Wednesday's analyst upgrades and downgrades

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

There were few surprises in the eagerly anticipated federal task force report on the legalization of marijuana for recreational use, according to Canaccord Genuity analyst Neil Maruoka.

However, Mr. Maruoka said the recommended legal age to purchase marijuana of 18, "much lower" than the expectation of 21, could open greater opportunities for the recreational market. He pointed to the fact that the largest consumers of the drug are men between the ages of 18 and 24.

"We view the task force report as a significant positive catalyst, as it provides us with increased confidence that the government will table legislation in the spring of 2017," he said.

Mr. Maruoka raised his target price for shares of Aurora Cannabis Inc. (ACB-X).

"Shares of Aurora were stronger than we had expected following the expiry of the lockup on Dec. 10, and have now been bolstered by the task force report," he said. "With the pathway to legalization now that much clearer, we believe that investors should now see significantly less risk to the implementation of the recreational market. We would remain buyers of the stock ahead of the receipt of Aurora's license to sell oils and significant industry catalysts expected in the first half of next year."

Mr. Maruoka said he expects near-term competition for the sector's companies, including Aurora, to remain limited. He said: "The resources Health Canada dedicates to licensing will remain limited in the near term. We believe the government remains concerned that supply not outstrip demand, and so existing licensed producers should continue to enjoy a substantial first-mover advantage."

"While distribution will likely remain the purview of the provinces (and is still largely undecided, in our view), the Task Force did make recommendations that could make branding and sponsorship of cannabis more difficult. We believe that Aurora will be unaffected as they have not, as yet, established a recreational branding strategy."

With a "speculative buy" rating, Mr. Maruoka bumped his target price for the stock to $3.15 from $2.75. The analyst consensus price target is $2.75, according to Thomson Reuters.

"We value Aurora using a sum-of-the-parts analysis: the medical cannabis market based on a DCF [discounted cash flow] model, using a 13.0-per-cent WACC [Weighted average cost of capital] and 2.0-per-cent terminal growth, and the higher-risk rec opportunity is valued using a probability-weighted NPV [net present value]," the analyst said. "While we have made no adjustments to our forecasts on the back of the Task Force report, we believe the increased certainty of the rec market warrants a lower discount rate (lowered from 20 per cent to 18 per cent) and a higher probability of success (increased from 60 per cent to 75 per cent). As a result, our valuation of the rec market increases from $1.00 to $1.42 per share. Based on these two analyses, we are raising our target price .. which reflects a 29.1% forecast return."

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With its balance sheet restructuring completed, BMO Nesbitt Burns analyst Michael Mazar upgraded his rating for Savanna Energy Services Corp. (SVY-T).

"Savanna has completed financings, which include a $200-million second lien senior secured term loan facility, a $18.9-million private placement (both with Alberta Investment Management Corp. or AIMCo), and a $21.7-million bought deal financing," said Mr. Mazar. "The transactions are pretty dilutive but provide needed capital and improve the company's risk profile."

"Pro forma 2017 estimated net debt to EBITDA now sits at 3.0 times, versus 3.6 times prior, in line with the Canadian drilling group. The restructuring reduces any lingering leverage fears, provides additional flexibility, and extends the debt maturity schedule."

Mr. Mazar noted AIMCo now holds an 11-per-cent stake of the company's outstanding common shares, with the potential to increase its stake to 16 per cent, if it exercises its 7 million warrants.

"Based on previous statements from the company, it appears that AIMCo is not interested in a change of control, such as would occur if [Total Energy Services Inc.'s] hostile bid is successful," he said. "Barring renegotiation, the $200-million term loan would immediately come due, plus an incremental 3 per cent, in the event of a change in control."

Mr. Mazar also emphasized Savanna's establishment of a special committee to respond to Total Energy's bid, which is expected to remain open through mid-March.

"TOT appears to have decent shareholder support already, but AimCo's defensive stance, coupled with its large ownership position, may make the acquisition challenging as it is currently proposed," he said.

Mr. Mazar moved his rating to "market perform" from "underperform." He raised his target price to $2.25 from $1.30. Consensus is $2.55.

"We still think SVY's fleet is on the wrong side of the secular trend towards more deep pad drilling, and continue to prefer PD among the Canadian drillers," the analyst said. "However, the restructuring provides capital for potential upgrades that could improve the fleet over time and for re-activations as activity picks up."

"We hold the view that high-spec rigs will go back to work first, at the best day rates, and that peak rig counts going forward will be below previous cycles due to rig efficiency."

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Chemtrade Logistics Income Fund's (CHE.UN-T) new offer for Canexus Corp. (CUS-T) represents "fair value and offers a solid, risk-adjusted outcome for CUS shareholders," according to Raymond James analyst Steve Hansen.

