In This Issue

OIL AND THE FALLING KNIFE

By Gordon Pape, Editor and Publisher

The falling knife scenario is back! That’s when you buy a stock on the way down, only to have it drop further.

We last saw it in 2008-2009 when the global financial system almost collapsed. Share prices of banks, trusts, mortgage companies, and everyone else connected with the industry plunged to what seemed like rock bottom. Then they fell even more. We saw bankruptcies, bailouts, forced mergers, and vulture acquisitions. It was the financial equivalent of blood in the streets.

It got to the point where no one had any idea where the nadir might be. Even the supposedly sound Canadian banks saw their prices drop to multi-year lows. At one point, Bank of Montreal stock traded as low as $24.05 to yield 11.6% as investors bet on a dividend cut that never came.

By the time the crisis ended, many once powerful companies had disappeared (e.g. Lehman Brothers, Washington Mutual, Wachovia) while others were subsisting on life support.

Today the sector appears relatively healthy again, with strict new controls in place to (hopefully) ensure we never see a repeat of that meltdown. Investors who bought shares in the survivors at the time have been well rewarded. Bank of Montreal stock, for one, is now back over $75.

The crisis gripping the energy sector today looks eerily similar to the banking debacle. Just when it seems things can’t get worse, they do. Oil prices have fallen below US$40 a barrel and $30 or even $20 does not seem out of range at this point. OPEC refuses to cut production, Iran is gearing up to increase output, U.S. shale producers are hanging in by the skin of their teeth, and no one is willing to cede market share. As a result, global supply is expected to exceed consumption by a wide margin in 2016, pushing prices ever lower.

The results are predictable. Producer profit margins will continue to shrink, capital spending will be slashed again, there will be more job losses, banks will become increasingly reluctant to extend credit, and share prices will trend ever lower.

At some point, we are likely to see some of the smaller companies go under and there will almost certainly be an uptick in merger and acquisition action as larger companies with cash reserves go bargain hunting. Suncor’s (TSX: SU) $4.3 billion hostile bid for Canadian Oil Sands (TSX: COS), which has been extended to Jan. 8, is probably just the beginning.

It seems very clear at this point that COS will be gone as an independent company before the end of 2016. It’s just a matter of who scoops it up. Management was able to persuade the Alberta Securities Commission to give it a little more time to find a white knight and the company claims to have four credible suitors. But it is clearly vulnerable and it’s only a matter of time.

Suncor is offering a share swap deal – one quarter of a Suncor share for each share of COS tendered. As of Friday’s close, Suncor was trading at $35.22 so the offer on that basis would be the equivalent of $8.805 for a COS share. At that point, COS was trading at $8.15 so the Suncor offer represented a premium of 8%. The COS board maintains the Suncor offer is “undervalued, opportunistic and exploitive”. There may be some truth to that but with results continuing to deteriorate it won’t be easy to find someone willing to top it.

For the record, COS reported a third-quarter loss of $174 million ($0.36 per share) compared to a profit of $87 million ($0.18 per share) in the same period last year. Cash flow from operations plunged from $302 million ($0.62 per share) to only $82 million ($0.17 per share).

As I said, this is probably just the beginning. The year ahead could be a trying time in the oil patch as the scavengers move in. The difficulty from an investment perspective is knowing when and what to buy.

The key is to focus on assets and balance sheets. We’ve seen this kind of bust cycle in the energy sector before and we know it will eventually recover. When it does, the companies with the most extensive and cost-efficient assets will be the ones that offer the greatest profit potential. Suncor and Imperial Oil (TSX: IMO) are in that group.

Companies with weak balance sheets but decent assets are the most likely takeover targets. If oil prices remain low, as expected, they are going to be squeezed to the wall and management will be looking for an out.

I don’t advise speculating on possible takeover stocks at this stage, in part due to the falling knife scenario. Share prices could go even lower from here and some of the weakest companies may end up in creditor protection. However, if you own shares in quality producing companies, I would hold on to them unless you need to do some tax loss selling. They could end up being the next takeover target.

Follow Gordon Pape on Twitter @GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

 

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HOW TO PROFIT FROM THE TAX CHANGES

The Liberals have yet to bring down their first budget but they aren’t wasting any time in implementing many of the tax pledges contained in their party platform. In a sweeping announcement that effectively amounted to a mini-budget without the detail, Finance Minister Bill Morneau last week announced several major changes, most of which take effect Jan. 1.

Here’s a quick run-down of what’s happening.

TFSA contribution limit rolled back. Effective for 2016, the annual contribution limit will drop back to $5,500. The $10,000 limit for 2015 remains and can be carried forward indefinitely. Indexing is restored.

Lower middle income tax rates. The applicable rate on income between $45,282 and $90,563 will be reduced to 20.5% from 22%. The maximum saving will be about $680 per person. People with incomes lower than $45,282 will get no tax relief but the cut will benefit everyone with incomes higher than that.

Higher upper income rates. Canadians with taxable income over $200,000 will see their marginal rate increase from 29% to 33%. Interestingly, anyone in the $200,000 to $217,000 range will actually pay less tax next year than in 2015 because of the carry-through effect of the middle bracket cut.

Increased charity tax credit for high-income earners. Taxpayers earning in excess of $200,000 will be able to claim a 33% federal credit (up from 29%) for charitable contributions in excess of $200 to the extent they have income that is subject to the new tax rate.

Family income splitting repealed. Income splitting for families with children, which had been worth up to $2,000 a year in tax savings, is being abolished. However, pension income splitting will still be allowed.

Canada Child Benefit. This benefit, which was a cornerstone of the Liberal platform, promises non-taxable payments of up to $6,400 a year for low-income families with one child. The pay out will reduce as income rises but the party claims a typical Canadian family with two children will receive $2,500 a year, tax-free. The plan has been criticised as extremely expensive and no firm details have been announced, beyond a commitment to implement it by mid-year.

Your response to these changes will depend to a large extent on your taxable income. Here are some strategies to consider.

Income less than $200,000 in 2016

Defer income. Where possible, delay receiving income until after Jan. 1. Christmas bonuses are one case where you may be able to work out an arrangement with your employer. Small business owners who draw a monthly salary may want to wait until January to write their December pay cheque.

Consider delaying capital gains. Half of all capital gains are taxed at your marginal rate. Therefore they’ll benefit from the lower middle tax bracket. If your 2016 income will be below $90,563, you’ll pay less tax on any gains taken next year. If it is above that amount, it doesn’t matter although deferring tax where possible is usually a good idea. If you have already taken some capital gains this year, consider selling some losing positions to offset them. This must be done by Dec. 24 to allow time for the transactions to settle by year-end.

Take deductions in 2015. Since tax rates are higher this year, apply any available deductions against 2015 income where possible rather than holding them until 2016. For example, some people don’t immediately claim deductions for RRSP contributions, preferring to wait until they are in a higher tax bracket. If you’re in that position, you may want to make the claim for 2015.

