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Tuesday's analyst upgrades and downgrades

An Air Canada Rouge plane prepares for a flight to Las Vegas at Vancouver International Airport in Richmond, B.C., on Monday, April 28, 2014.

DARRYL DYCK/THE CANADIAN PRESS

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

The third-quarter results for Air Canada (AC-T) reflected a "strategic contradiction," according to Raymond James analyst Ben Cherniavsky.

He upgraded his rating for the airline's stock to "market perform" from "underperform" in reaction to the results as well as "a narrative that is proving to be highly intractable (i.e. 'don't fight the tape')."

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"However, we still do not advise the purchase of these shares and continue to prefer other airline stocks over Air Canada," said Mr. Cherniavksy.

On Monday, Air Canada reported quarterly revenue and earnings before interest and taxes of $4.451-billion and $896-million, respectively. Both results topped the analyst's projections and were increases year over year.

"The major source of the 'beat' was monstrous capacity growth of 21 per cent, nearly twice our forecast," said Mr. Cherniavsky. "This juiced revenues and drove unit costs down. It also diluted yield and PRASM [passenger revenue per available seat mile], but not by as much as we feared. Atlantic and Pacific PRASM did plummet, although f/x offset some of the pressure. Also, PRASM in the domestic market was relatively stable.

"Once again, fuel boosted Air Canada's profits. Using 3Q15 fuel prices (and f/x rates), 3Q16 EBT would have declined $40-million year over year. This tailwind is now poised to become a headwind at current oil prices."

Mr. Cherniavksy noted its EBIT margins declined 0.2 per cent year over year despite lower fuel costs and "enormous" capacity growth, which he said should impact operating leverage.

"Its ROIC [return on invested capital] also fell a full 250 basis points, reflecting the incremental capital required to generate the growth," he said. "Similarly, year-to-date free cash flow is negative $628-million (approximately $2.25 per share).

"Another way of analyzing the fuel-adjusted net cost/benefit of excess capacity is to compare the change in RASM vs. non-fuel (NF) CASM. For 3Q16, the former fell 9 per cent and the latter 6 per cent (i.e. ASMs are diluting revenues more than costs). RASM, in fact, has fallen by more than NF CASM every quarter since oil prices collapsed …. This directly contradicts what management stated two years ago when they were pressed on the risks of accelerated capacity growth: 'our strategy [is that] we expect there to be RASM decline, but the CASM decline will be significantly greater. That is the business model we're looking for.' (2Q14 conference call, Aug. 7, 2014)."

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Mr. Cherniavsky raised his target price for the stock to $12.50 per share from $10.50. The analyst consensus price target is $15.16, according to Thomson Reuters.

"We advise investors not to extrapolate annualized trends from Air Canada's busiest (3Q) period," he said. "Indeed, the real litmus test always comes in the winter, when capacity gets parked and unit costs surge … Moreover, despite the 3Q16 beat, we still expect 2016 and 4Q16 profits and margins to be down year over year. We also note that Air Canada still has the industry's most leveraged balance sheet, lowest margins, and highest BELF [break-even load factor], which continues to support our discounted valuation."

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The market has only partially acknowledged the value of Ivanhoe Mines Ltd.'s (IVN-T) Kaklula copper deposit at its Kamoa project in the Democratic Republic of Congo, said BMO Nesbitt Burns analyst Andrew Mikitichook.

Expecting further revaluation with the delivery of both engineering and development milestone, Mr. Mikitichook reinstated coverage of Ivanhoe with an "outperform" rating.

"The Oct. 12 initial resource at Kakula - in our opinion - elevates the discovery's value above Ivanhoe's other assets and should attract the majority of the market's attention," he said. "Kakula's exceptionally high grades should allow early mining at almost twice the grade of Kamoa in addition to being thicker, flatter, and shallower. Kakula is the only large discovery we are aware of minable at 6-plus-per-cent copper.

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"For its three largest assets, Ivanhoe has arranged joint ventures to reduce financing risk. Zijin Mining is currently earning into a 40-per-cent interest in Kakula and Kamoa (with $82.4-million (U.S.) in payments left to complete) and holds a 9.9-per-cent interest in Ivanhoe mines. JOGMEC has purchased a 10-per-cent interest in the Platreef deposit. In our opinion, joint ventures on these sizeable assets still leave significant exposure for Ivanhoe's shareholders and do not extinguish potential takeover upside – a significant portion of world-class assets owned/developed/operated under joint ventures."

