Why we’re still cautious on the energy sector.   Debt-laden oil companies are not out of the woods yet, Moody’s Investors Service says.  The credit-rating agency said key leverage metrics at some of North America’s biggest energy companies are likely to deteriorate further this year, despite a slight improvement in commodity prices and efforts to shore up finances with asset sales and deep cuts to spending levels.  It found that leverage has more than quadrupled since 2011, and that it will get worse even if U.S. crude trades at US$50 a barrel.  Energy companies have aggressively slashed expenses to cope with the more than halving of oil prices since mid-2014.  Numerous assets have been put on the block and hundreds of drilling rigs have been idled. Layoffs in the sector number in the tens of thousands.  Even so, Moody’s forecasts earnings before interest, taxes, depreciation and amortization within the group will drop by between 22 and 38 per cent this year from 2015 levels, exacerbating financial strains.   Canadian energy stocks have rebounded sharply from their February 2016 lows and are reflecting oil prices in the US$60-65 range, more than 25% above today’s level.  There might be a bit too much optimism in these stocks right now.  We remain with an underweight position in this sector.

Depending on your movie knowledge, you may remember this classic line in the 1987 movie “Wall Street”: “It’s a dog with fleas, kid.”   That was how Gordon Gekko described a stock tip from a young, ambitious stockbroker named Bud Foxx.  A dog is an underperforming stock or asset.  We all get them from time to time in our portfolios, so the big decision becomes what to do with them.   We have dealt with two in particular in our managed portfolios: Concordia Health Care (CXR) and Torstar Corporation (TS).  Both stocks are down substantially over the past year as the companies deal with specific issues but we continue to hold both as we see strong potential upside and very little further downside.

Torstar has 80mm shares outstanding so has a market capitalization of about $120 million at the current stock price of $1.50.  The company has net cash of over $60 million so the entire company is being valued at less than 30% of the $200 million they paid to buy digital media company Vertical Scope in 2015.  The stock has become excessively under-valued relative to its asset value due to mismanagement and a loss of investor confidence!  The publisher of the Toronto Star and Metroland newspapers generates positive cash flow.  It has been spending aggressively to develop their StarTouch app, but this spending winding down and should be cash neutral by end of year.  Company continues to move to more digital platforms and away from ad dependence.  The sale of their Harlequin division for $450 million in 2014 was 40% higher than most analyst estimates and is example of how investors are under-estimating the break-up value of the total company.  Investor’s negative views on management, their strategy and the newspaper industry have created a significantly under-valued stock, even assuming dividend is cut further.  At current prices, the newspaper operations are effectively being valued at less than zero!

Concordia Healthcare has gotten swept into the ‘Valeant vortex’ which saw its stock drop over 90% as worries about drug pricing, roll-up acquisitions, high debt leverage and health care accounting drove valuations in the sector lower.  The acquisition of AMCo for US$2.1 billion was fully funded and the new assets performed well in their first three quarters, helping to diversify the product mix, adding substantially to their global product portfolio, lessening their dependence on any single product and contributing substantial cash flow. However, the AMCo assets are primarily in Great Britain so the impact of the Brexit vote on the Pound has hurt revenues there.  Some of their existing US drugs are also facing generic competition, which lead to a downgrade in the growth outlook for those products in the most recent earnings release.  Also, the debt is high post the deal but free cash flow is also strong so we expect them to pay down this debt aggressively over the next few years, which would see the Debt/EBITDA ratio to drop sharply. The company is also not dependent on product price increases to generate growth.   The stock valuation is extremely attractive on a free cash flow yield and forward earnings basis, even after taking into account the risks to growth and the high debt levels.  As the current panic over the sector subsides, we expect valuations to rebound from their extremely depressed level and the stock to outperform the market.  Both stocks essentially have been ‘dogs’, but maybe they are in the process of getting rid of their ‘fleas.’

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