Next Update Edition: January 16

Next regular issue: January 30

THE BEST OF 2013

By Gordon Pape, Editor and Publisher

It’s been a difficult year for income investors. The May spike in interest rates, which was caused by fears that the U.S. Federal Reserve Board was about to start “tapering” its quantitative easing program, not only hit the bond market but also caused a lot of collateral damage.

Many types of income securities suffered including REITs, preferred shares, and low-growth, dividend paying stocks. Many have still not recovered. As of the close of trading on Dec. 14, the S&P/TSX Capped REIT Index was down 13.1% for the year, the Capped Utilities Index had lost 10.1%, and the Preferred Share Index was down 7.4%.

It may be that the May shock was the worst we’ll see. But with rates likely to edge higher in 2014-15, pressure on bonds and other interest-sensitive securities is going to continue.

This creates a new dynamic for income investors. Many of the securities that did well from 2008 to early this year will struggle in the new environment. As a result, a change in strategy is needed. This involves increasing the percentage of dividend-paying growth securities in your portfolio. Granted, there is more risk involved in this but the alternative is a portfolio that is stagnant or may even decline in value.

This is not to say that your entire portfolio has to be in growth. I don’t believe in excess at any time. You should still retain some exposure to bonds, preferred shares (preferably floating rate), and conservative dividend-paying stocks. But if you have not yet added some growth securities to your holdings, it’s time to consider them.

I took a close look at all the securities we recommended in 2013 to see which had produced the best results for readers. Not surprisingly, almost all are growth-oriented. Here are the top performers of the year.

TAL International Group (NYSE: TAL). I recommended this shipping container company in early January at $37.11 (figures in U.S. dollars). It turned out to our best pick of 2013. The shares are now trading at $51.88 so we have a capital gain to date of 40% plus we have received dividends of $2.68 for a total return of 47% in less than a year. What is especially encouraging is that each quarterly dividend has been $0.02 higher than the one before, the latest (Nov. 27) being $0.70 a share. TAL’s dividends are directly tied to profits so this is a very positive trend pattern.

Third-quarter results reflected a continued improvement in the company’s fortunes. Adjusted pre-tax income was $1.60 per share, fully diluted, an improvement of 8.1% over the same period last year. Net income was $34.7 million ($1.03 per share) compared to $31.2 million ($0.93 a share) in 2012.

Leasing revenue was $143.9 million, up 6.4% from a year ago. Utilization averaged 97.3% for the third quarter and TAL has purchased over $620 million in new and sale-leaseback containers for delivery in 2013. 

Because of the price increase, TAL’s yield is lower than when I first recommended the stock, but it is still a respectable 5.4%. The shares remain a Buy.

FLY Leasing Ltd. (NYSE: FLY). This Irish-based international air leasing company was recommended in mid-October at $13.40 (figures in U.S. dollars). It got off to a strong start, with the shares now up to $15.43. So we have a gain of 15% in a little over two months.

The stock managed this advance despite a disappointing third-quarter financial report that showed adjusted net earnings of only $2.7 million ($0.07 a share) compared to $5.4 million ($0.21 a share) for the same period in 2012. For the first nine months of the fiscal year, adjusted net income was $52.5 million ($1.65 a share), down from $63.1 million ($2.43 a share) last year.

In spite of the reduced profit level, the board of directors approved an increase of $0.03 in the quarter dividend, bringing it to $0.25 a share ($1 annually). That translates to a yield of 6.5% at the current price.

The company owns 107 jets, which are on lease to 56 airlines in 32 countries. The use utilization factor during the quarter was 97%.

FLY remains a Buy for investors who are willing to accept above-average risk.

Cargojet Inc. (TSX: CJT). It’s a good time to be in the airline business. Activity is picking up and the stocks are reflecting the improvement in the overall climate. Contributing editor Gavin Graham picked this stock in September when it was trading at $11.36 and yielding 5.2%. Its fleet of 14 cargo jets operates between 13 Canadian cities as well as in the U.S., Bermuda and Poland.

The stock now trades at $12.93 for an advance of almost 14% in less than three months. The company pays a quarterly dividend of $0.1491 per share (about $0.60 annually) to yield 4.6% at the current price.

Third-quarter financial results (to Sept. 30) showed a year-over-year increase of 3.8% in total revenue to $43.4 million. However, net earnings fell to $225,000 ($0.03 a share) from $947,000 ($0.12 a share) last year. CEO Ajay K. Virmani blamed “unforeseen aircraft maintenance, flight operations training and operating costs.”

Year to date, the company has earned $0.12 a share, well below the current dividend level. For that reason, we are putting the stock on Hold for now. We will have a more complete update soon.

Premium Brands Holding Corp. (TSX: PBH, OTC: PRBZF). I recommended this company when it was trading at $19.49 and yielding 6.4%. Premium Brands owns a broad range of specialty food manufacturing and differentiated food distribution businesses. It has operations across Canada (with the exception of the Atlantic provinces), as well as in Nevada and Washington State.

The stock languished for a while, actually dipping briefly to the $18 range in early fall. However, it has been strong recently and is currently trading at $21.70 for a capital gain of 11.3%.

The company is coming off a strong third quarter that saw revenue increase by 13.5% to $287 million compared to $252.9 million for the same period last year. Net earnings were $5.2 million ($0.25 a share), up from $4.6 million ($0.22 a share) in 2012.

Rolling four quarters free cash flow increased to $47.2 million from $46.8 million in 2012 resulting in a dividend to free cash flow ratio of 54.7%. The stock pays a quarterly dividend of $0.3125 a share ($1.25 annually) to yield 5.8% at the current price. It remains a Buy.

Pizza Pizza Royalty Corp. (TSX: PZA, OTC: PZRIF). Everybody knows about Pizza Pizza’s tasty products. Now we’re finding out the stock is pretty tasty too. It was recommended by Gavin Graham in June at $12 and is now at $13.24 for a 10.3% advance. The shares pay a monthly dividend of $0.065 ($0.78 a year) to yield 5.9%.

At the time of his recommendation, Gavin noted that royalty companies such as this pay out virtually all of their distributable cash flow so a high payout ratio is to be expected. That was the case in the third quarter when Pizza Pizza reported a 101% payout ratio; the year-to-date figure is 99%.

While the payout ratio is not a major concern, same-store sales growth (SSSG) during the quarter was a little light at 1.9%. For the first nine months of the fiscal year it was 2.2%, down from 2.5% during the same period in 2012.

While the shares have done well for us, it would be nice to see stronger SSSG in the fourth quarter so we are putting the stock on Hold for now.

The pattern that we saw in 2013 is likely to continue next year. So if you want your income portfolio to outperform in the current environment, you have to be prepared to add more risk to the mix.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, can be pre-ordered now at 28% off the suggested retail price. Go to http://astore.amazon.ca/buildicaquizm-20

 

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REITS LOSING THEIR LUSTRE

By Tom Slee, Contributing Editor

REITs are an analyst’s nightmare. Structured as trusts, they function as quasi partnerships, are listed on the exchanges as stocks, and trade like bonds. Products of the disaster that engulfed the real estate mutual fund industry in 1993, REITs were a special breed of investments from day one and a great success story. Now, however, REITs face some serious winds as we head into 2014 and they are losing a lot of their appeal. As usual, nearly everything depends on interest rates.

