Nov 23, 2017

William Chin's Top Picks: November 23, 2017

BNN Bloomberg

William Chin , BNN

William Chin, portfolio manager at Caldwell Investment Management
FOCUS: Technical analysis and macro portfolio strategy
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MARKET OUTLOOK

The financial markets are intriguing. First of all, stocks are very strong, although economic fundamentals are less than stellar. The U.S. central bank, the Federal Reserve, cannot figure out why inflation is low but still wants to raise interest rates, despite uncertainties over the tax bill.

Here in Canada, we are beginning to see the full impact of the two interest rate increases by the Bank of Canada. This morning’s retail sales report for September came in very weak, increasing only by 0.1 per cent. Remember the second rate hike was on September 6. So far, we have a flat reading for gross domestic product for July, which turned into a negative 0.1 per cent in August. Exports have been falling for four straight months since June, losing over 10 per cent. So I am keen to see the full slate of September data, and of course, October data could be challenging as well, although by then the Canadian dollar has weakened, giving the economy a bit of a relief.

In this kind of environment, an active management style is extremely important for success in investing. You simply cannot afford to be passive like a sitting duck, such as buying ETFs or some big mutual funds that actually behave like ETFs (what we called "closet indexers"). Active management is the key feature of our firm. We use fundamental and technical analyses to actively pursue the best results for our clients.

TOP PICKS

CHORUS AVIATION (CHR.TO)
Chorus operates three businesses:

A capacity purchase agreement (CPA) with Air Canada. Through the CPA, Chorus operates Jazz Airline under a fixed-fee arrangement. This agreement accounts for 70 per cent of Air Canada's regional capacity with a fleet of 113 aircraft and accounts for the majority of Chorus' revenue.
Maintenance repair overhaul. They perform a comprehensive range of services such as aircraft inspections, installations, repairs, and inventory management.
Regional aircraft leasing. Utilizing a $200-million capital injection from Fairfax Financial, Chorus recently created a new division, Chorus Aviation Capital (CAC), where they buy regional aircraft and lease them out to regional operators globally. This is currently a small portion of Chorus' revenue but has considerable growth potential.

We like Chorus for the following reasons:

Diversifying away from CPA towards growth. Chorus is a strong operator that has executed very well on their CPA agreement with Air Canada. While the business is a stable cash flow generator, it has little growth opportunities. For this reason, Chorus is pursuing their regional aircraft leasing business. The leasing business has a long runway of growth, which should spark increased interest from investors.
Leasing is an attractive opportunity for Chorus. There are several reasons for this:
- Passenger traffic is expected to exhibit strong growth over the next 20 years (driven by emerging markets), which will drive strong demand for new aircraft from airlines;
- Aircraft leasing is an attractive option for airlines as it is less capital intensive, gives fleet flexibility, and eliminates residual value risk;
- Chorus is only competing in regional aircraft, where leasing remains under-penetrated and where they will face limited competition from major leasing players;
- Chorus has substantial competitive advantages in that they already lease planes to Air Canada under their CPA, they are an experience operator with strong OEM relationships, and that they repair aircraft internally.
Valuation. We believe Chorus will get an upwards multiple re-rate as they execute on this strategy given that aircraft lessors tend to trade at a premium to airline operators.

MARTINREA (MRE.TO)
Martinrea is a Tier One auto supplier that supplies parts to major auto OEMs (original equipment manufacturers). Segments include: a) Fluid management (engineering/production of products to store and transport fluids); b) Metal forming (body/chassis systems, engine blocks, transmissions); and c) Aluminum products (same type of products as metal forming but made with lightweight aluminum).

