Tuesday’s analyst upgrades and downgrades

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

The fallout from Brexit is likely to add further to the weaknesses seen in the auto parts sector, according to BMO Nesbitt Burns analyst Peter Sklar.

"We previously believed that multiples this cycle should be higher than the previous cycle as: i) Detroit Three OEMs [original equipment manufacturers] have improved their financial position and no longer face the prospect of bankruptcy, ii) corporate governance at Magna has improved and we believe all the publicly traded Canadian auto parts stocks are benchmarked relative to Magna, iii) continued consolidation of the supply base enables larger suppliers to secure a greater portion of the supply chain, and iv) OEMs are favouring larger auto parts suppliers that can supply their platforms on a global basis," said Mr. Sklar. "However, we now believe these positive valuation factors are being mitigated by three key developments."

The analyst pointed to three factors:

- key fundamental macro drivers of the auto cycle (U.S. unemployment, consumer confidence and housing starts) are likely to be more "tepid" than expected, causing U.S. light vehicle sales to remain "range-bound for the next few years;

- "the market appears to be penalizing the multiples of suppliers that are not considered to be pure plays in new technologies such as battery electric vehicles, autonomous driving, ride hailing, etc."

- Economic uncertainty from Brexit will likely "dampen" consumer confidence across Europe, leading to lower vehicle sales.

"We assessed the prior auto cycle (from 1992 to 2008) and identified two unique periods: cycle expansion (between 1992 and 1999) and a peak cycle period (from 2000 to 2007)," said Mr. Sklar. "When we compared the forward multiples of auto suppliers from 2000 to 2007 with current multiples, we observed that many of these suppliers, including the Canadian auto parts stocks, are currently valued at the mid-point of the prior period. Given the cumulative effect of these negative sector themes, the risk is that the Canadian auto parts stocks could experience further multiple compression."

Accordingly, he downgraded and lowered his target prices for several companies in his coverage universe. His changes were:

- Magna International Inc. (MGA-N, MG-T) to "market perform" from "outperform" with a target of $36 (U.S.), down from $50. The analyst consensus price target is $53.83, according to Thomson Reuters.

Mr. Sklar said: "We note that a potential risk to our rating revision would be if Magna announces a vehicle assembly partnership with Apple or Google. We believe that following such an announcement, investors would likely reward Magna with a higher valuation multiple. In terms of the likelihood of such partnerships, we believe there is a possibility for three reasons: i) neither Google nor Apple have explicitly indicated that they intend to assemble vehicles internally, ii) Magna has for many years conducted contract vehicle assembly services through its Steyr business, and iii) Magna has a broad range of assembly and engineering capabilities that an OEM partner could capitalize on."

- Linamar Corp. (LNR-T) to "market perform" from "outperform" with a revised target of $50 (Canadian), reduced from $75. Consensus is $74.40.

Mr. Sklar said: "While Linamar should generate a higher growth rate over the next few years due to its substantial backlog, size of the company, and strong track record of execution, we believe its multiple may continue to be under more pressure as investors continue to deliberate whether the penetration of the internal combustion engine will slow as BEVs [battery electric vehicles] are introduced into the fleet. We note that a potential risk to our rating revision is that Skyjack's peers (United Rentals (URI-N), not rated; Terex Corp. (TEX-N) $20.84 (U.S.), market [Perform rated by Joel Tiss, BMO Capital Markets Corp.; and Oshkosh Corp. (OSK-NE), not rated) have experienced significant stock rallies that Linamar has not participated in."

- Exco Technologies Ltd. (XTC-T) to "market perform" from "outperform" with a target of $13, down from $16. Consensus is $18.38.

- Martinrea International Inc. (MRE-T) to "underperform" from "market perform" with a target of $7 (from $11). Consensus is $15.58.

Mr. Sklar said: "We believe Martinrea shares are most susceptible to valuation pressure from the themes outlined in this report as the company maintains a significant amount of debt on its balance sheet. Currently, Martinrea's net debt as a percentage of its enterprise value is 52%, versus 16 per cent for Magna and 32 per cent for Linamar. Our target price is revised to $7 (from $11), which is based on a projected enterprise value that is about 4x (from 5x) our revised 2016 EBITDA estimate and 3.5x (from 4.3x) our revised 2017 EBITDA estimate."

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On Tuesday, Desjardins Securities analysts raised their 2017 West Texas Intermediate oil deck by 10 per cent to $55 (U.S.) per barrel.