Canadian REITs were particularly hard hit during the summer months by fears that the Fed would reduce its bond-buying program. Prices plummeted as institutions, over weighted in REITs because of the relatively high yields, started to unload their holdings. As I write the Canadian REIT index is down more than 16% since May, while the S&P/TSX Composite is up 8%. Those are brutal numbers and raise the question of whether this sector has been oversold. Are REITs a Black Friday bargain or now trading at their true values?

This is where we run into the problem of analyzing REITs. Normally I would apply relative net asset values or earnings and distribution forecasts when assessing an investment’s worth. In fact, for the last few years, investors have been treating these securities as proxies for their bonds and they are likely to continue trading on this basis. Therefore the best way to measure the sharp price declines is in terms of interest rates. The result is rather discouraging.

According to a BMO analysis based on current and historic rate spreads, the Canadian REIT market correction is priced in a 3.3% 10-year Government of Canada bond yield. In other words, investors marked down REIT prices, driving their yields up, on the assumption that long-term Canada bonds would soon be paying more than 3%. That has not happened because the Fed Chairman waffled and the economic numbers have softened. Canadian rates have been falling in recent weeks.

On Dec. 4, Bank of Canada Governor Stephen Poloz announced that the key overnight rate is to remain at 1% and the feeling is that it’s likely to stay there. With inflation at an anemic 0.7%, Mr. Poloz is more concerned with deflation than rising house prices. In the secondary markets, U.S. Treasuries and Canada bonds have been drifting sideways with a slight upward trend. The feeling is a lot of the quantitative easing taper has been priced in and yields will gradually inch higher. Ten-year Government of Canada bonds are yielding 2.5%.

All of which suggests that REITs have been oversold. The surge in interest rates has been far less than anticipated. My concern is many forecasters still believe long Canada bonds will be at 3.5% by the end of 2014 and on that basis REITs are reasonably priced. At least a lot of the institutions will see it that way. A broad bounce back is unlikely.

There is another headwind that we have to take into consideration. When Finance Minister Jim Flaherty introduced his income trust tax he denounced “a growing trend to corporate tax avoidance.” He saw income trusts as a scam. However, REITs were regarded as a special case in a small $50 billion market and exempted from the tax. That is one of the main reasons why they have remained attractive. In recent months, however, we have seen signs that major corporations are going to take full advantage of the loophole. The recent REIT issues from Canadian Tire and Loblaw’s were great successes and gave the underlying stocks a lift. They also potentially added $10 billion to the Canadian REIT market and showed other corporations how to please investors and avoid taxes.

As Professor Jack Mintz at the University of Calgary has pointed out, the clear advantage a REIT offers is to reduce corporate and personal taxes on income paid to investors. The REIT operates tax-free as long as its income is distributed. In turn, unit holders receive part of their income as dividends or capital gains, both of which receive favourable tax treatment. Therefore, a huge wave of new REITs as companies spin off their properties would reduce Canada’s tax base substantially. Hudson’s Bay Company is considering an issue, and there have been suggestions that oil companies could divest themselves of their service stations, banks could unload their branches. There is about $1.7 trillion of public and commercial properties out there. Any suggestion that a lot of this is going to be transferred into REITs is bound to attract Mr. Flaherty’s attention. Even a hint that REITs could lose their special tax status would cause the sector to sell off.

REITs also now face some operating challenges. Prolonged record-low interest rates that allowed commercial landlords to raise cheap financing are coming to an end. Mortgages and funds for new acquisitions will cost more and this comes at a time when REITs are being squeezed in the new property market by aggressive pension funds. Private equity funds are becoming active players as well. Publicly traded REITs accounted for only 29% of major commercial real estate transactions during the first half of this year compared to 48% during the same period in 2012.

Since we no longer have a rising tide, we have to treat REITs with a great deal of caution in 2014. Become selective and shop carefully for those with sound fundamentals and above all aggressive management. Keep in mind that a REIT’s yield is not directly comparable to the return from a corporate bond where the interest and return of capital at a predetermined date are guaranteed. Some potential growth is needed to pay for the additional risk and this is more likely to come from innovative REITs able to generate increased growth.

REITs that I like at this stage include Calloway and H&R REIT that Gordon follows. They are imaginative and looking for new ventures. Crombie on the other hand remains defensive and inclined to generate growth internally. Its units may mark time for a while. See more on Crombie in the updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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DECEMBER?S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Monday, Dec. 16 unless otherwise indicated.

Tim Horton’s (TSX, NYSE: THI)

Type: Common stock

Trading symbol: THI

Exchanges: TSX, NYSE

Current price: C$61.76, US$58.32

Entry price: Current price

Payout: $1.04

Yield: 1.7%

Risk Rating: Conservative

Recommended by: Gavin Graham

Website: www.timhortons.com

The business: Every Canadian will be familiar with Tim Horton’s, the ubiquitous coffee and doughnut chain which claims to serve eight out of every 10 coffees purchased in Canada. These days, it describes itself as a quick service restaurant (QSR), and is the unquestioned market leader, enjoying a 42% share of Canadian QSR revenue in the year to May 2013, against McDonalds’ 15.6%, independents’ 9.7% and Subway’s 5.3%. While it enjoys a commanding 72% of morning and 59% of afternoon snack traffic, a large part of its success has been due to expanding its menu to offer a full range of food items throughout the day. With 4,356 restaurants by the end of September 2013 – 99.6% of which are franchised – it earned $113.9 million ($0.75 cents per share), up 7.7% and 10% from $105.7 million ($0.68 cents per share). Sales are up 3% to $825 million in the third quarter ending Sept. 30.

Tim Horton’s same store sales growth (SSSG) was up 1.7% in Canada, generating 94.4% of its $2.36 billion in year-to-date revenues in 2013.

The security: Tim Horton’s trades as a common stock on both the Toronto and New York stock exchanges, after its spin out from Wendy’s in 2006.

Why we like it: Despite its seemingly near universal presence in Canada, Tim’s has managed to grow its revenues 40% to $3.12 billion in the five years to end December 2012. Its operating income increased 24% to $594 million and its net income was up 41% to $403 million. Meanwhile, it has reduced the number of its shares by 15.3% to 155.9 million, enabling it to grow its earnings per share by 67% to $2.59 from $1.55. Dividends have increased by 1.6 times over the same period, from $0.40 to $1.04. With its policy of menu extensions, geographical expansion into Western Canada and Quebec, and international moves into the United Arab Emirates, Oman and Kuwait, Tim’s is continuing to use its strong position in Canada to maintain its leadership and expand its brand. Tim’s has repurchased $1.7 billion worth of shares in the last seven years since going public and paid $0.6 billion in dividends.

Financial highlights: Tim’s is rated BBB with a stable outlook (investment grade) by DBRS and last month issued $450 million of 4.52% senior unsecured notes due 2023. Revenues for the nine months to Sept. 30 were up 2% to $2.36 billion, while net income rose 6.9% to $324 million. Earnings per share rose 9.3% to $2.12 as shares outstanding shrank to 150.4 million. Tim’s sells for a reasonable P/E of 21 times 2014’s earnings.

