Tuesday’s analyst upgrades and downgrades

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

Kinder Morgan Canada Ltd. (KML-T) presents an "interesting" opportunity for investors in a sector not known for sizable companies, with the potential to double in value per share, said RBC Dominion Securities analyst Robert Kwan.

Touting its "asymmetric upside potential," Mr. Kwan initiated coverage of the Calgary-based company, which completed its initial public offering on May 30, with an "outperform" rating.

"We value the base business at roughly $14-15 per share, which implies there is a modest premium, or option value, being paid for the TMEP that on an unrisked present value basis could be worth roughly $15 per share," he said. "As such, we believe that there is significant potential upside for investors that believe the [Trans Mountain Expansion Project ] will eventually come into service. In comparison, our $11 per share downside case assumes that KML spends the remainder of its 2017 capital budget for the TMEP (roughly $950-million) and that the project is stopped altogether."

Calling the company's existing business "solid," Mr. Kwan said he expects the existing Trans Mountain system to remain a "significant apportionment" given the lack of capacity leaving the Western Canadian Sedimentary Basin.

"The remaining parts of the business have a high degree of contractual cover with below average volume exposure and virtually no direct commodity price exposure," he said. "Many of the Canadian peers have 10-15 per cent of their EBITDA derived from commodity-exposed margins."

"We see a relatively near-term upside event in the form of moving to construction. KML plans to start construction on the project in the fall of 2017 and we see this as having the potential to be a material positive catalyst for the stock if the TMEP indeed moves to the construction phase. We see a high probability that work will begin in the fall on at least a portion of the TMEP given the ability to work 'inside the fence' at the port in addition to having flexibility to construct various pipeline spreads."

Setting a price target for the stock of $25, Mr. Kwan said investors are "getting paid to wait with a clean balance sheet out of the gate" and said there is a potential for "significant" dividend growth when the TMEP comes into service. The analyst average price target is currently $22, according to Bloomberg data.

"The stock is yielding about 4 per cent and KML will have no debt despite there being roughly $400-million of annual EBITDA generated from existing assets in operation with contracted growth initiatives that could cumulatively add about 10 per cent to EBITDA over the coming years," said Mr. Kwan. "Until the TMEP comes into service, we expect modest dividend growth (we forecast 2 cents per share growth per year from the current 65 cents per share dividend) with the potential for significant dividend growth once the TMEP comes into service (a dividend potentially in the range of $2.00 per share."

Mr. Kwan did caution, however, that Kinder Morgan Canada does come with potential downside, adding: "We caution investors not to confuse the value for the existing business with a 'floor' valuation as KML is proceeding with the TMEP with guidance for roughly $950-million of project capital spending for Q2-Q4 in 2017. As such, there is a risk that KML spends material capital for the TMEP that ultimately may be materially delayed or stopped altogether. … We set out a downside scenario of $11 per share."

Elsewhere, several other analysts also initiating coverage of the stock, including:

- BMO Nesbitt Burns' Danilo Juvane with a "market perform" rating and $17 target.

"Within KML's business segments, Pipelines and Terminals, the former is the primary driver of growth given proposals to advance TMX," said Mr. Juvane. "While we think the merits of the proposed pipeline are clear—egress out of Western Canada providing higher producer netbacks, economic benefits to British Columbia (BC), and more broadly Canada, among others—we nonetheless remain cautious on the name given shifts in political winds from recent B.C. provincial elections, which, in turn, could translate into significant delays or, in the most draconian scenario, cancellation of the TMX project."

- CIBC World Markets' Robert Catellier with an "outperformer" rating and $23 target.

Mr. Catellier said: "The Trans Mountain Expansion project (TMEP) is a potential company-maker and key to an investment in the company's shares. We believe the unique growth profile is a potential to generate alpha, though acknowledge the above-average legal and political risks. We expect the project to be completed, though think delays to the currently proposed timeline are likely. We account for this in our valuation by incorporating a 1.5-year margin of safety to derive our risked value for TMEP."

- Scotia Capital's Robert Hope with a "sector outperform" rating and $24 target.

- TD Securities' Linda Ezergailis with an "action list buy" rating and $26 target.

