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Tuesday’s analyst upgrades and downgrades

The Hydro One Pleasant Transfer Station is seen here in Brampton, Ont.

tim fraser The Globe and Mail

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

With almost 99 per cent of its revenue generated from regulated assets providing "very good" earnings visibility, Hydro One Ltd. (H-T) should represent a core holding for investors, said Canaccord Genuity analyst David Galison.

He initiated coverage of the stock with a "buy" rating.

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"We also believe the shares could see potential upside to our base case outlook as management continues to focus on consolidating the fragmented electric local distribution market in Ontario," he said. "The 15 largest local distribution companies account for 78 per cent of the province's customers. In addition, the company hopes to transition from the current cost of service regulation model to Ontario's incentive-based regulatory framework, providing the potential for additional shareholder value. Longer-term, we believe Hydro One could consider larger-scale acquisitions outside of Ontario to diversify its asset base, which could include companies located in other provinces as well as in the United States."

Mr. Galison pointed out an investment in Hydro One brings no "meaningful exposure" to variations in either power generation, which it does not undertake, or commodity costs. Costs for both are passed on to customers directly.

Another key tenet of his positive outlook rests in its plan to invest almost $9.8-billion in regulated capital from 2017 through 2021, subject to Ontario Energy Board approval, toward refurbishing, upgraded and replacing the province's "deteriorated" and end-of-service life infrastructure.

"Recall, the Ontario government had previously under-invested in the province's transmission and distribution infrastructure prior to the Hydro One IPO, adopting a more 'reactive' than a 'proactive or preventative' maintenance program," said Mr. Galison. "In addition, the Province also prioritized investments in generation assets, as it made a push into nuclear and renewable generation in its transition away from coal. As such, management expects that significant investments will continue to be required in its existing infrastructure over the long term, suggesting the potential for continued rate base growth beyond the 2021 planned capital expenditure horizon. Furthermore, the company's development capital expenditure plan is designed to address the changing generation profile in Ontario, accommodate load growth throughout the province and support connectivity to and transmission of the changing power generation mix. These capital investments are expected to be self-funded (no planned equity issuance) and in general, will not be undertaken without management having reasonable assurance of regulatory approval for the projects. … The company's capital program is expected to increase its rate base (net book value of assets for regulatory purposes) at a 5.6-per-cent compound annual growth rate (CAGR) from 2016-2021."

"Assuming a consistent (or increasing) allowed Return on Equity (ROE) by the OEB and capital structure of 40% equity, this growth in rate base should translate into similar growth in earnings per share and dividends per share, as net income growth typically follows rate base growth (all else equal). Management is currently targeting a payout of 70 per cent to 80 per cent of net income in dividends with the current annualized dividend of 84 cents per share. Assuming all else is constant; applying management's expected growth in rate base (through 2021) to our 2017 estimated EPS estimate of $1.22 per share could indicate a potential 2021E EPS in the $1.53 range. A 70 per cent to 80 per cent payout ratio could suggest a 2021 dividend in the $1.07-$1.22 per share range. We are currently modeling for a 70-per-cent dividend payout ratio. Regardless, we believe there is clear potential for upside to our current base case outlook. … While the shares have had a limited trading time (November 2015 IPO), they have ranged from a high of $26.59 to a low of $20.50, implying a dividend yield range (assuming a 84 cents per share annual dividend) of 3.16-4.10 per cent. The shares are currently yielding 3.46 per cent."

Mr. Galison also emphasized possible upside stemming from M&A activity, with the company's management focusing on the consolidation of Ontario's "fragmented" local electricity distribution (LEC) market.

"We believe Hydro One's significant available liquidity ($2.6-billion as of the end of Q4/16), good access to the capital markets, strong long-term investment grade credit rating (S&P - A, DBRS - A (high), Moody's - A3) and large customer base puts it in a favourable position to be a strong participant in continued consolidation within the segment," he said.

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Mr. Galison set a price target of $26 per share. The analyst consensus price target is $25.95, according to Thomson Reuters.

"Our $26.00 target represents 12.6 times our 2018 estimated EBITDA and 20.0 times our 2018 estimated fully diluted EPS outlooks," he said. "Considering the various avenues for potential upside to our base case outlook we feel comfortable with our target multiples slightly above the company's limited average historical trading range (post-IPO) of 12.0 times (11.5-12.3 times) and EBITDA and 19.5 times (18.2-20.6 times) FD EPS. On a DCF [discounted cash flow] basis, we generate a value for Hydro One of $27.81, suggesting upside to our current valuation. Continued growth through acquisitions or additional regulated capital projects as well as positive improvements in future regulated ROE's could mean further upside to our valuation."

