Tuesday's analyst upgrades and downgrades

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

Canadian building materials companies are "very well positioned to outperform," according to Raymond James analyst Daryl Swetlishoff.

However, he cautions investors to expect volatility in the wake of the U.S. Commerce Department's announcement of new preliminary anti-dumping duties on Canadian softwood lumber on Monday, averaging 6.87 per cent. With the preliminary countervailing duties announced in April, the cumulative duty total rises to 26.75 per cent.

"Under U.S. trade law, preliminary duties have finite lives and the current preliminary CVD is scheduled to expire at the end of August at which point cash deposits will no longer be required (until the final CVD determination from the ITC expected late 2017/early 2018)," said Mr. Swetlishoff. "We expect the deposit on/deposit off game to distort markets and contribute to increased price and share volatility. Similar to the 2001-2006 Lumber IV battle, we see a high a probability that final rates are materially reduced. Also similar to past disputes, as litigation drags on we expect investors to become desensitized to the process and focus instead on the increasingly attractive fundamentals. As the AD duty came in lighter than the market expected, and given their higher than average Canadian exposure, we expect Canfor, Conifex, and Western Forest to be the biggest beneficiaries and would expect them to outperform on the news."

In a research report on the sector, Mr. Swetlishoff said he's "increasingly bullish" on the outlook for lumber prices in 2018. He believes "steady" demand growth, with U.S. consumption up 6.5 per cent annually since 2011, is outstripping reduced Canadian supply.

"With excess lumber demand we forecast SPF lumber to average $400 U.S. per thousand board feet (mfbm) in 2018, supporting higher lumber segment earnings – despite the assumed duty rates," he said.

Accordingly, he said the building materials industry is "poised to outperform," adding: "Our estimates indicate lumber stocks are currently discounting $340-375 per mfbm pricing assuming 26.75 per cent combined export duties. While our expectation for materially higher commodity pricing (with a high probability of lower duties) largely backstops our bullish view, we also highlight the strong position of the western Canadian industry. Following years of elevated strategic capital spends (including accretive M&A) the industry is poised to capitalize with record productivity and efficiency. Further, with strong historic and forecast FCF generation, balance sheets are in good shape, setting the stage for further accretive capital spends or the return of excess cash to investors."

He did not change his rating or target prices for the sector's stocks following the announcement. They are currently:

- Acadian Timber Corp. (ADN-T): "strong buy" rating and $23 target. Consensus: $19.56.

- Canfor Corp. (CFP-T): "strong buy" and $24. Consensus: $21.83.

- Conifex Timber Inc. (CFF-T): "outperform" and $6. Consensus: $4.69.

- Interfor Corp. (IFP-T): "strong buy" and $26. Consensus: $22.50.

- Norbord Inc. (OSB-T, OSB-N): "strong buy" and $54. Consensus: $44.92.

- West Fraser Timber Co. Ltd. (WFT-T): "outperform" and $67. Consensus: $64.29

- Western Forest Products Inc. (WEF-T): "outperform" and $2.75. Consensus: $2.59.

- CanWel Building Materials Group Inc. (CWX-T): "strong buy" and $7.50. Consensus: $7.29.

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In reaction to a 9-per-cent increase in share price since late April, exceeding his target, CIBC World Markets analyst Scott Fromson downgraded his rating for Winpak Ltd. (WPK-T) to "neutral" from "outperformer."

"We are not aware of any specific development that has driven the price rise," he said. "We continue to view Winpak as a well-run company with a high quality product suite and good growth prospects. At this point in early summer, however, we could see the stock taking a pause."

Mr. Fromson questioned how Winpak, a Winnipeg-based company that manufactures and distributes packaging materials and related packaging machines, will utilize its current cash position of more than $200-million (U.S.). He suggested acquisitions will be difficult due to high valuation.

"Private equity continues to be active in the packaging deal space and multiples appear high," he said. "While valuations on most deals are undisclosed, anecdotally, typical enterprise value/EBITDA multiples are in the high-single to low-double digits - above what we believe Winpak would be likely willing to pay."