Risks: Tim’s faces challenges from other U.S. restaurant chains such as Starbucks and McDonalds, which have been aggressively expanding in Canada, while its large market share makes it difficult to grow fast. Its expansion south of the border is only marginally profitable, making just $2.7 million in the third quarter. Tim’s is attempting to increase its restaurant density in the border states of New York, Michigan, Ohio and Minnesota without using too much capital by expanding its franchise network. It lagged other chains in introducing software for mobile devices, only rolling out its own app this month. Its new dark roast blend of coffee and single serve offerings are also relatively recent, although it is too soon to judge whether they will prove successful.

Distribution policy: Dividends are paid quarterly in March, June, September and December. The yield was a relatively low 1.7% in December 2013, but Tim’s has raised its dividend every year so another increase is expected in 2014.

Tax implications: Tim Horton’s dividends are considered qualifying dividends for Canadian tax purposes, and subject to a reduced tax rate of two-thirds of an investor’s top marginal rate of tax in a non-registered account. For U.S. investors, the dividends are taxed at the lower dividend tax rate.

Who it’s for: Tim Horton’s is suitable for investors who are willing to receive a lower absolute yield in exchange for wanting a stock that raises its dividend on a regular basis and also repurchases stock, leading to a competitive total return.

How to buy: The stock trades on both the Toronto and New York exchanges and investors will easily be able to buy any amount within reason.

Summing up: Tim’s remains the market leader amongst Canadian QSRs, with a commanding market position, reasonable growth in SSSG and good growth in net income and earnings. New CEO Mark Caica has refocused the company on more profitable expansion, a wider and healthier menu offering and introducing innovations like ordering via mobile devices. – G.G.

 

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DECEMBER UPDATES

Here are this month’s updates. All prices are as of the close of trading on Dec. 16 unless otherwise indicated.

Brookfield Renewable Energy Partners (TSX: BEP.UN, NYSE: BEP)

Type: Limited partnership
Trading symbol: BEP.UN, BEP
Exchanges: TSX, NYSE
Current price: C$27.49, US$25.89
Originally recommended: July 22/09 at C$16.62, US$15.10
Annual payout: US$1.45
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.brookfieldrenewable.com

Comments: These shares have actually lost a bit of ground since our last update in August, due in part to the fact that third-quarter results came in short of analysts’ estimates. However, I continue to like this limited partnership for dependable cash flow and longer-term growth potential.

Total generation for this renewable power business was 5,124 GWh for the three months to Sept. 30, up from a long-term average of 4,960 GWh, with most of it coming from hydro in the U.S., Canada, and Brazil (the partnership also produces a small amount of wind power).

Funds from operations (FFO) for the quarter came in at $108 million ($0.41 a share). That was a big improvement over a year ago when FFO was only $11 million ($0.04 a share) due to reduced power generation as a result of very dry conditions. (Note that the partnership reports in U.S. currency). However, those results came in at $0.05 less than the estimate of RBC Capital Markets, due to lower-than-expected realized power prices in Brazil.

For the first nine months of the fiscal year, FFO was $457 million ($1.72 a share) compared to $273 million ($1.03 a share) in 2012.

The partnership is continuing to expand its operations and on Nov. 1 announced an agreement to acquire, with its institutional partners, a 70 MW hydroelectric portfolio in Maine consisting of nine facilities on three rivers. The portfolio is expected to generate approximately 375 GWh annually, approximately 40% of which is sold under long-term contract to local utilities with the remainder sold into the New England wholesale power market.

As well, Brookfield Renewable and its partners announced an agreement to acquire the remaining 50% interest in the 30 MW Malacha Hydro facility in California. The facility’s output is under long-term contract.

The partnership has set a target of annual distribution increases of between 3% and 5%. Management has indicated it expects the increases to be at the higher end of that range over the next few years. The LP currently makes quarterly payments of $0.3625 per unit ($1.45 annually). A 4% increase would take us to $1.51 in 2014.

The partnership announced a change to the timing of its quarterly distributions. The fourth quarter distribution will be paid as originally scheduled on Jan. 31, 2014. Shareholders of record at Feb. 28 will receive a payment on March 31 pro-rated for the two-month period. Thereafter, quarterly distributions will be paid on the last day of the quarter, to shareholders of record at the end of the prior month. So the new schedule calls for payments on the last day of March, June, September and December.

Action now: Buy. The drop in the share price and the prospect of an increased distribution make this an attractive holding at the current level. – G.P.

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

Type: Common stock
Trading symbol: MSI, MSIXF
Exchanges: TSX, Grey Market
Current price: C$15.14, US$13.57 (Oct. 21)
Originally recommended: July 27/11at C$10.24, US$10.76
Annual payout: $0.78
Yield: 5.2%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: Morneau Shepell is not well known to Canadians but it is the largest company in the country that provides human resources consulting and outsourcing services.

Last month the company released strong third-quarter numbers, which have helped to push the share price over $15. Revenue rose 17% to $118.5 million compared to $101.3 million in the same period last year. For the first nine months of the fiscal year, the company reported revenue of $352.6 million compared to $312.1 million in 2012. Net income for the quarter was $6.9 million, up from $6.1 million last year. For the nine months, earnings were $21.7 million compared to $16.8 million a year ago.

“All four lines of business continued to perform well through the third quarter of the year,” said CEO Alan Torrie. “We are particularly pleased with the success of the acquisition of the Mercer outsourcing business, which is approaching the end of the first year. Our performance is ahead of expectations.”

The company pays a monthly dividend of $0.065 per share ($0.78 a share). The 12-month normalized payout ratio was 73.2% compared to 77.1% in last year’s third quarter.

Action now: Buy below $15. – G.P.

Calloway REIT (TSX: CWT.UN, OTC: CWYUF)

Type: Real estate investment trust
Trading symbol: CWT.UN, CWYUF
Exchanges: TSX, Pink Sheets
Current price: C$24.32, US$22.97
Originally recommended: Mar. 19/08 at C$19.75, US$19.75
Annual payout: $1.55
Yield: 6.4%
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.callowayreit.com

Comments: Calloway had a solid third quarter reporting funds from operations (FFO) of $0.47 a unit in line with the consensus forecast and up 5% from 2012. The portfolio remains fully leased with occupancy at 99% or above for the 15th consecutive quarter. Calloway is on course to generate FFO of about $1.85 a unit in 2013 and $2 or more next year.

There are several reasons why I like Calloway at the moment. First of all, the core portfolio of Walmart-anchored shopping centres provides a solid base while the economic recovery remains a question mark. At the same time, management is aggressively expanding its field of operations. A second of the CWT’s Premium Outlets ventures is now underway in Montreal. There are plans for a monster 53-acre urban development north of Toronto. These high-profile undertakings are likely to give the units a boost even if the sector underperforms.

New CEO Huw Thomas is focused on growth avenues and you get a feeling of activity. Finally, Callaway’s payout ratio is declining steadily and will be a defensive 80% by 2015. The plan is to provide regular modest increases in the distributions.

