Tuesday's analyst upgrades and downgrades

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

The current price for shares of Freehold Royalties Ltd. (FRU-T) is a "reasonably strong" entry point for investors, said Acumen Capital analyst Trevor Reynolds.

He initiated coverage of the Calgary-based energy company with a "buy" rating.

"FRU is an O&G royalty company with an emphasis on the maximization of distributable income, while striving to achieve long term growth per share," said Mr. Reynolds. "The royalty model provides strong margins based on modest capital requirements, and returns which are not burdened by operating costs and crown royalties. FRU maintains a conservative balance sheet with a focus on an effective, strong audit process. Growth is driven by acquisitions, free drilling, and the creation of royalties and lease outs. FRU has a strong track record of growing production and royalty exposure through acquisitions, a trend that has continued in the current market environment. Over $30 per share has been paid out since the IPO, while the management team has been proactive in adjusting payout levels to remain 100-per-cent sustainable."

Mr. Reynolds emphasized Freehold has generated almost 93 per cent of its operating income through royalties in the third quarter of 2016. He noted royalties are "high margin for the owner, providing participation in the production from a well, without exposure to costs," adding this model has been resilient to cyclical pricing in recent years.

"FRU's focus is on the maximization and growth of income from royalties, to support payouts to shareholders," he said.

"With the depletion of reserves over time, capital is generally required to acquire production and CF [cash flow]. FRU generally targets individual, or groups of properties with a focus on royalty interests. Key points of focus in acquisitions include asset quality, return/risk profile, and life cycle. FRU generally funds acquisitions with equity, and have been quick to adjust the dividend to maintain a sub 100-per-cent payout ratio. As a result, FRU's debt to CF has generally remained strong. Over the last two years debt increased relative to declining CF based on industry activity, and continued participation in WI drilling. In the third quarter FRU produced Free CF of almost $11-million which was used to reduce debt, which currently sits at $87-million, or 0.9x annualized quarterly CF."

Mr. Reynolds set a price target of $16.15 per share. The analyst average price target is $15.56, according to Bloomberg.

"As FRU continues to execute on its transition, we see upside to the multiple and potentially a dividend increase over the near to medium term," he said. "We recommend investors take advantage of dips in this high quality name in order to build a position."

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In raising his target price for Advantage Oil & Gas Ltd. (AAV-T, AAV-N), Raymond James analyst Kurt Molnar said he is not aware of a comparable growth plus free cash flow combination in the Canadian energy equity market.

On Monday, Advantage released its 2017 budget and development plan as well as estimates for 2018 and 2019.

"Advantage provided formal 2017 guidance along with a broader insight into growth to 2019 that should see production grow at 16-per-cent per annum in that period (20-per-cent per annum in cash flow under their gas price forecast scenario) where debt should also fall from $165-million at the end of 2016 to as low as only $55-million as at the end of 2019," said Mr. Molnar. "By the end of 2017 debt to cash flow is already forecast to be approximately 0.8 times while it could be in the order of only 0.2 times while production growth of 16-per-cent per annum is delivered. Most importantly in our view, full PDP recycle ratios (returns on capital) should be in the order of 2:1. Within all these headline results the Company noted a number of updates that included reduced capital and cash costs."

He added: "The Company provided its first new information from early tests into the Upper and Middle Montney on their exploratory land block at Valhalla. We have long hinted this area held the potential for greater liquids leverage and the early data supports this view. The Company noted an NGL ratio of 45 bbls/mmcf suggesting liquids leverage in the order of 20 per cent while the current corporate cocktail is only 4-per-cent liquids. Advantage noted an accelerated expansion of the Glacier facilities (from 350 mmcfd to 400 mmcfd) that also included a material uptick in their liquids handling capacity to 6,800 Boed (while NGL production in 2017 is only forecast at 1,600 Boed). The size of build out in NGL capacity suggests to us: (1) Valhalla will get a material capital allocation in 2018 & 2019 in particular; and/or (2) Advantage is setting up the capacity to handle third party liquids which would bring industry leading cash operating costs even lower. Either of these, or some combination, is appealing to us."