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With a scarcity of investors in the U.S. cannabis market, iAnthus Capital Holdings Inc. (IAN-CNSX) has been able to obtain "favourable" valuations, said Canaccord Genuity analyst Matt Bottomley.

He initiated coverage of the Vancouver-based investment company, which sources Canadian financing to invest in licensed cannabis cultivators, processors and dispensaries in the United States, with a "speculative buy" rating and calling it his top pick in his cannabis coverage universe.

"The continued classification of cannabis as a Schedule I controlled substance at the federal level has created a liquidity trap in many legal markets where access to capital is essentially nonexistent," said Mr. Bottomley. "We believe this has resulted in a valuation arbitrage between the Canadian market (where the company raises capital) and the U.S. industry (where the company invests in assets). As a result, iAnthus has been able to acquire high quality U.S. assets at accretive valuations, with a number of strategic investments already in the bag; ranging from ownership in maturing medical markets to geographies with the potential for significant recreational upside."

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Mr. Bottomley said the acceptance of marijuana use has reached an "inflection point" south of the border, estimating 2016 saw almost $6.5-billion (U.S.) in legal sales across 29 states. He believes the U.S. industry can grow by almost 10 times from current levels.

He said iAnthus is in a "prime" position to benefit from such growth with "foundational pieces already in its arsenal," calling its portfolio of U.S. assets "compelling."

"After going public in September of last year, iAnthus has already deployed $35-million raised in the Canadian equity market into a number of strategic investments in the U.S. cannabis industry," the analyst said. "These investments range from modest ownership of vertically integrated operators in mature (but predictable) medical markets, to cultivation/sales licences in geographies with the potential for significant recreational upside."

Mr. Bottomley said its ownership of Mayflower Medicinals "alone could be worth the price of admission," adding: "To date, we believe the company's flagship asset is its majority interest in Massachusetts based Mayflower Medicinals. Based on the planned geographic locations of its three dispensaries and a head-start into the state's recreational program (expected to roll out in mid-2018), we estimate the value of this opportunity on its own could be worth $2.79 per share, which represents greater-than 100-per-cent iAnthus' stock price today.

"In our view, this investment alone could be worth the cost of admission, while providing investors with the potential for future optionality as the markets where iAnthus already has exposure continue to grow. Further, our 'Doomsday' scenario, which removes 100 per cent of all current and future recreational sales (highly unlikely, in our view), still supports a stock price of $1.64 (61 per cent of current trading levels); and, our 'Blue Sky' scenario assumes iAnthus will be able to deploy its existing cash on hand at the yields of its existing portfolio (without raising additional capital), and suggests a stock price of $5.80 (115-per-cent upside from the current stock price)."

Mr. Bottomley said U.S. federal restrictions on the legalization of cannabis represent the biggest risk to iAnthus, adding president Donald Trump's administration has caused "increased uncertainty" industry wide. However, he said state-level legalization is "forcing industry tides to turn."

"One of biggest challenges for U.S. operators is the ability to access capital in order to fund growth (let alone a cash chequing account), as most banking is regulated at the federal level," he said. "This has caused U.S .cannabis businesses to rely solely on state charter banks for operating lines, with almost no options for capital injections outside of private raises. We believe the illiquid nature of the industry is the primary reason iAnthus is able to deploy capital raised in Canadian equity markets to acquire U.S. cannabis companies at depressed valuations. We believe as the industry continues to evolve, this 'liquidity trap' will begin to dissipate (albeit very slowly, considering the current US federal administration in place). In our view, iAnthus may be adding assets to its arsenal today that could experience high growth in the near term in addition to the potential for a significant valuation re-rating as the stigma of cannabis in the U.S. continues to dissipate."

Mr. Bottomley set a price target of $4 for the stock.

The only other analyst currently covering the stock, according to Bloomberg, is Beacon Securities' Vahan Ajamian, who has given it a "buy" rating and $3.75 target.

"We believe its existing portfolio of U.S. cannabis assets support a price well in excess of current trading levels," said Mr. Bottomley. "If the company is able to deploy its remaining cash into investments with similar yields as its existing portfolio, we estimate the stock could have an additional $1.80 upside from our $4.00 target."

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Exchange Income Corp. (EIF-T) was added to Raymond James' Canadian top picks list, replacing Superior Plus Corp. (SPB-T).

Analyst Steve Hansen said the change was made based on "the presence of several growth drivers in the company's unique diversified platform and solid fundamental value at current levels."

He has a "strong buy" rating and $48 target for the stock. The analyst average target is $46.70.