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CIBC World Markets analyst Kevin Chiang continues to see a "big" disconnect between Air Canada's (AC-T) valuation and "the de-risking that has occurred within the organization."

Mr. Chiang raised his target for its stock following recent meetings on the road with the airline's management, including chief financial officer Michael Rousseau.

"It is clear that North American airline executives are frustrated with their company valuation despite the significant positive changes that have taken place within the industry," the analyst said. "In the past, legacy airlines had three strikes - over-leveraged balance sheet, thin margins and poor earnings resiliency, and a challenging culture. And while every investor has heard/read the phrase 'past performance is no guarantee of future results,' it is hard not to see that airline equity valuations are anchored to historical investor perception and biases. As investors change the lens in which they look at Air Canada, we believe this will result in a positive re-rating."

Mr. Chiang pointed to four key takeaways from his meetings. They were:

1. A "stronger" balance sheet.

"To say that Air Canada has improved its balance sheet is an understatement," he said. "Back in 2009, its net adjusted debt was over 8.0x EBITDAR versus 2.5x at the end of Q1/17 with Air Canada targeting 2.2 times by the end of 2018. With the company now generating structurally positive FCF (guiding to $200 million-$500-million in 2017), this FCF is being prioritized towards internal investments and deleveraging. We see the company hitting a net adjusted debt to EBITDAR ratio of below 2 times in 2019 suggesting there is line of sight to Air Canada becoming investment grade debt."

2. A "cultural revolution"

"Air Canada has worked hard to improve the culture within the organization," said Mr. Chiang. "The launch of Rouge provided increased upward mobility options for Air Canada's pilots; and addressing the pension deficit provided increased comfort to employees regarding their retirement. Air Canada also noted that service directors have been given increased training around customer service as these are the front line workers most travelers interact with. This cultural revolution is reflected in Air Canada having negotiated 10-year agreements with its pilots and flight attendants, unprecedented in the industry. It also signaled that the unions were onboard with Air Canada's multiyear plan and recognized that the company would need labour certainty to reduce execution risk."

3. Margin buffer

Mr. Chiang said: "The extreme cyclicality in Air Canada's margins historically reflected its higher cost structure, less diverse product offering, and less fleet flexibility. The company has addressed each of these issues and this is reflected in the fact that despite the significant increase in jet fuel price in 2017, Air Canada's margins remain at historically high levels."

4. Increasing earnings resiliency

"A key focus area for investors was Air Canada's decision to bring its loyalty program in-house," the analyst said. "The decision to do this was really two-fold. From an economic perspective, the airline has noted that running its own program is a $2 billion NPV [net present value] over 15 years or $6 per share. Since the announcement, Air Canada's share price is up $2.30, so we expect the airline to realize more of this upside as it provides more details on its plan. Air Canada will provide some additional color at its investor day on Sept.  19."

Maintaining an "outperformer" rating, Mr. Chiang bumped his target to $20.50 from $19.50. Consensus is $19.

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The reality of $45 (U.S.) per barrel oil is setting in for Canadian small and mid-cap energy companies, according to CIBC World Markets analyst Dave Popowich.

In a research report on the sector, he made "sweeping" changes to both spending and production estimates for producers.

" As strip pricing for both oil and gas have moved materially lower over the past month or so, it has become clear to us that Street estimates (ours included) for many producers in our coverage universe are too high," he said.

"Even though several stocks in our coverage universe are now down by more than 50 per cent year-to-date, this exercise has served as a reminder that 'value' is a moving target for oil & gas stocks. Reference to historical consensus valuations may give the impression that the sector is accurately reflecting strip commodity prices. However, in some cases our new strip cash flow estimates are more than 30 per cent below consensus; weighted by market cap, our strip estimates are an average of 25 per cent below consensus. The implication here is that we see substantial downside risk in these stocks if the market ever gets around to fully pricing in $45.00 (U.S.) per barrel oil - or worse."

Mr. Popowich said the second-quarter, with two weeks remaining, appears not to be a "banner" period for the sector, operationally or financially.

