In this issue:

Next Update Edition: July 14

Next regular issue: July 28

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A GOOD YEAR SO FAR

By Gordon Pape, Editor & Publisher

The first half of the year is winding down, and on the whole it has been a good one for income investors. You need look no further than interest rates for the reason.

Back in January, it appeared the U.S. Federal Reserve Board was about to embark on a yearlong escalation of rates in that country. The Fed’s Open Market Committee had raised its rate in December for the first time in seven years, to between 0.25% and 0.5%. Not one member voted against it, and it was seen as just the start. Before the end of 2016, it was expected that further increases would push the rate to at least 1% by year-end.

That has not happened. Last week, the Fed voted unanimously to keep the rate where it is, and the prospects for any more hikes this year look doubtful.

There are four factors at work here. The first is the recent U.S. job creation numbers, which are, quite frankly, abysmal. One of the Fed’s major concerns is jobs, and pushing up interest rates when companies are keeping a tight lid on new hires would exacerbate the situation.

The second issue is inflation. Like Canada, the U.S. maintains a target rate of about 2%. Neither country is anywhere near that, and deflation remains a concern if the economy goes back into recession.

Number three is the strong U.S. dollar. It is cutting into the profits of U.S. multi-national companies and raising the cost of U.S. exports to foreign buyers.

Finally, there is Brexit. Fed Chair Janet Yellen said during last week’s news conference that uncertainty over the outcome of Britain’s referendum on leaving the European Union weighed heavily on the decision not to make any move at this time.

We’ll know the results of the referendum this week, but even if Britain votes to stay within Europe, all the other issues remain. Without a return to strong job creation and a rebound in economic growth, it’s hard to see how the Fed can pull the trigger on another rate increase this year.

So what does all this have to do with your income investments? A lot. Many of the companies in your portfolio, including REITs, telecoms, and utilities, carry high debt loads. An upward move in interest rates will increase their carrying costs as loans mature or new borrowing is needed, and those higher costs will reflect on the bottom line.

As well, when the yields on safe government securities increase, the returns from income-producing stocks must go up accordingly to maintain the spread. If the companies don’t increase dividends, the share price will probably decline, pushing the yield higher to maintain the spread with bonds.

Right now, government bond yields are falling. In June 2015, the average yield on 5- to 10-year Government of Canada bonds was 1.5% according to the Bank of Canada website. In May of this year it was 1.04%, a decline of 46 basis points. That has eased pressure on interest sensitive stocks, and allowed them to move higher.

REITs have been the greatest beneficiary. In 2015, the S&P/TSX Capped REIT Index fell 10.1%. As of the close on June 17, the index was ahead 13.3% for 2016, a huge turnaround.

But the rebound doesn’t stop there. In 2015, the S&P/TSX Capped Utilities Index fell 7.8%, also in anticipation of an upward move in rates this year. When that didn’t happen, utilities stocks rallied and are up 10.7% year-to-date. It’s a similar story with telecoms, which are ahead 12.3% this year compared with a gain of only 2.2% in 2015.

Is there any room left for these interest-sensitive stocks to go higher? Yes, it appears there is. The average monthly rate for 5- to 10-year Government of Canada bonds could slip lower. It dropped to 0.89% in February and could test that level again if the economy goes not pick up steam soon. Also, the flight to the safety of government bonds has depressed yields in Europe to their lowest levels since at least World War II. Last week, the yields on 10-year German bonds slipped into negative territory for the first time ever. There is nothing to prevent that from happening here, giving the right circumstances.

When you buy income-producing stocks, it is presumably for cash flow and stability. But right now you’re getting the added bonus of some handsome capital gains. It won’t last forever, but enjoy it while you can.

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

 

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TOP PICK

By Gavin Graham, Contributing Editor

Here is our Top Pick for this month. Prices are as of the close of trading on June 20, unless otherwise indicated.

Medical Facilities Corp. (TSX: DR, OTC: MFCSF)

Type: Common stock
Trading symbols: DR, MFCSF
Exchanges: TSX, OTC
Current price: C$18.27, US$14.37
Entry level: current price
Annual payout: $1.128
Yield: 6.2%
Risk rating: Conservative
Recommended by: Gavin Graham
Website: www.medicalfacilitiescorp.ca/

The industry: Canadian healthcare, while regarded as one of the centrepieces of Canadian society and an important differentiator from the U.S., is among the most government-controlled health systems in the Western world. With the exception of a couple of procedures (laser eye surgery and cosmetic surgery), the provision of surgical services to Canadians is delivered through provincial health systems. This results in there being very few listed vehicles in Canada by which investors can gain exposure to the demographic trends such as an aging population, growing life spans, and rising healthcare spending.

I recommended Swiss drug giant Novartis (NYSE: NVS) last year, whose eyecare and oncology franchises are areas where expenditures will increase, although the price has not yet reflected the refocusing of the company. However, one Canadian listed company does provide exposure to these trends through its ownership of four specialty surgical hospitals and a surgical centre in the U.S.: Medical Facilities Corp.

The business: Medical Facilities owns 51% or more in four specialty surgical hospitals in Arkansas, Oklahoma, and North Dakota, and an ambulatory surgery centre in California. The remaining stakes in the hospitals and surgery centre are owned by the physicians who practice there. The specialty hospitals perform scheduled surgical, imaging, and diagnostic procedures, while the surgery centre specializes in outpatient procedures with patient stays of less than 24 hours.

The hospitals specialize in a limited number of high-volume, non-emergency procedures, primarily in orthopaedics and neurosurgery, which results in predictable scheduling and increased efficiencies. Turnaround times for operating rooms average 20 minutes at Medical Facilities’ hospitals compared with 40 minutes in traditional hospitals. Post-operative stays are usually one day or less compared with an average of seven days in traditional hospitals.

Orthopaedics are offered at its two South Dakota hospitals and in Arkansas, while neurosurgery is offered in South Dakota, Oklahoma, and Arkansas. Pain management and ENT are the specialties offered. The hospitals have 60 operating rooms and 136 overnight beds and are located in states that have proven to resilient in challenging economic environments. The physician owner model provides patients with innovative treatments and optimal service. Medical Facilities hospitals received a 91% satisfaction score compared with a national average of 71%.

Why we like it: Medical Facilities’ efficient use of its resources results in very high returns on capital employed. With an operating margin of 20%, and current cash and liquidity three times its net debt, Medical Facilities has high ability to generate free cash flow. Its free cash flow (FCF) to enterprise value (EV) ratio is 0.18, among the highest in the Canadian stock universe. FCF is simply the cash left over after all expenses, reinvestment, and capital expenditures, while EV is the value of the business, including debt, excluding cash.

