Double Down Dynamos
For the past 25+ years, The Motley Fool has helped thousands of investors around the world stay on the bleeding edge of innovation — guiding them to market-crushing returns by recommending disruptive companies like Amazon and Netflix in the U.S., or companies like Shopify and MercadoLibre here on the Canadian side.
Through those years of shining a spotlight on innovative companies with the potential to make a tangible impact on your portfolio, there’s been a number that we’ve been so enthused about that we’ve “doubled down.” In other words, we’ve been so confident in a company’s forward-looking potential that we go back to the well for a second recommendation.
In this special “Double Down Dynamos” report, we’ve pulled three 2X recommendations from our premium Hidden Gems Canada and Dividend Investor Canada services. That means you get full coverage of additional companies that we haven’t yet recommended here in Stock Advisor Canada for various reasons.
These “double down” recommendations have been carefully selected for your benefit, and they’re sure to give you immediate exposure to some of the most exciting companies on our Motley Fool Canada team’s radar.
To your wealth,
Your Motley Fool Canada Team
From Hidden Gems Canada, 12/7/2018
Provides in-home respiratory health care solutions and related equipment throughout the United States.
- A favourable demographic trend and compelling economics underly their offering.
- Long runway of organic growth opportunities within current footprint not well reflected by the stock.
- An engaged, founder-led management team with skin in the game ensures our interests are well represented.
If I were to guess, I’d say that us making Viemed (TSX:VMD) the first re-recommendation in the life of Hidden Gems Canada isn’t a huge surprise. If you’ve been following along, you know that Viemed’s stock came under significant pressure a few weeks ago. Pressure that was unexplained by anything related to the company. The stock has bounced from its lows, but we’re still left with a company that’s trading for less than it should be, in our opinion, given recent fundamentals (the same can be said for many on the Hidden Gems Canada Scorecard). And almost certainly (considerably) less than it will be in three- to five-years.
Since we just recommended Viemed in June, we’ll leave the back story to the original and encourage you to have a look if you’re new to the story, or the service. The same thesis is fully in place. We’ll use this re-recommendation to bring the story right up to date though. Providing further detail on what we’ll call the “comeuppance”, as well as a favourable KPMG report and Viemed’s strong growth as demonstrated by its recent quarterly release.
First though, a word on re-recommendations. If you’re a part of other Foolish services, you no doubt have a handle on this by now and are free to skip ahead. For those that are new, or are perhaps perplexed by this concept, here’s a quick rundown.
Here at the Fool, we don’t suggest you ever buy a full position right out of the gate. Exceptions may exist, but the majority of the time, we think you’re better to follow a buy-in-thirds strategy. That is, determine what a full allocation looks like, in percentage terms, and then plan to make three distinct purchases to get there. There are no hard and fast rules around when these purchases should be made, just that, you’re likely better off proceeding at a measured pace versus diving in with one fell swoop.
We tend to think about our Scorecards in a similar manner. After all, we’re trying to beat the market over the long-term and we feel a somewhat measured pace improves our chances of doing so. Therefore, whenever it’s time for a new recommendation, companies that we’ve already recommended are also considered.
Re-recommendations, or re-recs, are likely to enter the fray more as our list of recommendations grows, but for now, we really like what we’ve seen out of Viemed and are entirely perplexed by market’s treatment. A recipe to go back for a second helping, if there ever was.
With that, let’s get up-to-speed on our journey with Viemed thus far.
Or, in other words, the reason we’re here. Because without it, we probably would have turned elsewhere for this month’s Canadian recommendation.
Viemed’s stock closed on November 16th at $7.16. On November 20th, it closed at $4.11. That’s a 43% decline in two trading sessions (the 19th and 20th, there was a weekend stuck between). I’ve been around the block a time or two, and typically, whenever a stock declines by that much, over such a short period of time, there’s something to it.
In this case however, the apparent cause was almost entirely benign. Making this one of the most perplexing situations that I’ve come across during my years in the market.
The negative catalyst appears to have been a recent report that the Center for Medicare and Medicaid Services (CMS) is considering adding various codes to the next round of the Competitive Bidding Program (CBP). The codes under consideration include those associated with ventilators (of both the invasive and, most important for Viemed, non-invasive varieties). In other words, there is an apparent threat that CMS is going to cut the rate it pays Viemed for its services.
Viemed is a classic “price taker.” The company’s revenues are ostensibly all derived from the fee-for-service pricing guidelines set by CMS. These pricing guidelines are subject to change at the discretion of CMS; at the proverbial stroke of a pen, Viemed can have its top line slashed and, well, there’s really nothing it can do about it.