"While 2016 marked an impressive year for EIF in terms of earnings growth, share price gains, and strategic milestones, we see plenty more ahead (in 2017/18)," said Mr. Hansen. "Specifically, we believe EIF's outlook looks increasingly solid, underpinned by momentum building at both the company's Aerospace and Manufacturing divisions. Key factors supporting this view include: 1) Accelerated capital deployment in the company's flagship high-return Regional One platform; 2) Emerging growth associated with the recent Canadian Fixed Wing Search and Rescue Contract with Airbus; 3) The ongoing expansion of its airlines business into new, Northwestern Ontario markets; 4) Definitive signs of a recovery in EIF's Manufacturing segment—most notably at Stainless where backlogs have moved sharply higher; and 5) The company's recently re-bolstered balance sheet which will provide ample dry powder to pursue EIF's increasingly attractive growth pipeline."

Noting its "healthy" share price appreciation which reduced upside to his target and relative risk-reward to EIF, Mr. Hansen has a "buy" rating for Superior Plus. His target is $15, while the consensus is $13.97.

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Desjardins Securities analyst Benoit Poirier lowered his first-quarter financial estimates for TFI International Inc. (TFII-T) in reaction to profit warnings from a pair of U.S.-based bellwether truckload companies.

At the same time they announced a merger in an all-stock reaction on Monday, both Swift Transportation Co. (SWFT-N) and Knight Transportation Inc. (KNX-N) lowered their quarterly earnings guidance.

"Both KNX and SWFT confirmed that freight volumes in 1Q did not materialize to the extent anticipated, as the weakness in January and February more than offset the improvement in March," said Mr. Poirier. "This weakness was also confirmed by the American Trucking Association (ATA), which indicated that tonnage declined by 2.8 per cent year over year in February. This softness in volumes, combined with industry overcapacity, put pressure on rates. … However, both trucking companies and the ATA indicated that the rebound in March reflects an improving environment for the remainder of 2017. Nevertheless, both KNX and SWFT provided cautious 2Q guidance (ie reduced estimates) on the back of current market conditions and rising fuel prices."

Based on the "cautious" comments of both Swift and Knight, Mr. Poirier reduced his 2017 and 2018 earnings before interest, taxes, depreciation and amortization (EBITDA) expectations for TFII to $584-million and $625-million, respectively, from $606-million and $632-million. His earnings per share projections moved to $2 and $2.35 from $2.17 and $2.40.

Ahead of the release of its quarterly results, scheduled for April 26, he lowered his target price by a loonie to $34. Consensus is $36.04.

He maintained a "hold" rating.

"Despite the recent share price weakness, we remain cautious on TFII in the short term given the uncertainty and year-to-date softness in the TL market, which puts 2017 EBITDA guidance ($600–620-million) at risk, in our view," he said. "However, we believe TFII is approaching a support level as its impressive 10-per-cent FCF [free cash flow] yield, based on our revised estimates, provides room to make accretive acquisitions, buy back shares or deleverage the balance sheet."

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Citing an improved risk/reward profile, RBC Dominion Securities analyst Robert Wetenhall upgraded Toll Brothers Inc. (TOL-N) to "outperform" from "sector perform" after recent meetings with the Pennsylvania-based luxury home builder's management.

"Management has reduced risk by moving a number of capital-intensive projects off its balance sheet and into joint ventures while creating upside by transforming the business from being an East Coast luxury builder focused on the Boston/ Washington, D.C. corridor into a true national player starting with the purchase of Shapell Ranch in California for $1.6 -billion in 2014," he said. "As a result, TOL now generates more than 50 per cent of its revenues and deliveries from fast-growing states west of the Mississippi (AZ, CA, CO, NV, TX, & WA)."

Mr. Wetenhall also pointed to the company's "robust" growth in orders, "favourable" prices, an acceleration in its apartment business and "prudent" allocation of capital.

"We recognize that the luxury segment of the market for homes selling at price points above $1-million remains choppy in CT, NYC, Miami, and San Francisco," he said. "The company's focus on affordable luxury, however, gives it exposure to price points in the vicinity of $750,000, where activity remains robust. Finally, we believe that concerns about the loss of foreign buyers and the potential impact of higher interest rates on demand are overstated."

He said "solid" demand and "strong" execution led him to increase his 2017 earnings per share projection to $3.15 (U.S.) from $3.05. His 2018 estimate rose to $3.47 from $3.36.

His target price for the stock jumped to $43 from $37. Consensus is $37.77.

"[Year-to-date] returns for TOL (up 14.25 per cent) have trailed PulteGroup Inc. (up 28 per cent), D.R. Horton Inc. (up 21.5 per cent), and Lennar Corp. (up 20 per cent)," he said. "TOL, which normally trades at a sizable premium to its competitors, is trading at a fiscal 2017 estimated price-to-earnings (P/E) multiple of 11.2 times compared with the homebuilder peer group average of 11.5 times. Accordingly, we anticipate multiple expansion. Our price target is based on an FY17E P/E multiple of 13.5 times."

