In this issue:

Next issue: July 25

A NEW GROWTH PICK

By Gordon Pape, Editor and Publisher

In the June issue of Update Edition, I suggested that one of the ways to counteract the effect of higher interest rates on the prices of dividend stocks is to look for companies with above-average growth potential.

As examples, I cited Norbord (TSX: NBD, OTC: NBRXF) and TAL International Group (NYSE: TAL). Norbord is trading a little below our original recommended price while TAL is showing a nice gain. Both offer excellent yields and both are still buys for investors who can tolerate some risk.

Now I have another name to add to the growth stocks list. This particular company was brought to my attention by a reader who was intrigued by its high yield and wanted to know if it was worth buying.

High yields are almost always an indication that the market sees above-average risk in a stock. But in this case, the company appears to be sound, its growth record is impressive, and its payout ratio is conservative, based on the way it is calculated. More on that below. The stock is pricey on a trailing P/E ratio basis and is trading near its all-time high. But even in this range, it appears to offer decent value. Here’s the story.

Premium Brands Holdings Corporation (TSX: PBH, OTC: PRBZF)

Type: Common stock
Trading symbol: PBH, PRBZF
Exchange: TSX, Grey Market
Current price: C$19.49, US$18.34
Entry level: Current price
Annual payout: $1.25
Yield: 6.4%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.premiumbrandsholdings.com

The business: Premium Brands is a Vancouver-based company that owns a broad range of specialty food manufacturing and differentiated food distribution businesses. It has operations across Canada with the exception of the Atlantic provinces, as well as in Nevada and Washington State. Its brands and businesses include Grimm’s, Harvest, McSweeney’s, Bread Garden Go, Hygaard, Hempler’s, Quality Fast Foods, Gloria’s Best of Fresh, Direct Plus, National Direct-to-Store Distribution, Harlan Fairbanks, Creekside Bakehouse, Centennial Foodservice, B&C Food Distributors, Shahir, Wescadia, Duso’s, Maximum Seafood, SK Food Group, OvenPride, Hub City Fisheries, Audrey’s, Deli Chef, Piller’s and Freybe.

The security: We are recommending the common shares of Premium Brands, which trade under the symbol PBH on the Toronto Exchange. They are also listed on the U.S. over-the-counter Grey Market under PRBZF but they trade very infrequently there.

Why we like it: Let’s start with the payout. In March the company announced it was increasing its quarterly dividend by 6.3% to $0.3125 per share ($1.25 annually). It was the first increase since the company converted from income trust status in 2009. At the new rate, the stock yields 6.4%.

In announcing the increase, CEO George Paleologou commented: “Over the last seven years we have made significant progress towards achieving our goal of a 50% dividend payout ratio. Last year our payout ratio was 52%. This compares to a payout ratio of over 100% when we first started to declare distributions to our shareholders in mid-2005.”

The company’s growth profile is impressive. Over the four years from 2009 to 2012, sales increased by 109% from $462.8 million to $968.8 million. Operating income increased by 67.6% during that time, to $68.3 million. However, that did not translate into higher net earnings; in fact earnings per share dropped from $1.07 to $0.73 over the period.

Management is constantly on the look-out for new acquisitions and recently completed the purchase of Freybe Gourmet Foods Ltd. at a cost of $55 million. The company said the transaction will be immediately accretive to both earnings per share and free cash flow per share.

Financial highlights: The company reported record first-quarter revenue of $229.2 million, up 5.9% from the same period in 2012. Adjusted EBITDA also set a new record at $12.8 million, compared to $11.6 million in the first quarter of 2012. Over the past four quarters, free cash flow totalled $47.8 million or $2.30 a share.

Risks: The company bases its payout ratio on free cash flow rather than net earnings, a practice which I consider to be questionable in a conventional business. Using 2012 net earnings as a measure, the current payout ratio is a whopping 171%.

On the plus side, analysts estimate on average that Premium will earn $1.52 a share in 2014, according to Yahoo! Finance. That would be sufficient to cover the payout and then some, if it materializes.

