Tuesday's analyst upgrades and downgrades

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

North American railways are "catching a commodity bounce," said Citi analyst Christian Wetherbee, who said the outlook for 2017 is increasingly positive.

"Looking across rail volume, we believe there is a case to be made that upside exists in several commodities end markets as we transition into 2017," he said. "Most controversial is coal, which has been under massive pressure but could see at least 'less bad' trends if the recent natural gas rally is sustained through 2017. The case seems strongest for PRB coal which breaks even with natural gas at or near current prices. Grain appears more near-term, as early crop indications are positive and the combination of relatively full storage and less global competition could yield greater exports starting this fall. Finally, frac sand should benefit from steadily rising oil and gas prices, and rig counts."

Mr. Wetherbee added: "Collectively, we believe the commodity opportunity could add 100-200 bps of volume growth to the industry next year, and importantly provides positive revenue mix due to the higher revenue per car moves. However, we think the nearer term opportunity could come from a re-rating of the group back toward a market multiple. When commodities cracked in late 2014/early 2015 the rails de-rated, moving from a 12-per-cent premium to the market to a 12-per-cent discount and we think much of that can be recouped. In addition, the rails have de-rated vs. large industrial names making the group a potentially attractive space for a rotation. Finally, rails provide commodity exposure in good business models, making for a stable proxy investment at trough volume."

Though Mr. Wetherbee cut his second-quarter 2016 earnings per share estimates by an average of 5 per cent due to softer-than-projected volumes of approximately 8 per cent, he did raise his 2017 forecast based on commodity opportunities.

"In the context of a potential commodities bounce in 2017, we think there is both earnings upside as well as valuation re-rating potential," the analyst said. "From 2011 through 2014 rails enjoyed a premium valuation vs the broader market due to better earnings growth and high barriers to entry. Following the collapse in commodities, rails derated versus the broader market and recently vs other large cap industrials. We see this relative valuation as compelling, particularly as investors may look to the group to provide exposure to recovering commodities and U.S. industrial activity.

Mr. Wetherbee adjusted his target prices for a trio of stocks, including:

- Canadian National Railway Co. (CNI-N, CNR-T, "neutral" rating) to $61 (U.S.) from $62. Consensus: $78.76.

He said: "The change to our Canadian National estimate is driven by marking our volume estimates to current QTD [quarter to date] trends. Volume growth at Canadian National is trending more than 800 basis points below our initial -4.0-per-cent year-over-year estimate. While we expect improvement in overall volumes in 2H16, with stronger movement in grain contributing significantly, our 2016 EPS estimate moves down 5 cents to $4.45 (Canadian), implying flat EPS growth YoY in 2016."

- Canadian Pacific Railway Ltd. (CP-N, CP-T, buy) to $154 (U.S.) from $165. Consensus: $192.15.

He said: "Our price target on CP is $154, derived by applying a 16x target multiple on 2017 estimated Canadian dollar EPS, translated to U.S. dollar at a $1.25 CAD/USD exchange rate. Our target multiple is a 1x premium to the company's historical average, as we believe CP can unlock value from strong operating leverage and returns to shareholders in a gradually improving operating environment."

- Union Pacific Corp. (UNP-N, buy) to $100 from $95. Consensus: $90.92.

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A sector rally has left Ensign Energy Services Inc. (ESI-T) behind, said BMO Nesbitt Burns analyst Michael Mazar.

Noting the share price performance for Canada's second-largest driller has left investors out of a jump in energy services stocks, Mr. Mazar asked "where's the love?"

"ESI shares have underperformed its North American land drilling peers so far in 2016," he said. "In fact, it is the worst performer among relevant NA drillers, and it's really not close. ESI shares are up 1 per cent year to date, while the basket of peers is up 31 per cent with all of these peers up at least 20 per cent this year. Clearly, rig quality matters and while ESI has invested in its ADR platform over the last several years, the extent to which it has embraced high-spec rigs is lower than its NA comps.

"ESI doesn't promote its stock nearly as much as its competitors (it's the only major NA driller without an IR team for example), and its opaque financial reporting and disclosure policies don't help entice investors either. But ESI does a lot of things right, in our view, and performs near the top of the peer group on several key metrics. We believe some level of underperformance is warranted in light of the fleet quality delta versus its peers, but has the market over-emphasized this element while overlooking the positive attributes of the ESI story?"

He said Ensign is currently trading at a 53-per-cent discount to replacement value, in line with its Canadian peers, but, due to the underperformance, he raised his target price to $8 from $7.50. The analyst consensus price target is $7.90.

"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 far below previous cycles due to rig efficiency has weighed on ESI's stock," said Mr. Mazar. "Investors seem to believe that the investments peers have made in their fleets make them better positioned. We agree to a degree, but believe that there is still some room for a mid-tier driller with a great cost structure and that the magnitude of this year's underperformance has been too extreme."