Income more than $200,000 in 2016

Take income now. Bonuses, deferred income, etc. should be recognized in 2015 to avoid a significant tax hit next year.

Sell stock winners. If you’ve been considering taking profits on some of your stocks, do it now. You’ll save the equivalent of 2% federal tax plus the provincial share.

Draw dividends this month. RBC Capital Markets calculates that Ontario residents will save 5.52% in tax on non-eligible dividends by taking them this year. The amount of saving will vary depending on where you live. The saving on eligible dividends won’t be as high but taking them now if possible will cut some tax.

Postpone taking RRSP deductions. You’ll get more bang for your buck in 2016. The 2015 contribution limit is 18% of 2014 earned income to a maximum of $24,930. A maximum contribution will generate a refund of $12,348 at the top 2015 marginal rate. But RBC says by delaying the claim until 2016 it will be worth $13,345 for Ontario residents. That’s a tax saving of almost $1,000.

 

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RYAN IRVINE: CASH IS KING

Contributing editor Ryan Irvine joins us for this last issue of the year with some thoughts on the market and a review of some of his picks. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country’s top experts in small cap stocks. He is based in the Vancouver area. Here is his report.

Ryan Irvine writes:

The adage “cash is king” could be a whole lot more appropriate in today’s market than in recent years. For equity investors, after strong three and five year bull runs in Canada and the U.S. respectively, recent market volatility has caused a higher degree of uncertainty about keeping your entire nest egg in the market.

The sentiment is understandable against the backdrop of recent events including the Aug. 24 market “mini-crash” that Fortune Magazine referred to as “one of the biggest one-day declines in recent memory.” On that day the market fell more than 1,000 points in intraday trading.

While the resource laden TSX Composite Index remains down significantly on the year, it is important to point out that in the U.S. the S&P 500 and Dow Jones Industrial Average have already gained back all their losses from that short-term crash. The volatility is a concern, but there should be no panic in the streets.

Holding a portion of your overall portfolio in cash, with broader valuations relatively high and global growth a challenge, is prudent. But given the measly rates of return currently offered by “cash and cash equivalent” investments there are alternatives.

Before we get to one savvy alternative, we will scare you a bit by pointing out a few issues that could weigh on the markets in the near term.

QE3 has gone the way of the Dodo: Last year, the Federal Reserve voted to end QE3 (Quantitative Easing 3), its bond-buying stimulus program. During this program, the Fed pumped money into the economy, a huge portion of which flowed through the banks and into the stock market. This in turn drove up stock prices. Many analysts believe this is the primary reason Wall Street has done so well since 2009 despite the fact that Main Street has suffered from very slow growth. Without the stimulus program boosting the market, it could remain sluggish for a while. Having said this, while the U.S. has reigned in its program, China and much of Europe are stepping up their stimulus plans.

Commodity prices are low: This has been nowhere more apparent than in Canada. While the average Joe or Jane might enjoy a cut in the cost of commodities, this typically doesn’t bode well for investors (Canadian resource investors in particular) or the economy at large. Consider how much the price of oil, a “pillar of the global economy” according to many analysts, has fallen in the past year. When the cost of oil rises, so do the costs of other commodities, due to its inflationary effect. The inverse is also true when oil prices fall. Subsequently so do the prices of countless other commodities. Stocks are a claim on real assets, so the market responds accordingly when commodity prices are down.

It’s not just about oil either. Gold, silver, and platinum are now at five to eight year lows, as are basic materials, signaling that the construction and industrial sectors are weak.

Of course, the fact that these commodities are all denominated in the surging U.S. dollar also has to be factored in.

Interest rates will rise: Last year, the Feds promised to keep rates near zero for a “considerable time,” but now it is becoming more likely that they will rise sooner rather than later. This will cause a considerable strain on the market, since low rates encouraged stock market investments in the past.

What can you do?

First off, it is prudent to hold some of your investment portfolio in cash and cash equivalents at present.

However, you can also choose to own stocks that trade at reasonable valuations and are “cash rich.” These are profitable companies with huge net cash balances relative to their market capitalizations or the value investors assign to their business. They are the type of companies that can actually benefit, in the long term, from a market downturn as they are perfectly positioned to grow by cheap accretive acquisitions.

From our IWB Small-Cap growth stock list, a couple of companies matching these criteria would be Enghouse Systems Limited (TSX: ESL) and Espial Group Inc. (TSX: ESP). The former is a long-time favourite of KeyStone that continues to perform tremendously well, recently hitting new all time highs. Enghouse develops enterprise software solutions for a number of vertical markets, including traditional and web-based call centres, and holds over $90 million in cash with no debt. The company remains a long-term Buy.

Espial is a profitable and growing intuitive navigation software developer for video content providers with over 55% of its market cap in cash and zero debt. Espial is currently ranked as a Speculative Buy in both the near and long term for investors with an above average tolerance for risk.

 

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RYAN IRVINE’S UPDATES

Boyd Group Income Fund (TSX: BYD.UN, OTC: BFGIF)

Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Friday at C$68.55, US$50.03.

Background: Boyd is great because the business is very simple: they fix automobiles. Recession or not, most people find it essential to keep operational their method of getting from point A to point B. Boyd is the largest operator of non-franchised collision repair centres in North America in terms of number of locations and it is one of the largest in terms of sales. The company currently operates locations in five Canadian provinces under the trade name Boyd Autobody & Glass, as well as in 17 U.S. states.

Stock performance: I targeted this stock in my late August installment for IWB readers as a “potential opportunity” with the price in the $60 range. At the time (and today), we were firmly of the belief that Canadian companies with positive exposure to the U.S. dollar would continue to outperform and Boyd Group Income was one of the two we recommended. Today, with the stock closing near all-time highs just shy of $70, we update the company in light of its strong third-quarter results.

Recent developments: Third-quarter results were impressive. Sales increased by 38.1% to $301.1 million from $218.1 million in 2014, including same-store sales increases of 7.3%. Adjusted EBITDA increased 56.7% to $26.4 million, compared with $16.9 million in 2014. Adjusted net earnings came in at $10.3 million compared with $6.8 million in 2014.

Distribution: The company announced a distribution increase of 2.4% to $0.504 per unit annualized from $0.492 per unit. The yield going forward will be 0.7%. While that is not huge, it continues to grow year after year.

Conclusion: In the range of 80% of Boyd’s business is banked in U.S. dollars, so the company continues to benefit from the lagging loonie. Boyd is not cheap on a traditional valuation basis, trading at 29 times 2015 expected adjusted earnings and 25 times 2016 expected adjusted earnings. But given the fact EBITDA is expected to grow at over 25% once again, the stock remains attractive.

Action now: We maintain our long-term Buy rating on the stock for investors with an investment horizon of greater than one year.