The high share price should also factor into your investment decision. Premium has had a strong run, moving up from $16.95 in mid-January to the current level. It is now trading above its 50-day moving average so it could be due for a pull-back to consolidate. I rate it as Higher Risk.

Distribution policy: Dividends are paid quarterly in January, April, July, and October. If you don’t already own shares, your next dividend will be in October as the record date for the July payment was June 28.

Tax implications: Payments are eligible for the enhanced dividend tax credit if they are held by Canadians in a non-registered account. U.S. residents will have to pay a 15% withholding tax, which may be reclaimable as a foreign tax credit.

Who it’s for: This stock is suitable for investors who are looking for above-average yield plus capital gains potential and who are willing to assume some risk.

How to buy: The shares tend to be rather thinly traded with TSX volume under 10,000 on some days. So enter a limit order and be patient. U.S. residents should buy on the Toronto Exchange if possible. Average daily volume on the Grey Market is only 1,320 and the stock can sometimes go for several days with no trading.

Summing up: Premium Brands meets the qualifications for a high-yield growth stock, albeit with some risk.

Action now: Premium is a Buy for more aggressive investors. The shares closed on July 8 at C$19.49 and US$18.34. – G.P.

Follow Gordon Pape’s latest updates on Twitter: http://twitter.com/GPUpdates

 

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JULY UPDATES

Here are the updates for this issue. All prices are as of the close of trading on Monday, July 8 unless otherwise indicated.

First Capital Realty (TSX: FCR, OTC: FCRGF)

Type: Common stock
Trading symbol: FCR, FCRGF
Exchange: TSX, Grey Market
Current price: C$17.65, US$16.99 (June 27)
Originally recommended: Jan. 20/05 at C$11.97 (split-adjusted)
Annual payout: $0.84
Yield: 4.7%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.firstcapitalrealty.ca

Comments: Although it is also in the real estate business, First Capital fared better than some of the REITs in the sell-off that followed the recent spike in interest rates. The shares reached a 52-week high of $19.95 in mid-May, fell back to $17.25 on June 24, and have since rallied to close on Monday at $17.65 on the TSX.

First-quarter results showed an increase of almost 20% in funds from operations (FFO) compared to the same period in 2012. However, FFO per share remained unchanged at $0.25 due to an increase of almost 28 million in the number of shares outstanding. The company slightly adjusted its projected FFO per share for the full year to the $1.03 to $1.06 range.

First Capital has retained its quarterly dividend at $0.21 a share ($0.84 annually) thus far in 2013. The last increase was in August 2012.

Action now: Hold. Rising interest rates may put downward pressure on the stock. – G.P.

 

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Morneau Shepell Inc. (TSX: MSI, OTC: MSIXF)

Type: Common stock
Trading symbol: MSI, MSIXF
Exchange: TSX, Grey Market
Current price: C$14, US$13.42 (June 13)
Originally recommended: July 27/11 at C$10.24, US$10.76
Annual payout: $0.78
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: Morneau Shepell is the Canadian leader in human resources consulting and outsourcing services. That’s not the kind of business that is going to excite many people but the stock has been a good performer for us and offers a nice dividend of 5.6%. However, there are some weaknesses in the company’s financial profile that investors should be aware of.

The first-quarter numbers highlighted what I consider the most important of these. On the positive side, revenue was up by 11% to $115.7 million and net earnings per share increased to $0.14 compared to $0.09 a year ago. However, earnings are still well below the level of the dividend payment which is $0.065 per month or $0.195 per share for the quarter.

The company does generate enough free cash flow to cover the dividend but that figure fell by $500,000 in the first quarter compared to last year, to $12.7 million due to higher taxes and capital expenditures. As I said in my recommendation of Premium Brands, I am always more comfortable when net earnings exceed dividends paid by a healthy margin.