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The market is currently underestimating the value of ARC Resources Ltd.'s (ARX-T) land base, according to Raymond James analyst Jeremy McCrea, noting it has undertaken "rapid" change to its well designs in the Montney region.

"We believe that the market has yet to fully appreciate the impact of the changes on well performance and on ARC's land value," he said. "Although the market is aware of the recent Montney Tower results, we believe it is missing the strong results of ARC's 8-well pad at Parkland and the potential for more pads to follow. Although the data is limited, the Parkland wells have produced an average of 42 mbbls [million barrels] of oil over just 43 days. When looking at the TOUR reports, these wells had nearly double the frac intensity of the prior Tower pad wells with 97 frac intervals (48 stages with 2 clusters/stage) compared to 58 intervals."

Mr. McCrea said all three of the company's Montney initiatives – Dawson, Tower/Parkland and Sunset – have seen "material" increases in internal rate of return (IRR) assumptions and capital efficiencies despite a lower price environment. Based on the company's "greater" attention on IRR, he feels investors using historical capital efficiencies to project growth are underestimating the company's potential.

"On Feb. 10 (when WTI reached $27.45 U.S. per barrel), ARC released a revised capital budget of $390-million, down from $550-million," the analyst said. "Although prices have materially improved, the Street has yet to revise its capex assumptions for 2016, with the consensus average of $388-million. Potentially more interesting, consensus capex for 2017 has also remained steady despite the increase in crude prices, up only 4 per cent since February to $525-million. The consensus production estimate is also little changed since Feb. 10, revised up only 1 per cent for 2016 and 1.8 per cent for 2017 to 122.2 mboe/d. Even with recent NE B.C. well results, there has been little in way of upward revisions to 2017 forecasts. As the Street revises its commodity forecasts with the end of the quarter over the next of couple weeks, we believe that we could see an increase in spending expectations (especially given ARC's pristine balance sheet with a 2016E D/CF [debt to cash flow] at 1.1x). We also suspect the company will announce an increase to its capex budget, likely back to its original $550-million budget based on a fully funded model (in which ARC includes its DRIP proceeds).

"Overall, the market isn't forecasting much growth for ARC given the company's current guidance but we suspect that will change over the next four weeks, especially when the company announces its 2Q16 results on July 28. We believe higher growth should be a catalyst that improves ARC's relative valuation to a level that is more reflective of the emerging well economics across its NE B.C. asset base."

Saying ARC is "hitting it out of the park," he raised his target price for the stock to $27.50 from $27. Consensus is $23.56.

He maintained an "outperform" rating.

"One of the biggest pushbacks we hear on ARC is valuation, particularly on an EV/DACF [enterprise value to debt-adjusted cash flow] basis," said Mr. McCrea. "The EV/DACF metric is straight forward, simple to calculate, and easy to compare to other industry names. As such, we don't see this valuation approach going away any time soon. Unfortunately, EV/DACF fails to capture asset value or the undrilled land value and future growth potential. When investors look back at the best and worst performing names over the year, it's often a change in the EV/DACF multiple that has an equally large impact to share price performance as the underlying growth in funds flow per share. As such, by understanding a change in asset value (brought on by a change in well economics), which ultimately will show in growth projections, investors should be able to capture a positive change in EV/DACF multiple. We believe that ARC, given the step change in well economics in the B.C. Montney, has high potential for a reassessment of land value and subsequent change in EV/DACF."

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The "game has changed" for TSO3 Inc. (TOS-T) after it received U.S. Food and Drug Administration approval for its VP4 low-temperature sterilizer, said Canaccord Genuity analyst Neil Maruoka.

"This is a very positive development, in our view; by allowing broad claims on the end-sterilization of multiple-channel flexible endoscopes, we believe that the FDA has changed the dynamics of the market as no other competing sterilizer is capable of addressing this need," said Mr. Maruoka. "We expect that TSO3 could eventually enjoy a dominant position in the market, as adoption of VP4 will allow customers to 'futureproof' against regulatory changes. Nonetheless, we do not believe that the effects are going to be evident overnight, and it will likely take some time for the market to adapt. As such, we are comfortable with our 2016 assumptions but forecast accelerated adoption into 2017 and 2018."

He said the FDA's approval of a "disruptive" technology with the potential to "dominate" its market now makes the Quebec City-based company an attractive target for partners "interested in accessing a mature market with high barriers to entry."

"With over 4 million endoscopic procedures performed annually in the U.S., VP4 has been approved to sterilize the majority of these devices (with the exception of duodenoscopes, which represent approximately 500K procedures); this should give a good idea of the magnitude of the opportunity ahead for TSO3," the analyst said.

