Wednesday's analyst upgrades and downgrades

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

Stock of TransAlta Corp. (TA-T, TAC-N) is not currently reflecting deteriorating macro fundamentals, according to RBC Dominion Securities analyst Robert Kwan.

Saying he is "uncomfortable" justifying the current valuation for the stock without factoring in a "material" improvement in Alberta's power market or takeover scenarios, Mr. Kwan downgraded his rating to "underperform" from "sector perform."

"Based on our net asset value (NAV) framework … we believe that there is a very wide range of potential values, with the major drivers being the Alberta power price and the amount of compensation due to the early closure of some of TransAlta's coal plants in 2030," the analyst said. "Our $5.50 per share valuation (bumped up from $5.00/share) is based on a $45 per MWh [megawatt-hour] Alberta spot power price, which is admittedly below the forward curve in the medium/long-term but is markedly higher than the current $14/MWh average pool price (still under $30/MWh adjusting for increased carbon costs in the future). Our valuation also gives the stock credit for the estimated present value of stranded coal costs (about $450-million) in addition to upside from TransAlta receiving a contract to build a new gas-fired power plant as part of those negotiations."

Following the release of first-quarter earnings which largely met his expectations, Mr. Kwan said the stock has risen 33 per cent thus far in 2016, despite what he views to be deteriorating fundamentals, including the 30-day running average Alberta power price dropping to $14/MWh (from $21/MWh at the end of 2015).

He also said that there is "no news that could be construed as materially (or definitively) positive on coal closure compensation or market design, and buyers of the PPAs [purchase power arrangements] turning them back to the Balancing Pool, which we believe has negative implications for future power prices."

He added: "Could a takeover occur? That is a key risk to our thesis, particularly in the near term. Our greatest concern at this point is driven by shareholdings, by strategic investors, and whether any new investors of note emerge when SEC filings come out within the next couple of weeks, particularly given the trading activity year to date. That being said, we struggle with what a potential acquirer would be seeing, as the power data is transparent and no one with whom we have spoken (including the companies we cover) seems to have a good feel for how the government will move forward on compensation and market design. Further, we do not see the company as being mismanaged, and in fact, we think that management is taking the right steps to control what it can. Ultimately, we believe there are way too many material drivers of value beyond the company's control, which we believe could end up negatively impacting the company when eventually resolved."

Mr. Kwan did raise his target price for the stock to $5.50 from $5. The analyst average is $6.09, according to Bloomberg.

"We believe that the share price is reflecting optimistic scenarios for Alberta power prices and/or climate change regulations," he said. "Based on our valuation framework, we believe that the stock price is reflecting a material improvement in Alberta power prices and/or the government moving forward in a way that does not materially alter the spot power market framework (i.e., does not move forward with gas-fired power procurement or large-scale renewables)."

Elsewhere, TD Securities analyst Linda Ezergailis downgraded the stock to "hold" from "buy" with a 12-month target price of $7.50 per share (unchanged).

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WestJet Airlines Ltd. (WJA-T) holds  a "durable" competitive advantage and "has a significant runway to grow" in the coming years, said BMO Nesbitt Burns analyst Fadi Chamoun.

On Tuesday, the airline reported first-quarter earnings per share of 71 cents, down 35 year over year and in line with the analyst's projection. Its return on invested capital (ROIC) of 12.8 per cent over the past 12 months was below the target of 13-16 per cent.

"On the back of lowered domestic capacity, the overall supply/demand picture is improving and should be supportive of recovering average fares in the coming quarters," said Mr. Chamoun. "We view this to be positive and, in the context of a similar tactical reduction in capacity employed by Air Canada, underscores the continued competitive but also disciplined commitment to financial targets that we are seeing from both airlines. We believe that WestJet's expansion in international markets has the potential to be accretive to the company's network, stimulating traffic demand in both the domestic and regional markets."

Mr. Chamoun believes management's guidance is "realistic" and benefits from a conservative Canadian dollar assumption.

"Outside of the financial outlook, management provided disclosure surrounding a 'greatly expanded charter program,' and noted that full details will be announced within the next week or two," he said. "This has piqued our interest as a chartered capacity contract can be an effective way to improve utilization of the fleet, particularly in Alberta, and ultimately serve to support ROIC targets."