Mr. Molnar raised his target price for the stock to $13.50 from $12.75. The analyst consensus price target is $11.52, according to Thomson Reuters.

He did not change his "outperform" rating.

"In the past we have noted that Advantage was likely to face the investor debate of going faster or perhaps paying a dividend," said Mr. Molnar. "For the time being, management sees going faster while building a bullet proof balance sheet as the best strategy given risk inherent/possible in North American gas prices. We applaud their conviction in putting as much emphasis on safety as growth. With that said we expect there remain more potential positive surprises (at Glacier, Valhalla and Wembley) beyond this update over the balance of 2017."

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Desjardins Securities analyst Gary Ho initiated coverage of Founders Advantage Capital Corp. (FCF-X) with a "buy" rating.

"Founders Advantage Capital Corporation (FAC) is a public investment company with a unique investment model that creates long-term value for its shareholders and partner investees (sellers) by acquiring founder-run, cash-flow-positive, middle-market private entities while incentivizing investees through disproportionate upside in the company's future growth," said Mr. Ho. "This unique model has allowed FAC to tap into a niche market of reluctant sellers which has historically been untouched by traditional private equity players.

"FAC's unique investing structure requires it to have a controlling stake of partner companies. We view this as both a defensive and offensive strategy. Defensively, while FAC fully intends to be a passive permanent investor, having a controlling stake significantly reduces downside risk, in our view, and allows FAC management to step in if the investment underperforms. Offensively, we see the structure as mutually beneficial to the investee, FAC and FAC's shareholders—a win-win-win strategy. The disproportionate sharing structure allows FAC to acquire companies at a lower upfront multiple (a discount to an exit multiple). We go through a detailed example of how an investment could play out over a seven-year period using assumptions similar to FAC's first two acquisitions. Net-net, we forecast an attractive high-teens to low 20-per-cent IRR [internal rate of return], which compares favourably with FAC's 10–11-per-cent cost of capital."

Mr. Ho cited four reasons for being "positive on the FAC story." They are: "(1) Its unique investing structure incorporates both defensive (having a controlling stake reduces downside risk) and offensive (incentivizing investee to grow the company) attributes. (2) It taps into a niche market of reluctant sellers, which has historically been untouched by traditional PE firms. (3) CEO Stephen Reid has deep relationships with M&A advisors, providing FAC with a healthy deal pipeline. (4) We like DLC's positioning in the mortgage broker industry with 40-per-cent market share and great prospects with onboarding brokers and launching new ancillary products. That said, we expect some growing pains as investors digest FAC's unique structure. Moreover, concentration risk is a near-term concern (DLC represents 54-per-cent of our NAV), particularly around Canadian housing headline risk. With the company's ambitious plan to build out a portfolio of 10 investments over the next 2–3 years, we anticipate this risk to moderate."

Mr. Ho set a price target of $4.75 for the stock, citing a 28-per-cent total potential return. There are currently no other analysts covering the stock, according to Bloomberg.

"Founders Advantage Capital (FAC) is an investment company with a unique concept that creates long-term value for its shareholders and investees (sellers) by acquiring founder-run, cash-flow-positive, private entities while incentivizing investees through disproportionate upside," he said. "We believe this concept benefits the seller (better upside), FAC and shareholders (aligned interest, controlling stake, growing dividends)."

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Thor Industries Inc. (THO-N) is "in cruise control," said BMO Nesbitt Burns analyst Gerrick Johnson in reaction to the release of its first-quarter 2017 financial results.

"Demand in the RV industry remains quite solid, with consistent double-digit y/y retail sales growth in the US, benefitting from an ongoing replacement cycle (spurred by rising home prices, low interest rates, and innovation), the aging and retiring of America, and an overall renewed popularity of RVing and RV culture among younger consumers and families," said Mr. Johnson. "And we continue to see a positive outlook for the RV industry."