That said, Morneau Shepell shares are up more than 35% since I recommended them two years ago and the stock continues to offer an attractive yield. However, I don’t see much upside potential in the share price at this time and we are unlikely to see any dividend increase for quite a while.

Action now: Hold for income. – G.P.

 

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North West Company (TSX: NWC, OTC: NWTUF)

Type: Common stock
Trading symbol: NWC, NWTUF
Exchange: TSX, Grey Market
Current price: C$23.05, US$23.40
Originally recommended: April 25/07 at C$18.83, US$16.65
Annual payout: $1.12
Yield: 4.9%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.northwest.ca

Comments: This modern-day successor to the historic company that opened the Canadian north reported first-quarter 2013 results (to April 30) that were pretty much flat across the board.

Sales were down by $1 million compared to a year ago, at $364.5 million. Operating earnings increased by a modest 0.5% to $20.5 million but net earnings fell 2.5% to $12.9 million. However, on a per share basis, net earnings were flat at $0.27. That’s a penny less than the per share amount paid in dividends but the first quarter is normally the weakest of the year for the company.

North West operates general stores across the Canadian north and in Alaska, as well as the Giant Tiger outlets in urban centres. At the current price, the shares yield 4.9%.

There is not much growth potential here but neither is there significant downside risk as far as the business itself is concerned although the share price could be negatively affected by an increase in interest rates.

Action now: Hold. – G.P.

 

Return to the table of contents…

YOUR QUESTIONS ANSWERED

Worried about REITs

Q – Since being a subscriber I have enjoyed watching positive performance of Income Investor recommendations in my portfolio. A few articles ago we were forewarned that when interest rates started their rise, the interest sensitive sectors such as the REITs and utilities, in particular, would be adversely impacted.

I certainly did not imagine that the 10-year bond rate going from 1.6% to 2.2% would have such an immediate impact on those sectors. Anyway, I have held several REITS representing about 11% of our portfolio for about four years each but have added to positions during that time for income reasons (we are over age 70 but I enjoy managing our portfolio with some success).

If the REIT sector fell another 10% from the present levels, the REIT portion of our portfolio would still show a profit but I am more concerned about the probable negative impact on AFFOs (adjusted funds from operations) leading to distribution cuts as payout percentages increase. Moreover, am I correct in assuming that changes in the retail business models due to greater competition, over expansion, and lower pricing power are likely to lead to much lower growth for companies focused mainly in that sector, such as Riocan? Will changing business dynamics such as mergers and greater acceptance of working at home due to the support of business related software lead to less need for office space, not to mention Encana’s cost cuts that could impact the “Bow” in Calgary (Dundee, HR REIT)?

If you were in this position, what would you do? I already own some of the infrastructure recommendations given in the most recent Income Investor such as BIP.UN and IPL.UN that could be added to if cash were generated from the REIT positions.

Regards and thanks for the excellent product that I enjoy twice monthly! – Fraser E.

A – As you may recall, Gavin Graham did a comprehensive review of the REIT sector in the issue of May 30. At the time, he rated all his REIT recommendations as Buys.
 
The sharp drop in price is not so much a reflection of the recent move in rates as it is an expression of investor concern about more rate increases to come. Rate increases are bad news for REITs for two reasons. First, it increases the cost of financing. Second, it narrows the yield gap between higher-risk REITs and lower-risk bonds, resulting in a price correction in the REITs to enhance yields.
 
However, interest rate increases go hand-in-hand with an improving economy. Economic growth should be beneficial to the cash flow of most REITs as it would result in lower vacancy rates and enhanced pricing power.
 
The risk of distribution cuts with REITs, or any other security, is a fact of life. We have no reason to expect distribution cuts in any of our picks in the near future but there are no guarantees.
 
As for what I would do, let’s just say I have not sold any of my REITs and have no plans to do so right now. – G.P.

 

That’s all for this issue of Update Edition. Look for your next regular issue of The Income Investor on July 25.