"We believe that over the near- to medium-term, a central investment theme for oil & gas stocks will be the degree to which the market is prepared to look through medium-term weakness in commodity prices," he said. "A common sentiment we hear from investors is that oil prices are likely to be range bound between $40.00-60.00 per barrel for the foreseeable future, and that stocks start to look appealing when they are reflecting the lower end of that range. On this basis, we fear the sector may be in for additional weakness if sub-$45.00 per barrel oil lingers through H2/17."

With his lower estimates, he made numerous target price reductions as well, including:

Advantage Oil & Gas Ltd. (AAV-T, "outperformer") to $9 from $10. Consensus: $11.12.
Bonterra Energy Corp. (BNE-T, "neutral") to $17.50 from $27.50. Consensus: $30.
Baytex Energy Corp. (BTE-T, "neutral") to $4 from $5.75. Consensus: $6.36.
Crew Energy Inc. (CR-T, "outperformer") to $5 from $6.50. Consensus: $7.71.
Gran Tierra Energy Inc. (GTE-T, "outperformer") to $4 from $4.50. Consensus: $5.26.
Kelt Exploration Ltd. (KEL-T, "neutral") to $7 from $8.50. Consensus: $8.83.
Peyto Exploration & Development Corp. (PEY-T, "neutral") to $25 from $31.50. Consensus: $34.77.
Pine Cliff Energy Ltd. (PNE-T, "neutral") to 80 cents from 85 cents. Consensus: $1.24.
Painted Pony Energy Ltd. (PONY-T, "neutral") to $5 from $7. Consensus: $8.70.
Parex Resources Inc. (PXT-T, "outperformer") to $20 from $21.50. Consensus: $23.03.
Surge Energy Inc. (SGY-T, "neutral") to $2.25 from $3.50. Consensus: $3.67.
Spartan Energy Corp. (SPE-T, "outperformer") to $2.50 from $4. Consensus: $3.91.
Storm Resources Ltd. (SRX-X, "outperformer") to $5 from $5.75. Consensus: $6.15.
Tamarack Valley Energy Ltd. (TVE-T, "outperformer") to $3 from $5. Consensus: $4.52.
Vermilion Energy Inc. (VET-T, "outperformer") to $50 from $58. Consensus: $58.46.
Whitecap Resources Inc. (WCP-T, "outperformer") to $12.50 from $15. Consensus: $14.19.

"Against this backdrop, our current investment recommendations are heavily weighted towards best-in-class producers with the balance sheets and margin structure to withstand prolonged weakness in commodity pricing," said Mr. Popowich. "With that in mind, we believe Parex Resources, Whitecap Resources and Spartan Energy offer the best debt-adjusted growth visibility among oil producers at prevailing commodity prices, while Advantage Oil & Gas and Storm Resources appear the most attractive amongst our gas-weighted coverage universe."

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Desjardins Securities analyst Bill Cabel raised his target price for shares of Pattern Energy Group Inc. (PEGI-Q, PEGI-T) following Monday's announcement of its new growth strategy.

The San Francisco-based power company announced a series of initiatives aimed at "significantly" increasing its long-term growth outlook and access to capital.

The moves included a new strategic partnership with Canada's Public Sector Pension Investment Board (PSP Investments), which committed to co-invest $500-million (U.S.) in projects acquired by PEGI and acquired 9.9 per cent of PEGI shares from Pattern Development 1.0.

Pattern also announced it has obtained $1-billion in capital commitments from various investors for its Pattern Development 2.0, of which $724-million will be managed through a Riverstone Holdings LLC investment entity.

"We believe the capital commitment by PSP into PEGI and the backing of Riverstone on the development side should enable more dropdown-driven growth from PEGI's robust I-ROFO list," said Mr. Cabel. "Further, the participation in development activities alongside Pattern Development should produce a relative increase in returns for shareholders."

The analyst maintained his "buy" rating for the stock and bumped his target to $26 from $25.50. Consensus is $25.77.

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Enerflex Ltd.'s (EFX-T) $140-million acquisition of Mesa Compression LLC is likely to provide "meaningful cross-selling fabrication opportunities," said Industrial Alliance Securities analyst Elias Foscolos.

