Chris Damas, Editor, The BCMI Report

FOCUS: Cannabis, Ag and Fertilizer stocks

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MARKET OUTLOOK:

Style

I am a mainly a long equity contrarian looking to identify sectors that will soon be in a bull market but the market has not recognized them yet. Examples documented by BNN and media include fertilizers and banks in early 2009, lumber in 2010, airlines in 2012 and oil refiners in 2013. I also enjoy venture capital and making long term predictions.

We use thorough industry and field research to find the best three names in a sector for EPS growth, dividend yield, high operating leverage and try to pick attractive consolidation opportunities. We use technical analysis and “tape reading” to determine entry/exit points. 

Equity Market and Cannabis Stock Outlook

I will repeat an excerpt from my U.S. market outlook written immediately after the Trump November 8 election success:

“I would be buying the S&P bull ETFs for the long haul as the tax rate cut envisioned by Trump should be enough to send the market much higher.” On the con side I have higher (U.S.) bond yields reflecting investor sector rotation into stocks but also the likelihood of higher U.S. government deficits and inflation, trade wars and protectionism and possible forced repatriation of profits by U.S. multinationals.”

In Canada, I am concerned and believe we could relive the 1993-1994 panic when the loonie was called the “Peso of the North.” Growth is uneven with Ontario registering 2.6 per cent GDP in 2016 but Alberta shrinking GDP by 3.8 per cent. Residential construction represents 7.7 per cent of GDP nationwide, which means the economy is vulnerable to a downturn in housing. It is a concern that the Bank of Canada says a 5 per cent increase in rates would not impact housing speculation (because profits are 20 per cent or more).

Therefore, we are recommending U.S. sector plays in an area we believe is contrarian: Two picks are in oil refining. Reference my refinery call on January 10 2013 on BNN when I recommended Marathon Petroleum. The stock subsequently doubled not including dividends.

Cannabis and Ag/Fertilizer Markets

For three months I have been correct to be publicly bearish on Canadian public cannabis LPs (reference for example “The Green Rush,” Montreal Gazette February 25). On March 21, BNN with Andrew Bell I made the bear case again and said I was shorting Aphria and Cronos Group on valuation. Cronos has dropped about 50 per cent since that time.

I continue to see a bear market in Canadian cannabis stocks due to the upcoming Veterans Affairs Canada limitation on reimbursement to 3gm per day which kicks in May 21. These companies are going to have to compete for shelf space when retail models are developed by the provinces and they will not be allowed to advertise fully. Electricity rates could skyrocket in Ontario and regulatory costs due to testing requirements could cause the bulk of LP’s to suffer higher costs than expected. The constant flow of more public issues means recent RTOs and stock issues are trading under the price they were issued to the public even as insiders make ten times on their private placements, dampening retail investor enthusiasm. Plain packaging and no legalization of edibles means Canada’s legalization efforts are commercially behind the eight U.S. states that have liberalized adult use cannabis and several states such as Michigan which have well-defined rules for selling medical cannabis to the public beyond pure mail order.

I see the Canadian medical marijuana business to be slightly less unattractive than recreational but the rate of patient acquisition should slow as it was temporarily boosted by the shutdown of dispensaries. I expect the rate of patient growth to slow from the current 10 per cent a month pace reported by Health Canada.

Niche cannabis industry products such as gel caps on the medical side, peripherals (vape pens, infusions) and services (lab testing, consulting, investment banking) on the recreational side have some appeal. Oil extraction equipment, child proof packaging, and on-line mail order models have more appeal to me than marijuana cultivation, which is going to be oversupplied in Canada because analyst estimates are too bullish by far. In the US, these cannabis products and ventures are much more developed and stock valuations are less unattractive than in Canada but these stocks often have low liquidity.

We suggested to viewers that Agrium and PotashCorp were “dead money” when co-hosting with Paul Bagnell on September 23, 2016. I had no idea Trump would get elected. So Agrium/Potash rallied strongly. But fundamentals for the big three nutrients continue to be lousy and the stocks have come back to where they were in September.

Farmer income in the USA is projected to be half of what it was in 2013. The average small farm in the US only makes money from off-farm income (e.g. the spouse works) and accelerated depreciation on equipment purchases underreports cash flow. In Canada, excessive snow has delayed planting in the bread basket. Fertilizer prices continue to be depressed with domestic expansion projects in potash and nitrogen opening and shipping imminently. I think the AGU/POT hookup could face delays and regulatory remedies may be required. We rate these stocks a hold. 

Top Picks:

PBF Energy (PBF.N) US$22.48

This is a crude oil refining company that has grown from three facilities to five facilities over the past four years. The management is experienced and excellent and the company which was once private equity owned, is now 95 per cent in public hands. The stock is trading at 9.25X 2018 EPS and 5.34 per cent yield. A catalyst is the refurbishment of the Chalmette, LA refinery which is going to start providing incremental EBITDA (was not turned around for 14 years by the prior owner). Torrance, CA refinery bought from Exxon also will add diversification. Company has increased its refinery throughput from 450,000 bpd to 780,000 bpd and is guiding 805,000 bpd. The company did this without issuing shares over the past four years. The company has used dropdowns to its logistics LP (PBFX) to finance much of the CAPEX. The average P/E for a mid-sized refiner is about 12-13 so we have a one year target price of $29.16-$31.59 for PBF. I own it personally at $21.91/$22.60 and we do not have an investment banking relationship.

Alon USA Partners (ALDW.N) US$11.10

This MLP is 82 per cent owned by its General Partner Alon USA Energy (ALJ) which is being bought out by Delek USA Holdings (DK). The MLP subsidiary owns just one refinery, in Big Springs, TX, with throughput of 75,000 which is in the Permian Basin. The partnership announced better than expected Q1 results on Monday and guided for good results in Q2. We bought at $9.96 and most recently at $11.10. The increase in drilling activity in the Permian is causing strong demand for diesel fuel as the rigs run on this fuel. We expect Delek US Holdings to make an offer to take out the 18 per cent of the sub units that the Alon GP does not own once they have finalized the purchase of the GP. The prospective pre-tax yield on ALDW is 13.7 per cent but note there is significant withholding tax for Canadians even in registered accounts. We recommended ALDW to subscribers of The BCMI Report on Monday and I expect the yield to decrease to 10 per cent for a one year Target Price of $15.20. No investment banking relationship.

Twitter (TWTR.N) $18.41

Twitter is a unique brand and service integral to many people’s lives. Twitter is going to find a way to monetize its user base of 328 million unique users (up 6 per cent) and introduce a premium service similar to what LinkedIn has done. Data mining and a 139 per cent y/y increase in advertisement engagements in the first quarter are driving more attention towards this unique platform. If Twitter charged just $20 per year the revenue increase would be $6.6 billion versus $717 million in 2016 revenues. We bought TWTR last year but sold and we do not own it currently. Q1 adj. EBITDA was $170 million and the market cap is $13.3 billion. The stock had been depressed due to the Snap IPO but that has come and gone, and the CEO has been buying the stock. My two to three year Target Price for Twitter is a 10 P/S ratio on prospective revenues of $7.3 billion or $101 per share. We do not have a IB relationship. 

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