12/13/12: What’s Next After IBI’s Dividend Cut?

By Roger Conrad • December 13, 2012

IBI Group (TSX: IBG, OTC: IBIBF) has apparently made the move Bay Street wanted: converting to a quarterly dividend at half the previous annualized rate, and using the projected CAD13 million in yearly savings to cut debt.

The move comes about a month after the release of third-quarter numbers that supported the previous dividend level, but also highlights several headwinds facing the company. Those included a slowdown in orders in several key global markets and a lack of progress meeting internal efficiency targets.

IBI’s November earnings news immediately triggered selling momentum, resulting in three sharp down days in the stock, as four analysts cut their ratings. By contrast, the dividend cut announced this week has already resulted in two Bay Street upgrades and the stock has actually managed a gain. 

Over the past several years, we’ve seen more than a few high-yielding stocks take big hits because investors anticipated dividend cuts that never happened. Once those fears waned, buyers came back and share prices recovered, sometimes going on to new all-time highs. That was the case this year with Parkland Fuels Corp (TSX: PKI, OTC: PKIUF), which has emerged as the biggest winner in the Canadian Edge Portfolio.

Unfortunately, sometimes there’s been real fire where we’ve been seeing smoke. Mainly, a dividend cut actually appears behind the selling momentum that’s driven down prices.

In the case of IBI, the pre-cut share price apparently reflected something worse than a 50 percent dividend cut. Now that we have one, the uncertainty is diminished and the insiders and large institutions that know the company best are stepping up to buy.

I have two questions. First, is this dividend cut really the nadir for IBI, or just the tip of the iceberg in a long-term decline? Second, is there a better place for our money than IBI, say a sector stock with better prospects?

A Likely Bottom

IBI’s core business of infrastructure design attracted me initially for the same reasons Bird Construction (TSX: BDT, OTC: BIRDF) did. Mainly, the company stands to benefit from a huge amount of business in coming years related to escalating global needs for infrastructure. Bird’s bailiwick is the actual management of major projects, while IBI’s expertise is designing them.

Both companies have been hit by the decline in infrastructure spending in recent years, particularly in the private sector, as the global economy has struggled to get on track. Both have maintained strong backlogs throughout, largely by successfully winning public sector contracts. But the nature of Bird’s business means its revenue flows more steadily, it’s focused purely on Canada, and it has no debt. Meanwhile, IBI has had trouble managing its far-flung business during its rapid expansion, and now faces a challenge from the debt it’s issued to finance acquisitions.

To be sure, IBI’s next debt maturity is some time off, a 7 percent convertible bond maturing Dec. 31, 2014. That’s followed by a CAD120 million credit facility maturing July 29, 2016 on which CAD67.6 million is drawn, a CAD20 million 5.75 percent convertible maturing June 30, 2017, and finally a 6 percent convertible issue maturing a year after that.

Management guidance to this point had been that expansion and new contracts would provide cash flows to bring debt balances down. That expectation doesn’t appear to have changed. In fact, IBI this week announced the close of another acquisition: Ohio-based M*E Companies Inc., which specializes in transport engineering design. M*E will dramatically increase the company’s capability in this market as well as its ability to grow revenue.

The company does, however, have a pressing need to pare debt due to the drop in its share price the past month. The 7 percent convertible maturing at the end of next year, for example, is exchangeable at holders’ option for 52.1648 shares of IBI. That’s a conversion value of barely $350, versus a cash maturity value of $1,000. The securities maturing in 2017 have a conversion ratio of 48.7329 shares for an exchange value of only about $330 at IBI’s current price. And the 2018 issue is convertible to 47.619 shares, for a value of around $320.

Clearly, with IBI at its current price, investors in these securities are going to want to take the cash option. And the company will either have to pay them with cash on hand or else refinance by issuing more debt.

If there is a positive in the dividend cut, it’s that this company is suddenly going to have a lot of free cash flow, with a projected payout ratio of less than 50 percent based on even the worst estimates for 2013. And that’s not including the possibility of better market conditions or improvement in efficiency that could provide a much better result.

The CAD13 million saved annually from the dividend cut provides a great deal of ammunition for bringing down borrowing and has been targeted for that purpose. But perhaps more important, the freed-up cash flow is going to make creditors much more likely to want to lend money to IBI at something less than loan shark rates when the time comes.

In other words, by cutting its dividend now, IBI has likely put a limit on prospective share price gains any time soon. A higher share price will only happen if and when business conditions improve and the company is able to meet its cost-reduction targets. But by acting quickly and decisively, management has apparently taken the possibility of a death spiral out of the equation.

That makes it likely we’re seeing IBI’s nadir now, rather than another step down the road to oblivion. The real question then is whether we want to keep holding this stock as a bet on an improving market and better results from management, or move on to a better alternative.

The logical replacement in this case is a stock I don’t yet cover in Canadian Edge, Genivar Inc (TSX: GNV, OTC: GNVUF). Like IBI, Genivar is also a former income trust, but has a somewhat larger market capitalization than IBI and is wholly focused on Canada. The stock’s yield is comparable to IBI, and the company has a history of dividend increases, though it’s paid the same rate since July 2008.

I’m going to add Genivar to coverage in How They Rate starting in January, along with a handful of other Canadian companies that are converting to a dividend-paying model. And I may ultimately recommend a swap. For now, however, I’m going to stick with IBI.

Turning to the rest of the Canadian Edge Portfolio, it’s undeniable that dividend-cut speculation has grown for several recommended stocks. The upshot is dividend cuts are priced in for Atlantic Power Corp (TSX: ATP, NYSE: AT), Extendicare Inc (TSX: EXE, OTC: EXETF), Just Energy Group (TSX: JE, NYSE: JE), Noranda Income Fund (TSX: NIF-U, OTC: NNDIF), Poseidon Concepts Corp (TSX: PSN, OTC: POOSF) and possibly even Student Transportation (TSX: STB, NSDQ: STB).

It’s important to acknowledge that each of these companies does face a challenge that’s been recognized by investors. But based on the numbers and guidance we’ve seen, there’s also no reason to doubt they won’t be able to prevail. And if they do, they’ll not only maintain their current level of dividends, but will enjoy mighty share price recoveries as well.

Importantly, each of these companies has posted profits this year that have supported the current level of payout. And none of them face a debt mountain that they need to reduce quickly.

The key takeaway from IBI’s positive post-cut performance is that when a stock is pricing in a dividend cut, the damage has already been done to the share price. At the very least, when a dividend cut finally happens, it eliminates the uncertainty that had been plaguing the stock. On the other hand, an actual improvement in the company’s fortunes that reduces the pressure on the payout can trigger a sharp recovery in the stock.

Either way, the wise course is to hold on and continue collecting dividends until there is an actual cut. If the companies get their acts together–as most do–our red ink will vanish. And if not, we’ll at least have facts on which to base an opinion about the company’s future viability and whether switching to an alternative makes sense. That even goes for Poseidon Concepts, easily my worst recommendation this year.


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