Best regards,
Gordon Pape, editor-in-chief

In this issue:

Next issue: July 25

A NEW GROWTH PICK

By Gordon Pape, Editor and Publisher

In the June issue of Update Edition, I suggested that one of the ways to counteract the effect of higher interest rates on the prices of dividend stocks is to look for companies with above-average growth potential.

As examples, I cited Norbord (TSX: NBD, OTC: NBRXF) and TAL International Group (NYSE: TAL). Norbord is trading a little below our original recommended price while TAL is showing a nice gain. Both offer excellent yields and both are still buys for investors who can tolerate some risk.

Now I have another name to add to the growth stocks list. This particular company was brought to my attention by a reader who was intrigued by its high yield and wanted to know if it was worth buying.

High yields are almost always an indication that the market sees above-average risk in a stock. But in this case, the company appears to be sound, its growth record is impressive, and its payout ratio is conservative, based on the way it is calculated. More on that below. The stock is pricey on a trailing P/E ratio basis and is trading near its all-time high. But even in this range, it appears to offer decent value. Here’s the story.

Premium Brands Holdings Corporation (TSX: PBH, OTC: PRBZF)

Type: Common stock
Trading symbol: PBH, PRBZF
Exchange: TSX, Grey Market
Current price: C$19.49, US$18.34
Entry level: Current price
Annual payout: $1.25
Yield: 6.4%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.premiumbrandsholdings.com

The business: Premium Brands is a Vancouver-based company that owns a broad range of specialty food manufacturing and differentiated food distribution businesses. It has operations across Canada with the exception of the Atlantic provinces, as well as in Nevada and Washington State. Its brands and businesses include Grimm’s, Harvest, McSweeney’s, Bread Garden Go, Hygaard, Hempler’s, Quality Fast Foods, Gloria’s Best of Fresh, Direct Plus, National Direct-to-Store Distribution, Harlan Fairbanks, Creekside Bakehouse, Centennial Foodservice, B&C Food Distributors, Shahir, Wescadia, Duso’s, Maximum Seafood, SK Food Group, OvenPride, Hub City Fisheries, Audrey’s, Deli Chef, Piller’s and Freybe.

The security: We are recommending the common shares of Premium Brands, which trade under the symbol PBH on the Toronto Exchange. They are also listed on the U.S. over-the-counter Grey Market under PRBZF but they trade very infrequently there.

Why we like it: Let’s start with the payout. In March the company announced it was increasing its quarterly dividend by 6.3% to $0.3125 per share ($1.25 annually). It was the first increase since the company converted from income trust status in 2009. At the new rate, the stock yields 6.4%.

In announcing the increase, CEO George Paleologou commented: “Over the last seven years we have made significant progress towards achieving our goal of a 50% dividend payout ratio. Last year our payout ratio was 52%. This compares to a payout ratio of over 100% when we first started to declare distributions to our shareholders in mid-2005.”

The company’s growth profile is impressive. Over the four years from 2009 to 2012, sales increased by 109% from $462.8 million to $968.8 million. Operating income increased by 67.6% during that time, to $68.3 million. However, that did not translate into higher net earnings; in fact earnings per share dropped from $1.07 to $0.73 over the period.

Management is constantly on the look-out for new acquisitions and recently completed the purchase of Freybe Gourmet Foods Ltd. at a cost of $55 million. The company said the transaction will be immediately accretive to both earnings per share and free cash flow per share.

Financial highlights: The company reported record first-quarter revenue of $229.2 million, up 5.9% from the same period in 2012. Adjusted EBITDA also set a new record at $12.8 million, compared to $11.6 million in the first quarter of 2012. Over the past four quarters, free cash flow totalled $47.8 million or $2.30 a share.

Risks: The company bases its payout ratio on free cash flow rather than net earnings, a practice which I consider to be questionable in a conventional business. Using 2012 net earnings as a measure, the current payout ratio is a whopping 171%.

On the plus side, analysts estimate on average that Premium will earn $1.52 a share in 2014, according to Yahoo! Finance. That would be sufficient to cover the payout and then some, if it materializes.