There is an increasing demand for surgical services, due to the aging population, overall population growth, and increased coverage under healthcare reform. While the introduction of healthcare reform in the U.S. (the so-called Obamacare) has created some challenges, it has also resulted in opportunities. The 300 or so specialty surgical hospitals that existed when Obamacare was introduced, including Medical Facilities, were grandfathered (i.e., could remain in operation), although their ability to add operating rooms or beds is limited. While the aggregate percentage of physician ownership is capped, the number of physician owners can increase, and the 300-odd existing specialty hospitals are potential acquisition targets for operators such as Medical Facilities.

Medical Facilities receives fees from the insurers for patients. In 2015, 27% was from Medicare/Medicaid, 33% from Blue Cross/Blue Shield, 19% private insurance, 10% workers’ compensation, and the remainder from other sources. It also owns a diversified healthcare services company in Oklahoma City, which provides business solutions to healthcare entities such as physician practices and insurance companies.

The security: Medical Facilities is capitalized at $580 million and trades 10,000-15,000 shares a day on the TSX. Liquidity on the OTC is very limited. Its stable revenues make it one of the least volatile stocks on the TSX, with a beta of only 0.52 (a beta of 1.0 mean a stock moves exactly in line with the index).

Financial highlights: Medical Facilities generated revenues of $75.9 million (all figures in U.S. dollars unless otherwise stated) in the quarter ending March 31, up 5.1% from the previous year. Income from continuing operations was down 8.6%, to $14.8 million, which dropped the operating margin to 19.5% from 22.4%. While cash available for distributions was down slightly to $8.7 million, the payout ratio was actually down to 73.2% from 78.5%. For 2015, revenue grew 3.8% to $308.8 million, while consolidated income was up 12% to $74.7 million, and cash available for distribution rose 10.8%, to $45.9 million ($1.47 per share). Distributions were $35.2 million ($1.125 per share), a payout ratio of 76.7% compared with 85.2% in the year-ago period.

Risks: The U.S. healthcare landscape has changed drastically over the last five years, and, as noted, physician-owned specialty surgical hospitals are limited in the number of beds and operating rooms they can add. However, Medical Facilities has come through the introduction of Obamacare unscathed, with its cash available for distribution having grown to $51.9 million in 2015 from $33.3 million in 2011 (excluding foreign exchange gains/losses). It was able to buy 51% of the Arkansas Surgical Center in late 2012 for $36.8 million, adding $50 million to its annual revenues, and may acquire other specialist surgical hospitals.

As a Canadian listed company with U.S. operations, Medical Facilities will be exposed to moves in the Canadian/U.S. dollar exchange rate, although this has benefited the company in the last five years owing to the weakness in the loonie.

As more patients are funded by Medicare/Medicaid, margins are affected as they pay lower rates. For Medical Facilities, those payments account for 36% of gross but only 27% of net revenue, but the company is addressing margin pressure by increasing efficiencies and selling additional services such as imaging.

Distribution policy: Medical Facilities has paid $0.094 per month since it last increased its dividend in late September 2012, giving it a yield of 6.2%. It has paid monthly distributions since listing in 2004. Dividends are eligible for the dividend tax credit for Canadian residents and are subject to a 15% withholding tax for U.S. residents.

Who’s it for: Medical Facilities is suitable for investor who require a relatively high and stable yield backed by a business that generates high return on equity and free cash flow, and where there may be some growth from further acquisitions of other specialty hospitals.

Action now: Buy at the current price. ? G.G.

 

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GORDON PAPE’S JUNE UPDATES

Alaris Royalty Corp. (TSX: AD, OTC: ALARF)

Type: Common stock
Trading symbols: AD, ALARF
Exchanges: TSX, Grey Market
Current price: C$30.54, US$22.80 (May 26)
Originally recommended: July 10/14 at C$29.65, US$26.90
Annual payout: $1.62
Yield: 5.30%
Risk: Moderate
Recommended by: Gordon Pape
Website: www.alarisroyalty.com

Comments: Alaris is an investment company that provides alternative financing to its partners in exchange for royalties, with the principal objective of generating stable and predictable cash flows for dividend payments to shareholders. Distributions from the partners are structured as a percentage of a top-line financial performance measure, such as gross margin and same-store sales, and rank in priority to the owners’ common equity position.

When I last reviewed Alaris in November, the shares had been in a downward trend for several months. Investor concerns were heightened by a writedown of $3.6 million in relation to unpaid distributions from one of its partners. I said at the time that the stock appeared oversold, but suggested that only aggressive investors should buy at that point. For everyone else, I suggested waiting until we had more evidence about the soundness of the partner companies.

After falling below $22 last winter, the shares have rallied on more encouraging financial news and are now trading more than $4 ahead of last fall’s level.

First-quarter returns released in May were soft compared with the same period in 2015 but much better than what we saw at the end of last year. Revenue came in at $24.6 million, up from just over $19 million in the same period of 2015. However, earnings per share were at $0.57, down from $0.68 in the same period a year ago, in part due to an increase of over four million outstanding shares as a result of a new issue.

The company said it expects revenue of about $101.5 million for 2016, with a payout ratio of 77%. That compares with revenue of $77.7 million in 2015 with a payout ratio of 80%. If Alaris can deliver those results, it would be a significant step forward and could result in another divided increase (there were two last year).

Alaris continues to expand its portfolio. It added new annual revenue streams of US$9.3 million during the quarter (two-thirds of the company’s income is from the U.S.). After quarter-end, it adding another US$5.4 million from two new partners.

Action now: Alaris is restored to a Buy but only for more aggressive investors.

Evertz Technologies Ltd. (TSX: ET, OTC: EVTZF)

Type: Common stock
Trading symbols: TSX: ET, OTC: EVTZF
Exchanges: TSX, Grey Market
Current price: C$17.97, US$14.28 (June 3)
Originally recommended: Aug. 14/14 at C$17.67, US$16.35
Annual payout: $0.72
Yield: 4.01%
Risk: Higher risk
Recommended by: Gordon Pape
Website: www.evertz.com

Comments: Evertz designs, manufactures and markets video and audio infrastructure solutions for the television, telecommunications, and new media industries. Although it is seen it as a higher-risk company, I like it for its sound balance sheet, good growth record, and the potential for dividend increases.

When I last reviewed the stock in November, it was coming off a weak third quarter that had knocked the share price down to below $16. However, the stock has since recovered and briefly broke through $19 earlier this month before retreating to the current level.

Two weeks ago the company reported year-end results for its 2016 fiscal year, to April 30. Revenue for the 12 months was up about 5% over the previous year, to $381.6 million, a record for the company. Net earnings were just under $71 million ($0.94 per share) compared with $66.4 million ($0.87 per share) in fiscal 2015. Gross margin percentage improved slightly, to 57% from 56.7% in the prior year.

Action now: Buy. The company appears to be back on track.