On Tuesday, Canexus announced it was in discussions on a new takeover bid after Chemtrade increased its offer to $1.65 per share, up from a previously rejected $1.50-per-share proposal.

Mr. Hansen said he sees "strong net benefits accruing to Chemtrade over time."

"In addition to representing fair value, we like the certainty that the Chemtrade's revised offer provides," he said. "While some CUS shareholders might be inclined to a) hold out for a higher offer, and/or b) forge ahead alone under management's business improvement plan, we believe both approaches carry incremental, asymmetric risk relative to the certainty that a firm cash offer provides. In short, we believe Chemtrade management has the discipline to walk if pushed, an outcome that would likely carry more downside than the incremental nickel some shareholders would like to see. Moreover, with no additional white knights expected to emerge, we also see heightened risk to going it alone given CUS' highly levered balance sheet and volatile operating history in recent years"

He added: "As a reminder, we also like this potential deal for Chemtrade, with significant net benefits expected to accrue over time. Specifically, we see: 1) healthy earnings/cash flow accretion; 2) strong synergy potential given the complementary asset base; 3) increased scale in sodium chlorate and a marked shift to the low-end of the NA cost curve; 4) increased product/earnings diversification; and 5) healthy torque/leverage to rising oil (& HCl) prices."

Citing "our favorable view on the potential transaction, and limited further upside [to the offer]," Mr. Hansen maintained his "outperform" rating and $19.50 target price for Chemtrade. The analyst consensus is $18.83

He kept his "market perform" rating for Canexus and raised his target price to $1.65 from $1.60. Consensus is $1.58.

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There is "deep value" in Essential Energy Services Ltd. (ESN-T), said Raymond James analyst Andrew Bradford.

"We think it's normal for smaller market cap companies to participate in equity rallies later than their larger-cap counterparts," he said. "But as returns and value become more difficult to find in the more liquid companies, market participants are ultimately willing to trade some liquidity for value, thus prompting what in some cases can be spectacular returns among smaller caps. To be sure, small cap multiples almost never achieve the heights in the large cap grouping.

"ESN generally averages just over 5.0 times EBITDA during non-downturn years. But according to our estimates, Essential is trading at 4.0 times 2017 and 1.8 times 2018 EBITDA – 65-per-cent and 73-per-cent unlevered discounts to the broad group average. Hence, our Strong Buy rating."

On Tuesday, Essential announced it has reached a definitive agreement with Precision Drilling Corp. to sell its service rig business for $28-million. Precision will pay for the acquisition with the transfer of its coil tubing and pumping assets and cash proceeds of $12-million.

"We don't envision a material impact on Essential's EBITDA figures as a function of its 'Coil-for-Service-Rig' swap," said Mr. Bradford. "Our perception at this time is that service rigs are abundantly-supplied and regionally oriented, implying low current margins and some measure of fixed cost. At the same time, we expect only very modest contribution from PD's four coiled tubing rigs until 3Q17, as they are currently unstaffed."

Mr. Bradford said he believes the consensus estimates for Essential are "too low" and inconsistent with the EBITDA progression of larger oilfield services companies through the sector's recovery.

"This is especially true since ESN materially expanded its high-spec coiled tubing fleet through the downturn," he said. "In our view, the rise in general oilfield services demand – and fracturing demand in particular (ESN's products and services are strongly oriented to horizontal well completions) – implies a corresponding rise in ESN's EBITDA.

"To put numbers to it, our 2018 EBITDA estimate is $52-million – far above the $22-million median consensus figure. But at the same time, our 2018 estimate is 23 per cent below what ESN achieved in 2014 when it had less higher-margin-potential equipment in its fleet. The consensus estimate on the other hand implies that 2018 EBITDA will be a full 68% lower than 2014. This magnitude of decline doesn't square with the range of consensus estimates across the oilfield space: large-cap driller consensus figures imply 2018 EBITDA will be only 27 per cent below 2014 levels. The median pumper is 34% lower. Thus, we see a logical disconnection between the consensus figures for larger-cap service companies and Essential in particular."

Mr. Bradford kept his "strong buy" rating for the stock and raised his target to $1.50 from $1.35. Consensus is 86 cents.

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Surge Energy Inc. (SGY-T) is "well positioned to outperform in the improving commodity price environment," said Acumen Capital analyst Trevor Reynolds.

On Tuesday, Surge, based in Calgary, announced an upward revision to 2017 production guidance based on "strong" drilling results. It raised its average production to 14,000 barrels of oil equivalent per day (boe/d) from 13,500 boe/d. Its 2017 exit projection increased to 14,450 boe/d from 14,150 boe/d.