The high share price should also factor into your investment decision. Premium has had a strong run, moving up from $16.95 in mid-January to the current level. It is now trading above its 50-day moving average so it could be due for a pull-back to consolidate. I rate it as Higher Risk.

Distribution policy: Dividends are paid quarterly in January, April, July, and October. If you don’t already own shares, your next dividend will be in October as the record date for the July payment was June 28.

Tax implications: Payments are eligible for the enhanced dividend tax credit if they are held by Canadians in a non-registered account. U.S. residents will have to pay a 15% withholding tax, which may be reclaimable as a foreign tax credit.

Who it’s for: This stock is suitable for investors who are looking for above-average yield plus capital gains potential and who are willing to assume some risk.

How to buy: The shares tend to be rather thinly traded with TSX volume under 10,000 on some days. So enter a limit order and be patient. U.S. residents should buy on the Toronto Exchange if possible. Average daily volume on the Grey Market is only 1,320 and the stock can sometimes go for several days with no trading.

Summing up: Premium Brands meets the qualifications for a high-yield growth stock, albeit with some risk.

Action now: Premium is a Buy for more aggressive investors. The shares closed on July 8 at C$19.49 and US$18.34. – G.P.

Follow Gordon Pape’s latest updates on Twitter: http://twitter.com/GPUpdates

 

Return to the table of contents…

JULY UPDATES

Here are the updates for this issue. All prices are as of the close of trading on Monday, July 8 unless otherwise indicated.

First Capital Realty (TSX: FCR, OTC: FCRGF)

Type: Common stock
Trading symbol: FCR, FCRGF
Exchange: TSX, Grey Market
Current price: C$17.65, US$16.99 (June 27)
Originally recommended: Jan. 20/05 at C$11.97 (split-adjusted)
Annual payout: $0.84
Yield: 4.7%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.firstcapitalrealty.ca

Comments: Although it is also in the real estate business, First Capital fared better than some of the REITs in the sell-off that followed the recent spike in interest rates. The shares reached a 52-week high of $19.95 in mid-May, fell back to $17.25 on June 24, and have since rallied to close on Monday at $17.65 on the TSX.

First-quarter results showed an increase of almost 20% in funds from operations (FFO) compared to the same period in 2012. However, FFO per share remained unchanged at $0.25 due to an increase of almost 28 million in the number of shares outstanding. The company slightly adjusted its projected FFO per share for the full year to the $1.03 to $1.06 range.

First Capital has retained its quarterly dividend at $0.21 a share ($0.84 annually) thus far in 2013. The last increase was in August 2012.

Action now: Hold. Rising interest rates may put downward pressure on the stock. – G.P.

 

Return to the table of contents…

Morneau Shepell Inc. (TSX: MSI, OTC: MSIXF)

Type: Common stock
Trading symbol: MSI, MSIXF
Exchange: TSX, Grey Market
Current price: C$14, US$13.42 (June 13)
Originally recommended: July 27/11 at C$10.24, US$10.76
Annual payout: $0.78
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: Morneau Shepell is the Canadian leader in human resources consulting and outsourcing services. That’s not the kind of business that is going to excite many people but the stock has been a good performer for us and offers a nice dividend of 5.6%. However, there are some weaknesses in the company’s financial profile that investors should be aware of.

The first-quarter numbers highlighted what I consider the most important of these. On the positive side, revenue was up by 11% to $115.7 million and net earnings per share increased to $0.14 compared to $0.09 a year ago. However, earnings are still well below the level of the dividend payment which is $0.065 per month or $0.195 per share for the quarter.

The company does generate enough free cash flow to cover the dividend but that figure fell by $500,000 in the first quarter compared to last year, to $12.7 million due to higher taxes and capital expenditures. As I said in my recommendation of Premium Brands, I am always more comfortable when net earnings exceed dividends paid by a healthy margin.

