.8 million BOE/d [barrels of oil equivalent per day] in 2018 estimated, this ranks Painted Pony as one of the largest pureplay Montney producers in the basin," he said. "Unlike other deals that we have seen lately, the Painted Pony/UGR transaction is strategic in that it expands an existing core area. And as we have discussed in the past, the continued weakness in commodity prices and western Canadian access to markets will necessitate consolidation in the E&P space in order to generate operating synergies, improved access to services, improved access to infrastructure, and improved access to capital markets. Therefore, we are of the strong view that not only is this transaction a strategic fit with existing assets, but it will help leapfrog Painted Pony into a position of strength in the near-term."

He added: "The total 61 million in shares issued as a result of the $111-million financing and 41 million share consideration paid for UGR has resulted in improved leverage metrics with Q4/17 net debt/cash flow decreasing to 1.3 times (from 1.6 times prior) and significantly improved bank line liquidity (64 per cent drawn versus 100 per cent in 2017 previously). In our view, the dilution is offset by an improved balance sheet (note that our 'prior' estimates exclude the impact of our commodity price update that took place during our restriction)."

Calling Painted Pony "an attractive investment relative to the peer group" based on its current valuation, he reduced his target price to $12 from $14.50. Consensus is $8.58.

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In other analyst actions:

Cantor Fitzgerald analyst Rob Chang initiated coverage of GoGold Resources Inc. (GGD-T) with a "buy" rating and $1.80 target. The analyst average target is $1.87, according to Bloomberg.

Raymond James analyst Justin Patterson downgraded Expedia Inc. (EXPE-Q) to "market perform" from "outperform" without a specified target. The consensus target is $153.30.

Wedbush analyst Nick Setyan upgraded Shake Shack Inc. (SHAK-N) to "outperform" from "neutral" and raised his target to $43 (U.S.) from $33. The average is $38.56.

Credit Suisse analyst Robert Moskow downgraded B&G Foods Inc. (BGS-N) to "neutral" from "outperform" and dropped his target to $42 (U.S.) from $47. The consensus average is $44.83.

Wedbush analyst Seth Basham upgraded CarMax Inc. (KMX-N) to "outperform" from "neutral" and increased his target to $70 (U.S.) from $60. The average is $67.

Baird analyst Ben Kallo downgraded First Solar Inc. (FSLR-Q) to "neutral" from "outperform" with an unchanged target of $38 (U.S.). The average is $36.95.

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