Exchange Income Corp. (TSX: EIF, OTC: EIFZF)

Type: Common stock
Trading symbol: EIF, EIFZF
Exchange: TSX, Grey Market
Current price: C$31.14, US$23.98 (June 14)
Originally recommended: Nov. 19/15 at C$26.89, US$20.01
Annual payout: $2.01
Yield: 6.45%
Risk: Higher risk
Recommended by: Gordon Pape
Website: www.ExchangeIncomeCorp.ca

Comments: Exchange Income Corp. has two operating segments: aviation and manufacturing. The aviation segment serves Northern Canada, while the manufacturing segment covers a number of sectors, including sheet metal and cellphone tower construction. This is a growth-by-acquisition company that has added new businesses every year since 2011.

The company was recommended in November 2015 when it was trading at $26.89 on the TSX. It dropped below $22 during the market selloff last winter but has since rallied dramatically and is now about $4 ahead of its original recommended price.

The company reported very strong first-quarter results. Revenue increased 25% to almost $218 million. Net earnings were $9.9 million ($0.36 per share), a big improvement from last year’s $934,000 ($0.04 per share). Free cash flow was $34.9 million ($1.26 per share) compared with $23.9 million ($1.04 per share) in the prior year. The payout ratio dropped to 79% from 109% a year ago, a very positive sign.

The positive results allowed the company to implement its third dividend increase in the past 18 months. The monthly dividend is now $0.1675 ($2.01 a year), a 5% increase over the previous level.

Action now: The stock remains a Buy for investors who can tolerate higher risk.

Intertape Polymer Group Inc. (TSX: ITP, OTC: ITPOF)

Type: Common stock
Trading symbols: ITP, ITPOF
Exchanges: TSX, Pink Sheets
Current price: C$19.79, US$15.20 (June 17)
Originally recommended: March 10/16 at C$17.28, US$13.13
Annual payout: US$0.52
Yield: 3.42%
Risk: Moderate
Recommended by: Gordon Pape
Website: www.itape.com

Comments: The company manufactures a variety of tapes for commercial use, including aerospace, automotive, and industrial applications.

I recommended this company in March when it was trading on the TSX at $17.28. At the time, I said I liked it for its steady cash flow and good dividend record. The shares traded as high as $21.01 earlier this month before slipping back a bit.

The company reported its first-quarter results in May. Revenue was up slightly over last year, but profit slipped by 19% to $9.53 million ($0.16 per share) from $11.78 million ($0.19 per share) in the prior year. The company said that last year’s flood at its Columbia, South Carolina facility had a negative impact of approximately $5 million of lost sales of masking tape and stencil products, and reductions in gross profit, net earnings, and adjusted EBITDA of approximately $3 million. The plant has since been closed; however, the company has announced that it will invest $44 to $49 million in the construction of a greenfield manufacturing facility in Cabarrus County, North Carolina, with a goal to increase its manufacturing capacity of water-activated tapes by the end of 2017.

Looking ahead, the company expects profit growth to resume in the current quarter, saying that revenue, gross margin, and adjusted EBITDA will be greater than in the second quarter of 2015. It expects insurance will cover most of the loss of the South Carolina plant, but the timing of the payments is not clear right now.

Action now: Take advantage of the price pullback to establish a position, if you don’t have one already.

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

Type: Common stock
Trading symbols: MSI, MSIXF
Exchanges: TSX, Grey Market
Current price: C$17.45, US$13.61
Originally recommended: July 27/11 at C$10.24
Annual payout: $0.78
Yield: 4.47 %
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: When I last reviewed this stock in December, it has recently sold off and I said it looked like a good buy at slightly over $15 per share. That turned out to be right on as the stock is up $2.30 since then.

The company, which is in the human resources consulting business, continues to report good results. First quarter revenue came in at $149.1 million, up 7.8% from the same period last year. Normalized free cash flow was ahead 8% to $15.3 million. However, net profit declined to $7.1 million compared to $8.2 million last year because of severance charges.

"As we move through 2016, we expect our organic revenue growth to continue to be in-line with our longer-term historical performance,” said CEO Alan Torrie. “I am particularly pleased to announce that after the quarter end, we signed a large, multi-year contract with the State of Illinois. Morneau Shepell will provide over 300,000 state employees with a comprehensive benefits administration solution for expected implementation in the fourth quarter of 2016."

The company held its monthly dividend at $0.065 ($0.78 per year). The increase in the share price means the yield is down to 4.47%.

Action now: Hold. The stock is looking expensive again.

Return to the table of contents…

GAVIN GRAHAM’S JUNE UPDATES

Capital Power (TSX: CPX, OTC: CPXWF)
Type: Common stock
Trading symbols: CPX, CPFWF
Exchanges: TSX, OTC
Current price: $19.24, US$15.30
Originally recommended: Jan 27/14 at $22.60, US$19.32
Annual payout: $1.46
Yield: 7.59%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.capitalpower.com

Comments: Alberta power generator Capital Power has suffered along with the rest of the electricity industry in the province as the new regulations on carbon emissions mandated by the NDP government have led to uncertainty about the outlook for power producers. CPF’s share price almost halved, to $15.40 in December 2015 from $28.50 in late 2014, although it has since recovered somewhat.

In January 2016, the Alberta government announced plans to develop new renewable electricity generation capacity to the grid by 2030 while phasing out coal-fired generation, which currently accounts for 17% of Alberta’s capacity.

In response, the energy companies have exercised their rights to return their Power Purchase Agreements (PPAs) from coal-fired power plants to the government. Capital Power did so in March with its PPA for the Sundance plants, taking a non-cash $53 million write-down ($46 million after tax).

While the ending of the PPAs for coal-fired plants is a short-term setback, the fall in the price of electricity in Alberta over the last year is a longer-term problem. For the first quarter of 2016, average realized prices for electricity were $18 per MWh against $29 per MWh in 2015. However, as I pointed out in my last review a year ago, Capital Power has consistently earned a 25% premium over average prices for the last six years, and it earned $52 per MWh in the first quarter through its hedging program.

For the first quarter, Capital Power had a net loss of $8 million ($0.11 per share) against a profit of $40 million ($0.41) last year. But after adjusting for the Sundance PPA write-down, its normalized earnings were up 3%, to $32 million ($0.33 per share) against $27 million ($0.32 per share) in the year-ago period. Cash flow from operating activities was up 22.4%, to $131 million from $107 million, and funds from operations were up 1%, to $109 million from $108 million.

For 2015 as a whole, while revenues were up only 2%, to $1.25 billion, as lower electricity prices offset the contribution from its 50% share of the 400MW Shepard gas-fired plant and 90MW K2 wind project coming on stream. However, adjusted earnings before interest, tax, depreciation & amortization (EBITDA) rose 19%, to $462 million. Funds from operations (FFO) climbed 10%, to $400 million, while normalized EPS rose 60%, to $1.15 a share.

Capital Power has forecast FFO of between $380 million and $430 million for 2016. It has committed to raising its annual dividend by 7% for 2016-18, following a 7.4% increase, to $1.46, last year. It also bought back six million shares (7% of the total in 2015).