WiLAN Inc. (TSX: WIN, NDQ: WILN)

Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Friday at C$1.50, US$1.11.

Background: Founded in 1992, WiLAN is an intellectual property (IP) licensing company that was originally created to develop and commercialize technology that made low-cost, high-speed wireless networking a reality. Today, some of the world’s largest technology companies license patents (more than 4,000 issued or pending) in WiLAN’s portfolio. WiLAN has licensed its intellectual property to over 290 companies worldwide.

Stock performance: In our most recent update on the stock in June, we maintained our Hold rating and advised readers not to enter new positions at that time. The stock has faltered significantly following the company reporting its second restructuring in the last 18 months.

Recent developments: We were not pleased with management’s announcement that WiLAN will restructure the business by the end of this year and slash the company’s dividend by 76% starting in January in response to a difficult environment for patent licensing companies.

The Ottawa-based company says the restructuring will affect about 30% of its workforce but it wasn’t immediately clear whether some would be transferred to a new research and development company that WiLAN is planning to spin off.

Just 18 months ago, WiLAN reported that “following a comprehensive process involving financial advisor Canaccord Genuity, the board of directors determined that it is in the best interests of the company and shareholders to execute an updated business plan focused on business diversification, licensing partnerships, improved profitability and increasing the return of cash generated from operations to shareholders.”

Incorporating these strategies, management established a “roadmap” to increase GAAP earnings to at least $0.30 per share by 2018. This would be done by more than doubling revenues and increasing the company’s operating leverage. If these targets were achieved, the strong profitability of the company’s business would drive higher returns to shareholders through quarterly dividends that the company said it would strive to increase regularly. The first increase, to $0.05 per quarter per share, represented a 25% hike and took effect in the second quarter of 2014.

Fast-forward a year and a half and WiLAN announced it will cut what it pays in dividends, which are paid in Canadian currency, to $0.05 per share annually from $0.21 per share. The Jan. 6 dividend will be $0.0125 per share, down from $0.0525 on Oct. 6.

Conclusion: While we understand the challenges that have hit the patent market, lack of foresight from management is not forgivable at this stage. The dramatic shift in business strategy has once again decreased our confidence in management.

Action now: We recommend investors Sell WiLAN and move to better-run Canadian companies. While the company has $95 million or over $0.75 per share in cash on hand and a potentially lucrative patent portfolio, we do not have confidence in management’s ability to employ the cash in a manner that creates significant shareholder value.

Exco Technologies Limited (TSX: XTC, OTC: EXCOF)

Originally recommended on Feb. 27/12 (#21208) at C$4.25, US$4.22. Closed Friday at C$17.13, US$12.32.

Background: Exco Technologies is a global supplier of innovative technologies servicing the die-cast, extrusion and automotive industries. Through its 18 strategic locations in 10 countries, it employs 5,081 people and services a broad customer base.

Stock performance: This stock was recommended in February 2012 as a Buy in the $4.25 range. In our most recent update in September of this year, we reiterated our near-term Hold at the $14.54 level. Today, with the stock trading at $17.13, we review the company’s record fourth-quarter and 2015 fiscal year-end financial results.

Recent developments: Revenues for the fourth quarter (to Sept. 30) rose 18% to $131 million. Full year, consolidated sales rose 35% to $498.3 million. Sales from the company’s seat cover business, which was acquired on March 1, 2014, were fully included in both the current and prior year quarters. However, full year sales this year included 12 months of seat cover sales compared to seven months last year. While seat cover sales accounted for a considerable amount of the sales growth, Exco’s other businesses also grew by 24% in the quarter and 21% in the year.

Net income for the fourth quarter rose 27% to $10.3 million ($0.24 per share, fully diluted) compared to consolidated net income of $8.1 million ($0.19 per share) in the same period of last year. Full year net income jumped 33% to $40.8 million ($0.96 per share) compared to $30.7 million ($0.73 per share) last year.

The quarter’s earnings were impacted by a 42% effective tax rate compared to 27% last year. In the quarter, Exco wrote off $1.9 million in deferred tax assets related to South Africa as the planned closure of that facility renders the utilization of these tax assets unlikely in the future. Without this write-off the tax expense would have been $5.5 million or 31% and earnings would have been $0.29 per share instead of $0.24 per share as reported.

Conclusion: Overall, we were very pleased with Exco’s financial results. Fundamentally, Exco now trades with a trailing price-to-earnings multiple of 17 based on its last 12 months, with the stock up about 300% (not including dividends) since our original recommendation. Given the company’s continued outlook for growth, Exco’s consensus estimate for 2016 of around $1.25 per share on an adjusted earnings basis give it a more attractive forward looking earnings multiple of 13.1.

The outlook for Exco over the near term should continue to remain strong. We continue to see a buoyant and dynamic quoting environment with light vehicle production continuing at least at current levels despite the possibility of moderate interest rate tightening in the U.S. The European market also seems to be improving with unit vehicle production climbing modestly yet consistently. The Automotive Solutions group is also actively engaged in quoting on both existing programs and new content.

In the company’s latest conference calls there has been renewed discussion about potential “tuck-in” acquisition opportunities with management building the company’s cash position; this could again help spur growth.

Action now: Given the sluggish prospects for global growth, we maintain our near-term rating at Hold (for those with an outlook of less than six months). We remain decidedly positive on the company mid-term and maintain our long-term rating at Buy (for investors with a greater than one year time horizon) given the above average long-term growth potential. While the company’s industry is cyclical, we believe the current environment appears positive for the next 12-24 months.

– end Ryan Irvine

 

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GORDON PAPE’S UPDATES

Badger Daylighting (TSX: BAD, OTC: BADFF)

Originally recommended on Nov. 23/14 (#21441) at C$32.77, US$27.72. Closed Friday at C$23.19, US$16.84.

Background: This Calgary-based company has developed a proprietary method for excavating using pressurized water to liquefy soil, which is then removed with a vacuum system and deposited into a storage tank housed on specialized trucks. This method is especially useful in areas where there are extensive underground pipes and cables since it eliminates the danger of severing vital lines.

Stock performance: I recommended Badger a little over a year ago, just about the time the price of oil began its plunge. Because about half of Badger’s work is for the energy sector, the company’s share price declined accordingly, briefly dipping below $18 last month before recovering to the current level after the company released third-quarter results that beat expectations.

Recent developments: Badger’s third-quarter numbers held up well despite the troubles in the oil and gas sector. Revenue was down only slightly compared to the same period last year and net profit actually increased to just over $17 million ($0.46 per share) from about $16 million ($0.43 per share) in 2014. However, for the first nine months of the fiscal year, profit dropped to $18 million ($0.49 per share) from $36.1 million ($0.97 per share) a year ago. The nine-month profit figure was hit by a legal ruling against the company in Oklahoma. Although the verdict is under appeal, Badger accrued the full amount of US$17.5 million, including legal costs and interest, in the second quarter. Without those charges, net profit would have been only slightly less than in 2014.

