RBC’s favourite utility, pipeline stocks to buy as interest rates rise

The Globe and Mail

Calgary pipeline operator Enbridge is the only one out of 57 Canadian companies rated by Morningstar that has both a wide moat and a positive “moat trend.” A key part of its competitive edge is its scale: it has pipeline presences in the oil sands, the Bakken fields in the Midwest U.S., and in Cushing, Okla., as well as growth opportunities in natural gas and electricity. (Nathan VanderKlippe/The Globe and Mail)

Inside the Market’s roundup of some of today’s key analyst actions. This post will be updated with more analyst commentary during the trading day.

Rising interest rates are often an enemy of Canadian energy infrastructure and utility stocks, as they can increase debt burdens in the capital-intensive industry and encourage income-seeking investors to flock to the perceived safety of bond markets.

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Predictably, many of these companies saw sharp share price declines over the past couple of months when longer-term bond yields spiked in anticipation of less quantitative easing – or bond buying – by the U.S. Federal Reserve.

While bond yields have retreated somewhat over the past couple of weeks, RBC Dominion Securities analyst Robert Kwan believes investors need to become more selective in the Canadian energy infrastructure stocks they hold to prepare for the inevitable return to higher interest rates.

Specifically, he says investors should look for two things in particular: companies with higher-growth profiles and long-term contracts, and those companies with regulated assets that can offset the impact of higher interest rates by boosting the rates they charge customers.

RBC analysts, led by Mr. Kwan, revisited their coverage of the sector to account for a gradual – but significant – move up in interest rates. The bank’s strategists are now forecasting that the 10-year government of Canada bond yield will rise to 2.70 per cent at the end of 2013 and to 3.40 per cent at the end of 2014.

Overall, Mr. Kwan believes price-to-earnings valuations in the sector may compress 10 per cent to 15 per cent over the next 18 months.

“With that in mind, we recommend that investors favour stocks within the sector that have above-average dividend growth, underpinned by similar earnings and/or cash flow per share growth, in addition to businesses that have a measure of interest rate protection,” he said.

As a result of the new analysis, RBC downgraded four firms: AltaGas Ltd. and Keyera Corp. (both to “sector perform” from “outperform”) as well as Atlantic Power Corp. and Valener Inc. (both to “underperform” from “sector perform.”)

Its favourites now are Brookfield Infrastructure Partners L.P., Enbridge Inc. and Pembina Pipeline Corp., along with regulated utility stocks such as Algonquin Power & Utilities Corp. and Canadian Utilities Ltd., which was upgraded to “outperform” instead of “sector perform.”

“For AltaGas and Keyera, while we continue to view both companies’ businesses positively, both stocks are among the best performing stocks in our coverage year-to-date and the expected total returns to our price targets are consistent with other stocks that we have ranked sector perform,” the RBC analysts said.

“Valener’s stock is the only one in our energy infrastructure coverage universe that is up since comments from the Federal Reserve triggered 10-year GOC yields to begin rising towards the end of May. Further, with limited prospects for dividend growth, we believe that investors will gravitate to other stocks that are poised to deliver dividend growth.

"We see headwinds for Atlantic Power as the combination of higher benchmark interest rates and a recent credit rating downgrade by S&P (placed under review for potential downgrade by Moody’s) may increase the cost of capital with respect to refinancing the 2014/15 debt maturities ($386-million U.S). We do not see any medium-term dividend growth, and believe management will need to balance the use of excess cash between growing the company and deleveraging its balance sheet.

"The increased ranking for Canadian Utilities is driven by our view that regulated utility assets provide a relative measure of defensiveness against rising interest rates due to an assumed increase in regulated return on equity along with the ability to pass through higher interest expense in customer rates over time. Further, we see the shares as delivering an above average dividend growth profile along with benefiting from near-term strength in Alberta power prices.”

You can click here to see RBC’s summary of price target and ranking changes in the sector.

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While it may take a while to pay off, investors who buy Potash Corp. of Saskatchewan Inc. now will ultimately be rewarded, said Raymond James analyst Steve Hansen.

The potash industry has been busy cutting long-term capacity plans over the past nine months, with a flurry of project deferrals and cancellations around the world. While the shift is arguably for the better for the potash industry, “it will likely take time to fully appreciate,” Mr. Hansen said in a research note.

For one thing, “near-term forces” suggest muted pricing for potash in the second half of this year, he said.

“While we acknowledge it’s difficult to identify any near-term catalysts for Potash shares, we believe the current share price fails to account for the compelling medium and long-term upside we see for the shares,” he said.

Target: Mr. Hansen cut his price target by $4 to $44 (U.S.) but reiterated an “outperform” rating. The average target is $45.32 (U.S.), according to Bloomberg data.

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Cineplex Inc.’s acquisition of EK3 Technologies Inc. this week positions the company strongly in a niche growth business that is potentially still in its early phase, said Canaccord Genuity analyst Aravinda Galappatthige.

The purchase of the digital signage business may generate as much as $20-million in incremental EBITDA to Cineplex over a three-year period, he projected.

“This is meaningful for Cineplex and serves to tick up the growth profile of the business by a couple of points,” Mr. Galappatthige said. “We believe initiatives such as this, UltraViolet, and others, if successfully implemented, can help Cineplex maintain an EBITDA growth profile of 6-8 per cent over the next four-to-five years, notwithstanding its mature core business. It should also allow Cineplex to better utilize its balance sheet flexibility and move toward a more optimal capital structure.”

Target: Mr. Galappatthige maintained a “hold” rating and $31 price target. The average target is $37.08.

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SNC-Lavalin Group Inc.’s 16.77-per-cent owned 407 International toll highway declared a 54 per cent dividend hike for the third quarter, surprising Canaccord Genuity analyst Yuri Lynk.

As a result, he increased his earnings per share estimate for SNC’s third quarter to 67 cents from 60 cents.

He noted that EBITDA and revenues from 407 International in the second quarter came in above his estimates thanks to higher tolls and a new toll structure.

Overall, Mr. Lynk continues to “see deep value potential in SNC shares” and believes management can add significant value over time.”

Target: Mr. Lynk reiterated a “buy” rating and $50 price target. The average target is $48.35.

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Coca-Cola Co. had a lacklustre second quarter, but investors who focus on the long term will be rewarded for owning the stock, said BMO Nesbitt Burns analyst Amit Sharma.

“We maintain our view that the KO stock is one of the most effective investment vehicles to gain exposure to faster economic growth, favourable demographics and increasing packaged food/beverage consumption in developing/emerging countries,” Mr. Sharma said in a research note.

“While the operating environment in some of the key markets (e.g., China, Brazil, U.S.) will remain challenging in the near term, we expect volume trends to improve sequentially as weather and some of the other one-time issues, which negatively affected quarterly performance (e.g., social unrest, demonstrations) subside.”

Target: Mr. Sharma maintained a “market perform” rating and $45 (U.S.) price target. The average target is $45.62.

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