Action now: Capital Power remains a Buy on a p/e of 17.2 and a 7.6% yield.

Leon’s Furniture (TSX: LNF, OTC: LEFUF)
Type: Common stock
Trading symbols: LNF, LEFUF
Exchanges: TSX, OTC
Current price: $15.50, US$11.85 (May 9)
Originally recommended: August 25/10 at $12.40
Annual payout: $0.40
Yield: 2.6%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.leons.ca

Comments: Furniture and appliance chain Leon’s continues to be the definition of boring, which is no bad thing in investing. While 2015 revenues were up only 1.2%, to $2.03 billion, and net income rose 1.5%, to $76.6 million ($1.08 per share). However, this occurred in a year when economic weakness in the Prairies, home to many of the Brick stores it acquired in 2013, and a weakening Canadian dollar were negative factors.

In the first quarter of 2016, in contrast, same store sales growth (SSSG) rose 7.7%. Revenue increased by 7.9%, to $63.4 million, and adjusted net income expanded 89%, to $5.17 million (EPS up 75% to $0.07). Leon’s acquired eight Sears Home stores, four in B.C., to introduce its brand to the province for the first time. Three Sears stores are in the Toronto area, and one in Moncton. The new stores will reopen in September. Meanwhile, Leon’s recently finalized a deal to open a 430,000 sq. ft. state of the art distribution centre in Vancouver to service its new stores and its existing 27 Brick stores in the province.

Action now: Leon’s rock solid balance sheet, increased national presence, aggressive cost cutting, and increased marketing, make it a Buy at a forecast p/e of 14 and a 2.6% yield.

Boston Pizza Royalties Income Fund (TSX: BPF.UN, OTC: BPZZF)
Type: Income trust
Trading symbols: BPF, BPZZF
Exchanges: TSX, Grey Market
Current price: $18.75, US$14.44 (June 16)
Originally recommended: June 27/13 at $20.95
Annual payout: $1.38
Yield: 7.36%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.bpincomefund.com

Comments: Casual dining chain Boston Pizza has been affected by the downturn in the oil patch, with Alberta representing 28% of its restaurants, the second largest number of provincial outlets after Ontario (35%). As a result, while franchise sales (which exclude liquor) were up 4.1%, to $814 million, in 2015 and gross sales hit an all-time record of $1.05 billion, same store sales growth (SSSG) was up only 1.8%. The share price reflected concerns over this exposure, falling 14% over the last 12 months.

This is an over-reaction in my view. Boston Pizza issued 5.05 million shares to raise $112.5 million in May 2015, increasing its share of the royalty by 1.5%, to 5.5%, and raised the distribution by 6.2%, to $1.30 annually, as the acquisition was immediately accretive. It raised the payout again in January by 6.2%, to $0.115 a month, equivalent to $1.38 annually for a yield of 7.4%. While the payout ratio was 105.7%, this was down slightly from the previous year, and Boston Pizza always generates more cash in the second and third quarters as better weather encourages casual diners. For 2015, the payout ratio was 94%.

For the first quarter ending March 31, franchise sales were $198 million, up 2.3% from the year-ago period, while SSSG was up only 0.6% against 1.9% in 2015, as weak conditions in areas exposed to oil and gas took their toll. On Jan. 1 six new restaurants were added to the royalty pool, which now totals 372 outlets.

Action now: Boston pizza remains a Buy for its steady expansion, higher royalty rate, and ability to grow its distributions even during economic weakness in one of its core areas.

Pizza Pizza Royalty Trust (TSX: PZA, OTC: PZRIF)
Type: Common stock
Trading symbols: PZA, PZRIF
Exchanges: TSX, Grey market
Current price: $18.75, US$10.51 (May 24)
Originally recommended: June 27/13 at $12.00
Annual payout: $0.86
Yield: 7.36%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.pizzapizza.ca

Comments: Ubiquitous chain Pizza Pizza has also been suffering from its Alberta exposure, as its Pizza 73 operation, formerly the leader in SSSG growth, saw fourth quarter sales growth fall 5.3%. The share price has slid around 10% over the last 12 months.

However, its much larger Pizza Pizza operations in Ontario and elsewhere had SSSG growth of 5.3% with the result that overall SSSG was 3.5%, and for 2015 as a whole, SSSG rose 4.5%, the best showing for eight years. For 2015, sales increased 5.6%, to $533.8 million, helped by the seven new restaurants added to the royalty pool on Jan. 1, making a total of 730 outlets.

Adjusted earnings grew 5.8%, to $27.5 million ($0.895 per share), while dividends were increased twice during the year, first by 1.95% in April and then by 2.5% in November, equivalent to an annualized $0.86. This represents a payout ratio of 95%, down from 99% in 2014. Pizza Pizza also reduced its interest expense by 1.37% by refinancing its $47 million credit line at 2.75%. This is estimated to save $640,000 annually, equivalent to $0.021 a share.

Pizza Pizza’s first-quarter royalty pool sales increased 3.3%, to $133.1 million, while SSSG rose 2.5%, with Pizza 73 down 7.9% and Pizza Pizza up 4.9%. Earnings per share came in at $0.214 (fully diluted) against $0.21 a year ago. In June, Pizza Pizza increased its annual dividend 2.4%, to $0.856 from $0.836, giving it a yield of 7.4%.

Action now: Pizza Pizza remains a Buy for its strong Ontario performance and geographical diversification, lowered interest costs, and robust SSSG.

The Keg Royalties Income Fund (TSX: KEG.UN, OTC: KRIUF)
Type: Income trust
Trading symbols: KEG, KRIUF
Exchanges: TSX, Grey Market
Current price: $18.00, US$13.68 (June 1)
Originally recommended: June 21/06 at $13.38, US$12.28
Annual payout: $1.08
Yield: 6%
Risk: Moderate
Recommended by: Gavin graham
Website: www.kegincomefund.com

Comments: Steakhouse chain The Keg reported record revenues of $574 million for 2015 (up 10.2% from 2014) from its 102 restaurants in the royalty pool, including three new ones added at the beginning of the year. SSSG rose 6.5% in Canada and 7% in the U.S. (8% in Canadian dollar terms). Royalty revenue increased 11.3%, to $23.3 million. Distributable cash increased 7.7%, to $12.3 million ($1.083 per share), while distributions were raised three times to $0.09 a month ($1.08 annually), plus a special $0.07 payout in December. The payout ratio was 98.9% in 2015.

For the first quarter, sales were up 0.3%, to $146.8 million, despite the loss of two restaurants from the royalty pool, and lower New Year’s Eve 2015 sales. SSSG grew 1.1% despite flat growth in the larger Canadian operations, thanks to a 2.2% increase in the U.S. Distributable cash was up 11.2%, to $3.63 million ($0.32 per share).

Action now: The Keg remains a Buy for its conservative positioning as a mid-price steakhouse chain, geographical diversification, and strong cash generation.

