Wednesday’s analyst upgrades and downgrades

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

Investor reaction to Berkshire Hathaway’s “substantial exit” of its position in Home Capital Group Inc. (HCG-T) is “overdone,” according to Raymond James analyst Brenna Phelan.

Shares of the Canadian mortgage lender were down over 11 per cent in late morning trading on Wednesday in reaction to news that Warren Buffett’s stake will drop to less than 10 per cent following the completion of a share buyback.

Seeing an “attractive” entry point for HCG shares, Ms. Phelan upgraded her rating to “outperform” from “market perform.”

“As Berkshire commented in a press release that the size of this investment is now not of a size to justify ongoing involvement, we suspect Berkshire may exit its remaining 2.7 million shares,” she said. "While the market reacted negatively to the news that Berkshire had sold, our more objective view is that the investment is in fact too small to be meaningful for this entity, and that the position was nicely profitable over the investment horizon.

“Our mortgage origination and net interest margin forecasts, which were already conservative, are unchanged. Our forecasts assume a continuing slow-down in housing and originations, ongoing margin pressure, and modestly higher losses than in 2018; not a full-on recession. We have now added a forecast reinstatement of a dividend, beginning in 1Q19, of 10 cents per quarter. This represents a yield of 3.00 per cent at the current share price, and a payout ratio of 19% in 2019 and 18 per cent in 2020.”

Seeing valuation upside, Ms. Phelan maintained a target price of $18.50 per share. The average target on the Street is $19.29, according to Bloomberg data.

“While we have a positive view on the steps taken by Home Capital to return to business as usual after last year’s liquidity event, we have been cautious on the outlook for earnings growth and a meaningful valuation re-rate, given the combination of each of regulatory reform and higher interest rates’ pressure on volumes and funding costs, as well as the potential for higher loan losses due to both the impact of higher interest rates on debt service ratios and from the impact of increased volatility in the inputs to HCG’s IFRS 9 Allowance for Credit Loss model,” the analyst said.

Elsewhere, Industrial Alliance Securities analyst Dylan Steuart maintained a "speculative buy" rating and $22 target.

Mr. Steuart said: “While we expect some near term weakness, given the Buffett exit and the overhang of Berkshire’s remaining position, continued operational stabilization into 2019 will continue to close the valuation gap to book value.”

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Credit Suisse analyst Fahad Tariq expects to see a further recovery in gold prices in 2019, pointing to “a prevailing risk-off sentiment due to a combination of tightening monetary policy, trade war risks, and potential for slowing economic growth.”

“Also, there are signs of peak USD, real yields potentially topping out, and increased central bank buying, all of which support higher gold prices,” said Mr. Tariq in a research report released Tuesday.

In the wake of a 4-per-cent drop through 2018, the analyst projects average gold prices will rise to US$1,275 per ounce in 2018 and continue to increase to US$1,300 in 2020 and beyond.

“Gold equities sold off heavily in 2018, with our coverage down 19 per cent (though gold was down only 4 per cent),” he said. “This presents an attractive entry point, particularly for equities with favorable valuations (i.e., trading at historically lower bound P/NAV, EV/EBITDA, and/or P/E). We have therefore increased the valuation weight in our scorecard. The other two important factors for outperformance in 2019 in our view, along with valuation, are relative execution risk and growth profile.”

Mr. Tariq upgraded IAMGOLD Corp. (IAG-N, IMG-T) to “outperform” from “neutral” with a target of US$6.50, rising from US$6 and above the consensus of US$6.18.

However, he downgraded a pair of equities.

He lowered Wheaton Precious Metals Corp. (WPM-T, WPM-N) to “neutral” from “outperform” with a $30 target. The average is $35.98.

His rating for Kinross Gold Corp. (KGC-N, K-T) fell to “underperform” from “neutral" with a US$3.25, which falls below the US$3.88 average.

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A pair of equity analysts downgraded their ratings for Neo Performance Materials (NEO-T) in reaction to Tuesday’s announcement that it has signed a definitive agreement to be acquired by Luxfer Holdings PLC (LXFR-N) for US$612-million in cash and stock.

Manchester, England-based Luxfer is set pay to US$5.98 in cash and issue 0.395 LXFR share for each NEO share held.

Raymond James analyst Frederic Bastien called it a “steal of a deal” for Luxfer.

“While the offer initially valued Neo Performance Materials at US$612 mln (C$19.35 per share) pre-open, or roughly 8.0 times the firm’s TTM [trailing 12-month] adjusted EBITDA, it would eventually slip to an implied purchase price of US$570 mln (C$18.06 per share and 7.3 times TTM EBITDA) by market close due to a 12-per-cent drop in the LXFR share price,” he said. “Evidently, Luxfer’s plot to tie up with a China-centric supplier of rare earth based functional materials amid an ongoing trade war didn’t sit well with its shareholders. But as they start better appreciating just how strategic Neo’s engineered products are, we expect the original deal parameters to be largely respected.