Cash flow from operating activities for nine months was $67.7 million ($1.82 per share), a slight improvement from $65.8 million ($1.78 per share) in 2014.

The company said that going forward it will continue to focus on increasing its U.S. business to offset the weakness in Western Canada due to the oil and gas slump. Management also strengthened its team in Eastern Canada in an effort to generate more business there.

Dividend: The shares pay a monthly dividend of $0.03 ($0.36 per year) to yield 1.6% at the current price. The dividend has remained the same since November 2012 and no increase is expected until economic conditions in Western Canada improve.

Action now: Hold. Badger’s results are better than we might have expected given the depth of the plunge in the oil price and the resulting spending cuts in the energy sector. The company has a unique and useful technology and the share price should eventually recover.

Gibson Energy (TSX: GEI, OTC: GBNXF)

Originally recommended on Oct. 1/12 (#21234) at C$23.03, US$23.26. Closed Friday at C$13.50, US$9.85.

Background: Gibson Energy is a large independent midstream company with operations across major oil and gas producing regions throughout North America. The company is engaged in the movement, storage, blending, processing, marketing, and distribution of crude oil, condensate, natural gas liquids, water, oilfield waste, and refined products. It transports energy products by utilizing its integrated network of terminals, pipelines, storage tanks, and trucks located throughout western Canada and through its significant truck transportation and injection station network in the United States.

Stock performance: Like virtually every other energy-related stock, Gibson has seen its price fall significantly in reaction to the plunge in the price of oil. The shares traded in he high $30s in September 2014, just prior to the start of the collapse. They are now at less than half that level and still in a downward trend.

Recent developments: Third-quarter results showed just how badly the company has been hurt by the decline of the energy sector. Revenue was down 43% from the same period in 2014 to $1.3 billion. The company reported a loss of $41.2 million (-$0.33 per share, fully diluted) compared to a profit of $8.5 million ($0.07 per share) in the year-ago period.

For the first nine months of the fiscal year, the loss was $68.4 million (-$0.54 per share) compared to a profit of $78.5 million ($0.63 per share) a year ago.

The company said that in the short term low oil prices will continue to have an impact on its business. However, management was more optimistic when looking out farther saying “over the medium to long term, as crude oil supply and demand rebalances and crude oil prices realign with global cost structures, the company anticipates a return to increased activity and production levels and a continued demand for midstream value chain assets.”

Dividend: Despite the big drop in revenue and the bottom line losses, the company is maintaining its quarterly dividend of $0.32 ($1.28 a year), at least for now. That translates into a yield of 9.5% at the current price. I do not believe that dividend is sustainable and, judging by the share price and the yield, neither does the market. The company has suspended its dividend reinvestment plan for now.

Action now: Sell. This is a good company with strong infrastructure. However, it is in the wrong industry at the wrong time. It will eventually recover but that will take time and the share price will likely take another hit if the dividend is cut in 2016. Therefore, I suggest taking a capital loss at this point. Hopefully, you can write it off against some capital gains.

 

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YOUR QUESTIONS

Why are prices falling?

Q – I’m getting more than a little antsy at the erosion of my portfolio balance by the significant and ongoing decline in the stock prices of companies such as Enbridge, Enbridge Income Fund, Inter Pipeline, Altagas, and Brookfield Renewable Energy.

All have been recommended in your newsletters, are profitable, and are even raising their dividends.

My question is: what are the factors driving the price declines? Is it the price of oil, or the prevailing anti-pipeline sentiment, or the fear that the need for fossil fuel will suddenly cease, or the impending Fed interest rate increase? Or all of these factors?
Should we continue to “chill”? – C.L.W.

A – As you might expect, the reasons are complex and vary from one company to another. Higher interest rates in the U.S. certainly play a role as all of these stocks are interest-sensitive. That means when rates on safe securities such as T-bills increase, investors demand more of a risk premium from stocks. That tends to drive prices lower and push yields higher. As well, these companies normally carry a high level of debt, which costs more to service when rates rise.

Pipeline companies, which just a couple of years ago were frantically adding infrastructure to meet the needs of the shale oil boom, now find themselves with overcapacity in some areas. Reduced throughput may mean less revenue and lower profits in some cases.

Renewable energy companies are under increasing pressure from low oil prices, especially high-cost producers such as solar and wind. The less the cost of oil to consumers, the less demand there is for very expensive alternatives. The scathing report of the Ontario auditor-general on the blatant excesses in the province’s green energy program appears to have had the effect of turning public opinion against such projects.

The bottom line is that cheap oil is having a ripple effect across a range of companies that, at first glance, have no direct connection to the industry. Unfortunately, this pattern is likely to continue until the price of oil begins to recover. – G.P.

 

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MEMBERS’ CORNER

Oil price war

Member comment: From IWB #21543: “The world is paying a big economic price for this [oil price] war of attrition; an estimated $625 billion in cancelled investments and about 250,000 jobs lost.”

Anyone who has read Joseph Schumpeter clearly sees this as just another example of “creative destruction,” a process he described in detail more than seventy years ago (although Marxist economist Werner Sombart is credited with the first such analysis some thirty years earlier). The oil sands and shale producers primarily targeted by the Saudis and their allies are, quite simply, high-cost producers who, by the “laws” of free market supply/demand, should be driven out of business, at least until their high-cost product is needed (i.e. when demand increases beyond the supply available from the lower-cost producers, which may or may not occur at some point in the future). Thus the statement “paying a big economic price” is somewhat misleading (if not disingenuous) insofar as Schumpeter’s analysis more or less predicts that the destruction of “the old” will result in “the creation of [the] new,” that is, that resources, both labour and capital, will shift elsewhere, not be “destroyed” as such. Of course, only time will tell what the “new” will be. – Jim B.

Response: This assumes that free market supply/demand is the only factor at play here. In reality, this is a huge geopolitical struggle. The last thing the U.S. wants is to again become hostage to Middle Eastern oil, which is what would happen if the thesis of creative destruction were applied to its domestic petroleum industry.

As for the comment about paying a big economic price being misleading, the reality is those jobs and investments are gone for now and the foreseeable future. Perhaps, as the creative destruction thesis suggests, eventually they will be replaced – but it may happen in Iran, Saudi Arabia, and Iraq. – G.P.

 

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PRICE CHANGE

This is a final reminder to renew your membership before Dec. 31 and beat the $10 price increase that will take effect in the New Year. Call Customer Service at 1-888-287-8229 or go to www.BuildingWealth.ca/subscribe.

That wraps up the IWB for 2015. We’re taking the next two weeks off so that our staff can enjoy this special time of year with their families. Our very best wishes to you and your loved ones for a happy holiday season. We will see you again on Jan. 4.