"Despite the broad market uncertainty stemming from last week's Brexit vote, we retain our view that the physical oil market will continue rebalancing as U.S. crude inventories (and shale production) roll over and non-OPEC volumes decline following the collapse in global capital investment," the analysts said in a research note. "Supply outages have also been supportive, particularly from Nigeria, and still represent the key wildcard that could potentially send prices higher."

"While we ultimately expect commodity prices to trend higher in 2017, we are also cognizant of the potential for significant near-term volatility amid shifts in macro-related sentiment, particularly following the Brexit vote. "As a result, we remain defensively minded in our stock selection, maintaining a preference for well-capitalized producers that have re-established sustainable business models in the current environment."

Concurrent with the WTI increase, analyst Justin Bouchard upgraded his rating for Husky Energy Inc. (HSE-T)

"On the back of our revised commodity price outlook, we have adjusted our assumptions for the largecap/oil sands E&P companies," he said. "As one would expect, a rising tide lifts all boats; however, the change in assumptions to CNQ [Canadian Natural Resources Ltd.] — and most notably to HSE — result in more dramatic changes to target prices. In addition, we have moved our rating for HSE to buy from hold to reflect what we believe is compelling valuation."

On Husky, Mr. Bouchard increased his target to $21 from $17. Consensus is $19.

"From our perspective, the sell-off in Husky shares has created a compelling investment opportunity as the company screens attractively against its peers and on an absolute basis under a range of oil price assumptions," the analyst said. "Meanwhile, the decision to delever the company's balance sheet has reduced its risk profile and added a strong level of downside protection. The quality of the asset base and the sustainable and scalable growth runway in a $40 (U.S.)/bbl+ WTI world also increase the attractiveness of the story, especially at its current valuation. One of the pushbacks relative to Canadian peers is that Husky has less torque to a recovery in oil prices; while we agree, the lower torque is a concern at oil prices greater than $70/bbl WTI (and we are still a long way off)."

Mr. Bouchard also made the following target price adjustments:

- Athabasca Oil Corp. (ATH-T, hold) to $1.75 from $1.50. Consensus is $1.98.

Mr. Bouchard said: "In our view, ATH continues to move in the right direction and improve its positioning. The latest GORR [gross overriding royalty] on Hangingstone is a perfect example, in our opinion. However, we remain concerned with its gross debt levels (despite having net cash) and note that ATH still needs higher prices for the story to work. Thus, while we have maintained our Hold rating, we have reduced our risk qualifier to above-average Risk (from Speculative)."

- Canadian Natural Resources Ltd. (CNQ-T, hold) to $41 from $36. Consensus is $42.67.

Mr. Bouchard said: "When we downgraded CNQ to Hold in March, it was predicated on a flat production profile as a result of lower oil prices. Not only does CNQ benefit from higher commodity prices, but we have also increased our production forecasts; activity levels should increase with higher commodity prices."

- Cenovus Energy Inc. (CVE-T, buy) to $24 from $23. Consensus is $20.60.

Mr. Bouchard said: "We continue to believe that Cenovus offers good downside protection in a volatile and uncertain commodity price environment. Meanwhile, owing to its operational leverage to higher oil prices, its clean balance sheet and its best-in-class growth opportunities at Narrows Lake and FCCL, we believe the company offers significant torque to rising oil prices."

- Imperial Oil Ltd. (IMO-T, hold) to $41 from $39. Consensus is $45.33.

Mr. Bouchard said: "Imperial has historically traded at what we viewed as an unjustifiably rich premium to its peer group — we suspect this is somewhat driven by the majority ownership position held by Exxon and the liquidity it affords Imperial. And while the premium has narrowed significantly since the beginning of 2015, it still looks rich relative to its peers (especially at lower long-term oil price assumptions, given the operational torque in its upstream portfolio where the company is levered to non-upgraded bitumen)."

- MEG Energy Corp. (MEG-T, hold) to $8 from $7.50. Consensus is $8.42.

Mr. Bouchard said: "MEG is a story that exudes operational and financial leverage. While its debt levels remain sky high, the company's operating netbacks improve markedly as oil moves up from $40 (U.S.)/bbl WTI. As a result, there is no question that an increase in oil prices is more impactful for MEG than it is for pretty much every other Canadian E&P."

- Blackpearl Resources Inc. (PXX-T, hold) to $1 from 75 cents. Consensus is $1.07.

Mr. Bouchard said: "While the company's low debt levels, lean cost structure and low sustaining capital requirements at the Onion Lake thermal project have been a saving grace, without much higher oil prices, BlackPearl's ability to grow is severely handicapped. We have moved our target price up nominally, reflecting our higher oil price assumption."

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Canadian airlines are "piloting through some turbulence," said Canaccord Genuity analyst Doug Taylor.