“For Luxfer, the acquisition of Neo would meet several strategic goals. It’d complement LXFR’s current portfolio of aluminum, zirconium and magnesium based products with high-value rare earth based magnetic products, opening the door of a multi-billion dollar market opportunity—the electrification of the automotive industry. The deal would also boost Luxfer’s Asian business to 33 per cent of revenues from 10 per cent, expanding its access to high-growth markets and creating more direct channels to procure raw materials. Last but not least, Neo would almost double the firm’s size (to just under $1-billionn in revenues) and allow for cross-selling opportunities across customers and geographies.”

Viewing the potential interloper risk as low, Mr. Bastien moved Neo to “outperform” from “strong buy” with a target price of $19.25, down from $24. The average target on the Street is $20.16.

“Although we expect the deal to face no competing bid and obtain all necessary regulatory clearances in early 2Q19, there is sufficient noise around it and NEO’s outsized exposure to China’s rare earths market to create an opportunity for arbitrage,” he said. “For this reason we maintain a positive bias on the stock.”

Elsewhere, CIBC World Markets analyst Scott Fromson dropped Neo to “neutral” from “outperform” with a target of $18, falling from $20.50.

Mr. Fromson said: “In the current environment – a jittery market (particularly for small caps), an unrelenting U.S./China trade dispute and a softening vehicle sales outlook – we see the deal as positive for NEO and its shareholders. We are reducing our price target from $20.50 to $18.00, in line with implied transaction valuation. Further, we are downgrading the stock from Outperformer to Neutral to account for a potentially prolonged deal closing, as well as our limited familiarity with Luxfer’s business prospects. While our new price target implies 9-per-cent return from the current price (16 per cent on an annualized basis, assuming end of Q2/19 deal closing), we see the investment case as one better suited to investors with higher-risk tolerances.”

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With the removal of the overhang stemming from its strategic review and possessing a “clear path ahead,” Canaccord Genuity analyst Jenny Xenos upgraded Parex Resources Inc. (PXT-T) to “top pick.”

“PXT announced [Tuesday evening] that its strategic review process ‘did not result in an acceptable proposal,’” she said. “In other words, there will be no sale or other strategic transaction and the company will continue on.

“We think that the stock may be down substantially [Wednesday], as event-driven shareholders exit the name. We see it as a great opportunity to buy PXT, a premium International E&P name with an unmatched track record of growth and value creation, at current undervalued levels.”

Calling it a “growth machine” and believing it possesses an “attractive valuation,” Ms. Xenox has a “buy” rating and $32 target for the stock. The average on the Street is $29.39.

“The stock is down nearly 50 per cent off its peak, since the review of strategic alternatives was announced by the company in July,” the analyst said. “It now trades at 2.3 times 2019 estimated enterprise value-to-debt-adjusted cash flow (EV/DACF), below its peer average of 2.9 times, despite having the best growth track record in the group. Parex’s shares are trading at less than half their five-year average EV/DACF multiple of 6.3 times. Based on consensus estimates of EV/Forward 12-month DACF, the stock is trading more than one standard deviation below its five-year average multiple.”

She added: “We recommend taking advantage of what we believe will likely be a short-lived weakness in the PXT share price, and buying the stock at current levels.”

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Seeing near-term headwinds and calling the rapid change in is valuation multiple “somewhat jarring,” CIBC World Markets Paul Holden slashed his target for shares of Onex Corp. (ONEX-T).

“We had become accustomed to the stock consistently trading at a premium to proprietary capital for much of the last six years,” he said. “The premium averaged 8.5 per cent since the beginning of 2013 and even exceeded 20 per cent not that long ago. Now the multiple sits at negative 12 per cent. How did it get there and why? We believe there are four primary explanations for the change in valuation multiple: 1) the macro environment changed with negative implications for both equity and credit valuations; 2) specific concerns around the levered loan market and Onex’s exposure through its CLO [collateralized loan obligation] investments; 3) below-target trailing returns, which have raised questions around future return expectations; and 4) a number of underlying investments are struggling accentuating concerns around the basis of value (i.e., the value of proprietary capital itself) in the near term.

“We have seen what factors #1 and #4 have done to the stock in the past. Onex was trading at a material premium to proprietary capital in 2007 and just one year later was at a near 50-per-cent discount. The change in proprietary capital was not nearly as significant with a 9-per-cent decline from peak to trough and that includes the impact of one investment going bankrupt (Hawker Beechcraft). This is not to say that we are heading for similar situation – either for the macro environment or for Onex. Rather we are pointing out that the risk in the stock is from a valuation multiple perspective far more so than from a capital perspective.”

Pointing to several short-term risks, including exposure to levered loans through investments in CLOs and private equity returns, Mr. Holden dropped his target to $65 from $85 with a “neutral” rating (unchanged). The average is currently $106.

“Onex’s valuation multiple has rapidly re-rated lower, similar to 2007- 2008,” he said. “We do not dispute that this provides an interesting entry point for those with long time horizons, but we see potential for further downside in the near term given rapidly repricing equity and credit markets. Moreover, we could make the same long-term valuation conclusion for many of the stocks in our coverage universe.”

