During this time of market volatility, price stability is highly prized by nervous investors. Holding a portfolio of quality stocks, those delivering solid financial results and led by proven management teams, can provide downside protection.
Leon Aghazarian, special situations analyst from National Bank Financial, stresses the importance of owning high-quality companies. In a recent conversation with The Globe and Mail, he discussed three such companies he believes will deliver attractive returns in 2018.
Your first stock pick is Stella-Jones Inc., a producer of pressure treated wood products serving the railway and utility markets.
It's one of the best run companies. It is a market leader in the two major business that it operates, railway ties and utility poles. It's a well– managed market leader in a defensive sector and it has a pretty amazing growth track record.
There were issues that plagued them in 2017 on the railway ties side. There was a lot of inventory in the market place and the demand from the Class 1 rails was down. It created some pressure on their top line but more importantly on their profitability.
What is going on this year is the complete opposite. The higher cost inventory is out of the market place and the demand, particularly on the Class 1 rail side [the major railways], has actually gone up; they have announced capex budgets increasing for 2018 vis-à-vis 2017.
The other thing we like is on the de-levering side. In 2016, they were quite active in terms of M&A (mergers and acquisitions). In 2017, they didn't buy anything. Their leverage actually decreased from about 3.2 times (debt-to-EBITDA) all the way down to 1.8 times right now. That de-levering I think is going to help them, they are going to get back on the acquisition front in 2018.
You have a target price of $55. How do you arrive at that valuation?
Yes, I have an 'outperform' recommendation and a $55 target. I value it at 13.5 times 2019 EV/EBITDA at the five year average.
The stock is currently yielding around 1 per cent, do you think management could announce a significant dividend increase in the future?
Yes, I do think in the future. I don't think that's a 2018 or 2019 event but I do think longer-term, once the company become more mature…Over time, I think they will switch over to significantly increasing their dividend and basically become very similar to utilities companies which are basically their clients. In the long-term, the dividend can substantially increase.
Is there anything you want to add on Stella-Jones before we move on?
I think the main thing is higher capex budgets by the rails. They are delivering more high margin poles in 2018 so that is going to lead to more free cash flow. The tax reforms could help and I think the tone on M&A is more positive for 2018.
Consumer staples stock Premium Brands Inc., a manufacturer and distributor of food products, is your second recommendation.
It is a company that has had tremendous growth. If you look at 2014 to 2017, over that period of time the company's revenues doubled from $1.2-billion to $2.2-billion or so. EBITDA went from $76-million to $205-million, that is my expectation for 2017 [2017 figures are his forecasts].
This is a company that has been quite acquisitive over the last number of years and they haven't really slowed down. They made three acquisitions in November.
What's most interesting about this company and most people don't know about it is that they do all the sandwich packaging for Starbucks in North America except for Florida. That is a substantial part of their business….That's about $350-million to $400-million in revenues for the company, representing around 15 per cent of their business.
This is a company that has strong organic growth. Their organic growth profile over the last number of years is between 6 to 8 per cent. The industry is growing around 2 per cent. They are growing between 6 to 8 per cent because they sell premium price-point, high quality products. I think that growth continues into 2018. I am forecasting 7 per cent organic growth for 2018.
They have done a very good job at integrating all their acquisitions. Their return on invested capital is very high, it's one of the best in my universe along with Stella-Jones.
How are they achieving that success?
It has nothing to do with price increases. This is all due to volume growth, which is even more impressive. They have good branded products – high quality, high margin products.
Your earnings per share estimates are $3.04 in 2017 rising to $3.86 in 2018, implying an impressive 27-per-cent growth rate.
[The growth is a combination of] organic growth and acquisitions, they have been active on that and I don't expect that to stop…We continue to expect [EBITDA] margin expansion going forward. If you take a look at their margin expansion profile, I think that it has one of the best that I track, 7.5 per cent in 2015, 8.3 per cent in 2016, 8.8 per cent is my expectation this year, and I am going all the way up to 9.5 per cent next year.
Your target price is $115?
Yes and that is based on 15 times 2019 EBITDA.
For the past three years, the company has announced a dividend increase of 10 per cent or higher in March. Will this trend continue for a fourth consecutive year?
We do expect dividend growth to continue with the same strategy.
The commodity price environment, how has it been for the company?
That has been okay, flattish, a little higher but nothing unusual there. Obviously, if you see the price of cattle or pork or some of those main inputs go up materially, that can have a near-term impact but they do have the ability to pass along costs.
Park Lawn Corp. is your final stock recommendation. What is your investment thesis?
It's the only publicly traded provider of cemetery, cremation and funeral services on the TSX. They have been quite acquisitive in the U.S., I don't expect that to stop. Management had a goal to triple EBITDA to $25-million by the end of 2019, that was set out three years ago. My expectation is that they are going to comfortably achieve that.
Obviously, demographics are a big thing. Approximately, 80 per cent of their revenues are cemeteries, and about 20 per cent are funeral homes. Cemeteries have the highest barriers to entry. They expect to see cemetery organic growth in the high single digits and funeral homes organic growth of 1 to 2 per cent so overall you get mid to high single digit organic growth, plus M&A that they are working on. I think there is a tremendous amount of growth and potential in this company and it should be on everyone's radar.
Can they fund this growth?
Their balance sheet is something that is noteworthy – it's debt free. There is no debt despite all these acquisitions, they have raised equity. They have done five equity raises since December 2013 and each time it's been an increasing size and a higher share price every time. They actually have $18-million in cash on the balance sheet.
Your target price is $25. How do you arrive at it ?
We get to the number by applying 11 times 2019 EV/EBITDA. The publicly traded peers, there are some in the U.S. and non-US. locally traded comps, [trade] around 12.1 times, and they are not growing nearly as fast, the average [growth rate] of the entire peer group is around 6 per cent.
There is no debt on their balance sheet whereas the average for the peers put together is 3.6 times so typically a very highly levered industry with low growth. They have actually done the opposite which is no debt on their balance sheet, very high sales growth, and even their dividend yield is best in class as well at 2 per cent. I think I can easily make the case that it should be trading above its peers in terms of its multiple.
If it was trading at a multiple of 12 times, where would the stock price be?
That takes it to about $27 today, and obviously there is some M&A that you could add to that. I would be very surprised if there was no M&A this year.
Would they come to market then with an M&A announcement?
It's about nine acquisitions they've done since November 2015, they've come to market five times so it depends on the size of what they buy. I am not saying they are going to do something transformational every time. Their last equity raise, which was for their largest acquisition, they did raise more cash than they needed to fund the deal so I don't think they would necessarily raise equity with the next acquisition unless it's a big one.
The dividend has remained stable at its present level since 2011. Will the dividend continue to be unchanged in the near-term?
Their 2 per cent yield is better than any of the publicly traded peers but I don't expect that dividend to increase, they are more focused on M&A at this point.
What are your adjusted EBITDA expectations?
It was $5.3-million in 2015, and then in 2017 my estimate is $18.1-million. For 2018, my estimate is $28.9-million, and then in 2019, $32.9-million.
Any closing remarks, Leon?
These are three quality names that aren't necessarily on the inexpensive side but I do think that they all have their merits in terms of growth and I do feel that each one of them has good opportunities in 2018.
Jennifer Dowty, CFA, Globe Investor's in-house equities analyst, writes exclusively for our subscribers at Inside the Market.