In fact, as we outlined in the original recommendation, Viemed’s already been through this very situation. Payments for non-invasive ventilation were slashed by about 30% in early 2016. It seemed to us, with this having occurred in the recent past, there was less risk it would happen again anytime soon. However, fears were stirred by the report mentioned.
We acknowledge the potential for CMS rate changes, which has always been there, but hold that the market reaction was illogical. Taking a “Shoot-first/ask-questions-never” stance.
Not only do we still think the risk of another cut so soon after the last one was made is low, CMS is currently only taking comments on these new categories to be added to the CBP through Deember 3, 2018. Any actual changes will not, under the current structure, come into force before 2021. At the very least then, this gives Viemed more than two years under the current pricing regime.
In addition, let’s consider how Viemed performed in the wake of that 2016 reimbursement-rate cut. Demand growth for its services saw it overtake the CMS drop—2016’s revenue fell by 16.5% versus the prior year, but it more than made up for that with 49% revenue growth in 2017. Compared to the last full year under the prior pricing guideline, Viemed has compounded revenue by 18.7% inclusive of that reimbursement cut.
Significant growth remains in this company’s future, and though it’s rather implied by the fact that we’re making this re-recommendation, we’re of the mind that we’ll be well served to look past this hiccup.
Contributing to this is the fact that CMS is almost incentivized to ensure Viemed remains a viable, growing business. This case was laid out in a recent KPMG report that we mentioned in the forums, but will provide a bit more detail on here.
You see, Viemed provides ventilators and in-home treatments for patients suffering from a number of progressive lung diseases, otherwise known as Chronic Obstructive Pulmonary Disease (COPD).
For starters, the KPMG study demonstrated that patients that receive the treatments offered by Viemed live longer. Which is presumably a good outcome.
The biggest difference though between Viemed’s treatments, other treatments, and no treatment was cost. Over a six-month period, this dynamic is outlined below:
- Patients with no ventilation support cost CMS $41,000
- Patients using a bi-level positive airway pressure device (BPAP – another form of treatment) cost $39,000
- Patients using Viemed’s treatments coupled with a high-touch care model cost $29,000
- 25 percent of untreated patients were admitted to a hospital
- 26 percent of patients using a BPAP were admitted to a hospital
- Less than 20 percent of patients using NIV and receiving high-touch care model were admitted to hospital.
Again, this furthers the case that it’s in the best interest of CMS to fuel, not restrict Viemed’s growth in any way.
Growth is exactly what Viemed’s demonstrated since we became acquainted with it. And before, for that matter.
The company released its third quarter results at the beginning of November, which indicated revenues and were up 38% year-over-year and 11% compared to the second quarter. In addition, its ventilator patient count grew by 35% over the prior year as the company ploughed $9.8 million over the first nine-months of 2018 into new ventilator equipment to drive this growth. Perhaps best of all though is that it’s self-funding. The balance sheet is clean and cash flows are such that management expects to continue recycling capital in this manner to fuel future growth. And, it’s profitable.
Foolish bottom line
Viemed was highly responsive when it came to “the comeuppance” as we reached out a couple of times. Indeed, they shared our confusion. And to prove it, they’ve put in place a normal course issuer bid that allows them to buy up to 5% of the company back. Presumably should something like that ever occur again.
We’ll reiterate that the threat of a CMS price cut will always be associated with this entity. There’s no getting around it. But we don’t think it’s nearly the threat that the market does, at this point. If you didn’t the first time around, it’s time to start building a position in Viemed. If you did, buy some more. We’re thrilled that it’s our first re-recommendation and look forward to significant gains in the years ahead.
From Dividend Investor Canada, 5/17/2018
Freehold is an acquirer and manager of oil and gas royalties in Western Canada.
- It has an attractive valuation and a well-covered dividend.
- Freehold offers exposure to rising WTI oil prices.
- Cash flow growth is poised for a rebound and it has plenty of financial flexibility.
Points to consider…
- Freehold’s monthly dividend is eligible for the federal Dividend Tax Credit if this Canadian dividend payer is held in a taxable, non-registered account.
- The company does not offer a dividend-reinvestment plan (DRIP) at this time after suspending its program in August 2016, but your brokerage may. You can contact your brokerage for more details.
The information regarding tax treatment in this piece is informational only and not intended as tax advice. For information on your individual tax situation and how it could be affected by dividends, please consult your tax advisor.
This month, we’re taking the opportunity to increase our exposure to the energy markets given the recent rise in oil prices and improving outlook. West Texas Intermediate (WTI) oil prices have risen sharply from ~US$42.50/barrel in June 2017 to over $70/barrel today.