Maintaining his "outperform" rating, he raised his target to $25 from $22. The average is $21.88.

"With some of the domestic fare pressure in the rear-view mirror and the execution of the international expansion strategy remaining solid, the risk/reward appears favourable, in our view," said Mr. Chamoun.

His optimistic view wasn't held by a trio of analysts who downgraded the stock following the release of the financial results.

They were:

• National Bank analyst Cameron Doerksen, who moved it to “sector perform” from “outperform” with a target of $23 (unchanged).
• Beacon Securities analyst George Trapkov, who moved his rating to “hold” from “buy” with a $22 target (up from $19.50).
• Alta Corp. analyst Chris Murray, who moved it to “sector perform” from “outperform” with a $23 target (down from $26).

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Though he acknowledges its leverage in an "improving" commodity environment , Alta Corp. Capital analyst Nick Lupick downgraded Encana Corp. (ECA-N, ECA-T) after the release of "weak" first-quarter 2016 financial results.

He moved his rating for the company to "sector perform" from "outperform."

On Tuesday, Encana reported quarterly operating cash flow 12 cents per share, down 73 per cent from the previous quarter and 77 per cent year over year. The result was below Mr. Lupick's projection of 15 cents. Production of 383.4 mboe/d  [thousand barrels of oil equivalent per day] was a drop of 6 per cent from the fourth quarter and 11 per cent from the previous year. It was largely in line with the analyst's estimates.

"It should be highlighted that given ECA's current capital structure and leverage, shareholders' equity is levered to a rebounding commodity forward curve," said Mr. Lupick. "As an example …  based on flat pricing scenarios, for those who believe in $70-$80 (U.S.)/bbl WTI in the medium term (a thesis often supported by the prediction of a crude oil supply shortage before the end of the decade), ECA still has significant upside with an implied NAV [net asset value] per share of nearly $10-$14 (U.S.)."

"Unfortunately, however, based on our base case forecast of a gradually improving commodity tape over the balance of the decade, our price deck does not support a NAV which provides enough upside to warrant a Sector Outperform rating."

Mr. Lupick maintained his price target of $7 (U.S.) per share. The average is $7.73.

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Shares of Argonaut Gold Inc. (AR-T) have risen in price by almost 120 per cent thus far in 2016, closing in on the target price of RBC Dominion Securities analyst Sam Crittenden.

That has led the analyst to downgraded his rating to "sector perform" from "outperform."

"Argonaut shares are now approaching our $3 target," he said. "Our target price is based on 1.0 times NAV [net asset value] and 10 times adjusted cash, which is in line with peers. Argonaut is trading at 0.9 times our NAV estimate, which remains at a discount to Tier III peers trading at 1.2 times. However, excluding San Antonio and Magino, Argonaut would be trading at 1.2 times. Given the permitting, financing and execution risk, it could take some time for the market to attribute more value for these growth assets."

On Tuesday, the Nevada-based company reported first-quarter adjusted earnings per share of 1 cent, beating Mr. Crittenden's projection by a penny and the consensus by 3 cents. Cash flow per share of 6 cents was a cent below the analyst's estimate and in line with the consensus. Cash costs met expectations, while all-in sustaining costs beat estimates.

"The current producing assets, El Castillo and La Colorada, currently drive 36 per cent of our operating NAV," he said. "We attribute the remainder to the growth projects currently in the pipeline for Argonaut Gold, including 33 per cent for San Agustin. We believe this reflects the significant potential for added ounces that would transform AR into a more meaningful producer and provide a potential re-rating amongst intermediate gold producers."

He did not change his $3 target. The analyst consensus is $2.94, according to Thomson Reuters.

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Though Kelt Exploration Ltd. (KEL-T) is "making progress," Raymond James analyst Jeremy McCrea downgraded  the Calgary-based oil and gas company.

Mr. McCrea moved his rating to "outperform" from "strong buy" after updating his model for the company following the recent issue of $90-million in convertible debt. He noted "the increased bank line flexibility, high conversion premium, and low interest costs look attractive."