Best regards,
Gordon Pape

In This Issue

OIL AND THE FALLING KNIFE

By Gordon Pape, Editor and Publisher

The falling knife scenario is back! That’s when you buy a stock on the way down, only to have it drop further.

We last saw it in 2008-2009 when the global financial system almost collapsed. Share prices of banks, trusts, mortgage companies, and everyone else connected with the industry plunged to what seemed like rock bottom. Then they fell even more. We saw bankruptcies, bailouts, forced mergers, and vulture acquisitions. It was the financial equivalent of blood in the streets.

It got to the point where no one had any idea where the nadir might be. Even the supposedly sound Canadian banks saw their prices drop to multi-year lows. At one point, Bank of Montreal stock traded as low as $24.05 to yield 11.6% as investors bet on a dividend cut that never came.

By the time the crisis ended, many once powerful companies had disappeared (e.g. Lehman Brothers, Washington Mutual, Wachovia) while others were subsisting on life support.

Today the sector appears relatively healthy again, with strict new controls in place to (hopefully) ensure we never see a repeat of that meltdown. Investors who bought shares in the survivors at the time have been well rewarded. Bank of Montreal stock, for one, is now back over $75.

The crisis gripping the energy sector today looks eerily similar to the banking debacle. Just when it seems things can’t get worse, they do. Oil prices have fallen below US$40 a barrel and $30 or even $20 does not seem out of range at this point. OPEC refuses to cut production, Iran is gearing up to increase output, U.S. shale producers are hanging in by the skin of their teeth, and no one is willing to cede market share. As a result, global supply is expected to exceed consumption by a wide margin in 2016, pushing prices ever lower.

The results are predictable. Producer profit margins will continue to shrink, capital spending will be slashed again, there will be more job losses, banks will become increasingly reluctant to extend credit, and share prices will trend ever lower.

At some point, we are likely to see some of the smaller companies go under and there will almost certainly be an uptick in merger and acquisition action as larger companies with cash reserves go bargain hunting. Suncor’s (TSX: SU) $4.3 billion hostile bid for Canadian Oil Sands (TSX: COS), which has been extended to Jan. 8, is probably just the beginning.

It seems very clear at this point that COS will be gone as an independent company before the end of 2016. It’s just a matter of who scoops it up. Management was able to persuade the Alberta Securities Commission to give it a little more time to find a white knight and the company claims to have four credible suitors. But it is clearly vulnerable and it’s only a matter of time.

Suncor is offering a share swap deal – one quarter of a Suncor share for each share of COS tendered. As of Friday’s close, Suncor was trading at $35.22 so the offer on that basis would be the equivalent of $8.805 for a COS share. At that point, COS was trading at $8.15 so the Suncor offer represented a premium of 8%. The COS board maintains the Suncor offer is “undervalued, opportunistic and exploitive”. There may be some truth to that but with results continuing to deteriorate it won’t be easy to find someone willing to top it.

For the record, COS reported a third-quarter loss of $174 million ($0.36 per share) compared to a profit of $87 million ($0.18 per share) in the same period last year. Cash flow from operations plunged from $302 million ($0.62 per share) to only $82 million ($0.17 per share).

As I said, this is probably just the beginning. The year ahead could be a trying time in the oil patch as the scavengers move in. The difficulty from an investment perspective is knowing when and what to buy.

The key is to focus on assets and balance sheets. We’ve seen this kind of bust cycle in the energy sector before and we know it will eventually recover. When it does, the companies with the most extensive and cost-efficient assets will be the ones that offer the greatest profit potential. Suncor and Imperial Oil (TSX: IMO) are in that group.

Companies with weak balance sheets but decent assets are the most likely takeover targets. If oil prices remain low, as expected, they are going to be squeezed to the wall and management will be looking for an out.

I don’t advise speculating on possible takeover stocks at this stage, in part due to the falling knife scenario. Share prices could go even lower from here and some of the weakest companies may end up in creditor protection. However, if you own shares in quality producing companies, I would hold on to them unless you need to do some tax loss selling. They could end up being the next takeover target.

Follow Gordon Pape on Twitter @GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

 

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HOW TO PROFIT FROM THE TAX CHANGES

The Liberals have yet to bring down their first budget but they aren’t wasting any time in implementing many of the tax pledges contained in their party platform. In a sweeping announcement that effectively amounted to a mini-budget without the detail, Finance Minister Bill Morneau last week announced several major changes, most of which take effect Jan. 1.

Here’s a quick run-down of what’s happening.

TFSA contribution limit rolled back. Effective for 2016, the annual contribution limit will drop back to $5,500. The $10,000 limit for 2015 remains and can be carried forward indefinitely. Indexing is restored.

Lower middle income tax rates. The applicable rate on income between $45,282 and $90,563 will be reduced to 20.5% from 22%. The maximum saving will be about $680 per person. People with incomes lower than $45,282 will get no tax relief but the cut will benefit everyone with incomes higher than that.

Higher upper income rates. Canadians with taxable income over $200,000 will see their marginal rate increase from 29% to 33%. Interestingly, anyone in the $200,000 to $217,000 range will actually pay less tax next year than in 2015 because of the carry-through effect of the middle bracket cut.

Increased charity tax credit for high-income earners. Taxpayers earning in excess of $200,000 will be able to claim a 33% federal credit (up from 29%) for charitable contributions in excess of $200 to the extent they have income that is subject to the new tax rate.

Family income splitting repealed. Income splitting for families with children, which had been worth up to $2,000 a year in tax savings, is being abolished. However, pension income splitting will still be allowed.

Canada Child Benefit. This benefit, which was a cornerstone of the Liberal platform, promises non-taxable payments of up to $6,400 a year for low-income families with one child. The pay out will reduce as income rises but the party claims a typical Canadian family with two children will receive $2,500 a year, tax-free. The plan has been criticised as extremely expensive and no firm details have been announced, beyond a commitment to implement it by mid-year.

Your response to these changes will depend to a large extent on your taxable income. Here are some strategies to consider.

Income less than $200,000 in 2016

Defer income. Where possible, delay receiving income until after Jan. 1. Christmas bonuses are one case where you may be able to work out an arrangement with your employer. Small business owners who draw a monthly salary may want to wait until January to write their December pay cheque.

Consider delaying capital gains. Half of all capital gains are taxed at your marginal rate. Therefore they’ll benefit from the lower middle tax bracket. If your 2016 income will be below $90,563, you’ll pay less tax on any gains taken next year. If it is above that amount, it doesn’t matter although deferring tax where possible is usually a good idea. If you have already taken some capital gains this year, consider selling some losing positions to offset them. This must be done by Dec. 24 to allow time for the transactions to settle by year-end.

Take deductions in 2015. Since tax rates are higher this year, apply any available deductions against 2015 income where possible rather than holding them until 2016. For example, some people don’t immediately claim deductions for RRSP contributions, preferring to wait until they are in a higher tax bracket. If you’re in that position, you may want to make the claim for 2015.