We looked at a number of companies outside the oil and gas space, but we certainly wanted to explore whether we could add some exposure to an industry that’s beginning to feel some long-awaited relief from the prolonged downturn in commodity prices.
There were several companies that we strongly considered for this month’s recommendation within the industry, but we ultimately kept coming back to one of our current recommendations. While most Canadian producers have lagged the rebound enjoyed by U.S. producers due in part to weakness in the price of Western Canadian Select (WCS) oil and natural gas prices, we feel that Freehold Royalties’s (TSX:FRU) exposure to rising WTI prices is underappreciated. In addition, WCS prices have rebounded in a material way since March from a low of US$28.65 to US$56.40 today. The differential between WCS and WTI oil prices have also narrowed considerably from a high of US$32.50/barrel in March to approx. US$15/ barrel today.
Despite the rise in oil prices, Freehold still trades nearly 10% below our original recommendation price in October 2017. For this, and a number of additional reasons we’ll cover below, we’re headed back to the well again with Freehold Royalties.
Freehold is an oil and gas royalty company which owns royalty rights encompassing approximately six million acres of land in Western Canada. This includes one million acres of mineral title lands, which Freehold will hold in perpetuity, and five million acres of gross overriding royalty (GORR) interests. The GORR rights do expire, but only after the end of the production life of the underlying asset. Freehold’s collection of GORR interests will be around for a long time.
We gave a broad overview of Freehold’s acreage in our original recommendation, so we’ll focus on new information obtained since then. That brings us to Freehold’s Investor Day, which was held in April, where management unveiled its 2017 Asset Book, a comprehensive report detailing its royalty acreage. The report can be found on the company’s website.
In its new report, the company dives into its undeveloped land holdings identifying over 21,000 prospect locations for future drilling. These locations are only a snapshot of its geographic locations near current producing acreage with similar characteristics. In addition to its 24 million barrels of oil equivalent (boe) included in its proven reserves, the company estimates it currently has 163 million boe of upside in its deep inventory of undeveloped lands. At current production rates, this represents more than 40 years’ worth of drilling.
In addition, most of that land is in oil-rich areas of Western Canada, accounting for ~70% of the upside opportunity. The important takeaway: while the 163 million boe is an estimate, it provides further transparency on the long-life nature of Freehold’s asset base, which is highly likely to outlast our holding period and most of our investing lifetimes. It’s also highly likely the company will continue to add additional barrels to that estimate in the coming years through further acquisitions.
Given the capital-light nature of the company’s royalty business, it won’t require access to capital to develop these lands either. The majority of the operating and capital costs are covered by the producers, which license the right to drill on its lands. This allows the company to return 60-80% of its annual free cash flow (FCF) to shareholders in the form of a dividend and redirect the balance of its cash flows toward additional acquisitions.
On that front, the company has invested nearly $700 million over the past four years on additional royalty acres, doubling its mineral title holdings and greatly expanding its overall royalty holdings. Due to its relatively low cash costs, which are currently running around $5/barrel, the company has plenty of financial flexibility to redirect cash flow to expand its asset base. It also means the company’s cash flows are highly levered to rising prices thanks to minimal costs associated with the royalty model. We think this advantage makes Freehold a great alternative to riskier oil and gas producers, particularly for dividend-focused investors.
Why We’re Doubling Down
I do realize that at least some of our members would much rather have a new recommendation each month than a re-recommendation. I truly do appreciate that. However, as we’ll explain below, we think Freehold is simply too attractive to pass up right now.
As we scoured the Canadian market for oil and gas companies, we tend to focus on the highest-quality companies with cost structures and capital requirements that make sense for dividend payers. The industry can be very demanding on a company’s cash flows, as we’ve witnessed over the past few years.
We also were looking for companies exposed to WTI prices. While Freehold’s land holdings are spread across Western Canada, offering exposure to a mix of natural gas and heavy, light, and medium oil, and natural gas liquids (NGL), the company’s exposure to WTI prices may be underappreciated. This may be due to the fact that approximately 45% of current production is weighted towards natural gas. Although, only 15% of total royalty revenue came from natural gas last year, and only 12% of revenue is expected to be derived from natural gas this year.
This means liquids is the primary driver of cash flows, and the majority of its liquids production is tied to WTI price movements. In fact, only 25% of its liquids production comes from heavy oil, and Freehold’s average selling prices for its oil has historically come in above WCS benchmark prices. For instance, in its most recent quarter, Freehold’s average selling price for oil was C$8.65 above the average price of WCS during the quarter.