The Calgary-based company expects to pay for the acquisition, announced Monday, with cash on hand and debt.

"The acquisition will increase the company's service and rental revenue in the U.S., generating consistent and stable revenue, allowing EFX to approach its goal of 35-40% recurring revenue," he said.

"As well, EFX is anticipating that significant cross-selling opportunities will exist in servicing and fabrication."

Mr. Foscolos maintained a "strong buy" rating and $23 target. Consensus is $24.28.

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EQT Corp.'s (EQT-N) $6.7-billion (U.S.) acquisition of Rice Energy Inc. (RICE-N) strengthens its core Marcellus shale position and is likely to provide "significant" operational efficiencies, said BMO Nesbitt Burns analyst Phillip Jungwirth.

He upgraded his rating for the Pittsburgh-based natural gas company to "outperform" from "market perform."

"QT's acquisition of Rice Energy expands its Greene and Washington County inventory, while adding a competitive Core Ohio Utica position," said Mr. Jungwirth. "On a pro-forma basis, EQT will be the largest natural gas producer in the U.S., while maintaining a high-teens production growth rate through 2020 (BMOe). Our analysis shows Rice drills among the most productive Marcellus wells and the most productive Utica wells, which will high-grade EQT's capital allocation, while providing synergies from longer laterals. Midstream and G&A synergies are incremental to this."

Though he said the purchase price was at a premium, the analyst noted Rice shares were "inexpensive."

"While the deal comes at a 37-per-cent premium (27 per cent using June. 19 close), we viewed Rice shares as significantly undervalued," he said. "Our after-tax NAV [net asset value] on Rice was $31 per share, resulting in a price/NAV of 0.64 times. This compares to our EQT NAV of $68 per share or 0.87 times. As such, the combination of EQT and Rice, is 44 cents accretive to EQT NAV before any other adjustments."

Mr. Jungwirth maintained a target of $70 (U.S.) for EQT shares. The analyst average target is $77.

"Part of EQT's 2018 strategy is to address the persistent SOTP [sum-of-the-parts] discount, which has been absent from the story over the past year," he said. "With the addition of Rice and underperformance of EQT shares on the deal announcement, this gap has widened, while optionality has increased."

At the same time, RBC Dominion Securities analyst Brad Heffern downgraded Rice Energy Inc. to "sector perform" from "outperform," looking at the deal price "favourably."

"While we see the acquisition and valuation as positive for RICE shareholders, the transaction comes as a bit of surprise," said Mr. Heffern. "We had viewed RICE as a natural consolidator in Appalachia, given its quality acreage position, strong balance sheet, midstream upside and strong operational abilities. However, the acquisition does makes sense in our view with the combined company emerging as the largest gas producer in the US with a more contiguous acreage footprint, opening the door to significant potential synergies through longer laterals, cost savings and improved execution."

His target fell to $25 (U.S.) from $28, versus the average of $29.55.

"We see the deal metrics as advantageous and consider the valuation of RICE to be very fair compared to our long-term NAV of $29 per share," he said. "We do not think the offer will increase and we also do not see any other natural bidders. As a result, we are downgrading RICE."

Capital One Securities analyst Brian Velie also downgraded Rice, moving it to "equalweight" from "overweight" with a target of $27 (down from $32).

MUFG Securities Americas analyst Michael McAllister downgraded the stock to "neutral" from "overweight" with a target of $27, down from $31.

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In other analyst actions:

Macquarie analyst Jiang Zhang initiated coverage of People Corp. (PEO-X) with a "outperform" rating and $7 target. The average is $6.17.

Wells Fargo Securities analyst Neil Kalton initiated coverage of Algonquin Power & Utilities Corp. (AQN-T) with a "market perform" rating and $15 target. The average is $15.07.

Cowen analyst Andrew Charles upgraded McDonald's Corp. (MCD-N) to "outperform" from "market perform" with a target of $180 (U.S.), up from $142. The average is $155.58.

Northcoast Research analyst Charles Cerankosky upgraded Costco Wholesale Corp. (COST-Q) to "buy" from "neutral" with a target of $190 (U.S.). The average is $185.84.