Income more than $200,000 in 2016

Take income now. Bonuses, deferred income, etc. should be recognized in 2015 to avoid a significant tax hit next year.

Sell stock winners. If you’ve been considering taking profits on some of your stocks, do it now. You’ll save the equivalent of 2% federal tax plus the provincial share.

Draw dividends this month. RBC Capital Markets calculates that Ontario residents will save 5.52% in tax on non-eligible dividends by taking them this year. The amount of saving will vary depending on where you live. The saving on eligible dividends won’t be as high but taking them now if possible will cut some tax.

Postpone taking RRSP deductions. You’ll get more bang for your buck in 2016. The 2015 contribution limit is 18% of 2014 earned income to a maximum of $24,930. A maximum contribution will generate a refund of $12,348 at the top 2015 marginal rate. But RBC says by delaying the claim until 2016 it will be worth $13,345 for Ontario residents. That’s a tax saving of almost $1,000.

 

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RYAN IRVINE: CASH IS KING

Contributing editor Ryan Irvine joins us for this last issue of the year with some thoughts on the market and a review of some of his picks. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country’s top experts in small cap stocks. He is based in the Vancouver area. Here is his report.

Ryan Irvine writes:

The adage “cash is king” could be a whole lot more appropriate in today’s market than in recent years. For equity investors, after strong three and five year bull runs in Canada and the U.S. respectively, recent market volatility has caused a higher degree of uncertainty about keeping your entire nest egg in the market.

The sentiment is understandable against the backdrop of recent events including the Aug. 24 market “mini-crash” that Fortune Magazine referred to as “one of the biggest one-day declines in recent memory.” On that day the market fell more than 1,000 points in intraday trading.

While the resource laden TSX Composite Index remains down significantly on the year, it is important to point out that in the U.S. the S&P 500 and Dow Jones Industrial Average have already gained back all their losses from that short-term crash. The volatility is a concern, but there should be no panic in the streets.

Holding a portion of your overall portfolio in cash, with broader valuations relatively high and global growth a challenge, is prudent. But given the measly rates of return currently offered by “cash and cash equivalent” investments there are alternatives.

Before we get to one savvy alternative, we will scare you a bit by pointing out a few issues that could weigh on the markets in the near term.

QE3 has gone the way of the Dodo: Last year, the Federal Reserve voted to end QE3 (Quantitative Easing 3), its bond-buying stimulus program. During this program, the Fed pumped money into the economy, a huge portion of which flowed through the banks and into the stock market. This in turn drove up stock prices. Many analysts believe this is the primary reason Wall Street has done so well since 2009 despite the fact that Main Street has suffered from very slow growth. Without the stimulus program boosting the market, it could remain sluggish for a while. Having said this, while the U.S. has reigned in its program, China and much of Europe are stepping up their stimulus plans.

Commodity prices are low: This has been nowhere more apparent than in Canada. While the average Joe or Jane might enjoy a cut in the cost of commodities, this typically doesn’t bode well for investors (Canadian resource investors in particular) or the economy at large. Consider how much the price of oil, a “pillar of the global economy” according to many analysts, has fallen in the past year. When the cost of oil rises, so do the costs of other commodities, due to its inflationary effect. The inverse is also true when oil prices fall. Subsequently so do the prices of countless other commodities. Stocks are a claim on real assets, so the market responds accordingly when commodity prices are down.

It’s not just about oil either. Gold, silver, and platinum are now at five to eight year lows, as are basic materials, signaling that the construction and industrial sectors are weak.

Of course, the fact that these commodities are all denominated in the surging U.S. dollar also has to be factored in.

Interest rates will rise: Last year, the Feds promised to keep rates near zero for a “considerable time,” but now it is becoming more likely that they will rise sooner rather than later. This will cause a considerable strain on the market, since low rates encouraged stock market investments in the past.

What can you do?

First off, it is prudent to hold some of your investment portfolio in cash and cash equivalents at present.

However, you can also choose to own stocks that trade at reasonable valuations and are “cash rich.” These are profitable companies with huge net cash balances relative to their market capitalizations or the value investors assign to their business. They are the type of companies that can actually benefit, in the long term, from a market downturn as they are perfectly positioned to grow by cheap accretive acquisitions.

From our IWB Small-Cap growth stock list, a couple of companies matching these criteria would be Enghouse Systems Limited (TSX: ESL) and Espial Group Inc. (TSX: ESP). The former is a long-time favourite of KeyStone that continues to perform tremendously well, recently hitting new all time highs. Enghouse develops enterprise software solutions for a number of vertical markets, including traditional and web-based call centres, and holds over $90 million in cash with no debt. The company remains a long-term Buy.

Espial is a profitable and growing intuitive navigation software developer for video content providers with over 55% of its market cap in cash and zero debt. Espial is currently ranked as a Speculative Buy in both the near and long term for investors with an above average tolerance for risk.

 

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RYAN IRVINE’S UPDATES

Boyd Group Income Fund (TSX: BYD.UN, OTC: BFGIF)

Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Friday at C$68.55, US$50.03.

Background: Boyd is great because the business is very simple: they fix automobiles. Recession or not, most people find it essential to keep operational their method of getting from point A to point B. Boyd is the largest operator of non-franchised collision repair centres in North America in terms of number of locations and it is one of the largest in terms of sales. The company currently operates locations in five Canadian provinces under the trade name Boyd Autobody & Glass, as well as in 17 U.S. states.

Stock performance: I targeted this stock in my late August installment for IWB readers as a “potential opportunity” with the price in the $60 range. At the time (and today), we were firmly of the belief that Canadian companies with positive exposure to the U.S. dollar would continue to outperform and Boyd Group Income was one of the two we recommended. Today, with the stock closing near all-time highs just shy of $70, we update the company in light of its strong third-quarter results.

Recent developments: Third-quarter results were impressive. Sales increased by 38.1% to $301.1 million from $218.1 million in 2014, including same-store sales increases of 7.3%. Adjusted EBITDA increased 56.7% to $26.4 million, compared with $16.9 million in 2014. Adjusted net earnings came in at $10.3 million compared with $6.8 million in 2014.

Distribution: The company announced a distribution increase of 2.4% to $0.504 per unit annualized from $0.492 per unit. The yield going forward will be 0.7%. While that is not huge, it continues to grow year after year.

Conclusion: In the range of 80% of Boyd’s business is banked in U.S. dollars, so the company continues to benefit from the lagging loonie. Boyd is not cheap on a traditional valuation basis, trading at 29 times 2015 expected adjusted earnings and 25 times 2016 expected adjusted earnings. But given the fact EBITDA is expected to grow at over 25% once again, the stock remains attractive.

Action now: We maintain our long-term Buy rating on the stock for investors with an investment horizon of greater than one year.