Mr. Mikitichook pointed to the presence of both financing and political risks as reasons for concern from investors.

"Ivanhoe's valuation is most sensitive to the copper commodity price assumptions," he said. "The long asset lives and high grades reduce their leverage to both capex and unit costs. Technically, we see only moderate development and operating risks as we are assuming relatively common mining and processing methods. The proposed scale of development, especially in probable expansions beyond our assumptions, will likely present as the most challenging technical risk. Financing risk is always a concern for development-stage assets. While Ivanhoe has four assets in relatively advanced stages of development, they have secured joint ventures on three of them to offset some financing burden. We would also suggest that management has flexibility to delay or slow spending on some projects to focus resources on higher-value assets. With $477-million of cash and purchase price receivables, our forecasts show the company is fully financed to advance all four assets through 2017 at least. We believe any development decisions will likely include debt financing (there is currently no project debt) to further reduce equity dilution. Our valuation does not include any assumptions of financing dilution/costs but we use a P/NAV [price to net asset value] target-setting multiple below that of financed peers. We maintain this multiple above those of other developers due to the exceptional grades and scale of Ivanhoe's assets.

"Investors always monitor political/jurisdictional risk for projects – especially on the African continent. The lead Kakula/Kamoa assets in the southern Congolese copper belt are in the vicinity of several operating mines with extended operating track records including those owned by seniors Glencore, FreeportMcMoRan, and MMG. Overall, we consider this a more stable portion of the Congo and a justifiable investment destination, especially considering the scale and grade of Kakula/Kamoa. The Platreef deposit in South Africa is also perceived to be exposed to jurisdictional risk but we contend that South Africa is a known destination for investments in platinum/palladium deposits."

Mr. Mikitichook's target price for the stock is $3.25. Consensus is $2.15.

"Our valuation shows that Kakula, discovered in early 2016 and having delivered an initial resource in October 2016, represents 53-per-cent of Ivanhoe's total NAV [net asset value]," he said. "In our opinion, the impact of this discovery is not fully recognized by the market and we expect the PEA – due at the end of 2016 – to be an important catalyst for the company. We have chosen not to include any comparable tables as we are not aware of any advanced base metals developers with assets of similar size and grade to Ivanhoe's."

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Though he said there were "no surprises" in the first-quarter 2017 results for Absolute Software Corp. (ABT-T), BMO Nesbitt Burns analyst Thanos Moschopoulos lowered his target price for the stock.

"The stock has sold off significantly in recent weeks in the aftermath of Q4/16 results, when management had guided for an unexpectedly large ramp in R&D spending," said Mr. Moschopoulos. "We don't see much downside from current levels, given the stock's current valuation of 1.4 times enterprise value/sales (which makes it, quite literally, one of the cheapest stocks in the SaaS universe—at least based on that metric) and the fact that Absolute is a growing, recurring revenue business with a high revenue retention rate.

"However, it's been our experience that a cheap EV/sales valuation alone isn't necessarily sufficient to drive upside to a small-cap tech stock; we think the stock might be range-bound until Absolute's growth rate accelerates, and/or until operating leverage resumes (and Absolute's EV/EBITDA valuation starts to look more reasonable). The latter might take some time, although the former could possibly happen sooner, contingent on the success that Absolute might have with all the new capabilities that it's planning to add to its platform over the coming months."

On Monday, the Vancouver-based company reported revenues of $22.5-million, in line with projections and up 6 per cent year over year. Adjusted earnings before interest, taxes, depreciation and amortization of $1.9-million fell slightly below the consensus estimate of $2.3-million. Cash flow from operations per share was 5 cents, below the consensus of 15 cents due largely to the timing of cash taxes.

"DDS [Data and Device Security] billings of $19.7-million were up 1 per cent year over year," the analyst said. "The consensus for billings is unclear; however, management had previously guided for soft billings growth this quarter due to a tough year-over-year renewal comp. Management noted that the overall renewal opportunity is up in the mid-single-digits on a year-over-year basis, and up most significantly in Q4/17. We consequently expect double-digit billings growth through the remainder of the year."