Action now: Calloway REIT remains a Buy for income and growth. – T.S.

Crombie REIT (TSX: CRR.UN)

Type: Real estate investment trust
Trading symbol: CRR.UN
Exchange: TSX
Current price: $13.48
Originally recommended: July 25/13 at $13.35
Annual payout: $0.89
Yield: 6.6%
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.crombiereit.com

Comments: Crombie has a different strategy and intends to strengthen its balance sheet and grow organically. The $1 billion acquisition of 70 Safeway properties is complete and this increases Crombie’s asset base by about 35%. It also provided exposure to the Western Canadian markets. As a result Dominion Bond Rating Service (DBRS) upgraded the REIT to BBB (low), providing it with access to unsecured debenture market.

As I have mentioned before, the Safeway deal was transformational for Crombie. For the moment, however, it adds very little to the FFO. Going forward, the REIT is going to digest the new assets and reduce additional debt that was incurred for the purchase. Crombie is a first-class REIT and should generate an FFO of about $1.10 in 2014 and about $1.15 the following year. For now, however, it has the characteristics of an investment grade bond and that is likely to cap unit growth as interest rates rise.

Action now: Crombie becomes a Hold for income. – T.S.

Cineplex Galaxy (TSX: CGX, OTC: CPXGF)

Type: Common stock
Trading symbol: CGX, CPXGF
Exchanges: TSX, Pink Sheets
Current price: C$43.89, US$40.99
Originally recommended: Feb. 25/09 at C$13.72, US$11.47
Annual payout: $1.44
Yield: 3.3%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.cineplex.com

Comments: Cineplex, owner and operator of 70% of the cinema screens in Canada, continues to go from strength to strength. The company had 161 theatres and 1,635 auditoriums but in October, it closed the purchase of an additional 24 theatres in Atlantic Canada from Empire Ltd for $194 million, making a truly coast-to- coast chain. It funded the deal with new credit facilities and $100 million 4.5% convertible debentures.

It also bought EK3 Technology for an initial payment of $39.1 million and up to an additional $39 million based on 2015 earnings. EK3, renamed Cineplex Digital Networks, designs, installs and manages some of the largest digital marketing networks in North America for clients like Tim Horton’s, Target, Walmart, McDonalds and RBC and BMO.

Cineplex is up 43% over the last 12 months and more than three times since my initial recommendation in 2009. For the first three quarters of 2013 ending Sept. 30, Cineplex saw revenues up 6.8% to $848 million. Attendance was up 2.3% to 58.3 million, with other revenues, including digital media, up 24.4% to $103.4 million. The average ticket price per patron matched last year’s record high of $8.84 in the third quarter, while concession revenues were up 2.8% to $91.3 million ($4.81 per patron). Also, 38.2% of Cineplex’s box office revenues were premium priced for 3-D, Imax and AVX versions of the releases against 31.6%.

As the management always points out, attendance is driven by the quality of the films being released and this year has seen a wider range of movies than last year’s blockbuster dominated slate.

Action Now: Cineplex is now a Hold as it has become fully valued at 28 times 2013’s earnings. – G.G.

Corus Entertainment (TSX: CJR.B OTC: CJREF)

Type: Common stock
Trading symbol: CJR.B, CJREF
Exchanges: TSX, Pink Sheets
Current price: C$25.64, US$24.22
Originally recommended: Apr. 25/12 at C$24.10, US$24.38
Annual payout: $1.02
Yield: 4%
Risk rating: Moderate Risk
Recommended by: Gavin Graham
Website: www.corusent.com

Comments: Corus Entertainment owns a number of leading cable channels in Canada, with a specialization in children’s programming. Among its brands are YTV, Treehouse, Nickelodeon, 50% of Teletoon, ABC Spark, W Network, the Oprah Winfrey Network (OWN), as well as three conventional TV stations in southern Ontario and the children’s content producer Nelvana. Its radio division consists of 37 English radio stations primarily in southern Ontario.

For the year ending Aug. 31, 2013, Corus’ revenues were down 4.7% to $802 million. TV was down 4.8% to $620 million and radio decreased 4% to $183 million. Profit from TV dropped 5.1% to $249 million and radio 5% to $55.1 million. After special charges of $20.1 million ($0.40 per share) for early debt repayment, licence impairment and restructuring offset by $55.4 million ($0.66) on the sale of its half share in the Food Network to its parent Shaw Communications, earnings per share for 2012-13 were $1.91 against $1.79. On an operating basis, however, EPS was $1.65 versus $1.90.

While Corus’ revenues and earnings have been under pressure from the cautious nature of the recovery, the major event in 2013 was the soon-to-be finalized acquisition of the other 50% of Teletoon, its French affiliates, Cartoon Network, French-specialty channels Historia and Series+ and two English radio stations in Ottawa from BCE, as part of its acquisition of Astral Media. The deal was approved on the condition that Astral and BCE’s dominant position in Quebec was reduced through the sale of these valuable assets. The sale to Corus is expected to be finalized early in 2014.

With a 7% total return since recommendation last April, Corus is still cheap at 13 times 2013-14’s earnings and will benefit from the Astral Media’s deal.

Action Now: Corus remains a Buy. – G.G.

 

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YOUR QUESTIONS

What about ZPR?

Q – In a recent issue of The Income Investor you recommended selling my (beloved) iShares S&P/TSX Canadian Preferred Share Fund (TSX: CPD). As per your recommendation I sold a lot of shares of CPD but I have bought the BMO S&P/TSX Laddered Preferred ETF (TSX: ZPR). I like it because since it is laddered and holds rate-reset preferred shares (rather than a predominance of perpetual preferred shares) it should do better in a rising interest rate environment. Could you comment? – Barry M.

A – The theory sounds fine, however we really don’t have enough history to know how it will work out in practice. The fund has only been in existence for a year (it was launched in November 2012) and it hasn’t been an easy time for preferred shares because of the uptick in interest rates last spring. Over the six months to the end of October, the ETF was showing a loss of 4.6%. That’s slightly better than the category average but worse than CPD, which was down 4.2% in the same period.

ZPR may work out fine over the long term once the resets start to kick in. But over the years I have seen too many fund concepts that looked good on paper but failed to deliver. That’s why I usually wait for firm evidence before making recommendations. – G.P.

Convertibles as bonds

Q – Are convertible debentures are considered bonds when you allocate weightings to your portfolio?

A – Yes, because your interest income and capital are guaranteed. Certainly the company regards them as a debt. However, major, high- quality corporations rarely issue this type of security. Most of the convertibles are junior grade. You may even want to create a separate category as a reminder that these debentures involve risk and may fluctuate in value if the common stock becomes volatile. – T.S.

 

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That’s all for this issue. On behalf of everyone associated with The Income Investor, Merry Christmas, happy holidays, and a prosperous New Year. Look for your next Update Edition on Jan. 16. The next regular issue will be published on Jan. 30.