That brings us to the company’s valuation. While the company has benefited from higher oil prices, the stock has still lagged the overall move in both WTI and WCS prices. Based on full-year production and cash flow targets for the company, we’re looking at a stock that sports an 8% FCF yield. In addition, the company is in a great position to grow its cash flows in the current environment thanks to rising oil prices, which could also lead to more capital spending in Western Canada.
This is where the company’s favourable cost structure comes into play. At this point in the cycle, Freehold is one of the rare producer-like companies that should enjoy nearly full operating leverage, as production and prices rise. In essence, Freehold doesn’t have to spend more money to make more money, which puts it in an unusual and attractive position right now. If the environment continues to improve, that should lead to solid year-over-year FCF growth on a per-share basis.
Despite raising its dividend by 5% earlier in the year to an annualized rate of $0.63 per share, the company finds itself running below the low end of its targeted dividend-payout ratio of 60-80%. Management anticipates its payout ratio to land around 55% for the full year. Thanks to the supportive commodity prices and financial flexibility enjoyed by the company, we’re likely to see another dividend hike this year.
Depressed natural gas prices in Western Canada could continue to create an overhang for the stock in the near term. However, we think oil-driven growth in cash flows is likely to outweigh this concern, as the company’s results begin to reflect rising oil prices. In addition, at just 12% of total revenues, the impact from fluctuating natural gas prices is less impactful than changes in oil prices.
As we highlighted in our original recommendation, production growth is dependent on third-party producers. This can create some variability relative to expectations from quarter to quarter and year to year. That said, the company has done a great job proactively leasing its lands over the past year or two which will begin to impact cash flows in the second half of the year and well into 2019.
As we look out over the next few years, a recession, global economic downturn, or a change in OPEC’s stance on production could dampen the outlook for oil prices and weigh on investor sentiment. In addition, rising interest rates will have an impact on the company’s overall valuation.
Valuation & Dividend
As we covered above, we think the stock is attractively priced today at just 12.5 times this year’s projected FCF per share. This equates to an 8% FCF yield, including a well-covered 4.6% dividend yield. Looking ahead, we think Freehold is in a position to grow production and realize higher average selling prices for its mix of commodities. This should lead to solid growth in cash flow per share and dividend growth. In fact, we expect the company to raise full-year guidance in the not-too-distant future, given its acknowledgement of its conservative stance in its most recent quarterly conference call. Also, as we previously mentioned, this could include another dividend hike, as the company’s dividend-payout ratio is currently running ~55% of FCF.
In addition, the balance sheet is in great shape with $98 million in debt, offering plenty of capacity to use leverage to expand its portfolio if an attractive, large deal presents itself. The company’s ratio of net debt to funds from operations is currently only around 0.7 times, and is expected to decline to 0.3 times by the end of the year.
Foolish Bottom Line
Given the recent rise in oil prices, we’re surprised we still have the opportunity to invest in Freehold at an 8% FCF yield. While we seriously considered adding a new company to the scorecard this month, we just kept being drawn back to everything Freehold has going for it right now. Given the nature of the business model, and its geographic diversification, with about 300 different operators active on its lands, we think an above-average position is reasonable. Thanks to Freehold’s current valuation and improving operating environment, we’re taking another trip to the well with Freehold Royalties.
From Hidden Gems Canada, 1/4/2019
Quarterhill is focused on the acquisition and management of technology companies that provide products and services worldwide, while managing an extensive collection of patents it’s acquired through the years.
- The valuation is ridiculous.
- The market hates the legacy patent business due to poor short-term performance.
- Recent acquisitions are working well, with more to come.
Scenario. Pretend you’re worth $1.39. I know, I know, all of us are worth a lot more than that, especially if we’re talking intrinsic value, but bear with me.
Then, somewhat out of the blue, a judge orders that one of the biggest companies in the world must pay you about $1.65.
Now, as you might expect, big companies don’t take kindly to these kinds of rulings, and therefore, you get smoke blown in your direction. But it’s reasonable to assume you’re probably going to get a piece of that $1.65 ruling.
Apply whatever percentage you’d like. Regardless, when the smoke clears, you’re likely to be worth more than $1.39. Right? Assuming all else is equal, of course.
This is the very scenario we’re staring in the face with Quarterhill…
The market has obviously been wobbly of late, and I best preface this by saying that I far prefer zeroing in on company fundamentals and their long-term outlook versus stock prices. Sometimes, though, exceptions must be made. This is one of those times.
I’ll also say that we’re not going to go too far into Quarterhill’s story as a company here. After all, we just recommended it for the first time in September, and this story is virtually unchanged, save for some updates that we will pass along.