On Monday, the Illinois-based recreational vehicle manufacturer reported quarterly earnings per share of $1.49 (U.S.), 21 cents higher than Mr. Johnson's estimate and 26 cents higher than the Street consensus. It's a 53-cent improvement year over year.

"If anything, the beat should have been higher, as non-recurring and non-cash amortization cost attributable to the Jayco acquisition amounted to $12.9-million, or about 17 cents per share," the analyst said. "The primary source of the earnings 'beat' was significantly better-than-expected revenue (particularly at Jayco) and slightly better gross margin performance.

"Thor has now beaten consensus EPS for six consecutive quarters by an average of nearly 17 per cent according to FactSet. And Thor does not provide earnings guidance; thus the beats have been true beats and not engineered by management through lowballing guidance."

Though he maintained his "market perform" rating for the stock, Mr. Johnson expressed concern that its valuation "is such that the risk outweighs potential reward."

"We downgraded the stock in June, as we had been concerned that potential cost issues could arise from capacity constraints, rising input costs, and mix towards entry-level and lower-cost RVs," he said. "We have seen constraints in capacity and labour have an adverse impact on the company's margins and earnings in the past. And with many of the company's factories once again reaching full capacity, our fear that another round of buildouts and expansion could increase start-up costs and add to depreciation expense while triggering labor inflation and warranty expense increases. We are still concerned about capacity constraints. But the company has, thus far, managed to grow its business and satisfy continued strong demand while avoiding these issues. And the financial results the company has been able to generate have been truly impressive, in our opinion. At this point, however, after a strong run for the stock, which now commands a premium valuation on massive increases in earnings estimates, we are concerned that risks could outweigh rewards. We will be attending the National RV Show in Louisville later on [Tuesday] where we will meet with management. We hope to learn more about the details behind the strong first quarter earnings results as well as the outlook for the company."

Mr. Johnson raised his 2017 fiscal EPS projection to $6.80 from $5.90. His calendar year estimate, which he notes is more comparable with its sector peers, rose to $7.30 from $6.23.

He increased his target price for the stock to $102 from $80. The analyst average is $100.70.

Elsewhere, EVA Dimensions analyst Neil Fonseca upgraded the stock to "overweight" from "hold" without a specified target price.

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McDonald's Corp. (MCD-N) was removed from Credit Suisse's U.S. Focus List due to "a combination of higher valuation, limited near-term catalysts, and below-average exposure to potential positive drivers under the new U.S. leadership."

Analyst Jason West lowered his 2017 earnings per share estimate by 11 cents, or 2 per cent, based on a stronger U.S. dollar.

He maintained an "outperform" rating for the stock and target price of $128 (U.S.). Consensus is $127.20.

In a research report on the U.S. restaurant sector, Mr. West upgraded Del Frisco's Restaurant Group Inc. (DRFG-Q) to "outperform" from "neutral." He raised his target for the stock to $19 (U.S.) from $15. Consensus is $16.25.

"We view DFRG as the most effective way (in restaurants) to gain exposure to several of Trump's stated priorities, notably individual and corporate tax reform," the analyst said. "Under Trump's proposal, consumers in the top two income quintiles would see their after-tax incomes rise by 2.2 per cent and 6.6 per cent, respectively, versus 0.8 per cent to 1.8 per cent for those in the bottom three quintiles. As the most upscale chain within our coverage, DFRG is best positioned to benefit from a high-income consumer with more disposable income. Revitalized business spending from a corporate tax cut could also drive an uplift in DFRG's private dining business (15 per cent of sales excluding the Grille)."

He downgraded Darden Restaurants Inc. (DRI-N) to "neutral" from "outperform" based on valuation. He said the stock "already traded at a premium to low-growth casual dining peers." His target did rise to $72 from $59, compared to the consensus of $69.10.

"We still see DRI as an above-average story in a challenging restaurant sector," said Mr. West. "At Olive Garden (60 per cent of restaurant-level profit), we believe the combination of compelling value, ongoing operational improvements, remodels, an improved innovation and marketing function, and growth in To Go/catering should allow the brand to continue to take share. Further, based on casual dining SSS trends (per Knapp-Track) in Sept. and Oct., we believe Olive Garden and LongHorn are on track to hit F2Q17 consensus. Performance of these two core brands tends to drive investor sentiment on DRI."