"Overall, the updated numbers are generally in-line with the preliminary guidance released in September. Q4/16 production was impacted by wet field conditions," said Mr. Reynolds. "However, the production delays, coupled with strong well results has increased production guidance for 2017."

In analyzing the announcement, which saw Surge maintained its capex guidance of $85-million, Mr. Reynolds said: "Overall, another step in the right direction for SGY in our opinion, as the company appears well positioned based on dispositions over the past two years, coupled with an active program in [the second half of 2016."

He maintained his "buy" rating for the stock and increased his target to $4.25 from $4.10.Consensus is $3.45.

"Management continues to deliver on [cash flow] maximization from their three core plays through cost reductions and strong drilling results," Mr. Reynolds said. "We maintain our view that SGY is one of the best positioned names in our coverage universe moving forward and believe shareholders will be rewarded as they continue to deliver strong results."

Elsewhere, BMO Nesbitt Burns analyst Ray Kwan raised his target price to $3.50 from $3.25 with a "outperform" rating (unchanged) based on higher forecast production and cash flow estimates.

"Surge's balance sheet has improved, with a 2017 estimated D/CF [debt to cash flow] of 1.3 times versus its peers at 2.7 times (BMO deck)," said Mr. Kwan. "In our view, Surge Energy's shares continue to have leverage to rising commodity prices."

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BMO Nesbitt Burns analyst Joe Levesque initiated coverage of Storm Resources Ltd. (SRX-X) with a "market perform" rating.

"We believe shares are fairly valued given the company's growth profile, debt levels, and growing exposure to relatively discounted Station 2 pricing," said Mr. Levesque. "The company has built a track record of improving well results and executing well on planned growth."

Expressing caution about its current valuation, Mr. Levesque set a target price of $5.50 for the stock. Consensus is $6.25.

"On BMO's price deck, Storm trades at 2017 estimated EV/EBITDA [enterprise value to earnings before interest, taxes, depreciation and amortization] of 9.5 times versus the peer group at 8.9x," he said. "We forecast debt to cash flow at 2.5 times in 2016, falling to 1.3 times in 2017. Our target price is a modest premium to our estimate of the company's 3P NAV of $5.27 per share."

"We are cautious on the shares given the elevated valuation. The company is led by a strong management team and is delivering attractive production per share growth. Offsetting this incremental production growth is the increasing exposure to Station 2, an area where we see potential pricing issues."

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The consensus is favouring the wrong Canadian oilfield driller, according to Citi analyst Michael Sabella.

"Current consensus ratings include 54-per-cent buys on Precision versus just 18 per cent for Ensign, favoring the investment in the largest and most well established Canadian land driller," he said. "However, we see better value for investors by taking the opposite position, with current valuation favouring the more under the radar Ensign where the relative discount is near decade highs and consensus bogeys more achievable. With Ensign, investors also get lower leverage, a dividend, and less exposure to Canada."

In a research note on the sector, Mr. Sabella initiated coverage of Ensign Energy Services Inc. (ESI-T) with a "buy" rating and Precision Drilling Corp. (PD-T) with a "neutral" rating.

He did emphasize that the outlook for the Canadian oil and gas industry "remains very challenging."

"While the near term outlook for Canada favors a higher bounce next year relative to the U.S. rig count, the bounce is off a more depressed level," the analyst said. "Additionally, as U.S. shale volumes appear set to grow again next year, the Canadians could again be fighting for a piece of a shrinking U.S. import pie. We view the longer term outlook as more challenging relative to U.S. shale …but these land drillers aren't just Canadian, especially Ensign — Ensign's U.S. business is its largest by revenues, setting up for growth during what we see as the ongoing recovery in U.S. shale. Canada is its smallest segment, surpassed even by its operations outside of North America. Precision maintains heavy exposure to Canada but its US operations should gain revenue share moving forward.

Mr. Sabella set a target price of $12 for Ensign stock. The consensus is $9.02.

"For investors pondering U.S. land driller valuations, Ensign looks like bargain — Ensign's relative discount on consensus EBITDA has blown out to more than 40 per cent compared to the average U.S. land driller and more than 25 per cent versus Precision," he said. "This creates an opportunity for investors seeking some relative value in a space where multiples are reaching new highs. If the U.S. fleet were valued at the recent Patterson/Seventy Seven transaction, we think the shares are pricing in a very affordable [approximately] 5 times 2018 estimated EBITDA for non-U.S. drilling businesses."

Mr. Savella set a target of $8 for Precision. Consensus is $8.01. 

"Precision may look cheap on consensus, but is consensus achievable?," he said. "Precision's relative forward EBITDA multiple has underperformed its US peers, but we see consensus as too high for the driller. Thus, relatively we don't see an opportunity here at current valuation."