Rather than company fundamentals, this re-recommendation is spurred by a market disconnection that we view as too attractive to pass up. To be sure, when we first met Quarterhill, valuation was a focus, and we walked through the case in some detail. With the stock down 25% since, it becomes the sole focus.
Back to our scenario. On August 1, Quarterhill shares closed at $1.39. That day, after the market closed, Quarterhill announced that it had won a US$145.1 ruling in a patent dispute with Apple—an amount that, using today’s exchange rate, equates to CAD$1.65 per share.
Justifiably, the stock jumped on this news, closing on August 2 at $1.78 and moving as high as $1.96 in early September, after our original recommendation was made. Seemingly, the market got it. Although, at the time of our recommendation, when Quarterhill traded at $1.87, we still didn’t think it was getting enough credit for the ruling, nor the underlying, ongoing business that exists, which was essentially being given away.
Fast forward to today, and without any developments on the Apple front since our recommendation, here we are back at $1.39. This means one of two things, or a combination of each, has occurred in the market’s eye:
1) The market believes Quarterhill will realize nothing from the Apple settlement.
2) The rest of the business has deteriorated, permanently, and is therefore worth less than it was about four months ago.
We disagree—on both fronts.
Admittedly, patent disputes aren’t an area of expertise for us, but it seems virtually impossible that a ruling of this magnitude will be entirely reversed. Timing is unknowable, but odds are very good this ruling is worth something to Quarterhill. Admittedly, once frictional costs such as legal fees are considered, it probably won’t be the whole shot, but even if we see 50%, and the exchange rate remains as is, we’re still looking at a meaningful bump.
Now, the market isn’t entirely ignorant and therefore, even though it doesn’t like timing uncertainty, there’s good reason to believe it too has priced in some of the Apple settlement coming through.
This means it’s likely there’s a combination of 1) and 2) from above in play.
And if we look through our long-term lens, that’s where we think Mr. Market really has it wrong.
Since our recommendation, we’ve seen Quarterhill’s third-quarter results. Yes, the lumpiness of WiLan, which is the name of the underlying patent-focused company, was on full display. And yes, at ($9.0) million, cash from operations was negative for the third quarter in a row.
BUT … we’re still talking quarters, not years. A broken business this is not. As illustrated by a string of new licensing agreements that have been signed since quarter’s end. These licensing agreements, which serve as singles that complement the occasional home run from the likes of Apple this year and a licensing agreement with Samsung that was inked in September 2017, form the basis of what is an unpredictable, yet entirely viable operation.
As indicated in our original recommendation, WiLan has generated average annual free cash flow of more than US$30 million dating to 2009, which says to us that this recent three-quarter stretch is more like an anomaly than the norm.
The thing is, the market hates the unpredictability associated with this business—to the point that Canaccord’s analyst ascribes $0 to WiLan in his sum-of-the-parts model—just because quarterly cash flows aren’t predictable??? We’re taking the other side of that entirely short-sighted conclusion with this re-recommendation.
Beyond WiLan, which is the legacy business, Quarterhill remains in evolution mode. Its two other businesses, International Road Dynamics (IRD) and VIZIYA, continue to establish themselves. Especially IRD, which, like WiLan, has strung together a series of new opportunities since September. The most notable of which was a five-year contract worth US$8.1 million with the State of Hawaii Department of Transportation (DOT). Similar deals were inked with the DOT in Arizona and South Dakota, which are all keen to put IRD’s data-gathering capabilities into practice.
And key to the whole situation is that this remains early days in the company’s evolution. The balance sheet remains in wonderful shape, and there’s nothing better for an acquisition-oriented strategy than a market that’s caught a cold. If anything, prospects on this front have improved since we last heard from the company. It was reported that Quarterhill reviewed 27 potential opportunities and signed six non-disclosure agreements in the third quarter. If price was a factor in any of these deals, it’s almost assuredly less of an issue now.
Foolish Bottom Line
Our “Risks and Considerations” from the original recommendation remain, and if you’re new to the name, or need an overall refresh, I encourage to go back and check it out. Indeed, over the past four months, these risks and considerations have won out. But we don’t think this will be the case when we look back in four years. Not by a long shot. And if we’re right, we’re going to be looking at a diversified company with a collection of cash-flowing businesses under its watch that’s worth considerably more than it is today. I’ve personally added shares since our original recommendation and am firmly of the mind that you should, too.
Disclosure: Iain Butler owns shares of Quarterhill. The Motley Fool owns shares of Quarterhill and Viemed. Iain Butler, Jim Gillies and Bryan White contributed to this report.