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Beyond the Earnings Drag

Now that 92% of the companies on the Canadian benchmark S&P/TSX Composite Index have reported second-quarter earnings, let’s see how the various sectors stack up and whether their results reveal any new stocks to watch.

Although last year may very well turn out to be the earnings trough for this cycle, the next six months will prove pivotal in that regard. That comports with the macroeconomic picture as well.

In 2015, Canadian economic growth slowed to just 1.1%, the weakest pace since the downturn. Publicly traded companies performed even worse than the economy last year, with earnings per share down 10% on a sales decline of 6.1%.

One major complication this year is that the Alberta wildfires, which essentially shut down oil-sands production for about six weeks, were a major drag on second-quarter earnings and will likely prove the same for gross domestic product growth (Statistics Canada doesn’t report second-quarter GDP until the end of August).

Unfortunately, discounted-cash flow models don’t usually factor in when the most expensive natural disaster in a country’s history might occur.

But while bottom lines took a big hit during the second quarter, so far sales have grown by 8.2%, following top-line growth of 2.4% in the first quarter.

Earnings per share, however, fell 18.7% year over year during the second quarter, following a 9.9% decline in the first quarter. Okay, so maybe we were a little hasty about declaring 2015 the earnings trough for this cycle.

Even with the near-term challenges from the wildfires, the Canadian economy is still forecast to slightly accelerate this year, to 1.2%. Well, very slightly.

Most of the hard work will happen during the second half of the year. To that end, the rebuilding and normalization of activity following a major disaster typically give economic growth a short-term boost that sometimes more than fully offsets the growth that was deferred.

Indeed, the consensus forecast is for the economy to grow by 3.2% in the third quarter before slowing to 2.0% in the year’s final quarter.

Despite the disappointing profit picture so far this year, we’re impressed that companies have somehow managed to grow sales in this environment. After all, the top line is one of the few things that management can’t manipulate.

At the same time, assuming bottom lines are subject to goosing, the real earnings picture may be somewhat more disturbing than the numbers would suggest. But that’s all speculative, of course. We have to go with what we know.

Safety in Staples

Drilling down into individual sectors, consumer staples was the only sector to deliver growth in sales and earnings during both the first and second quarters.

Given the headwinds Canada’s economy has faced, it makes sense that one of the most recession-resistant sectors would perform best in this environment.

We’re still waiting for results from Canadian Edge’s one Dividend Champion that operates in this sector. But among the other firms that have already reported, Premium Brands Holdings Corp. (TSX: PBH, OTC: PRBZF) has delivered a consistently strong performance so far this year.

The C$1.8 billion food-processing company has generated adjusted earnings per share growth of 42% and 40% during the first and second quarters, respectively, on sales growth of 15% and 16%.

For full-year 2016, adjusted earnings per share are projected to grow 35%, to C$2.44, on sales growth of 23%, to C$1.8 billion.

Over the next two calendar years, PBH is expected to continue producing strong double-digit sales and earnings growth.

Naturally, those kinds of numbers have driven equally strong share-price appreciation. The stock has nearly doubled over the trailing year and currently trades with a lofty valuation of 31.7 times earnings.

While PBH does offer something for income investors, its dividend is not the sort of payout that typically excites yield chasers. The company’s C$1.52 annualized payout translates into a forward yield of 2.5%.

But that seemingly paltry yield is largely a function of the stock’s extraordinary ascent. At the beginning of the year when the share price was lower, the stock yielded a much more attractive 3.6%.

Nevertheless, PBH bears watching, not just for an opportunity to pick up the company’s turbo-charged growth at a more reasonable price, but also the possibility of greater dividend growth.

PBH grew its dividend 10.3% over the trailing year and 6.7% annually over the past three years.

Our main concern on the dividend front is that on a GAAP basis, the payout exceeds profits. And while leverage ratios are improving, we’d like to see them come down even further.

As we continue to sift through second-quarter earnings, we’ll look for other compelling ideas to share with you and possibly add to our Dividend Champions Portfolio.

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