"We are comfortable with Winpak staying away from a heated acquisition market; the company already has a viable production footprint and a high degree of production expertise in its product lines. We continue to believe the company is more likely to pursue internal investment in additional production capacity. Winpak has a well-established track record of designing and building manufacturing facilities, based on a 20-per-cent IRR [internal rate of return] hurdle. Geographically, Winpak could brownfield, including Winnipeg, or it could greenfield, particularly in the Central U.S. The flipside to the less costly internal-build option is longer timeline, around 18 to 24 months. This means near-term catalysts are less likely."

Mr. Fromson kept his target price for the stock of $60. Consensus is $62.42.

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RBC Dominion Securities analyst Elvira Scotto lowered her financial estimates for Kinder Morgan Inc. (KMI-N) to incorporate the initial public offering of 30 per cent of its Canadian business.

Kinder Morgan Canada Ltd. (KML-T) was priced at $17 (Canadian) per share and generated $1.75-billion in gross proceeds. KML was given an "outperform" rating and $25 target by Ms. Scotto's colleague Robert Kwan last week.

"KMI used net proceeds of $1.2-billion U.S. to repay debt and now expects to exit 2017 with 5.2 times Net Debt/EBITDA (previously expected 5.4 times)," the analyst said. "KMI still expects to provide its revised dividend guidance later in 2017."

She added: "We still expect KMI to restart dividend growth in 4Q18, which is when we forecast 5.0 times debt/EBITDA."

Ms. Scotto's earnings before interest, taxes, depreciation and amortization and discounted cash flow projection for 2017 are now $7.18-billion and $4.408-billion, respectively, from $7.135-billion and $4.458-billion. Her estimates moved to $7.521-billion and $4.713-billion from $7.464-billion and $4.794-billion.

With an unchanged "sector perform" rating, Ms. Scotto's target fell to $22 (U.S.) from $25. The analyst consensus price target is $25.14.

"While we believe a robust multibillion-dollar organic growth project backlog will drive visible cash flow growth longer-term, high leverage keeps us on the sidelines," she said.

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Recent weakness in the share performance of Fairfax Financial Holdings Ltd. (FFH.U-T, FFH-T) presents a buying opportunity for investors, according to RBC Dominion Securities analyst Mark Dwelle.

He blamed the stock's decline of nearly 10 per cent over the past few weeks on merger arbitrage positioning ahead of its acquisition of Allied World Assurance Company Holdings Ltd. (AWH-N). He expects the transaction to be accretive to core 2017 operating earnings by 50 cents and $1.75 in 2018.

"We do not believe the share movement is primarily indicative of any underlying concerns about the deal being completed or any company specific concerns related to either Fairfax or Allied World," said Mr. Dwelle. "Rather we believe it is primarily driven by positioning in advance of the closing of the deal. We have seen this sort of activity in other transactions which involve a fairly low-average daily volume stock like Fairfax and transactions which have a meaningful stock component (Markel's acquisition of Alterra is one example that comes to mind)."

Mr. Dwelle also cited a positive outlook for Fairfax's book value growth in the second quarter.

"Indeed over the course of the second quarter Fairfax has had some positive news related to several of its investment holdings which should result in favorable marks at June 30th," he said. "Most notably, the company said it would sell about one-third of its stake in ICICI Lombard which we calculate will ultimately produce realized and unrealized gains of about $680 million pre-tax (i.e. Fairfax's full stake would be valued at approximately $1.05-billion and is carried at a value of about $370-million resulting in a total gain of $680-million of which $240-million will be realized upon closing which will likely be in the third quarter and the balance will be an unrealized gain). After applying a 35-per-cent tax rate we'd estimate a book value gain of around $19 per share from this transaction. We would also anticipate favorable marks for the company's holdings in Fairfax India and Blackberry as well. We'd note that these could be offset by any adverse marks on other specific holdings although equity and bond markets have been favorable during the quarter. We'd also note that 2Q cat losses have been average so we wouldn't expect any big surprises in operating results."

Mr. Dwelle has an "outperform" rating for the stock. He did not specify a target.

