Portfolio Update

RioCan REIT (TSX: REI-U, OTC: RIOCF) reported first-quarter funds from operations per unit (FFO) were essentially flat compared to a year ago, at C$142.8 million, on a 2.1% increase in revenue, to C$290 million.

However, the comparable period benefited from the inclusion of the real estate investment trust’s (REIT) former U.S. operations, which it subsequently sold for US$1.9 billion. On a continuing basis, funds from operations actually grew 31.3% year over year, offsetting the loss of C$33.9 million in FFO from the divestiture of the U.S. properties.

Before you get too excited about this performance, however, it should be noted that more than a third of the increase in continuing FFO came from the sale of marketable securities that RioCan had been holding on its balance sheet. Meanwhile, the actual performance of the REIT’s property portfolio contributed about 27.4% of the gain, with most of the balance coming from lower expenses.

At a portfolio level, same-property net operating income grew 1.5%, to C$162.7 million, mainly due to higher occupancy, though redevelopment was also a factor.

RioCan has been working diligently to fill the vacancies resulting from Target’s ill-fated Canadian venture. The committed occupancy rate (i.e., tenants that have signed leases) climbed 1.4 percentage points, to 96.2%, which is approaching the level that prevailed prior to the American retailer’s departure.

In-place occupancy was up 1.6 percentage points, to 94.4%. And rents following lease renewals rose 8.2%, with an 88.6% retention rate.

The headline occupancy rate will continue to improve over the course of the year as more of the former Target properties are re-leased, while the gap between the two occupancy rates will narrow as more tenants take possession of these spaces.

As the biggest contributor to the increase in continuing FFO suggests, RioCan is anxious to deleverage and, to this end, it’s been recycling capital (including marketable securities, properties, and joint-venture stakes) to raise funds and pay down debt.

Accordingly, the REIT’s debt-to-assets ratio has improved to 40.5% from 45.4% a year ago. In the near term, that metric could head a bit higher due to the REIT’s development activity, but management is targeting a leverage ratio between 38% and 42% longer term.

With all the headlines about the death of retail in the U.S., investors are probably wondering what to expect from a REIT that’s focused primarily on shopping malls in Canada, especially given that RioCan is still recovering from the Target debacle.

While Canadian consumers are certainly spending more time shopping from the comfort of their couches, online retail has yet to reach the level of market penetration that it has in the U.S. Additionally, Canada’s vast and sparsely populated territory means that shipping costs are a bigger factor there, as one of our Canadian editors recently wrote.

And as RioCan CEO Edward Sonshine also noted, Canada has a growing population, while the construction of new shopping centers is basically stuck at zero. That means more shoppers will be forced to patronize existing retail centers.

Beyond that, the REIT is a shrewd investor that focuses on prime locations in Canada’s six major markets, thereby helping ensure that it won’t be stuck with zombie malls.

Nevertheless, RioCan is taking steps to adapt to a changing marketplace. One of the ways that it’s diversifying its cash flows is through development, redevelopment, and intensification of its urban and suburban properties, particularly in and around Toronto. These mixed-use properties are being built up and out to include a combination of retail, residential, and office space.

The total pipeline of properties under development amounts to about 2.8 million square feet of net leasable area, which is equivalent to nearly 7% of RioCan’s portfolio of income-producing properties.

With a portfolio and balance sheet in transition, RioCan is unlikely to return to distribution growth anytime soon. It’s been more than four years since the REIT last boosted its payout. And it may take at least another two years, if not longer, for distribution growth to resume.

Management is keen to present the board with a plan to return the REIT to consistent distribution growth over a three- to five-year period, rather than just a one-off increase, and RioCan is simply not there yet.

Still, the current 5.7% yield is reasonably attractive. RioCan is a buy below C$28, or US$21.

Since hitting a trailing-year high in early April, ShawCor Ltd.’s (TSX: SCL, OTC: SAWLF) shares have dropped 21.4% on a price basis in local currency terms.

Until a week ago, the pipeline coating and repair specialist’s stock seemed to be declining in sympathy with the price of oil. However, crude prices have since partially rebounded, while ShawCor’s share price continues to head lower. Meanwhile, its energy sector peers are only down about 3% over the same period.

So what gives?

While ShawCor’s first-quarter earnings fell short of the consensus forecast by 2.2%, that was its narrowest miss in the past five quarters. And sales managed to surprise to the upside by 2.5%, for the second consecutive quarter in which revenue exceeded expectations.

First-quarter adjusted earnings per share surged 83.3% year over year, to C$0.22, despite a 1.6% decline in revenue, to C$360 million.

Although the slight sales decline was disappointing, revenue has continued to climb sequentially and has now risen for the fourth consecutive quarter.

Management attributed the quarter’s results to timely execution of projects in its Asia-Pacific pipeline and pipe services segment, as well as improving demand for its products and services in North America, where it generates about half of sales.

The company has been a disciplined cost-cutter during the energy sector’s downturn, with selling, general, and administrative expenses declining another 5.7%, to C$79.0 million, during the first quarter. Lower overhead accounted for nearly half of the first quarter’s 62% jump in operating income from a year ago.

Looking ahead, management expects to see a “renewed acceleration” in earnings growth during the second half of the year as the Tuxpan pipeline project in Mexico reaches full production. ShawCor’s current order backlog stands at C$648 million, and it has put out another C$600 million of bids for other projects.

Assuming the energy markets continue their recovery, then 2016 was likely ShawCor’s earnings trough for this cycle. Adjusted earnings per share are expected to rebound to C$1.54 for full-year 2017, compared to a loss of C$1.33 last year, on sales growth of 30%, to C$1.6 billion.

Meanwhile, the C$2.2 billion company has just C$272.7 million in debt on its balance sheet. And it’s back to comfortably covering its dividend.

That makes the continuing selloff all the more puzzling. And none of the usual culprits appear to be a factor here, ranging from short interest (just 0.5% of the float as of May 15) to secondary equity issuances (the last one was in December).

Analyst sentiment has weakened slightly during this period, with AltaCorp downgrading the stock to “sector perform,” which is equivalent to “hold.” And two analysts recently lowered their forecasts for full-year earnings per share by about 2.9%.

But while ShawCor isn’t widely followed on Bay Street, it enjoys mostly bullish sentiment among the analysts who track it, at four “buys,” two “holds,” and no “sells.”

The consensus 12-month target price is C$41.46, which suggests potential appreciation of 33.4%. Even the lowest target price is 22.3% above the current share price.

ShawCor has fallen short of earnings estimates in six of the last eight quarters. And in terms of seasonality, the second quarter tends to be among the weaker quarters of the year. Indeed, two analysts recently lowered their forecasts for the second quarter by 10.3%, though the consensus estimate of C$0.20 would still be a huge improvement over last year’s C$0.51 loss. Even so, perhaps some traders are adjusting their portfolios in anticipation of an earnings miss.

However, nothing else that we can see seems to be amiss. So unless someone knows something, odds are this selloff is overdone. With a yield of 1.9%, ShawCor is a buy below C$36, or US$27.

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