In this issue:

Next Update Edition: July 14

Next regular issue: July 28

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A GOOD YEAR SO FAR

By Gordon Pape, Editor & Publisher

The first half of the year is winding down, and on the whole it has been a good one for income investors. You need look no further than interest rates for the reason.

Back in January, it appeared the U.S. Federal Reserve Board was about to embark on a yearlong escalation of rates in that country. The Fed’s Open Market Committee had raised its rate in December for the first time in seven years, to between 0.25% and 0.5%. Not one member voted against it, and it was seen as just the start. Before the end of 2016, it was expected that further increases would push the rate to at least 1% by year-end.

That has not happened. Last week, the Fed voted unanimously to keep the rate where it is, and the prospects for any more hikes this year look doubtful.

There are four factors at work here. The first is the recent U.S. job creation numbers, which are, quite frankly, abysmal. One of the Fed’s major concerns is jobs, and pushing up interest rates when companies are keeping a tight lid on new hires would exacerbate the situation.

The second issue is inflation. Like Canada, the U.S. maintains a target rate of about 2%. Neither country is anywhere near that, and deflation remains a concern if the economy goes back into recession.

Number three is the strong U.S. dollar. It is cutting into the profits of U.S. multi-national companies and raising the cost of U.S. exports to foreign buyers.

Finally, there is Brexit. Fed Chair Janet Yellen said during last week’s news conference that uncertainty over the outcome of Britain’s referendum on leaving the European Union weighed heavily on the decision not to make any move at this time.

We’ll know the results of the referendum this week, but even if Britain votes to stay within Europe, all the other issues remain. Without a return to strong job creation and a rebound in economic growth, it’s hard to see how the Fed can pull the trigger on another rate increase this year.

So what does all this have to do with your income investments? A lot. Many of the companies in your portfolio, including REITs, telecoms, and utilities, carry high debt loads. An upward move in interest rates will increase their carrying costs as loans mature or new borrowing is needed, and those higher costs will reflect on the bottom line.

As well, when the yields on safe government securities increase, the returns from income-producing stocks must go up accordingly to maintain the spread. If the companies don’t increase dividends, the share price will probably decline, pushing the yield higher to maintain the spread with bonds.

Right now, government bond yields are falling. In June 2015, the average yield on 5- to 10-year Government of Canada bonds was 1.5% according to the Bank of Canada website. In May of this year it was 1.04%, a decline of 46 basis points. That has eased pressure on interest sensitive stocks, and allowed them to move higher.

REITs have been the greatest beneficiary. In 2015, the S&P/TSX Capped REIT Index fell 10.1%. As of the close on June 17, the index was ahead 13.3% for 2016, a huge turnaround.

But the rebound doesn’t stop there. In 2015, the S&P/TSX Capped Utilities Index fell 7.8%, also in anticipation of an upward move in rates this year. When that didn’t happen, utilities stocks rallied and are up 10.7% year-to-date. It’s a similar story with telecoms, which are ahead 12.3% this year compared with a gain of only 2.2% in 2015.

Is there any room left for these interest-sensitive stocks to go higher? Yes, it appears there is. The average monthly rate for 5- to 10-year Government of Canada bonds could slip lower. It dropped to 0.89% in February and could test that level again if the economy goes not pick up steam soon. Also, the flight to the safety of government bonds has depressed yields in Europe to their lowest levels since at least World War II. Last week, the yields on 10-year German bonds slipped into negative territory for the first time ever. There is nothing to prevent that from happening here, giving the right circumstances.

When you buy income-producing stocks, it is presumably for cash flow and stability. But right now you’re getting the added bonus of some handsome capital gains. It won’t last forever, but enjoy it while you can.

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

 

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TOP PICK

By Gavin Graham, Contributing Editor

Here is our Top Pick for this month. Prices are as of the close of trading on June 20, unless otherwise indicated.

Medical Facilities Corp. (TSX: DR, OTC: MFCSF)

Type: Common stock
Trading symbols: DR, MFCSF
Exchanges: TSX, OTC
Current price: C$18.27, US$14.37
Entry level: current price
Annual payout: $1.128
Yield: 6.2%
Risk rating: Conservative
Recommended by: Gavin Graham
Website: www.medicalfacilitiescorp.ca/

The industry: Canadian healthcare, while regarded as one of the centrepieces of Canadian society and an important differentiator from the U.S., is among the most government-controlled health systems in the Western world. With the exception of a couple of procedures (laser eye surgery and cosmetic surgery), the provision of surgical services to Canadians is delivered through provincial health systems. This results in there being very few listed vehicles in Canada by which investors can gain exposure to the demographic trends such as an aging population, growing life spans, and rising healthcare spending.

I recommended Swiss drug giant Novartis (NYSE: NVS) last year, whose eyecare and oncology franchises are areas where expenditures will increase, although the price has not yet reflected the refocusing of the company. However, one Canadian listed company does provide exposure to these trends through its ownership of four specialty surgical hospitals and a surgical centre in the U.S.: Medical Facilities Corp.

The business: Medical Facilities owns 51% or more in four specialty surgical hospitals in Arkansas, Oklahoma, and North Dakota, and an ambulatory surgery centre in California. The remaining stakes in the hospitals and surgery centre are owned by the physicians who practice there. The specialty hospitals perform scheduled surgical, imaging, and diagnostic procedures, while the surgery centre specializes in outpatient procedures with patient stays of less than 24 hours.

The hospitals specialize in a limited number of high-volume, non-emergency procedures, primarily in orthopaedics and neurosurgery, which results in predictable scheduling and increased efficiencies. Turnaround times for operating rooms average 20 minutes at Medical Facilities’ hospitals compared with 40 minutes in traditional hospitals. Post-operative stays are usually one day or less compared with an average of seven days in traditional hospitals.

Orthopaedics are offered at its two South Dakota hospitals and in Arkansas, while neurosurgery is offered in South Dakota, Oklahoma, and Arkansas. Pain management and ENT are the specialties offered. The hospitals have 60 operating rooms and 136 overnight beds and are located in states that have proven to resilient in challenging economic environments. The physician owner model provides patients with innovative treatments and optimal service. Medical Facilities hospitals received a 91% satisfaction score compared with a national average of 71%.

Why we like it: Medical Facilities’ efficient use of its resources results in very high returns on capital employed. With an operating margin of 20%, and current cash and liquidity three times its net debt, Medical Facilities has high ability to generate free cash flow. Its free cash flow (FCF) to enterprise value (EV) ratio is 0.18, among the highest in the Canadian stock universe. FCF is simply the cash left over after all expenses, reinvestment, and capital expenditures, while EV is the value of the business, including debt, excluding cash.