Though the stock jumped in price by 32 per cent on Monday, Mr. Maruoka said "significant" upside remains. He did caution, however, that the implications of the FDA approval "can be difficult to quantify."

"Although a lack of liquidity (following the long weekend) and a short squeeze may have, in part, fuelled the rally, we continue believe that TSO3 remains undervalued with respect to its improving growth potential," he said.

Mr. Maruoka kept his "buy" rating for the stock and raised his target to $5.25 from $3.50. 

"Following this development, we have raised our medium- and longer-term forecasts to reflect expected accelerating demand for VP4," he said. "However, we have increased our discount rate to 13.5 per cent (from 11.0 per cent) to capture the higher risks to achieving our projections; we have also bumped our terminal growth rate to 3.0 per cent (from 2.0 per cent) to capture the longer-term growth potential."

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BMO Nesbitt Burns analyst Gerrick Johnson raised his target for Harley-Davidson Inc. (HOG-N) in response to reports might be a takeover target.

On Friday, shares of the motorcycle company jumped almost 20 per cent after it was linked to potential interest from KKR & Co. (KKR-N). The private equity firm reportedly was set to offer $65 (U.S.) per share for the acquisition.

"We have no particular insights into the veracity of these reports, but given the company's strong balance sheet, solid cash flow, superior brand name, and encouraging new product strategies, we think a leverage buyout could work," said Mr. Johnson. "At minimum, a $65 deal would appear to be sustainable, with cash flow better than potential interest expense. Given an inexpensive valuation, if the acquirer could improve business performance, such a deal could provide value over time, in our opinion."

He maintained a "market perform" rating for the stock and bumped his target to $54 from $50. The analyst average is $49.40.

"Our estimate represents a 13x multiple on 2017 EPS estimate of $4.20, which is unchanged," he said. "We are increasing the earnings multiple we use in valuing HOG to 13x from 12x to account for the increased probability, even if it may be small, that the company could be 'in play.' Risks to our target include a decline in consumer confidence and spending or an inability to bring compelling new products to market on a timely basis."

At the same time, the stock was downgraded to "neutral" from "outperform" by Robert Baird analyst Craig Kennison. He left his target of $54 unchanged.

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Citi analyst Jim Suva said he expects shares of Apple Inc. (AAPL-Q) to remain range bound in the near term, pointing to data points during the "seasonally slow" summer and ahead of the release of the iPhone 7.

"We are lowering our estimates for June and September quarters given potential for lower demand from macro uncertainty (Brexit related), currency volatility and lengthening replacement cycles (average replacement rate has gone from 24 months in 2013 to 28 months recently and our model implies replacement rates could extend to 30-36 months," said Mr. Suva. "Our supply chain checks suggest demand strength in iPhone SE as partial offset."

Mr. Suva lowered his third- and fourth-quarter earnings per share forecasts to $1.35 (U.S.) and $1.54, respectively, from $1.40 and $1.63. His full-year 2016 and 2017 projections fell to $8.11 and $8.34 from $8.25 and $8.63.

He said: "We believe investors will soon start to: 1) look out beyond this near term stock price weakness on near term sales and gross margin disappointment; 2) look out to the iPhone 7 launch later in the year and realize expectations are tempered with December iPhone consensus units for 75 million (flattish year-over-year growth) with OLED [organic light-emitting diode] phones in 2018 likely to spur further upgrades by the install base, and 3) look out longer term to realize Apple can still gain share especially in large markets such as India which we call. Additionally continued growth in services revenues with margins at slightly above corporate average coupled with declining PCs and tablets should provide a positive uplift to overall margins."

The analyst maintained his "buy" rating and $115 target. Consensus is $124.23.

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In other analyst actions:

Methanex Corp. (MEOH-Q, MX-T) was upgraded to "sector outperform" from "sector perform" by CIBC World Markets analyst Jacob Bout with a target of $37 (U.S.), up from $36. The analyst average is $39.90, according to Bloomberg.

Argus Research analyst David Coleman downgraded Hershey Co. (HSY-N) to "hold" from "buy" without a specified target price. The consensus target is $91.83 (U.S.).

Netflix Inc. (NFLX-Q) was downgraded to "hold" from "buy" by Needham & Co. analyst Laura Martin. She did not specify a target. Consensus is $119 (U.S.).

Southwestern Energy Co. (SWN-N) was upgraded to "market perform" from "underperform" by Raymond James analyst Kevin Smith. He did not set a target. Consensus is $11.91 (U.S.).

Miller Tabak + Co. analyst Rick Snyder upgraded Nordstrom Inc. (JWN-N) to "hold" from "sell" and raised his target to $39.50 (U.S.) from $30. Consensus is $40.74.