Mr. Moschopoulos maintained a "market perform" rating for the stock and lowered his target to $7.50 from $8.50. Consensus is $9.48.

"We believe that Absolute is making steady progress in re-accelerating its revenue growth, following significant changes to its sales team and go-to-market strategy," he said. "However, we believe that the near-term upside to the stock will be constrained by the negative operating leverage that Absolute will experience in FY2017."

Elsewhere, Canaccord Genuity analyst Doug Taylor called the results "mixed" and maintained his "buy" rating with a $8.50 target.

He said: "We are willing to look through lower near-term profitability as Absolute builds toward a targeted 20-per-cent growth/20-per-cent EBITDA margin model over the next 3-5 years. We believe this type of model should command a higher valuation multiple, however Absolute is likely to trade at a discounted valuation while traction builds through a year of investment. Still, we believe that the current 5-per-cent-plus yield adequately compensates investors to wait through the year of investment given the potential for a much higher reward if the company is successful in achieving its target."

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The valuations for U.S. banks are now full with limited upside, according to Citi analyst Keith Horowitz.

"Our favorite valuation metric, the implied cost of equity, is now at 10 per cent for the banks which based on history indicates the banks are fairly valued," he said. "We believe 1-2 rate hikes are priced into the group, and thus we believe the bar is relatively high with our expectations of prolonged low rate/low growth environment. We believe the best time to take profits is when the risk/reward is not compelling, and with the BKX just 6 per cent off its all-time high back in July of 2015 (when we estimate the market was pricing in 150-200 basis points of rate hikes), we are downgrading 3 of our 6 buy rated names."

He lowered his ratings for Citizens Financial Group Inc. (CFG-N), KeyCorp (KEY-N) and Goldman Sachs Group Inc. (GS-N) to "neutral" from "buy."

"We had upgraded KEY to buy a year ago post the FNFG [First Niagara Financial Group] deal as we felt the market was considering only the cost without looking at the underlying returns, which were attractive (about 15-per-cent internal rate of return)," he said. "The negative sentiment is rolling off with the deal closed, as KEY's implied cost of equity is just 10.5 per cent now versus 10.1 per cent for the group, reducing upside (9 per cent). CFG has also been on a nice run post earnings, outperforming the BKX by 310 bps, which has limited upside, now trading at 12.6x 2017 EPS [earnings per share] and a 10.1-per-cent implied cost of equity, both inline with the group (12-per-cent upside). We are downgrading GS to Neutral as under our valuation methodology we would need to see a path to 14-per-cent ROTE [return on tangible equity] which seems like a relatively high bar for GS given it's expected ROTE in 2017 10.5 per cent."

Mr. Horowitz also said the best outcome from Tuesday's U.S. presidential election, from the point of view of the banks, is status quo.

"It seems to us that there are two main risks around stocks at this point: political risk heading into Tuesday's election and interest rate risk," he said. "We do not like the risk/reward on the political side. Best case scenario seems to us to be a 'status quo' with a Clinton victory combined with a Republican-controlled Senate, as detailed in our note from May. A Trump victory, given the uncertainty around policy implications, or a Clinton victory with the Democrat-controlled Senate, would likely result in downside, particularly for the banks in the latter case, as it would renew fears about increased regulation. Also, a Clinton victory without a Trump concession also would not be an ideal scenario. From a fundamental perspective, the key driver of the stocks recently has been rates, with the banks basically moving inline with rates. However, with the market now pricing in a 80-per-cent plus probability of a December rate hike which is embedded in estimates (our estimates are roughly inline with consensus for 2017), we don't see significant upside."

Mr. Horowitz made several target price changes to stocks in the sector, including:
 
- Bank of America Corp. (BAC-N, "buy" rating) to $19 (U.S.) from $18. Consensus: $17.92.
- BB&T Corp. (BBT-N, "neutral" rating) to $37 from $35. Consensus: $39.91.
- Goldman Sachs to $200 from $195. Consensus is $187.38.
- JP Morgan Chase & Co. (JPM-N, "neutral" rating) to $72 from $70. Consensus: $72.14.
- Morgan Stanley (MS-N, "neutral" rating) to $34 from $33. Consensus: $35.13.
- U.S. Bancorp (USB-N, "neutral" rating) to $44 from $40. Consensus: $45.56.
- Wells Fargo & Co. (WFC-N, "buy" rating) to $51 from $54. Consensus:  $49.29.