There is an increasing demand for surgical services, due to the aging population, overall population growth, and increased coverage under healthcare reform. While the introduction of healthcare reform in the U.S. (the so-called Obamacare) has created some challenges, it has also resulted in opportunities. The 300 or so specialty surgical hospitals that existed when Obamacare was introduced, including Medical Facilities, were grandfathered (i.e., could remain in operation), although their ability to add operating rooms or beds is limited. While the aggregate percentage of physician ownership is capped, the number of physician owners can increase, and the 300-odd existing specialty hospitals are potential acquisition targets for operators such as Medical Facilities.

Medical Facilities receives fees from the insurers for patients. In 2015, 27% was from Medicare/Medicaid, 33% from Blue Cross/Blue Shield, 19% private insurance, 10% workers’ compensation, and the remainder from other sources. It also owns a diversified healthcare services company in Oklahoma City, which provides business solutions to healthcare entities such as physician practices and insurance companies.

The security: Medical Facilities is capitalized at $580 million and trades 10,000-15,000 shares a day on the TSX. Liquidity on the OTC is very limited. Its stable revenues make it one of the least volatile stocks on the TSX, with a beta of only 0.52 (a beta of 1.0 mean a stock moves exactly in line with the index).

Financial highlights: Medical Facilities generated revenues of $75.9 million (all figures in U.S. dollars unless otherwise stated) in the quarter ending March 31, up 5.1% from the previous year. Income from continuing operations was down 8.6%, to $14.8 million, which dropped the operating margin to 19.5% from 22.4%. While cash available for distributions was down slightly to $8.7 million, the payout ratio was actually down to 73.2% from 78.5%. For 2015, revenue grew 3.8% to $308.8 million, while consolidated income was up 12% to $74.7 million, and cash available for distribution rose 10.8%, to $45.9 million ($1.47 per share). Distributions were $35.2 million ($1.125 per share), a payout ratio of 76.7% compared with 85.2% in the year-ago period.

Risks: The U.S. healthcare landscape has changed drastically over the last five years, and, as noted, physician-owned specialty surgical hospitals are limited in the number of beds and operating rooms they can add. However, Medical Facilities has come through the introduction of Obamacare unscathed, with its cash available for distribution having grown to $51.9 million in 2015 from $33.3 million in 2011 (excluding foreign exchange gains/losses). It was able to buy 51% of the Arkansas Surgical Center in late 2012 for $36.8 million, adding $50 million to its annual revenues, and may acquire other specialist surgical hospitals.

As a Canadian listed company with U.S. operations, Medical Facilities will be exposed to moves in the Canadian/U.S. dollar exchange rate, although this has benefited the company in the last five years owing to the weakness in the loonie.

As more patients are funded by Medicare/Medicaid, margins are affected as they pay lower rates. For Medical Facilities, those payments account for 36% of gross but only 27% of net revenue, but the company is addressing margin pressure by increasing efficiencies and selling additional services such as imaging.

Distribution policy: Medical Facilities has paid $0.094 per month since it last increased its dividend in late September 2012, giving it a yield of 6.2%. It has paid monthly distributions since listing in 2004. Dividends are eligible for the dividend tax credit for Canadian residents and are subject to a 15% withholding tax for U.S. residents.

Who’s it for: Medical Facilities is suitable for investor who require a relatively high and stable yield backed by a business that generates high return on equity and free cash flow, and where there may be some growth from further acquisitions of other specialty hospitals.

Action now: Buy at the current price. ? G.G.

 

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GORDON PAPE’S JUNE UPDATES

Alaris Royalty Corp. (TSX: AD, OTC: ALARF)

Type: Common stock
Trading symbols: AD, ALARF
Exchanges: TSX, Grey Market
Current price: C$30.54, US$22.80 (May 26)
Originally recommended: July 10/14 at C$29.65, US$26.90
Annual payout: $1.62
Yield: 5.30%
Risk: Moderate
Recommended by: Gordon Pape
Website: www.alarisroyalty.com

Comments: Alaris is an investment company that provides alternative financing to its partners in exchange for royalties, with the principal objective of generating stable and predictable cash flows for dividend payments to shareholders. Distributions from the partners are structured as a percentage of a top-line financial performance measure, such as gross margin and same-store sales, and rank in priority to the owners’ common equity position.

When I last reviewed Alaris in November, the shares had been in a downward trend for several months. Investor concerns were heightened by a writedown of $3.6 million in relation to unpaid distributions from one of its partners. I said at the time that the stock appeared oversold, but suggested that only aggressive investors should buy at that point. For everyone else, I suggested waiting until we had more evidence about the soundness of the partner companies.

After falling below $22 last winter, the shares have rallied on more encouraging financial news and are now trading more than $4 ahead of last fall’s level.

First-quarter returns released in May were soft compared with the same period in 2015 but much better than what we saw at the end of last year. Revenue came in at $24.6 million, up from just over $19 million in the same period of 2015. However, earnings per share were at $0.57, down from $0.68 in the same period a year ago, in part due to an increase of over four million outstanding shares as a result of a new issue.

The company said it expects revenue of about $101.5 million for 2016, with a payout ratio of 77%. That compares with revenue of $77.7 million in 2015 with a payout ratio of 80%. If Alaris can deliver those results, it would be a significant step forward and could result in another divided increase (there were two last year).

Alaris continues to expand its portfolio. It added new annual revenue streams of US$9.3 million during the quarter (two-thirds of the company’s income is from the U.S.). After quarter-end, it adding another US$5.4 million from two new partners.

Action now: Alaris is restored to a Buy but only for more aggressive investors.

Evertz Technologies Ltd. (TSX: ET, OTC: EVTZF)

Type: Common stock
Trading symbols: TSX: ET, OTC: EVTZF
Exchanges: TSX, Grey Market
Current price: C$17.97, US$14.28 (June 3)
Originally recommended: Aug. 14/14 at C$17.67, US$16.35
Annual payout: $0.72
Yield: 4.01%
Risk: Higher risk
Recommended by: Gordon Pape
Website: www.evertz.com

Comments: Evertz designs, manufactures and markets video and audio infrastructure solutions for the television, telecommunications, and new media industries. Although it is seen it as a higher-risk company, I like it for its sound balance sheet, good growth record, and the potential for dividend increases.

When I last reviewed the stock in November, it was coming off a weak third quarter that had knocked the share price down to below $16. However, the stock has since recovered and briefly broke through $19 earlier this month before retreating to the current level.

Two weeks ago the company reported year-end results for its 2016 fiscal year, to April 30. Revenue for the 12 months was up about 5% over the previous year, to $381.6 million, a record for the company. Net earnings were just under $71 million ($0.94 per share) compared with $66.4 million ($0.87 per share) in fiscal 2015. Gross margin percentage improved slightly, to 57% from 56.7% in the prior year.

Action now: Buy. The company appears to be back on track.