Best regards,
Gordon Pape, editor-in-chief

Next Update Edition: January 16

Next regular issue: January 30

THE BEST OF 2013

By Gordon Pape, Editor and Publisher

It’s been a difficult year for income investors. The May spike in interest rates, which was caused by fears that the U.S. Federal Reserve Board was about to start “tapering” its quantitative easing program, not only hit the bond market but also caused a lot of collateral damage.

Many types of income securities suffered including REITs, preferred shares, and low-growth, dividend paying stocks. Many have still not recovered. As of the close of trading on Dec. 14, the S&P/TSX Capped REIT Index was down 13.1% for the year, the Capped Utilities Index had lost 10.1%, and the Preferred Share Index was down 7.4%.

It may be that the May shock was the worst we’ll see. But with rates likely to edge higher in 2014-15, pressure on bonds and other interest-sensitive securities is going to continue.

This creates a new dynamic for income investors. Many of the securities that did well from 2008 to early this year will struggle in the new environment. As a result, a change in strategy is needed. This involves increasing the percentage of dividend-paying growth securities in your portfolio. Granted, there is more risk involved in this but the alternative is a portfolio that is stagnant or may even decline in value.

This is not to say that your entire portfolio has to be in growth. I don’t believe in excess at any time. You should still retain some exposure to bonds, preferred shares (preferably floating rate), and conservative dividend-paying stocks. But if you have not yet added some growth securities to your holdings, it’s time to consider them.

I took a close look at all the securities we recommended in 2013 to see which had produced the best results for readers. Not surprisingly, almost all are growth-oriented. Here are the top performers of the year.

TAL International Group (NYSE: TAL). I recommended this shipping container company in early January at $37.11 (figures in U.S. dollars). It turned out to our best pick of 2013. The shares are now trading at $51.88 so we have a capital gain to date of 40% plus we have received dividends of $2.68 for a total return of 47% in less than a year. What is especially encouraging is that each quarterly dividend has been $0.02 higher than the one before, the latest (Nov. 27) being $0.70 a share. TAL’s dividends are directly tied to profits so this is a very positive trend pattern.

Third-quarter results reflected a continued improvement in the company’s fortunes. Adjusted pre-tax income was $1.60 per share, fully diluted, an improvement of 8.1% over the same period last year. Net income was $34.7 million ($1.03 per share) compared to $31.2 million ($0.93 a share) in 2012.

Leasing revenue was $143.9 million, up 6.4% from a year ago. Utilization averaged 97.3% for the third quarter and TAL has purchased over $620 million in new and sale-leaseback containers for delivery in 2013. 

Because of the price increase, TAL’s yield is lower than when I first recommended the stock, but it is still a respectable 5.4%. The shares remain a Buy.

FLY Leasing Ltd. (NYSE: FLY). This Irish-based international air leasing company was recommended in mid-October at $13.40 (figures in U.S. dollars). It got off to a strong start, with the shares now up to $15.43. So we have a gain of 15% in a little over two months.

The stock managed this advance despite a disappointing third-quarter financial report that showed adjusted net earnings of only $2.7 million ($0.07 a share) compared to $5.4 million ($0.21 a share) for the same period in 2012. For the first nine months of the fiscal year, adjusted net income was $52.5 million ($1.65 a share), down from $63.1 million ($2.43 a share) last year.

In spite of the reduced profit level, the board of directors approved an increase of $0.03 in the quarter dividend, bringing it to $0.25 a share ($1 annually). That translates to a yield of 6.5% at the current price.

The company owns 107 jets, which are on lease to 56 airlines in 32 countries. The use utilization factor during the quarter was 97%.

FLY remains a Buy for investors who are willing to accept above-average risk.

Cargojet Inc. (TSX: CJT). It’s a good time to be in the airline business. Activity is picking up and the stocks are reflecting the improvement in the overall climate. Contributing editor Gavin Graham picked this stock in September when it was trading at $11.36 and yielding 5.2%. Its fleet of 14 cargo jets operates between 13 Canadian cities as well as in the U.S., Bermuda and Poland.

The stock now trades at $12.93 for an advance of almost 14% in less than three months. The company pays a quarterly dividend of $0.1491 per share (about $0.60 annually) to yield 4.6% at the current price.

Third-quarter financial results (to Sept. 30) showed a year-over-year increase of 3.8% in total revenue to $43.4 million. However, net earnings fell to $225,000 ($0.03 a share) from $947,000 ($0.12 a share) last year. CEO Ajay K. Virmani blamed “unforeseen aircraft maintenance, flight operations training and operating costs.”

Year to date, the company has earned $0.12 a share, well below the current dividend level. For that reason, we are putting the stock on Hold for now. We will have a more complete update soon.

Premium Brands Holding Corp. (TSX: PBH, OTC: PRBZF). I recommended this company when it was trading at $19.49 and yielding 6.4%. Premium Brands owns a broad range of specialty food manufacturing and differentiated food distribution businesses. It has operations across Canada (with the exception of the Atlantic provinces), as well as in Nevada and Washington State.

The stock languished for a while, actually dipping briefly to the $18 range in early fall. However, it has been strong recently and is currently trading at $21.70 for a capital gain of 11.3%.

The company is coming off a strong third quarter that saw revenue increase by 13.5% to $287 million compared to $252.9 million for the same period last year. Net earnings were $5.2 million ($0.25 a share), up from $4.6 million ($0.22 a share) in 2012.

Rolling four quarters free cash flow increased to $47.2 million from $46.8 million in 2012 resulting in a dividend to free cash flow ratio of 54.7%. The stock pays a quarterly dividend of $0.3125 a share ($1.25 annually) to yield 5.8% at the current price. It remains a Buy.

Pizza Pizza Royalty Corp. (TSX: PZA, OTC: PZRIF). Everybody knows about Pizza Pizza’s tasty products. Now we’re finding out the stock is pretty tasty too. It was recommended by Gavin Graham in June at $12 and is now at $13.24 for a 10.3% advance. The shares pay a monthly dividend of $0.065 ($0.78 a year) to yield 5.9%.

At the time of his recommendation, Gavin noted that royalty companies such as this pay out virtually all of their distributable cash flow so a high payout ratio is to be expected. That was the case in the third quarter when Pizza Pizza reported a 101% payout ratio; the year-to-date figure is 99%.

While the payout ratio is not a major concern, same-store sales growth (SSSG) during the quarter was a little light at 1.9%. For the first nine months of the fiscal year it was 2.2%, down from 2.5% during the same period in 2012.

While the shares have done well for us, it would be nice to see stronger SSSG in the fourth quarter so we are putting the stock on Hold for now.

The pattern that we saw in 2013 is likely to continue next year. So if you want your income portfolio to outperform in the current environment, you have to be prepared to add more risk to the mix.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, can be pre-ordered now at 28% off the suggested retail price. Go to http://astore.amazon.ca/buildicaquizm-20

 

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REITS LOSING THEIR LUSTRE

By Tom Slee, Contributing Editor

REITs are an analyst’s nightmare. Structured as trusts, they function as quasi partnerships, are listed on the exchanges as stocks, and trade like bonds. Products of the disaster that engulfed the real estate mutual fund industry in 1993, REITs were a special breed of investments from day one and a great success story. Now, however, REITs face some serious winds as we head into 2014 and they are losing a lot of their appeal. As usual, nearly everything depends on interest rates.