We like Martinrea for the following reasons:

Strong position in light weighting. Regulations are driving better fuel efficiency, which is often achieved through the "lightweighting" of vehicles by using higher strength-to-weight metals like aluminum/stainless steel. We are in the early innings of this trend and MRE is well-positioned here.
Margin improvements. MRE have executed well on improving margins and expect to continue improvements over the next few years. Drivers of the margin improvement are: better pricing/mix benefits (more discipline on pricing and shift to higher margin light-weight aluminum); normalization of costs following the launch of new facilities; better capacity utilization (new facilities being put to work); and more efficient operations.
Attractive valuation. MRE, like many autos, trade at a substantial discount to the index and we believe the "peak auto fear" is the primary driver (other reasons: electrification of cars, autonomous cars, Trump potentially changing NAFTA). Furthermore, MRE trades at a further discount to their auto supplier pear group, despite better projected growth. We believe there is a good probability that their multiple gets re-rated upwards.

WSP GLOBAL (WSP.TO)
WSP Global Inc. provides engineering, project management, and environmental consulting services to a variety of end-markets worldwide.

We like WSP Global for the following reasons:

M&A ability/global scope. WSP has evolved from a pure Canadian company to a global engineering powerhouse through strategic M&A, which should ultimately lead to continued growth, lower volatility and a higher multiple.
They have focused on higher growing segments like buildings, transportation and infrastructure (now 85 per cent of revenue), with specific focus on countries with good long-term infrastructure spending programs (Canada, U.S., Australia and Sweden). Exposure to volatile segments like industrial/energy has been reduced to 15 per cent.
The E&C industry is fragmented with lots of acquisition opportunities. WSP focuses on acquiring growing companies with revenue synergy potential, which is encouraging. Backing from their big pension plan has helped WSP acquire internationally and their M&A track record (PB, MMM) gives confidence of continued execution.
Improved organic growth. Organic growth has improved in recent quarters. WSP aims for 5 per cent organic growth through 2018 and this appears achievable. A healthy backlog supports this.
Improvement in Canada. Organic growth was soft from FQ32015 and FQ32016, dragged down by negative double-digits in Canada due to the oil downturn (large exposure to Western Canada). However, their acquisition of MMM (engineering firm with a focus in transportation and infrastructure in Ontario) in August 2015 helped WSP significantly diversify their Canadian operations away from the volatility of the energy sector and towards areas of growth. They have reorganized the team under new leadership as well. We have seen a stabilization of organic growth in Canada in recent quarters and continued improvement is expected from MMM revenue synergies and as infrastructure spending ($120 bln in 10 yrs) begins to make an impact in late 2017/2018.
Continued strength in the U.S. Expect MSD organic growth with several drivers here including: a) the Parsons Brickerhoff acquisition yielding revenue synergies (already exceeded $100m target); b) Fixing America's Surface Transportation (FAST) Act providing long-term funding certainty; c) better funding at the state level. They have not seen any impact from the expected Trump stimulus but it appears that would be an added bonus.
Other growth areas. Growth remains strong in countries like Australia and Sweden, backed by long-term infrastructure spending commitments.
Margin improvement. Expect another 100 bps of EBITDA margin improvement by 2018 to 11 per cent.
Potentially taking equity stake. WSP has noted that in some large projects, they have been left out of the key partnership, instead having work outsourced to them. By taking an equity stake, this would give them more opportunities for meaningful partnerships of big projects.

DISCLOSURE	PERSONAL	FAMILY	PORTFOLIO/FUND
CHR	N	N	Y
MRE	N	N	Y
WSP	N	N	Y

PAST PICKS: MARCH 8, 2017

SLEEP COUNTRY CANADA (ZZZ.TO)
Bought at $31.24, sold at $33.79. We sold Sleep Country following a disappointing recent quarter which saw slower-than-expected sales in accessories (a higher-margin product) and higher-than-expected costs. Overall, Sleep Country is executing well on its plan of taking share of the mattress industry through several means (sales-focused team with well-trained sales staff; taking advantage of weaker competition, i.e. Sears Canada bankruptcy; opening new stores in under-penetrated areas and refreshing existing stores to increase traffic). However, its high multiple left little room for error and this recent quarter highlighted that advertising costs will remain elevated. While higher advertising spending is a prudent move by management, it will result in less opportunity for margin expansion.

Then: $32.07
Now: $32.78
Return: 2.21%
Total return: 3.67%

TRANSCONTINENTAL (TCLa.TO)