Exchange Income Corp. (TSX: EIF, OTC: EIFZF)

Type: Common stock
Trading symbol: EIF, EIFZF
Exchange: TSX, Grey Market
Current price: C$31.14, US$23.98 (June 14)
Originally recommended: Nov. 19/15 at C$26.89, US$20.01
Annual payout: $2.01
Yield: 6.45%
Risk: Higher risk
Recommended by: Gordon Pape
Website: www.ExchangeIncomeCorp.ca

Comments: Exchange Income Corp. has two operating segments: aviation and manufacturing. The aviation segment serves Northern Canada, while the manufacturing segment covers a number of sectors, including sheet metal and cellphone tower construction. This is a growth-by-acquisition company that has added new businesses every year since 2011.

The company was recommended in November 2015 when it was trading at $26.89 on the TSX. It dropped below $22 during the market selloff last winter but has since rallied dramatically and is now about $4 ahead of its original recommended price.

The company reported very strong first-quarter results. Revenue increased 25% to almost $218 million. Net earnings were $9.9 million ($0.36 per share), a big improvement from last year’s $934,000 ($0.04 per share). Free cash flow was $34.9 million ($1.26 per share) compared with $23.9 million ($1.04 per share) in the prior year. The payout ratio dropped to 79% from 109% a year ago, a very positive sign.

The positive results allowed the company to implement its third dividend increase in the past 18 months. The monthly dividend is now $0.1675 ($2.01 a year), a 5% increase over the previous level.

Action now: The stock remains a Buy for investors who can tolerate higher risk.

Intertape Polymer Group Inc. (TSX: ITP, OTC: ITPOF)

Type: Common stock
Trading symbols: ITP, ITPOF
Exchanges: TSX, Pink Sheets
Current price: C$19.79, US$15.20 (June 17)
Originally recommended: March 10/16 at C$17.28, US$13.13
Annual payout: US$0.52
Yield: 3.42%
Risk: Moderate
Recommended by: Gordon Pape
Website: www.itape.com

Comments: The company manufactures a variety of tapes for commercial use, including aerospace, automotive, and industrial applications.

I recommended this company in March when it was trading on the TSX at $17.28. At the time, I said I liked it for its steady cash flow and good dividend record. The shares traded as high as $21.01 earlier this month before slipping back a bit.

The company reported its first-quarter results in May. Revenue was up slightly over last year, but profit slipped by 19% to $9.53 million ($0.16 per share) from $11.78 million ($0.19 per share) in the prior year. The company said that last year’s flood at its Columbia, South Carolina facility had a negative impact of approximately $5 million of lost sales of masking tape and stencil products, and reductions in gross profit, net earnings, and adjusted EBITDA of approximately $3 million. The plant has since been closed; however, the company has announced that it will invest $44 to $49 million in the construction of a greenfield manufacturing facility in Cabarrus County, North Carolina, with a goal to increase its manufacturing capacity of water-activated tapes by the end of 2017.

Looking ahead, the company expects profit growth to resume in the current quarter, saying that revenue, gross margin, and adjusted EBITDA will be greater than in the second quarter of 2015. It expects insurance will cover most of the loss of the South Carolina plant, but the timing of the payments is not clear right now.

Action now: Take advantage of the price pullback to establish a position, if you don’t have one already.

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

Type: Common stock
Trading symbols: MSI, MSIXF
Exchanges: TSX, Grey Market
Current price: C$17.45, US$13.61
Originally recommended: July 27/11 at C$10.24
Annual payout: $0.78
Yield: 4.47 %
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: When I last reviewed this stock in December, it has recently sold off and I said it looked like a good buy at slightly over $15 per share. That turned out to be right on as the stock is up $2.30 since then.

The company, which is in the human resources consulting business, continues to report good results. First quarter revenue came in at $149.1 million, up 7.8% from the same period last year. Normalized free cash flow was ahead 8% to $15.3 million. However, net profit declined to $7.1 million compared to $8.2 million last year because of severance charges.

"As we move through 2016, we expect our organic revenue growth to continue to be in-line with our longer-term historical performance,” said CEO Alan Torrie. “I am particularly pleased to announce that after the quarter end, we signed a large, multi-year contract with the State of Illinois. Morneau Shepell will provide over 300,000 state employees with a comprehensive benefits administration solution for expected implementation in the fourth quarter of 2016."

The company held its monthly dividend at $0.065 ($0.78 per year). The increase in the share price means the yield is down to 4.47%.

Action now: Hold. The stock is looking expensive again.

Return to the table of contents…

GAVIN GRAHAM’S JUNE UPDATES

Capital Power (TSX: CPX, OTC: CPXWF)
Type: Common stock
Trading symbols: CPX, CPFWF
Exchanges: TSX, OTC
Current price: $19.24, US$15.30
Originally recommended: Jan 27/14 at $22.60, US$19.32
Annual payout: $1.46
Yield: 7.59%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.capitalpower.com

Comments: Alberta power generator Capital Power has suffered along with the rest of the electricity industry in the province as the new regulations on carbon emissions mandated by the NDP government have led to uncertainty about the outlook for power producers. CPF’s share price almost halved, to $15.40 in December 2015 from $28.50 in late 2014, although it has since recovered somewhat.

In January 2016, the Alberta government announced plans to develop new renewable electricity generation capacity to the grid by 2030 while phasing out coal-fired generation, which currently accounts for 17% of Alberta’s capacity.

In response, the energy companies have exercised their rights to return their Power Purchase Agreements (PPAs) from coal-fired power plants to the government. Capital Power did so in March with its PPA for the Sundance plants, taking a non-cash $53 million write-down ($46 million after tax).

While the ending of the PPAs for coal-fired plants is a short-term setback, the fall in the price of electricity in Alberta over the last year is a longer-term problem. For the first quarter of 2016, average realized prices for electricity were $18 per MWh against $29 per MWh in 2015. However, as I pointed out in my last review a year ago, Capital Power has consistently earned a 25% premium over average prices for the last six years, and it earned $52 per MWh in the first quarter through its hedging program.

For the first quarter, Capital Power had a net loss of $8 million ($0.11 per share) against a profit of $40 million ($0.41) last year. But after adjusting for the Sundance PPA write-down, its normalized earnings were up 3%, to $32 million ($0.33 per share) against $27 million ($0.32 per share) in the year-ago period. Cash flow from operating activities was up 22.4%, to $131 million from $107 million, and funds from operations were up 1%, to $109 million from $108 million.

For 2015 as a whole, while revenues were up only 2%, to $1.25 billion, as lower electricity prices offset the contribution from its 50% share of the 400MW Shepard gas-fired plant and 90MW K2 wind project coming on stream. However, adjusted earnings before interest, tax, depreciation & amortization (EBITDA) rose 19%, to $462 million. Funds from operations (FFO) climbed 10%, to $400 million, while normalized EPS rose 60%, to $1.15 a share.

Capital Power has forecast FFO of between $380 million and $430 million for 2016. It has committed to raising its annual dividend by 7% for 2016-18, following a 7.4% increase, to $1.46, last year. It also bought back six million shares (7% of the total in 2015).

Action now: Capital Power remains a Buy on a p/e of 17.2 and a 7.6% yield.

