Mar 8, 2018

Dennis da Silva's Top Picks: March 8, 2018

BNN Bloomberg

Dennis da Silva , BNN

Dennis da Silva, managing director and senior portfolio manager at Middlefield Group
Focus: Resource stocks

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MARKET OUTLOOK

Volatility returned to equity markets in early February, triggered by inflationary concerns and higher interest rates. Market gyrations were also exacerbated by the growth in passive strategies and complex algorithmic trading products. We believe markets are underpinned by positive economic momentum and corporate earnings growth, which will be the ultimate driver of strong mid to long-term returns.

The significant improvement in oil prices since mid-2017 hasn’t led to a proportionate response from energy stocks. More specifically, Canadian energy companies have suffered from extreme negative sentiment despite material improvements in margin, strong balance sheets and efficient use of capital. The significant value of Canadian energy stocks will be realized over the next few years as there are several projects with the potential to resolve the transportation issues, such as the expansion of the Trans Mountain Pipeline, the approval of Keystone XL Pipeline and the proposed LNG Canada joint venture. While we enter 2018 with a more balanced oil demand/supply backdrop, geopolitical risks have become elevated with continued unrest and supply curtailments in Venezuela and the ongoing Iran-Saudi Arabia conflict.

The quality of Canadian gold development projects combined with their low geopolitical risk has led to significant mergers and acquisitions over the years. We expect this to continue as a result of the high level of direct investment by senior gold companies in junior stocks. Interestingly, over one-third of equity raised by junior gold stocks on the TSX in 2017 was through direct investments, more than double the amounts invested in 2015 or 2016. Global manufacturing has continued to increase, with all of the major global economies showing PMIs above the key expansionary reading of 50. Base metals and bulk materials prices have rallied strongly since early 2016, resulting from greater demand together with a slowdown in supply due to a lack of large new projects being sanctioned. The outlook for 2018 remains positive as both developed and emerging economies experience solid growth.

TOP PICKS

ATLANTIC GOLD (AGB.TO) — Sept. 17 at $1.80

Atlantic Gold is a new gold producer in Nova Scotia. A single open pit mine started last October will undergo a re-rating from “developer” valuation to “producer.” Insiders own 35 per cent. It’s got a production of 85,000 ounces per year over eight and a half years, with all-in sustaining costs (AISC) under US$600 per ounce. Atlantic has an impressive track record, as this asset was acquired, consolidated and put into production in just three years. Using a unique fixed-cost EPC contract, they were able to build the project within budget and on time. Mid-term growth from satellite deposits being incorporated into the mine plan by 2021 leads to 200,000 ounces per year at AISC under US$550 per ounce. There’s regional exploration upside longer-term. Atlantic Gold is inexpensive when you look at other takeovers, such as Alamos paying $900 million for Richmont, while Atlantic has an enterprise value of less than $400 million.

CARDINAL ENERGY (CJ.TO) — Dec. 17, $6.00

Cardinal is a Canadian junior oil producer with current production near 21,000 barrels of oil equivalent per day (boepd). It’s trading at the largest discount to its historical multiple and greater than a 150 bps differential to the junior peer group in terms of current multiple to historic numbers. In 2017, it suffered from the timing of a key $330 million light oil acquisition and a corresponding $170 million equity deal. It was a largely telegraphed transaction, which was important to lighten the oil mix (50/50 medium/light by year end 2018), improve margins and expand drilling inventory. Leverage initially increased, but have been selling royalties with the goal of raising $130 million ($40 million so far) to restore balance sheet to traditional 1.0 times net debt to cash flow ratio. A 10 per cent decline rate offsets lower margins and supports a sustainable model of low single digit growth, a strong balance sheet and its current 10 per cent dividend.

TOURMALINE OIL (TOU.TO) — Dec. 17, $31.20

Tourmaline is a core holding. It’s the second largest gas producer in Canada (270,000 boepd, 20 per cent liquids). Near-term LNG catalyst if Shell makes decision to proceed. It’s trading near six year lows despite solid balance sheet, liquids growth and strong economics in an environment of weak gas prices. Heading and marketing arrangements have reduced actual AECO exposure to about 24 per cent. Overall 2018 growth of 6 per cent will come from high-value liquids, with gas remaining flat through 2019 when a new gas plant starts up. Meantime, they will keep spending at cash flow and deliver a new dividend in March (1.7 per cent yield). 2017 results show impressive reserve growth over 20 per cent per share and a recycle ratio of over 1.7 times. Toumaline trades at the peer group valuation which is well below historical level (at 2 times) despite track record and quality of asset base.