That said, Morneau Shepell shares are up more than 35% since I recommended them two years ago and the stock continues to offer an attractive yield. However, I don’t see much upside potential in the share price at this time and we are unlikely to see any dividend increase for quite a while.

Action now: Hold for income. – G.P.

 

Return to the table of contents…

North West Company (TSX: NWC, OTC: NWTUF)

Type: Common stock
Trading symbol: NWC, NWTUF
Exchange: TSX, Grey Market
Current price: C$23.05, US$23.40
Originally recommended: April 25/07 at C$18.83, US$16.65
Annual payout: $1.12
Yield: 4.9%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.northwest.ca

Comments: This modern-day successor to the historic company that opened the Canadian north reported first-quarter 2013 results (to April 30) that were pretty much flat across the board.

Sales were down by $1 million compared to a year ago, at $364.5 million. Operating earnings increased by a modest 0.5% to $20.5 million but net earnings fell 2.5% to $12.9 million. However, on a per share basis, net earnings were flat at $0.27. That’s a penny less than the per share amount paid in dividends but the first quarter is normally the weakest of the year for the company.

North West operates general stores across the Canadian north and in Alaska, as well as the Giant Tiger outlets in urban centres. At the current price, the shares yield 4.9%.

There is not much growth potential here but neither is there significant downside risk as far as the business itself is concerned although the share price could be negatively affected by an increase in interest rates.

Action now: Hold. – G.P.

 

Return to the table of contents…

YOUR QUESTIONS ANSWERED

Worried about REITs

Q – Since being a subscriber I have enjoyed watching positive performance of Income Investor recommendations in my portfolio. A few articles ago we were forewarned that when interest rates started their rise, the interest sensitive sectors such as the REITs and utilities, in particular, would be adversely impacted.

I certainly did not imagine that the 10-year bond rate going from 1.6% to 2.2% would have such an immediate impact on those sectors. Anyway, I have held several REITS representing about 11% of our portfolio for about four years each but have added to positions during that time for income reasons (we are over age 70 but I enjoy managing our portfolio with some success).

If the REIT sector fell another 10% from the present levels, the REIT portion of our portfolio would still show a profit but I am more concerned about the probable negative impact on AFFOs (adjusted funds from operations) leading to distribution cuts as payout percentages increase. Moreover, am I correct in assuming that changes in the retail business models due to greater competition, over expansion, and lower pricing power are likely to lead to much lower growth for companies focused mainly in that sector, such as Riocan? Will changing business dynamics such as mergers and greater acceptance of working at home due to the support of business related software lead to less need for office space, not to mention Encana’s cost cuts that could impact the “Bow” in Calgary (Dundee, HR REIT)?

If you were in this position, what would you do? I already own some of the infrastructure recommendations given in the most recent Income Investor such as BIP.UN and IPL.UN that could be added to if cash were generated from the REIT positions.

Regards and thanks for the excellent product that I enjoy twice monthly! – Fraser E.

A – As you may recall, Gavin Graham did a comprehensive review of the REIT sector in the issue of May 30. At the time, he rated all his REIT recommendations as Buys.
 
The sharp drop in price is not so much a reflection of the recent move in rates as it is an expression of investor concern about more rate increases to come. Rate increases are bad news for REITs for two reasons. First, it increases the cost of financing. Second, it narrows the yield gap between higher-risk REITs and lower-risk bonds, resulting in a price correction in the REITs to enhance yields.
 
However, interest rate increases go hand-in-hand with an improving economy. Economic growth should be beneficial to the cash flow of most REITs as it would result in lower vacancy rates and enhanced pricing power.
 
The risk of distribution cuts with REITs, or any other security, is a fact of life. We have no reason to expect distribution cuts in any of our picks in the near future but there are no guarantees.
 
As for what I would do, let’s just say I have not sold any of my REITs and have no plans to do so right now. – G.P.

 

That’s all for this issue of Update Edition. Look for your next regular issue of The Income Investor on July 25.

Best regards,
Gordon Pape, editor-in-chief