Leon’s Furniture (TSX: LNF, OTC: LEFUF)
Type: Common stock
Trading symbols: LNF, LEFUF
Exchanges: TSX, OTC
Current price: $15.50, US$11.85 (May 9)
Originally recommended: August 25/10 at $12.40
Annual payout: $0.40
Yield: 2.6%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.leons.ca

Comments: Furniture and appliance chain Leon’s continues to be the definition of boring, which is no bad thing in investing. While 2015 revenues were up only 1.2%, to $2.03 billion, and net income rose 1.5%, to $76.6 million ($1.08 per share). However, this occurred in a year when economic weakness in the Prairies, home to many of the Brick stores it acquired in 2013, and a weakening Canadian dollar were negative factors.

In the first quarter of 2016, in contrast, same store sales growth (SSSG) rose 7.7%. Revenue increased by 7.9%, to $63.4 million, and adjusted net income expanded 89%, to $5.17 million (EPS up 75% to $0.07). Leon’s acquired eight Sears Home stores, four in B.C., to introduce its brand to the province for the first time. Three Sears stores are in the Toronto area, and one in Moncton. The new stores will reopen in September. Meanwhile, Leon’s recently finalized a deal to open a 430,000 sq. ft. state of the art distribution centre in Vancouver to service its new stores and its existing 27 Brick stores in the province.

Action now: Leon’s rock solid balance sheet, increased national presence, aggressive cost cutting, and increased marketing, make it a Buy at a forecast p/e of 14 and a 2.6% yield.

Boston Pizza Royalties Income Fund (TSX: BPF.UN, OTC: BPZZF)
Type: Income trust
Trading symbols: BPF, BPZZF
Exchanges: TSX, Grey Market
Current price: $18.75, US$14.44 (June 16)
Originally recommended: June 27/13 at $20.95
Annual payout: $1.38
Yield: 7.36%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.bpincomefund.com

Comments: Casual dining chain Boston Pizza has been affected by the downturn in the oil patch, with Alberta representing 28% of its restaurants, the second largest number of provincial outlets after Ontario (35%). As a result, while franchise sales (which exclude liquor) were up 4.1%, to $814 million, in 2015 and gross sales hit an all-time record of $1.05 billion, same store sales growth (SSSG) was up only 1.8%. The share price reflected concerns over this exposure, falling 14% over the last 12 months.

This is an over-reaction in my view. Boston Pizza issued 5.05 million shares to raise $112.5 million in May 2015, increasing its share of the royalty by 1.5%, to 5.5%, and raised the distribution by 6.2%, to $1.30 annually, as the acquisition was immediately accretive. It raised the payout again in January by 6.2%, to $0.115 a month, equivalent to $1.38 annually for a yield of 7.4%. While the payout ratio was 105.7%, this was down slightly from the previous year, and Boston Pizza always generates more cash in the second and third quarters as better weather encourages casual diners. For 2015, the payout ratio was 94%.

For the first quarter ending March 31, franchise sales were $198 million, up 2.3% from the year-ago period, while SSSG was up only 0.6% against 1.9% in 2015, as weak conditions in areas exposed to oil and gas took their toll. On Jan. 1 six new restaurants were added to the royalty pool, which now totals 372 outlets.

Action now: Boston pizza remains a Buy for its steady expansion, higher royalty rate, and ability to grow its distributions even during economic weakness in one of its core areas.

Pizza Pizza Royalty Trust (TSX: PZA, OTC: PZRIF)
Type: Common stock
Trading symbols: PZA, PZRIF
Exchanges: TSX, Grey market
Current price: $18.75, US$10.51 (May 24)
Originally recommended: June 27/13 at $12.00
Annual payout: $0.86
Yield: 7.36%
Risk: Moderate
Recommended by: Gavin Graham
Website: www.pizzapizza.ca

Comments: Ubiquitous chain Pizza Pizza has also been suffering from its Alberta exposure, as its Pizza 73 operation, formerly the leader in SSSG growth, saw fourth quarter sales growth fall 5.3%. The share price has slid around 10% over the last 12 months.

However, its much larger Pizza Pizza operations in Ontario and elsewhere had SSSG growth of 5.3% with the result that overall SSSG was 3.5%, and for 2015 as a whole, SSSG rose 4.5%, the best showing for eight years. For 2015, sales increased 5.6%, to $533.8 million, helped by the seven new restaurants added to the royalty pool on Jan. 1, making a total of 730 outlets.

Adjusted earnings grew 5.8%, to $27.5 million ($0.895 per share), while dividends were increased twice during the year, first by 1.95% in April and then by 2.5% in November, equivalent to an annualized $0.86. This represents a payout ratio of 95%, down from 99% in 2014. Pizza Pizza also reduced its interest expense by 1.37% by refinancing its $47 million credit line at 2.75%. This is estimated to save $640,000 annually, equivalent to $0.021 a share.

Pizza Pizza’s first-quarter royalty pool sales increased 3.3%, to $133.1 million, while SSSG rose 2.5%, with Pizza 73 down 7.9% and Pizza Pizza up 4.9%. Earnings per share came in at $0.214 (fully diluted) against $0.21 a year ago. In June, Pizza Pizza increased its annual dividend 2.4%, to $0.856 from $0.836, giving it a yield of 7.4%.

Action now: Pizza Pizza remains a Buy for its strong Ontario performance and geographical diversification, lowered interest costs, and robust SSSG.

The Keg Royalties Income Fund (TSX: KEG.UN, OTC: KRIUF)
Type: Income trust
Trading symbols: KEG, KRIUF
Exchanges: TSX, Grey Market
Current price: $18.00, US$13.68 (June 1)
Originally recommended: June 21/06 at $13.38, US$12.28
Annual payout: $1.08
Yield: 6%
Risk: Moderate
Recommended by: Gavin graham
Website: www.kegincomefund.com

Comments: Steakhouse chain The Keg reported record revenues of $574 million for 2015 (up 10.2% from 2014) from its 102 restaurants in the royalty pool, including three new ones added at the beginning of the year. SSSG rose 6.5% in Canada and 7% in the U.S. (8% in Canadian dollar terms). Royalty revenue increased 11.3%, to $23.3 million. Distributable cash increased 7.7%, to $12.3 million ($1.083 per share), while distributions were raised three times to $0.09 a month ($1.08 annually), plus a special $0.07 payout in December. The payout ratio was 98.9% in 2015.

For the first quarter, sales were up 0.3%, to $146.8 million, despite the loss of two restaurants from the royalty pool, and lower New Year’s Eve 2015 sales. SSSG grew 1.1% despite flat growth in the larger Canadian operations, thanks to a 2.2% increase in the U.S. Distributable cash was up 11.2%, to $3.63 million ($0.32 per share).

Action now: The Keg remains a Buy for its conservative positioning as a mid-price steakhouse chain, geographical diversification, and strong cash generation.