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In the wake of recent outperformance, Bank of America Merrill Lynch analyst Kenneth Bruce downgraded American Express Co. (AXP-N) to “neutral” from “buy.”

“It’s been a good run but ... given the broader market volatility and elevated uncertainty relating to the macro backdrop, we anticipate weaker sentiment,” he said.

“We think valuation will be restrained in a market backdrop highlighted by wild and unpredictable swings.”

Believing shareholders could lock in gains following its strong 2018, he lowered his target for the stock to US$115 from US$125, which falls below the consensus of US$116.40.

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“The struggle is real” for Micron Technology Inc. (MU-Q), said RBC Dominion Securities analyst Amit Daryanani, who downgraded his rating for its stock to “sector perform” from “outperform.”

On Tuesday after market close, the Idaho-based chip maker reported quarterly earnings per share and revenue of US$2.97 and US$7.91-billion, versus the Street’s expectation of US$2.95 and US$8.0-billion. Its second-quarter guidance of US$1.75 and US$6-billion at the mid-point was well short of expectations (US$2.39 and US$7.26-billion).

Lowering his financial expectations for Micron in reaction to the guidance miss, Mr. Daryanani said: “While MU has corrected severely year-to-date our rationale to lower our rating is: 1) Inventory risk: MU’s reaction to ongoing downturn is to hold extra inventory on their books (inventory up 22 per cent year-over-year and heading higher in Feb). We see risk to the strategy given memory is a depreciating asset specially if the correction gets severe, 2) Demand risk: While MU is taking steps to adjust capacity their over-arching belief is this is an inventory issue at customers coupled with some excess supply. We see a real possibility there is a demand issue mid-CY19 needing further reduction in capacity and/or lower pricing, 3) Competitive Risks: While MU intends to reduce DRAM bit supply rrom 20 per cent to 15 per cent, its unclear if others in DRAM (especially Hynix) would curtail output. On NAND, we yet have to see reductions from Toshiba among others. 4) OPEX levels: MU’s OPEX is inflecting higher (currently $200M above CY17 levels), this could compress EPS further in May-quarter vs. street expectations. Net/net: While MU (and memory) is an attractive asset to own long-term (especially DRAM) and stock at book/replacement value is likely troughing. Our shift to SP rating reflects our belief that there is sizable risk for rev/GM/EPS reductions over the next 2-3 quarters.”

His target for the stock dropped to US$40 from US$59. The average is now US$50.23.

Elsewhere, Needham analyst Rajvindra Gill lowered the stock to “hold” from “strong buy,” expressing concern about a deterioration in demand conditions and the impact on margins.

“While we are hesitant about downgrading at this valuation level, we believe the overall demand environment will remain murky for at least the next six months and therefore we move to the sidelines," said the analyst.

Mr. Gill did not specify a target price.

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Bank of America Merrill Lynch analyst Bryan Spillane upgraded Hershey Co. (HSY-N) by two notches to “buy” from “underperform,” seeing its business investments in 2017 and 2018 resulting in “improved organic sales and operating profit growth.”

Mr. Spillane thinks a combination of new products, full year of new stand up packaging, expanded capacity, U.S. price increases, and “lapping” of the Amplify deal have positioned the company to accelerate organic sales growth by 200 basis points in 2019.

“While the chocolate, candy and gum category is slowing, Hershey has taken strategic actions through reinvestment, acquisitions and divestitures and cost savings to drive both sales and earnings growth. Hershey has positioned itself better than peers to grow sales and profits while maintaining flexibility to return cash to shareholders,” he said.

The analyst hiked his target to US$120 from US$92, which exceeds the average on the Street of US$104.75.

“We believe that Hershey has good visibility into their growth algorithm with relatively low exposure to international risk. We expect earnings to grow 6 percent over the next few years as accelerated investments made in 2018 start to flow through,” he said.

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Mackie Research Capital analysts Greg McLeish and Nicola McFadden initiated coverage of Flower One Holdings Inc. (FONE-CN) with a “buy” rating and $4.50 target. The average is $3.

The analyst said: “We forecast that the majority of companies operating in the cannabis sector will not experience material revenue or earnings growth until at least 2019 or 2020. As a result, we value Flower One based on our financial projections through 2020. However, investing in the cannabis sector is not for the faint of heart since companies operating in the sector will most likely experience both regulatory and operational challenges. While Flower One could experience operational challenges ramping up its new 455,000-square foot facility, management’s knowledge of high-density agriculture should help to de-risk this process which should result in strong revenue and earnings growth through our forecast period.”

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In other analyst actions:

JPMorgan Chase & Co. analyst Christopher Turnure initiated coverage of AltaGas Ltd. (ALA-T) with a “neutral” rating and target price of $14. The average target on the Street is currently $19.50.

Northland Securities Inc initiated coverage of Planet 13 Holdings Inc. (PLTH-CN) with an “outperform” rating and $3.75 target, which falls below the average of $4.83

With files from Bloomberg News