On the sector as a whole, Mr. West said: "We have updated our analysis of restaurant labor costs and revised our base case scenario for minimum wage increases following the U.S. presidential election. Recall we have built a labour model that calculates the path of minimum and tipped wages on a state-by-state level, and then maps this inflation to each company's geographical store base. Our conclusion is that consensus is still under-modeling labour costs for 2017-18, even though a fed minimum wage increase is now unlikely. We have also extended our labor model to calculate EPS risk around higher-than-expected labor costs for each company. We see 3-5-per-cent EPS risk around this issue in 2017 and 2018, on average, exacerbated by diminished pricing power for the group (food deflation headwind remains)."
 
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Citi analyst Andrew Baum downgraded his rating for AbbVie Inc. (ABBV-N), citing "the substantial relative and absolute performance over the past 14 month coupled with increasing concerns over the competitive environment for its key in market assets."

He moved the Illinois-based biopharmaceutical company to "neutral" from "buy," expressing concern about its rheumatoid arthritis treatment Humira.

"We anticipate that ABBV will offset slowing U.S. script growth with continued net price increases to a much greater extent than industry peers," said Mr. Baum. "This is reflected in our above consensus 2017 and 2018 EPS forecasts. However, more importantly to the valuation, the risk to post 2017 Humira estimates has materially increased in the last 12 months for both (i) anticipated timing of U.S. biosimilar Humira entry (ii) the gradient of erosion curve post biosimilar introduction. Our price target and earnings forecasts continue to reflect first U.S. biosimilar launch of Humira in 2020, however our confidence in this outcome is significantly lower than previously envisaged. We anticipate that invalidation of the '135 patent by Boehringer in the ongoing IPR (ruling anticipated May/June 2017) would materially increase the risk of biosimilar launch in 2018 representing material downside risk to our EPS forecasts and valuation …. Given the shift in risk/ reward and mindful of the proximity of the PTAB hearings (March 2017), we have moved to the sidelines."

Mr. Baum said he has growing reservations about his stance on the Humira '35 patent.

"Namely, the commentary from one of AbbVie's own expert witnesses on a Citi hosted conference that in our eyes partly undermined AbbVie's central defense in the ongoing PTAB case relating to dose stretching/immunogenicity," he  said. "In addition, our discussions with clinical pharmacologist intrinsically involved with the original scheduling decisions for Humira materially undermine AbbVie's defense. Separately, the recent delisting of Sanofi's Lantus and Amgen's Neupogen in CVS 2017 formulary underpins the appetite to embrace biosimilars in both newly treated and established patients."

Mr. Baum lowered his target price to $60 (U.S.) from $65. Consensus is $70.

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In other analyst actions:

Tudor Pickering analyst Byron Pope expects land driller stocks to move higher in the next 12 months. Accordingly, he upgraded Precision Drilling Corp. (PD-T) to "buy" from "hold." He did not specify a target. The analyst average target is $7.54.

Home Capital Group Inc.(HCG-T) was downgraded to "neutral" from "outperform" by Macquarie analyst Jason Bilodeau. He maintained a price target of $30, compared to the average of $30.02.

Savaria Corp.(SIS-T) was rated a new "buy" from GMP FirstEnergy analyst Stephen Harris with a $14.50 target. The average is $15.56.

Buckingham analyst Kelly Halsor initiated coverage of Lululemon Athletica Inc. (LULU-Q) with a "neutral" rating and $55 (U.S.) target. The average is $68.07.

Bank of America Corp. (BAC-N) was raised to "outperform" from "market perform" at Keefe Bruyette by analyst Brian Kleinhanzl. His target rose to $23 (U.S.) from $17.50. The average is $19.72.

Mr. Kleinhanzl also upgraded Goldman Sachs Group Inc. (GS-N) to "outperform" from "market perform." His target increased to $240 (U.S.) from $185. The average is $208.45.