Canadian REITs were particularly hard hit during the summer months by fears that the Fed would reduce its bond-buying program. Prices plummeted as institutions, over weighted in REITs because of the relatively high yields, started to unload their holdings. As I write the Canadian REIT index is down more than 16% since May, while the S&P/TSX Composite is up 8%. Those are brutal numbers and raise the question of whether this sector has been oversold. Are REITs a Black Friday bargain or now trading at their true values?

This is where we run into the problem of analyzing REITs. Normally I would apply relative net asset values or earnings and distribution forecasts when assessing an investment’s worth. In fact, for the last few years, investors have been treating these securities as proxies for their bonds and they are likely to continue trading on this basis. Therefore the best way to measure the sharp price declines is in terms of interest rates. The result is rather discouraging.

According to a BMO analysis based on current and historic rate spreads, the Canadian REIT market correction is priced in a 3.3% 10-year Government of Canada bond yield. In other words, investors marked down REIT prices, driving their yields up, on the assumption that long-term Canada bonds would soon be paying more than 3%. That has not happened because the Fed Chairman waffled and the economic numbers have softened. Canadian rates have been falling in recent weeks.

On Dec. 4, Bank of Canada Governor Stephen Poloz announced that the key overnight rate is to remain at 1% and the feeling is that it’s likely to stay there. With inflation at an anemic 0.7%, Mr. Poloz is more concerned with deflation than rising house prices. In the secondary markets, U.S. Treasuries and Canada bonds have been drifting sideways with a slight upward trend. The feeling is a lot of the quantitative easing taper has been priced in and yields will gradually inch higher. Ten-year Government of Canada bonds are yielding 2.5%.

All of which suggests that REITs have been oversold. The surge in interest rates has been far less than anticipated. My concern is many forecasters still believe long Canada bonds will be at 3.5% by the end of 2014 and on that basis REITs are reasonably priced. At least a lot of the institutions will see it that way. A broad bounce back is unlikely.

There is another headwind that we have to take into consideration. When Finance Minister Jim Flaherty introduced his income trust tax he denounced “a growing trend to corporate tax avoidance.” He saw income trusts as a scam. However, REITs were regarded as a special case in a small $50 billion market and exempted from the tax. That is one of the main reasons why they have remained attractive. In recent months, however, we have seen signs that major corporations are going to take full advantage of the loophole. The recent REIT issues from Canadian Tire and Loblaw’s were great successes and gave the underlying stocks a lift. They also potentially added $10 billion to the Canadian REIT market and showed other corporations how to please investors and avoid taxes.

As Professor Jack Mintz at the University of Calgary has pointed out, the clear advantage a REIT offers is to reduce corporate and personal taxes on income paid to investors. The REIT operates tax-free as long as its income is distributed. In turn, unit holders receive part of their income as dividends or capital gains, both of which receive favourable tax treatment. Therefore, a huge wave of new REITs as companies spin off their properties would reduce Canada’s tax base substantially. Hudson’s Bay Company is considering an issue, and there have been suggestions that oil companies could divest themselves of their service stations, banks could unload their branches. There is about $1.7 trillion of public and commercial properties out there. Any suggestion that a lot of this is going to be transferred into REITs is bound to attract Mr. Flaherty’s attention. Even a hint that REITs could lose their special tax status would cause the sector to sell off.

REITs also now face some operating challenges. Prolonged record-low interest rates that allowed commercial landlords to raise cheap financing are coming to an end. Mortgages and funds for new acquisitions will cost more and this comes at a time when REITs are being squeezed in the new property market by aggressive pension funds. Private equity funds are becoming active players as well. Publicly traded REITs accounted for only 29% of major commercial real estate transactions during the first half of this year compared to 48% during the same period in 2012.

Since we no longer have a rising tide, we have to treat REITs with a great deal of caution in 2014. Become selective and shop carefully for those with sound fundamentals and above all aggressive management. Keep in mind that a REIT’s yield is not directly comparable to the return from a corporate bond where the interest and return of capital at a predetermined date are guaranteed. Some potential growth is needed to pay for the additional risk and this is more likely to come from innovative REITs able to generate increased growth.

REITs that I like at this stage include Calloway and H&R REIT that Gordon follows. They are imaginative and looking for new ventures. Crombie on the other hand remains defensive and inclined to generate growth internally. Its units may mark time for a while. See more on Crombie in the updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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DECEMBER?S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Monday, Dec. 16 unless otherwise indicated.

Tim Horton’s (TSX, NYSE: THI)

Type: Common stock

Trading symbol: THI

Exchanges: TSX, NYSE

Current price: C$61.76, US$58.32

Entry price: Current price

Payout: $1.04

Yield: 1.7%

Risk Rating: Conservative

Recommended by: Gavin Graham

Website: www.timhortons.com

The business: Every Canadian will be familiar with Tim Horton’s, the ubiquitous coffee and doughnut chain which claims to serve eight out of every 10 coffees purchased in Canada. These days, it describes itself as a quick service restaurant (QSR), and is the unquestioned market leader, enjoying a 42% share of Canadian QSR revenue in the year to May 2013, against McDonalds’ 15.6%, independents’ 9.7% and Subway’s 5.3%. While it enjoys a commanding 72% of morning and 59% of afternoon snack traffic, a large part of its success has been due to expanding its menu to offer a full range of food items throughout the day. With 4,356 restaurants by the end of September 2013 – 99.6% of which are franchised – it earned $113.9 million ($0.75 cents per share), up 7.7% and 10% from $105.7 million ($0.68 cents per share). Sales are up 3% to $825 million in the third quarter ending Sept. 30.

Tim Horton’s same store sales growth (SSSG) was up 1.7% in Canada, generating 94.4% of its $2.36 billion in year-to-date revenues in 2013.

The security: Tim Horton’s trades as a common stock on both the Toronto and New York stock exchanges, after its spin out from Wendy’s in 2006.

Why we like it: Despite its seemingly near universal presence in Canada, Tim’s has managed to grow its revenues 40% to $3.12 billion in the five years to end December 2012. Its operating income increased 24% to $594 million and its net income was up 41% to $403 million. Meanwhile, it has reduced the number of its shares by 15.3% to 155.9 million, enabling it to grow its earnings per share by 67% to $2.59 from $1.55. Dividends have increased by 1.6 times over the same period, from $0.40 to $1.04. With its policy of menu extensions, geographical expansion into Western Canada and Quebec, and international moves into the United Arab Emirates, Oman and Kuwait, Tim’s is continuing to use its strong position in Canada to maintain its leadership and expand its brand. Tim’s has repurchased $1.7 billion worth of shares in the last seven years since going public and paid $0.6 billion in dividends.

Financial highlights: Tim’s is rated BBB with a stable outlook (investment grade) by DBRS and last month issued $450 million of 4.52% senior unsecured notes due 2023. Revenues for the nine months to Sept. 30 were up 2% to $2.36 billion, while net income rose 6.9% to $324 million. Earnings per share rose 9.3% to $2.12 as shares outstanding shrank to 150.4 million. Tim’s sells for a reasonable P/E of 21 times 2014’s earnings.