WiLAN Inc. (TSX: WIN, NDQ: WILN)

Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Friday at C$1.50, US$1.11.

Background: Founded in 1992, WiLAN is an intellectual property (IP) licensing company that was originally created to develop and commercialize technology that made low-cost, high-speed wireless networking a reality. Today, some of the world’s largest technology companies license patents (more than 4,000 issued or pending) in WiLAN’s portfolio. WiLAN has licensed its intellectual property to over 290 companies worldwide.

Stock performance: In our most recent update on the stock in June, we maintained our Hold rating and advised readers not to enter new positions at that time. The stock has faltered significantly following the company reporting its second restructuring in the last 18 months.

Recent developments: We were not pleased with management’s announcement that WiLAN will restructure the business by the end of this year and slash the company’s dividend by 76% starting in January in response to a difficult environment for patent licensing companies.

The Ottawa-based company says the restructuring will affect about 30% of its workforce but it wasn’t immediately clear whether some would be transferred to a new research and development company that WiLAN is planning to spin off.

Just 18 months ago, WiLAN reported that “following a comprehensive process involving financial advisor Canaccord Genuity, the board of directors determined that it is in the best interests of the company and shareholders to execute an updated business plan focused on business diversification, licensing partnerships, improved profitability and increasing the return of cash generated from operations to shareholders.”

Incorporating these strategies, management established a “roadmap” to increase GAAP earnings to at least $0.30 per share by 2018. This would be done by more than doubling revenues and increasing the company’s operating leverage. If these targets were achieved, the strong profitability of the company’s business would drive higher returns to shareholders through quarterly dividends that the company said it would strive to increase regularly. The first increase, to $0.05 per quarter per share, represented a 25% hike and took effect in the second quarter of 2014.

Fast-forward a year and a half and WiLAN announced it will cut what it pays in dividends, which are paid in Canadian currency, to $0.05 per share annually from $0.21 per share. The Jan. 6 dividend will be $0.0125 per share, down from $0.0525 on Oct. 6.

Conclusion: While we understand the challenges that have hit the patent market, lack of foresight from management is not forgivable at this stage. The dramatic shift in business strategy has once again decreased our confidence in management.

Action now: We recommend investors Sell WiLAN and move to better-run Canadian companies. While the company has $95 million or over $0.75 per share in cash on hand and a potentially lucrative patent portfolio, we do not have confidence in management’s ability to employ the cash in a manner that creates significant shareholder value.

Exco Technologies Limited (TSX: XTC, OTC: EXCOF)

Originally recommended on Feb. 27/12 (#21208) at C$4.25, US$4.22. Closed Friday at C$17.13, US$12.32.

Background: Exco Technologies is a global supplier of innovative technologies servicing the die-cast, extrusion and automotive industries. Through its 18 strategic locations in 10 countries, it employs 5,081 people and services a broad customer base.

Stock performance: This stock was recommended in February 2012 as a Buy in the $4.25 range. In our most recent update in September of this year, we reiterated our near-term Hold at the $14.54 level. Today, with the stock trading at $17.13, we review the company’s record fourth-quarter and 2015 fiscal year-end financial results.

Recent developments: Revenues for the fourth quarter (to Sept. 30) rose 18% to $131 million. Full year, consolidated sales rose 35% to $498.3 million. Sales from the company’s seat cover business, which was acquired on March 1, 2014, were fully included in both the current and prior year quarters. However, full year sales this year included 12 months of seat cover sales compared to seven months last year. While seat cover sales accounted for a considerable amount of the sales growth, Exco’s other businesses also grew by 24% in the quarter and 21% in the year.

Net income for the fourth quarter rose 27% to $10.3 million ($0.24 per share, fully diluted) compared to consolidated net income of $8.1 million ($0.19 per share) in the same period of last year. Full year net income jumped 33% to $40.8 million ($0.96 per share) compared to $30.7 million ($0.73 per share) last year.

The quarter’s earnings were impacted by a 42% effective tax rate compared to 27% last year. In the quarter, Exco wrote off $1.9 million in deferred tax assets related to South Africa as the planned closure of that facility renders the utilization of these tax assets unlikely in the future. Without this write-off the tax expense would have been $5.5 million or 31% and earnings would have been $0.29 per share instead of $0.24 per share as reported.

Conclusion: Overall, we were very pleased with Exco’s financial results. Fundamentally, Exco now trades with a trailing price-to-earnings multiple of 17 based on its last 12 months, with the stock up about 300% (not including dividends) since our original recommendation. Given the company’s continued outlook for growth, Exco’s consensus estimate for 2016 of around $1.25 per share on an adjusted earnings basis give it a more attractive forward looking earnings multiple of 13.1.

The outlook for Exco over the near term should continue to remain strong. We continue to see a buoyant and dynamic quoting environment with light vehicle production continuing at least at current levels despite the possibility of moderate interest rate tightening in the U.S. The European market also seems to be improving with unit vehicle production climbing modestly yet consistently. The Automotive Solutions group is also actively engaged in quoting on both existing programs and new content.

In the company’s latest conference calls there has been renewed discussion about potential “tuck-in” acquisition opportunities with management building the company’s cash position; this could again help spur growth.

Action now: Given the sluggish prospects for global growth, we maintain our near-term rating at Hold (for those with an outlook of less than six months). We remain decidedly positive on the company mid-term and maintain our long-term rating at Buy (for investors with a greater than one year time horizon) given the above average long-term growth potential. While the company’s industry is cyclical, we believe the current environment appears positive for the next 12-24 months.

– end Ryan Irvine

 

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GORDON PAPE’S UPDATES

Badger Daylighting (TSX: BAD, OTC: BADFF)

Originally recommended on Nov. 23/14 (#21441) at C$32.77, US$27.72. Closed Friday at C$23.19, US$16.84.

Background: This Calgary-based company has developed a proprietary method for excavating using pressurized water to liquefy soil, which is then removed with a vacuum system and deposited into a storage tank housed on specialized trucks. This method is especially useful in areas where there are extensive underground pipes and cables since it eliminates the danger of severing vital lines.

Stock performance: I recommended Badger a little over a year ago, just about the time the price of oil began its plunge. Because about half of Badger’s work is for the energy sector, the company’s share price declined accordingly, briefly dipping below $18 last month before recovering to the current level after the company released third-quarter results that beat expectations.

Recent developments: Badger’s third-quarter numbers held up well despite the troubles in the oil and gas sector. Revenue was down only slightly compared to the same period last year and net profit actually increased to just over $17 million ($0.46 per share) from about $16 million ($0.43 per share) in 2014. However, for the first nine months of the fiscal year, profit dropped to $18 million ($0.49 per share) from $36.1 million ($0.97 per share) a year ago. The nine-month profit figure was hit by a legal ruling against the company in Oklahoma. Although the verdict is under appeal, Badger accrued the full amount of US$17.5 million, including legal costs and interest, in the second quarter. Without those charges, net profit would have been only slightly less than in 2014.

