Two high-yield Canadian stocks that could takeoff in 2013

US-PDGov

By Roger Conrad

The appeal of Canadian stocks’ dividends is as great in 2013 as it was in 2012 and the world’s highest payouts are arguably even more attractive now that sudden US austerity and a major recession are off the table. If 2013 turns out to be a turning point in the global recovery, the energy and high-yield groups will produce the biggest winners.

Two companies that I’m particularly bullish on are Ag Growth International Inc (TSX: AFN, OTC: AGGZF) and Atlantic Power Corp (TSX: ATP, NYSE: AT). Both companies have been dramatically expanding their businesses in recent years.

Ag Growth’s annual sales have surged by better than a third the past three years, as it’s taken its grain-handling equipment business global.

Atlantic Power’s revenue is up 120 percent over that same time, thanks to a series of acquisitions of power plants operating in wholesale markets under long-term contracts.

Each company stumbled a bit in 2012. Ag Growth’s US sales were down 20 percent in the third quarter from year-earlier levels due to reduced harvests from an historic drought. Dry conditions are expected to extend in many parts of the country, which accounted for roughly 60 percent of 2012 sales, through at least the first quarter 2013.

Atlantic Power, meanwhile, has been unable to renew contracts set to expire in July and December for the power sold by two natural gas-fired plants in Florida. Last month management announced it would take a USD50 million charge to fourth-quarter 2012 earnings to reflect the impairment of those plants.

The move won’t directly affect cash flow and the ability to pay dividends. But it reaffirms management’s warning that it will face “substantial decreases” in returns from the plants, which it will have to replace by adding new assets. But both companies remain well on track to continue growing their businesses and building shareholder wealth in the process.

Ag Growth's sales outside of North America, for example, actually now exceed its sales in Canada. And with improved profitability selling to agricultural centers in Russia and Ukraine, the company is well on its way toward reaching 30 percent of sales from international sources.

Going global limits Ag Growth’s exposure to adverse weather conditions in North America, which inhibit harvests and, consequently, demand for grain-handling equipment. But the company is also growing its worldwide distribution network to meet high-capacity demand more cheaply, even as it enjoys more repeat sales and relies less on what it calls “transactional business.”

The result is Ag Growth’s sales are far more resilient overall than they were just a few years ago, when a severe drought in the US could have crushed them. Coupled with extremely conservative balance-sheet management, that’s strong protection for the dividend despite the past year’s adverse weather event and its temporary negative impact on distributable cash flows.

As for Atlantic Power, a steep loss of revenue from the Florida plants starting in the third quarter isn’t what management had hoped for. But neither was it unexpected, given recent years’ weakness in wholesale power markets. In fact management has been preparing against it the past several years. Atlantic Power’s acquisition last year of the former Capital Power LP, for example, more than doubled both generating capacity and revenue. That dramatically reduced the Florida plants’ share of overall profits.

In December 2012, the company achieved two additional milestones. First, it closed the previously announced acquisition of Ridgeline Energy, the renewable power assets of Veolia Environment SA (France: VIE, NYSE: VE) in North America. The USD88 million purchase adds 150 megawatts of operating wind power capacity as well as a development pipeline of 20 wind and solar projects totaling 1,000 megawatts of potential capacity.

The latter became a lot more valuable earlier this year, as Congress extended the wind power tax credit for another year. Meanwhile, management has also announced its Canadian Hills wind project in Oklahoma became fully operational Dec. 22, 2012, on time and within budget. The plant is now selling power under a 20-year contract to OG&E Energy Corp (NYSE: OGE).

Getting Canadian Hills running by the end of 2012 was no longer critical once the wind credits won another year of life. But completing the largest project in the company’s history does demonstrate Atlantic Power’s proficiency as a wind power developer, which is very promising for the continued development of the Ridgeline project pipeline. And the more scale the company achieves in this area the easier its expansion efforts are likely to become.

Financing has been challenging for expanding companies since early 2012. Here too, however, Atlantic Power has demonstrated success, closing a CAD101 million convertible bond offering last month to fund the Ridgeline purchase. That security doesn’t mature until Dec. 31, 2019, and carries a competitive annual interest rate of 6 percent. The company has now also fully repaid the USD272 million construction loan used to finance completion of Canadian Hills, using tax equity funds mostly drawn from a consortium of four institutional equity investors. The total cost of that 300 megawatt project was USD470 million.