Risks: Tim’s faces challenges from other U.S. restaurant chains such as Starbucks and McDonalds, which have been aggressively expanding in Canada, while its large market share makes it difficult to grow fast. Its expansion south of the border is only marginally profitable, making just $2.7 million in the third quarter. Tim’s is attempting to increase its restaurant density in the border states of New York, Michigan, Ohio and Minnesota without using too much capital by expanding its franchise network. It lagged other chains in introducing software for mobile devices, only rolling out its own app this month. Its new dark roast blend of coffee and single serve offerings are also relatively recent, although it is too soon to judge whether they will prove successful.

Distribution policy: Dividends are paid quarterly in March, June, September and December. The yield was a relatively low 1.7% in December 2013, but Tim’s has raised its dividend every year so another increase is expected in 2014.

Tax implications: Tim Horton’s dividends are considered qualifying dividends for Canadian tax purposes, and subject to a reduced tax rate of two-thirds of an investor’s top marginal rate of tax in a non-registered account. For U.S. investors, the dividends are taxed at the lower dividend tax rate.

Who it’s for: Tim Horton’s is suitable for investors who are willing to receive a lower absolute yield in exchange for wanting a stock that raises its dividend on a regular basis and also repurchases stock, leading to a competitive total return.

How to buy: The stock trades on both the Toronto and New York exchanges and investors will easily be able to buy any amount within reason.

Summing up: Tim’s remains the market leader amongst Canadian QSRs, with a commanding market position, reasonable growth in SSSG and good growth in net income and earnings. New CEO Mark Caica has refocused the company on more profitable expansion, a wider and healthier menu offering and introducing innovations like ordering via mobile devices. – G.G.

 

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DECEMBER UPDATES

Here are this month’s updates. All prices are as of the close of trading on Dec. 16 unless otherwise indicated.

Brookfield Renewable Energy Partners (TSX: BEP.UN, NYSE: BEP)

Type: Limited partnership
Trading symbol: BEP.UN, BEP
Exchanges: TSX, NYSE
Current price: C$27.49, US$25.89
Originally recommended: July 22/09 at C$16.62, US$15.10
Annual payout: US$1.45
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.brookfieldrenewable.com

Comments: These shares have actually lost a bit of ground since our last update in August, due in part to the fact that third-quarter results came in short of analysts’ estimates. However, I continue to like this limited partnership for dependable cash flow and longer-term growth potential.

Total generation for this renewable power business was 5,124 GWh for the three months to Sept. 30, up from a long-term average of 4,960 GWh, with most of it coming from hydro in the U.S., Canada, and Brazil (the partnership also produces a small amount of wind power).

Funds from operations (FFO) for the quarter came in at $108 million ($0.41 a share). That was a big improvement over a year ago when FFO was only $11 million ($0.04 a share) due to reduced power generation as a result of very dry conditions. (Note that the partnership reports in U.S. currency). However, those results came in at $0.05 less than the estimate of RBC Capital Markets, due to lower-than-expected realized power prices in Brazil.

For the first nine months of the fiscal year, FFO was $457 million ($1.72 a share) compared to $273 million ($1.03 a share) in 2012.

The partnership is continuing to expand its operations and on Nov. 1 announced an agreement to acquire, with its institutional partners, a 70 MW hydroelectric portfolio in Maine consisting of nine facilities on three rivers. The portfolio is expected to generate approximately 375 GWh annually, approximately 40% of which is sold under long-term contract to local utilities with the remainder sold into the New England wholesale power market.

As well, Brookfield Renewable and its partners announced an agreement to acquire the remaining 50% interest in the 30 MW Malacha Hydro facility in California. The facility’s output is under long-term contract.

The partnership has set a target of annual distribution increases of between 3% and 5%. Management has indicated it expects the increases to be at the higher end of that range over the next few years. The LP currently makes quarterly payments of $0.3625 per unit ($1.45 annually). A 4% increase would take us to $1.51 in 2014.

The partnership announced a change to the timing of its quarterly distributions. The fourth quarter distribution will be paid as originally scheduled on Jan. 31, 2014. Shareholders of record at Feb. 28 will receive a payment on March 31 pro-rated for the two-month period. Thereafter, quarterly distributions will be paid on the last day of the quarter, to shareholders of record at the end of the prior month. So the new schedule calls for payments on the last day of March, June, September and December.

Action now: Buy. The drop in the share price and the prospect of an increased distribution make this an attractive holding at the current level. – G.P.

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

Type: Common stock
Trading symbol: MSI, MSIXF
Exchanges: TSX, Grey Market
Current price: C$15.14, US$13.57 (Oct. 21)
Originally recommended: July 27/11at C$10.24, US$10.76
Annual payout: $0.78
Yield: 5.2%
Risk Rating: Moderate risk
Recommended by: Gordon Pape
Website: www.morneaushepell.com

Comments: Morneau Shepell is not well known to Canadians but it is the largest company in the country that provides human resources consulting and outsourcing services.

Last month the company released strong third-quarter numbers, which have helped to push the share price over $15. Revenue rose 17% to $118.5 million compared to $101.3 million in the same period last year. For the first nine months of the fiscal year, the company reported revenue of $352.6 million compared to $312.1 million in 2012. Net income for the quarter was $6.9 million, up from $6.1 million last year. For the nine months, earnings were $21.7 million compared to $16.8 million a year ago.

“All four lines of business continued to perform well through the third quarter of the year,” said CEO Alan Torrie. “We are particularly pleased with the success of the acquisition of the Mercer outsourcing business, which is approaching the end of the first year. Our performance is ahead of expectations.”

The company pays a monthly dividend of $0.065 per share ($0.78 a share). The 12-month normalized payout ratio was 73.2% compared to 77.1% in last year’s third quarter.

Action now: Buy below $15. – G.P.

Calloway REIT (TSX: CWT.UN, OTC: CWYUF)

Type: Real estate investment trust
Trading symbol: CWT.UN, CWYUF
Exchanges: TSX, Pink Sheets
Current price: C$24.32, US$22.97
Originally recommended: Mar. 19/08 at C$19.75, US$19.75
Annual payout: $1.55
Yield: 6.4%
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.callowayreit.com

Comments: Calloway had a solid third quarter reporting funds from operations (FFO) of $0.47 a unit in line with the consensus forecast and up 5% from 2012. The portfolio remains fully leased with occupancy at 99% or above for the 15th consecutive quarter. Calloway is on course to generate FFO of about $1.85 a unit in 2013 and $2 or more next year.

There are several reasons why I like Calloway at the moment. First of all, the core portfolio of Walmart-anchored shopping centres provides a solid base while the economic recovery remains a question mark. At the same time, management is aggressively expanding its field of operations. A second of the CWT’s Premium Outlets ventures is now underway in Montreal. There are plans for a monster 53-acre urban development north of Toronto. These high-profile undertakings are likely to give the units a boost even if the sector underperforms.

New CEO Huw Thomas is focused on growth avenues and you get a feeling of activity. Finally, Callaway’s payout ratio is declining steadily and will be a defensive 80% by 2015. The plan is to provide regular modest increases in the distributions.