His targets did not change for:

- Citizens at $29. Consensus is $28.43.
- KeyCorp at $15. Consensus is $15.25.

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Better quarters are to come from Tahoe Resources Inc. (THO-T, TAHO-N), said Desjardins Securities analyst Michael Parkin.

"After following up with management and updating our model for the weaker-than-expected 3Q16 results, we are slightly more positive on Tahoe," he said. "We see lower risk of an increase in the Guatemalan tax rate in the near term, based on management comments, and we expect modestly better operating results. We still believe Escobal has higher tax risk, but this could be a longer-term issue."

On Nov. 3, Tahoe reported earnings per share of 21 cents (U.S.), a penny ahead of both Mr. Parkin's estimate and the consensus. Cash flow per share of 34 cents, topped Mr. Parkin by 2 cents and the consensus by 4 cents.

"Gold production was weak compared with consensus of 103,200 ounces at total cash costs of $669/oz, while silver production was in line with 4.89-million ounces at total cash costs of $6.68/oz," said Mr. Parkin. "We note that the company capitalized $16-million of costs associated with pad inventory expected to be produced in later quarters at Shahuindo, which drove the cash cost beat for the gold division. We believe this was unexpected by the Street. Reversing that inventory charge would have increased the average cash cost for the gold division by $150/oz, thus missing consensus significantly. It is normal for heap leach producers to capitalize opex when they expect to recover an inventory build of ounces—in this case due to a water shortage—but it does make it difficult to compare results."

He added: "Looking more closely at the operational performance at the asset level, all gold mines produced less gold than we were forecasting, while silver production was in line with our estimates at Escobal. Overall we were underwhelmed by the operating results. Inventories in the category of 'finished goods' or 'work in process' rose by $6-million (U.S.) in the quarter, and have risen by $23-million year to date. We expect these inventory levels to stabilize going forward as Shahuindo now has sufficient water to run at planned capacity on the heap pad. The disappointing production from Shahuindo was due to the shortage of water at site (as a result of a regional drought and single well source), which has since been remedied with additional wells added. However, we were surprised by the lack of production from the Timmins mines, which produced 17 per cent less than we expected and fell 9 per cent quarter over quarter due to a series of development delays. Management did not provide details in the release, but confirmed that the delays have now been resolved."

With an unchanged "buy" rating, Mr. Parkin raised his target to $22 from $21.50. Consensus is $24.76.

"We believe Tahoe's significant silver production (37.1 per cent of 2016 revenue) is the main reason why it trades at a significant premium to gold-producing mid-tier peers, as the purest silver producers are generally trading at similar premiums," he said. "Further M&A activity that builds out the gold division could put this premium multiple at risk, in our opinion, but management has stated that it has no plans for further deals in the near term."

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In other analyst actions:

Concordia International Corp. (CXRX-Q) was downgraded to "sector perform" from "outperform" by RBC Capital Markets analyst Douglas Miehm with a 12-month target price of $2.50 (U.S.) per share, down from $10.. The analyst average is $1.93, according to Bloomberg.

IAMGOLD Corp. (IMG-T) was raised to "buy" from "hold" at TD Securities by analyst Steven Green. His target price is $7.50 (Canadian) per share, up from $7. The average is $7.25.

AT&T Inc. (T-N) was downgraded to "market perform" from "outperform" at Oppenheimer & Co by analyst Timothy Horan with a target price of $46 (U.S.) per share (unchanged). The average is $41.76.

Evercore ISI analyst Greg Melich upgraded Sherwin-Williams Co. (SHW-N) to "buy" from "hold." He did not specify a target price. The average is $307.85 (U.S.).

Mr. Melich downgraded Best Buy Co. Inc. (BBY-N) to "sell" from "hold." He did not specify a target. The average is $38.21 (U.S.).

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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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