Cash flow from operating activities for nine months was $67.7 million ($1.82 per share), a slight improvement from $65.8 million ($1.78 per share) in 2014.

The company said that going forward it will continue to focus on increasing its U.S. business to offset the weakness in Western Canada due to the oil and gas slump. Management also strengthened its team in Eastern Canada in an effort to generate more business there.

Dividend: The shares pay a monthly dividend of $0.03 ($0.36 per year) to yield 1.6% at the current price. The dividend has remained the same since November 2012 and no increase is expected until economic conditions in Western Canada improve.

Action now: Hold. Badger’s results are better than we might have expected given the depth of the plunge in the oil price and the resulting spending cuts in the energy sector. The company has a unique and useful technology and the share price should eventually recover.

Gibson Energy (TSX: GEI, OTC: GBNXF)

Originally recommended on Oct. 1/12 (#21234) at C$23.03, US$23.26. Closed Friday at C$13.50, US$9.85.

Background: Gibson Energy is a large independent midstream company with operations across major oil and gas producing regions throughout North America. The company is engaged in the movement, storage, blending, processing, marketing, and distribution of crude oil, condensate, natural gas liquids, water, oilfield waste, and refined products. It transports energy products by utilizing its integrated network of terminals, pipelines, storage tanks, and trucks located throughout western Canada and through its significant truck transportation and injection station network in the United States.

Stock performance: Like virtually every other energy-related stock, Gibson has seen its price fall significantly in reaction to the plunge in the price of oil. The shares traded in he high $30s in September 2014, just prior to the start of the collapse. They are now at less than half that level and still in a downward trend.

Recent developments: Third-quarter results showed just how badly the company has been hurt by the decline of the energy sector. Revenue was down 43% from the same period in 2014 to $1.3 billion. The company reported a loss of $41.2 million (-$0.33 per share, fully diluted) compared to a profit of $8.5 million ($0.07 per share) in the year-ago period.

For the first nine months of the fiscal year, the loss was $68.4 million (-$0.54 per share) compared to a profit of $78.5 million ($0.63 per share) a year ago.

The company said that in the short term low oil prices will continue to have an impact on its business. However, management was more optimistic when looking out farther saying “over the medium to long term, as crude oil supply and demand rebalances and crude oil prices realign with global cost structures, the company anticipates a return to increased activity and production levels and a continued demand for midstream value chain assets.”

Dividend: Despite the big drop in revenue and the bottom line losses, the company is maintaining its quarterly dividend of $0.32 ($1.28 a year), at least for now. That translates into a yield of 9.5% at the current price. I do not believe that dividend is sustainable and, judging by the share price and the yield, neither does the market. The company has suspended its dividend reinvestment plan for now.

Action now: Sell. This is a good company with strong infrastructure. However, it is in the wrong industry at the wrong time. It will eventually recover but that will take time and the share price will likely take another hit if the dividend is cut in 2016. Therefore, I suggest taking a capital loss at this point. Hopefully, you can write it off against some capital gains.

 

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YOUR QUESTIONS

Why are prices falling?

Q – I’m getting more than a little antsy at the erosion of my portfolio balance by the significant and ongoing decline in the stock prices of companies such as Enbridge, Enbridge Income Fund, Inter Pipeline, Altagas, and Brookfield Renewable Energy.

All have been recommended in your newsletters, are profitable, and are even raising their dividends.

My question is: what are the factors driving the price declines? Is it the price of oil, or the prevailing anti-pipeline sentiment, or the fear that the need for fossil fuel will suddenly cease, or the impending Fed interest rate increase? Or all of these factors?
Should we continue to “chill”? – C.L.W.

A – As you might expect, the reasons are complex and vary from one company to another. Higher interest rates in the U.S. certainly play a role as all of these stocks are interest-sensitive. That means when rates on safe securities such as T-bills increase, investors demand more of a risk premium from stocks. That tends to drive prices lower and push yields higher. As well, these companies normally carry a high level of debt, which costs more to service when rates rise.

Pipeline companies, which just a couple of years ago were frantically adding infrastructure to meet the needs of the shale oil boom, now find themselves with overcapacity in some areas. Reduced throughput may mean less revenue and lower profits in some cases.

Renewable energy companies are under increasing pressure from low oil prices, especially high-cost producers such as solar and wind. The less the cost of oil to consumers, the less demand there is for very expensive alternatives. The scathing report of the Ontario auditor-general on the blatant excesses in the province’s green energy program appears to have had the effect of turning public opinion against such projects.

The bottom line is that cheap oil is having a ripple effect across a range of companies that, at first glance, have no direct connection to the industry. Unfortunately, this pattern is likely to continue until the price of oil begins to recover. – G.P.

 

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MEMBERS’ CORNER

Oil price war

Member comment: From IWB #21543: “The world is paying a big economic price for this [oil price] war of attrition; an estimated $625 billion in cancelled investments and about 250,000 jobs lost.”

Anyone who has read Joseph Schumpeter clearly sees this as just another example of “creative destruction,” a process he described in detail more than seventy years ago (although Marxist economist Werner Sombart is credited with the first such analysis some thirty years earlier). The oil sands and shale producers primarily targeted by the Saudis and their allies are, quite simply, high-cost producers who, by the “laws” of free market supply/demand, should be driven out of business, at least until their high-cost product is needed (i.e. when demand increases beyond the supply available from the lower-cost producers, which may or may not occur at some point in the future). Thus the statement “paying a big economic price” is somewhat misleading (if not disingenuous) insofar as Schumpeter’s analysis more or less predicts that the destruction of “the old” will result in “the creation of [the] new,” that is, that resources, both labour and capital, will shift elsewhere, not be “destroyed” as such. Of course, only time will tell what the “new” will be. – Jim B.

Response: This assumes that free market supply/demand is the only factor at play here. In reality, this is a huge geopolitical struggle. The last thing the U.S. wants is to again become hostage to Middle Eastern oil, which is what would happen if the thesis of creative destruction were applied to its domestic petroleum industry.

As for the comment about paying a big economic price being misleading, the reality is those jobs and investments are gone for now and the foreseeable future. Perhaps, as the creative destruction thesis suggests, eventually they will be replaced – but it may happen in Iran, Saudi Arabia, and Iraq. – G.P.

 

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PRICE CHANGE

This is a final reminder to renew your membership before Dec. 31 and beat the $10 price increase that will take effect in the New Year. Call Customer Service at 1-888-287-8229 or go to www.BuildingWealth.ca/subscribe.

That wraps up the IWB for 2015. We’re taking the next two weeks off so that our staff can enjoy this special time of year with their families. Our very best wishes to you and your loved ones for a happy holiday season. We will see you again on Jan. 4.

Best regards,
Gordon Pape