Action now: Calloway REIT remains a Buy for income and growth. – T.S.

Crombie REIT (TSX: CRR.UN)

Type: Real estate investment trust
Trading symbol: CRR.UN
Exchange: TSX
Current price: $13.48
Originally recommended: July 25/13 at $13.35
Annual payout: $0.89
Yield: 6.6%
Risk Rating: Moderate risk
Recommended by: Tom Slee
Website: www.crombiereit.com

Comments: Crombie has a different strategy and intends to strengthen its balance sheet and grow organically. The $1 billion acquisition of 70 Safeway properties is complete and this increases Crombie’s asset base by about 35%. It also provided exposure to the Western Canadian markets. As a result Dominion Bond Rating Service (DBRS) upgraded the REIT to BBB (low), providing it with access to unsecured debenture market.

As I have mentioned before, the Safeway deal was transformational for Crombie. For the moment, however, it adds very little to the FFO. Going forward, the REIT is going to digest the new assets and reduce additional debt that was incurred for the purchase. Crombie is a first-class REIT and should generate an FFO of about $1.10 in 2014 and about $1.15 the following year. For now, however, it has the characteristics of an investment grade bond and that is likely to cap unit growth as interest rates rise.

Action now: Crombie becomes a Hold for income. – T.S.

Cineplex Galaxy (TSX: CGX, OTC: CPXGF)

Type: Common stock
Trading symbol: CGX, CPXGF
Exchanges: TSX, Pink Sheets
Current price: C$43.89, US$40.99
Originally recommended: Feb. 25/09 at C$13.72, US$11.47
Annual payout: $1.44
Yield: 3.3%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.cineplex.com

Comments: Cineplex, owner and operator of 70% of the cinema screens in Canada, continues to go from strength to strength. The company had 161 theatres and 1,635 auditoriums but in October, it closed the purchase of an additional 24 theatres in Atlantic Canada from Empire Ltd for $194 million, making a truly coast-to- coast chain. It funded the deal with new credit facilities and $100 million 4.5% convertible debentures.

It also bought EK3 Technology for an initial payment of $39.1 million and up to an additional $39 million based on 2015 earnings. EK3, renamed Cineplex Digital Networks, designs, installs and manages some of the largest digital marketing networks in North America for clients like Tim Horton’s, Target, Walmart, McDonalds and RBC and BMO.

Cineplex is up 43% over the last 12 months and more than three times since my initial recommendation in 2009. For the first three quarters of 2013 ending Sept. 30, Cineplex saw revenues up 6.8% to $848 million. Attendance was up 2.3% to 58.3 million, with other revenues, including digital media, up 24.4% to $103.4 million. The average ticket price per patron matched last year’s record high of $8.84 in the third quarter, while concession revenues were up 2.8% to $91.3 million ($4.81 per patron). Also, 38.2% of Cineplex’s box office revenues were premium priced for 3-D, Imax and AVX versions of the releases against 31.6%.

As the management always points out, attendance is driven by the quality of the films being released and this year has seen a wider range of movies than last year’s blockbuster dominated slate.

Action Now: Cineplex is now a Hold as it has become fully valued at 28 times 2013’s earnings. – G.G.

Corus Entertainment (TSX: CJR.B OTC: CJREF)

Type: Common stock
Trading symbol: CJR.B, CJREF
Exchanges: TSX, Pink Sheets
Current price: C$25.64, US$24.22
Originally recommended: Apr. 25/12 at C$24.10, US$24.38
Annual payout: $1.02
Yield: 4%
Risk rating: Moderate Risk
Recommended by: Gavin Graham
Website: www.corusent.com

Comments: Corus Entertainment owns a number of leading cable channels in Canada, with a specialization in children’s programming. Among its brands are YTV, Treehouse, Nickelodeon, 50% of Teletoon, ABC Spark, W Network, the Oprah Winfrey Network (OWN), as well as three conventional TV stations in southern Ontario and the children’s content producer Nelvana. Its radio division consists of 37 English radio stations primarily in southern Ontario.

For the year ending Aug. 31, 2013, Corus’ revenues were down 4.7% to $802 million. TV was down 4.8% to $620 million and radio decreased 4% to $183 million. Profit from TV dropped 5.1% to $249 million and radio 5% to $55.1 million. After special charges of $20.1 million ($0.40 per share) for early debt repayment, licence impairment and restructuring offset by $55.4 million ($0.66) on the sale of its half share in the Food Network to its parent Shaw Communications, earnings per share for 2012-13 were $1.91 against $1.79. On an operating basis, however, EPS was $1.65 versus $1.90.

While Corus’ revenues and earnings have been under pressure from the cautious nature of the recovery, the major event in 2013 was the soon-to-be finalized acquisition of the other 50% of Teletoon, its French affiliates, Cartoon Network, French-specialty channels Historia and Series+ and two English radio stations in Ottawa from BCE, as part of its acquisition of Astral Media. The deal was approved on the condition that Astral and BCE’s dominant position in Quebec was reduced through the sale of these valuable assets. The sale to Corus is expected to be finalized early in 2014.

With a 7% total return since recommendation last April, Corus is still cheap at 13 times 2013-14’s earnings and will benefit from the Astral Media’s deal.

Action Now: Corus remains a Buy. – G.G.

 

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YOUR QUESTIONS

What about ZPR?

Q – In a recent issue of The Income Investor you recommended selling my (beloved) iShares S&P/TSX Canadian Preferred Share Fund (TSX: CPD). As per your recommendation I sold a lot of shares of CPD but I have bought the BMO S&P/TSX Laddered Preferred ETF (TSX: ZPR). I like it because since it is laddered and holds rate-reset preferred shares (rather than a predominance of perpetual preferred shares) it should do better in a rising interest rate environment. Could you comment? – Barry M.

A – The theory sounds fine, however we really don’t have enough history to know how it will work out in practice. The fund has only been in existence for a year (it was launched in November 2012) and it hasn’t been an easy time for preferred shares because of the uptick in interest rates last spring. Over the six months to the end of October, the ETF was showing a loss of 4.6%. That’s slightly better than the category average but worse than CPD, which was down 4.2% in the same period.

ZPR may work out fine over the long term once the resets start to kick in. But over the years I have seen too many fund concepts that looked good on paper but failed to deliver. That’s why I usually wait for firm evidence before making recommendations. – G.P.

Convertibles as bonds

Q – Are convertible debentures are considered bonds when you allocate weightings to your portfolio?

A – Yes, because your interest income and capital are guaranteed. Certainly the company regards them as a debt. However, major, high- quality corporations rarely issue this type of security. Most of the convertibles are junior grade. You may even want to create a separate category as a reminder that these debentures involve risk and may fluctuate in value if the common stock becomes volatile. – T.S.

 

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That’s all for this issue. On behalf of everyone associated with The Income Investor, Merry Christmas, happy holidays, and a prosperous New Year. Look for your next Update Edition on Jan. 16. The next regular issue will be published on Jan. 30.

Best regards,
Gordon Pape, editor-in-chief