"With increased leverage flexibility and top tier assets emerging in the Progress area (not to dismiss the quality of its BC Inga play), Kelt continues to show the quality of its assets. However, with our lower commodity deck, we believe the market – which views valuation on an EV/DACF [enterprise value to debt-adjusted cash flow] basis – may take a longer time in appreciating Kelt's assets, especially as Kelt preserves future locations and performs delineation work. Combined with the recent run-up in share price, we are lowering our rating from strong buy to outperform."

Mr. McCrea added: "One of the biggest pushbacks we hear on Kelt is its valuation. Taking the traditional method of measuring value in the E&P sector (EV/DACF), we recognize that Kelt trades at a premium to its Montney peers (14.8 times EV/DACF vs 10.6 times EV/DACF) (based on a consensus rolling-12-month forward looking DACF estimate. Although investors acknowledge that a premium EV/DACF multiple is justified, it's difficult to give full credit to Kelt's extensive asset base (approximately 450 net Montney sections) using this valuation approach. This leads us to one of the more difficult predicaments in valuating energy investments – asset rich names where cash flow haven't caught up.

"One of the principle drawbacks of EV/DACF is the inability of near-term DACF to capture the upside potential of an asset. For example, Kelt has more locations that it could realistically drill (2,500+ locations at six locations per section – with the potential to drill up to eight locations per section). If Kelt sold its non-producing Montney land at its BC Inga property (162 net sections) for $500-million, this would suddenly drop its EV/DACF multiple to 7.9 times. Kelt would still have a considerable drilling inventory and $300-million in cash. Not only would Kelt have the strongest balance sheet in the sector, it would also be able to accelerate its growth and potentially become the highest growth name in the sector."

Mr. McCrea lowered his 2016 cash flow per share projection for 2016 to 30 cents from 34 cents. However, he raised his 2017 estimate to 55 cents from 51 cents. Similarly, his revenue model moved to $178-million and $225-million from $184-million and $219-million, respectively.

He maintained a target price of $6.25 for the stock. Consensus is $5.45.

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In other analyst actions:

Advance Auto Parts Inc. (AAP-N) was rated new "equal-weight" at Consumer Edge Research by equity analyst David Schick.

Anadarko Petroleum Corp. (APC-N) was downgraded to "market perform" from "outperform" at BMO Capital Markets by equity analyst Phillip Jungwirth. The target price is $50 (U.S.) per share. It was downgraded to "neutral" from "outperform" at Credit Suisse by equity analyst Edward Westlake with a target price of $55 per share.

AutoZone Inc. (AZO-N) was rated new "equal-weight" at Consumer Edge Research by equity analyst David Schick.

Baxter International Inc. (BAX-N) was rated new "buy" at Evercore ISI by equity analyst Vijay Kumar. The 12-month target price is $51 (U.S.) per share.

Brookfield Renewable Energy Partners LP (BEP-N) was rated new "neutral" at Guggenheim Securities by equity analyst Sophie Karp.

Hess Corp. (HES-N) was downgraded to "neutral" from "buy" at Tigress Financial by equity analyst Philip Van Deusen.

Starwood Hotels & Resorts Worldwide Inc. (HOT-N) was downgraded to "neutral" from "outperform" at Macquarie by equity analyst Chad Beynon. The 12-month target price is $85 (U.S.) per share. It was downgraded to "hold" from "buy" at Canaccord Genuity by equity analyst Ryan Meliker with a 12-month target price of $86 per share.

Quintiles Transnational Holdings Inc (Q-N) was downgraded to "hold" from "buy" at Evercore ISI by equity analyst Ross Muken. The 12-month target price is $74 (U.S.) per share. It was downgraded to "neutral" from "outperform" at Robert Baird by equity analyst Eric Coldwell with a 12-month target price of $74 per share.

RSP Permian Inc. (RSPP-N) was raised to "strong buy" from "outperform" at Raymond James by equity analyst John Freeman. The 12-month target price is $45 (U.S.) per share.

Under Armour Inc. (UA-N) was downgraded to "hold" from "buy" at Brean Capital by equity analyst Eric Tracy.

Zillow Group Inc. (Z-Q) was raised to "market perform" from "underperform" at Cowen by equity analyst Thomas Champion. The 12-month target price is $23 (U.S.) per share.

With files from Bloomberg News