"We believe that North American airlines are trading at trough valuations on the fear that substantial industry capacity growth combined with rising fuel prices will squeeze recent record profitability," he said. "We argue this multiple compression is overdone. Fuel prices remain accommodative despite the rebound in WTI, and Canadian airlines enjoy much better flexibility and lower sensitivity to fuel prices than at any point in recent history."

Mr. Taylor initiated coverage of Air Canada (AC-T) with a "buy" rating and $13 target (consensus is $13.84). He gave WestJet Airlines Ltd. (WJA-T) a "hold" rating and $21 target (versus a $22.39 consensus).

He said Air Canada is his "preferred avenue," pointing to better diversification of growth opportunities; better relative flexibility and less risk of new competition from entrants.

Mr. Taylor also said the historic reasons for a discounted valuation are fading.

"Relative to its recent history, Air Canada presently has 1) less labour and pension risk; 2) declining leverage ratios; 3) a modernized mainline fleet; 4) an established low-cost offering; and 5) is passing through peak capex," he said.

He added: "Despite pressure on yields driven by a competitive market and the flow-through of fuel cost savings to consumers, Air Canada's significant network expansion means it targets 4-8-per-cent EBITDAR growth in 2016. We model the low-end of this range, building in some cushion for rising fuel costs. Our buy rating is based on a $13.00 target that equates to 4.1x NTM [next 12 months] EBITDAR, one-year forward. This assumes little multiple expansion and leaves upside potential as Air Canada successfully executes on its expansion plans and transitions to a stronger FCF [free cash flow]/debt reduction story. Our preference for Air Canada is supported by Canaccord Genuity's proprietary Quest® quantitative analysis."

On WestJet, he said: "We believe the company continues to execute very well against strategic objectives and manage capital allocation effectively. Near-term profit growth – we model EBITDAR down year over year in 2016 – is challenged by higher exposure to relatively less attractive domestic growth and Western Canada economics."

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Tamarack Valley Energy Ltd. (TVE-T) offers investors "significant" downside protection and the potential for "outsized" returns as commodity prices bounce back, said Canaccord Genuity analyst Anthony Petrucci.

He initiated coverage of (TVE-T) with a "buy" rating.

"We believe TVE offers an impressive combination of asset quality, balance sheet strength and reasonable valuation," Mr. Petrucci said.

He set a price target of $5. Consensus is $4.96.

"TVE is trading at 6.6x 2017 estimated EV/DACF [enterprise value to debt-adjusted cash flow], which is a modest discount to the group at 7.2x," the analyst said. "In our view, the market has failed to recognize TVE's expanded drilling inventory and pristine balance sheet. These, combined with reaching recent milestones of $500-million in market cap and 10,000 boe/d [barrels of oil equivalent per day] in production, poise TVE for a re-rating in the market, in our view. Our target represents a 1.4x multiple of our C-NAV, mapping to a 9.0x 2017E EV/DACF. Our premium to C-NAV credits TVE for its acquisition potential, balance sheet strength, and conservative estimates of drilling inventory."

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Brookfield Infrastructure Partners LP (BIP-N) continues to find opportunities, said BMO Nesbitt Burns analyst Bert Powell.

He raised his target price for the stock in reaction to reports of the sale of a stake in a Peruvian toll road to Brookfield and discussions with Petrobas about a $5.5-billion (U.S.) acquisition of a natural gas pipeline network in Brazil.

"We believe that BIP has about $700-million of equity to deploy into these two assets between now and the end of the year," he said. 

Though he noted Brookfield has exposure to the British pound through its its U.K. connections and ports business, Mr. Powell saod: " We would make three observations related to the U.K.: 1) the F/X exposure is hedged until 2018; 2) the connections business, which is a bulk of GBP denominated FFO [funds from operations], is regulated and contracted; 3) 23 per cent of BIP's FFO was GBP denominated, or about $200-million on an annualized basis. Assuming there were no hedges, a 10-per-cent change in F/X would be about $20-million in FFO, or about a 2-per-cent impact on the current FFO run rate."

Maintaining his "outperform" rating, he raised his target to $53 (U.S.) from $47. Consensus is $47.75.

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In other analyst actions:

Tesla Motors Inc. (TSLA-Q) was downgraded to "hold" from "buy" with a target of $333 (U.S.) by Argus analyst William Selesky. The analyst average target is $261.77, according to Bloomberg

National Bank analyst Greg Colman upgraded Trinidad Drilling Ltd. (TDG-T) to "outperform" from "sector perform." He raised his target to $2.75 from $2.50, compared to the average of $2.95.