Canadian Hills is expected to generate USD16 million to USD19 million in annual cash flows through the end of 2020, with “higher amounts” for the remaining 12 years of the OG&E contract. Expectations for Ridgeline, meanwhile, are for operations to generate an additional USD9 million to USD12 million in cash flow starting in 2013, with more thereafter as the new project pipeline is developed.

In addition, the biomass-fueled Piedmont project is set to come on stream in the first quarter of 2013, while the company’s 50 percent interest in the Orlando project will be producing additional megawatts in 2014. That adds up to USD38 million to USD47 million in new cash flow. It also increases the average life of Atlantic’s power plants’ sales contracts to 9.9 years, insulating profits from likely continued weakness in wholesale electricity prices the next few years.

That closes a substantial portion of the gap left by the loss of cash flow from expired Florida plant contracts. It’s also worth noting that these plants’ debt fully amortizes when their contracts end, so they’ll be unencumbered assets and therefore easier to sell, as management has indicated is its preference. The company is also selling its Path 15 transmission line in California.

Atlantic Power plans to invest CAD300 million to CAD400 million a year of equity capital in transactions utilizing roughly 50 percent debt. That adds up to CAD600 million to CAD800 million in new assets every year in renewable and gas-fired power plants, all secured by long-term contracts. As CEO Barry Welch noted during Atlantic Power’s third-quarter conference call, “We’re confident in our ability to sustain the current dividend level.” In fact the more assets are expanded the more room the company has to increase its payout.

That’s also what I expect to see at Ag Growth, as it expands global revenue over time. Moreover, neither company has any debt coming due before mid-2014, ensuring financial flexibility. What can go wrong at these companies? Even a full-on recession in North America wouldn’t immediately hit their profitability. Both companies actually raised dividends in 2008, as they were able to continue building cash flows in their respective niches despite the chaos around them.

Sluggish economic growth would keep downward pressure on wholesale electricity prices in 2013, making it difficult for Atlantic Power to re-contract the Florida plants. But after taking a USD50 million writeoff in the fourth quarter, the worst is already in the numbers.

Renewable energy contracts, meanwhile, enjoy favorable terms by law. And the Ridgeline acquisition gives the company considerable opportunity for expansion. Rather, the primary risk at Atlantic Power is if management fails to execute on its expansion plans. The delay in the startup of the Piedmont plant into 2013 won’t critically affect cash flow going forward. But it did raise the payout ratio in 2012 and demonstrates clearly the risks involved with construction.

A rise in interest rates could also make it more difficult for Atlantic Power to follow through on project expansion plans by increasing the cost of borrowing. Meaningfully higher rates, however, aren’t likely unless there is a revival of economic growth, which in turn would improve cash flow at the company’s operating projects as well as potential selling prices for assets like Path 15.

Ensuring the company is following through on its expansion plans is my primary concern whenever I study numbers and new developments at Atlantic. And it’s true there are more moving parts at this company than, say, at fellow power company Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF). At this point, however, Atlantic Power is succeeding both in growing its business and returning substantial cash to shareholders. The strategy has provoked skepticism from more conventionally minded analysts, particularly in Canada. But so long as it does succeed, it will reliably build wealth over time.

As for Ag Growth, business would suffer from a sharp drop in prices of agricultural commodities, should that convince farmers to do less planting. Given the growing appetite of Asians and demand for ethanol, however, that doesn’t appear a likely development anytime soon.

Weather conditions are always a threat to derail profits in a given quarter or even fiscal year. But here too the impact is always temporary and likely to be reversed the next year. Even an attempt by the Canada Revenue Agency to collect back taxes resulting from the company’s corporate conversion wouldn’t affect cash flow enough to endanger dividends.

Rather, as with Atlantic Power, the greatest threat to Ag Growth’s dividends lies with management’s effectiveness growing the business. That’s why we have to continue looking at the numbers every quarter. But at least here in February Ag Growth looks like a great candidate for a big capital gain in 2013 as it continues to measure up to the challenges. See my free report for more of my favorite Canadian income investments for 2013.

About the author: Roger Conrad writes a weekly column on dividend investing for Investing Daily.