"We believe the current valuation is attractive and recent share price weakness is not reflective of fundamental concerns," he said. "With an attractive and accretive acquisition pending we're inclined to use the short-term pressure as a buying opportunity."

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Desjardins Securities analyst Keith Howlett updated his financial model for Alimentation Couche Tard Inc. (ATD.B-T) to include the $4.4-billion acquisition of CST Brands Inc. (CST-N).

On Monday, the Laval, Que.-based company won antitrust approval from the U.S. Federal Trade Commission to buy its U.S. peer on condition that it sell up to 71 stores in eight states. The closing of the deal is expected on Wednesday.

"The Federal Trade Commission (FTC) reviewed the proposed acquisition of CST Brands by Couche-Tard and required divestiture of 70 locations in the U.S. where CoucheTard would otherwise have had a monopoly in the trade area, or where there would have been only 2–3 competitors," said Mr. Howlett. "The agreed divestitures are concentrated in Arizona (25), Texas (19) and Colorado (10). Couche-Tard will acquire and operate the stores before it divests them in late August or early September. We do not expect the U.S. divestitures to materially affect Couche-Tard management's expectation that the CST Brands acquisition will add 40-50 cents U.S. of EPS by the third year post closing. The Canadian competition regulators are expected to announce their views later this week with respect to Couche-Tard's acquisition of CST's Ultramar assets in Canada. Couche-Tard has already privately agreed to divest all the dealer stores, a minimum of 45 per cent of the corporate stores, the card-lock sites and ancillary businesses to Parkland Fuel Corporation, subject to a separate evaluation by the competition authorities."

Mr. Howlett reduced his fiscal 2017 earnings per share estimate to $2.23 (U.S.) from $2.27 to account for higher fourth-quarter expenses. He maintained a 2018 projection of $2.52.

He maintained a "buy" rating and $76 (Canadian) target for the stock. Consensus is $76.34.

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Baytex Energy Corp. (BTE-T) had a "strong" second quarter of production, said TD Securities analyst Menno Hulshof.

However, he thinks the Calgary-based company missed an opportunity to "tighten up" its 2017 guidance range of 68,000-70,000 barrels of oil equivalent per day with its quarterly operational update on Monday.

"BTE instead elected to leave it unchanged given another sharp pullback in WTI prices (we entered 2017 at $57 U.S. per barrel, they have since pulled back to $43.50 per barrel)," said Mr. Hulshof. "In our view, this changes the investment outlook given its WTI corporate breakeven guidance of just over $50 per barrel."

Baytex announced a production estimate of 72,500 boe/d, topping both the analyst's expectation and the consensus estimate by 5 per cent. Mr. Hulshof said the beat was due largely from higher-than-anticipated volumes from its Eagle Ford operations in Texas, which topping his projection by 8 per cent.

"To achieve the midpoint of its full-year guidance range, H2/17 production now only needs to average 67,000 boe/d. It is also tracking in line with expectations, with Q2 capex of $78-million," the analyst said.

Mr. Hulshof maintained a $5 target for the stock. Consensus is $6.09.

"Although our target return currently stands at 65 per cent, we are maintaining our HOLD rating, given extreme share-price volatility and a pending commodity price deck update," he said.

Elsewhere, BMO Nesbitt Burns analyst Ray Kwan also called the production update "strong."

"We view Baytex as having option value to higher oil prices, although leverage remains high relative to its peers with a 2018 estimated debt/cash flow of 6.9 times verus the group at 2.3 times (BMO deck)," said Mr. Kwan. "However, we do note that the company does not have any meaningful maturities on its senior notes until 2021. We maintain our Market Perform rating and $3.50 target price."

Canaccord Genuity analyst Dennis Fong deemed the update "positive," keeping a "buy" rating and $7.50 target.

"We believe the above average leverage provides a perceived overhang on the stock, but with the securitization of debt and no near-term maturities, most of these concerns should be alleviated," he said. "As we proceed into the second half of 2017, we believe Baytex provides an investment opportunity in a company which has significant torque to oil, sustainable oil production and additional upside from its Peace River Arch asset base."