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Slate Office REIT (SOT.UN-T)  had a "very productive" 2016, said BMO Nesbitt Burns analyst Troy MacLean, pointing to "material" progress in both leasing and acquisitions.

"The REIT has several levers it could use to increase our estimates, including raising occupancy closer to its target," he said. "Filling vacant office space can provide material organic growth as newly leased space goes from negative cash flow (landlord paying operating costs) to positive (tenant takes over operating costs plus pays a base rent)."

On Friday, the Toronto-based REIT reported fourth-quarter funds from operations of 24 cents per unit, meeting the Street's expectations and flat year over year. Same property net operating income rose 4.8 per cent from the previous year, which Mr. MacLean called a "solid" result.

In reaction to the results, a recent equity raise of $120-million and new acquisition assumptions, Mr. MacLean adjusted his financial estimates for Slate. His 2017 and 2018 EBITDA and adjusted FFO payout percentage projections rose. His FFO per unit estimates fell to 94 cents and $1.02, respectively, from $1.07 and $1.08.
 
Maintaining a "market perform" rating, his target is $8.55 per unit, down from $8.70. Consensus is $8.76.

"Upon completion of the upcoming acquisition, when the subscription receipts convert to units, the REIT's market cap will increase to more than $500-million (using current market prices), which should increase its trading liquidity, and potentially improve its valuation (the REIT's market cap has approximately doubled since the end of 2015)," Mr. MacLean said.

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A catalyst has "finally" emerged for Whole Foods Market Inc. (WFM-Q) with activist investor Jana Partners' acquisition of an 8.8-per-cent stake and rumours of the exploration of a sale of the U.S. natural and organic foods retailer, according to Credit Suisse analyst Edward Kelly.

"The news represents the catalyst the stock has lacked and highlights the opportunity in this once-thriving company," said. Mr. Kelly. "We continue to see large opportunity in a fix or sell scenario and remain Outperform on the stock. We would buy the news even with the stock up [Monday]."

"Part of our positive thesis on WFM is that good brands don't underperform forever. We believe WFM has superior brand value but has arguably been mismanaged as the company failed to adapt to the evolving food retail landscape. The potential for activist involvement had provided downside support, but now the reality of outside influence dramatically changes the stock's outlook for the better."

Keeping his "outperform" rating, he raised his target to $40 (U.S.) per share from $36. The analyst average is $29.74.

"The problem at WFM is much deeper than many investors realize. Its weak price position has received most of the attention, but the broader issue is that WFM is not a well-run, modern day retailer at the moment. It's still somewhat decentralized, it has lacked adequate systems (now just being addressed), the company doesn't have adequate customer data, its category management/pricing strategy is weak, the cost structure looks high, and it's still opening stores against diminishing returns. Our biggest criticism is that management has not moved fast enough to reposition the company. That being said, we see these issues as opportunity and are encouraged the issue is bigger than just price. We still believe the company provides a differentiated, value-added experience, its brand remains strong, and there is large opportunity in a turnaround. Risks include an intensifying competitive landscape in food retail, execution risk as the company looks to accelerate its strategic turnaround, and uncertainty around management succession"

Elsewhere, EVA Dimensions analyst Neil Fonseca downgraded the stock to "underweight" from "hold" without a specified target price.

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In other analyst actions:

GMP analyst Ian Gillies upgraded Black Diamond Group Ltd. (BDI-T) to "hold" from "reduce" with a target of $4 (unchanged). The analyst average is $5.44.

Inter Pipeline Ltd. (IPL-T) was rated new "buy" at Cormark Securities by analyst Brent Watson with a target of $33. The average is $31.15.

Penn West Petroleum Ltd. (PWT-T) was downgraded to "sector perform" from "outperform" at by Alta Corp. analyst Thomas Matthews with a target of $2.60, down from $3.25.

Mr. Matthews downgraded Raging River Exploration Inc. (RRX-T) to "sector perform" from "outperform" and dropped his target to $11.50 from $12.50. The average is $12.52.

Pine Cliff Energy Ltd. (PNE-T) was downgraded to "sector perform" from "speculative buy" at Alta Corp. by analyst Patrick O'Rourke. He lowered his target to $1 from $1.30. The average is $1.17.

Paradigm Capital Inc analyst David Davidson initiated coverage of NGEx Resources Inc. (NGQ-T) with a "speculative buy" rating and $2.70 target, which is also the average target price.

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David Leeder is a content editor in the Report on Business. He was previously Deputy Sports Editor and Weekend Digital Editor at The Globe.  He holds an undergraduate degree from McMaster University and a graduate degree from Ryerson University. More

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