The risk of waiting

November 13, 2012 | Last updated on November 13, 2012
6 min read

Does it ever pay to wait? It’s a question faced by advisors when it comes to high-yield stocks that promise the potential to rebound in price.

For two stocks in particular, what seems like an intriguing play could include unexpected risks.

CML Healthcare

One of the stocks is CML Healthcare, a diagnostic lab operator that will receive close to 90% of its revenue going forward from the Ontario government. The stock has undergone a major restructuring over the past two years, shedding all its U.S. assets, as well as its imaging clinics in Alberta.

New management is promising to rejuvenate the stock and re-engineer growth through a new strategic plan. The shares currently yield 8.7%, but have been in a downtrend most of this year. Some analysts believe the stock has bottomed, and will eventually climb off the current level, while also providing a decent dividend from a non-traditional sector.

Bell Aliant Inc.

The other stock is Bell Aliant Inc., which provides wireline, wireless, and Internet Protocol TV (IPTV) services in Atlantic Canada, and rural Ontario and Quebec. The stock yields approximately 7%, but is saddled with a legacy business in long-term decline.

Solid company growth produces positive equity prices over the long term, says Gary Lisenbee, CEO and CIO of Metropolitan West Capital. His firm manages the Renaissance U.S. Equity Value Fund.

In the short term, markets and stocks are driven by macro events. Stocks often fluctuate based on what’s happening in volatile regions such as Greece, Europe and China, and due to current headlines.

But, over periods of three-to-five years, Lisenbee says advisors can get a handle on where stocks or equities will go by using a bottom-up approach.

“They should analyze earnings growth over a three-year period to come up with approximate estimates of possible returns,” says Lisenbee.

Since equity returns have diminished over the past few years, Lisenbee suggests looking for companies with high dividend yields, an important component of earnings.

He says over the next four-to-five years, investors can most likely expect 5% annual earnings growth on average, on top of dividend payouts.

“We’re in a low-inflation environment. Some might even argue we’re operating in a borderline deflationary environment. So, [investors] are looking at a projected mid-to-high single-digit return on equities.”

Down the road, Lisenbee predicts investment prospects will improve across the board. Returns may rise to 7% and above.

In the meantime, though, stocks are a good investment since they’re currently more lucrative than other asset classes.

Management is attempting to staunch the wireline losses and reintroduce some growth through the rollout of its IPTV product. The supposed carrot for investors is the stock is 44%-owned by BCE Inc., and there are perennial rumblings it will eventually be taken over completely.

This has led some to invest based on the thesis that you can be paid to wait (i.e., bank the dividend while waiting for the stock to be taken out at a premium).

But a takeover by its biggest owner is a questionable outcome for Bell Aliant. BCE is already saddled with its recent purchases of CTV and MLSE. The company will need billions more in cash for future wireless spectrum purchases, and to fund its mounting defined-benefit pension obligations. Also, BCE’s recent acquisitions are focused on its media assets, which offer a higher growth profile (especially compared to the declining wireline assets of Bell Aliant).

If anything, BCE has been trying to diversify its revenue away from wireline over the past five years, not acquire more. With wireline currently accounting for almost two-thirds of its top line, why would BCE spend cash it doesn’t have for an asset it doesn’t want?

Added risks

Regardless of the merits of any turnaround play, the factor usually overlooked by analysts is the added risk that comes with passing time.

Investors don’t typically focus on taxes or government subsidies, but in the case of Bell Aliant and CML respectively, they provide notable risks that could jeopardize their dividends. And if those cheques stop coming, the getting-paid-to-wait strategy falls to pieces.

In the case of Bell Aliant, unexpected taxes could start to push its payout ratio close to 100% starting next year, which, when combined with increasing pension obligations, could really see the company stretching to justify its current dividend. We estimate Bell Aliant will have a payout ratio of 84% in 2012 (i.e., it will use 84% of its free cash flow to pay dividends).

As a comparison to its Canadian large-cap telecom peers, Bell Aliant’s existing payout ratio is already higher than Manitoba Telecom’s (70%-80% of FCF from its Manitoba operations), BCE’s (65%-75% of FCF), TELUS’s (55%-65% of earnings), and Rogers’ (~50% of FCF).

Beginning in 2013, Bell Aliant’s free cash flow will be further impacted by additional cash taxes since it can no longer take advantage of loss carry-forwards, which previously shielded its taxable income. If the company’s commitment to capital expenditures remains the same, then its payout ratio could exceed 100% in 2013 and beyond.

That payout level doesn’t even include pension funding concerns. If Bell Aliant were to use the same discount rate as TELUS, its pension obligations would increase by an additional ~$308 million.

Recognizing these obligations, and smoothing them into free cash-flow estimates (even over several years), would cause further deterioration in Bell Aliant’s payout ratios.

Tax issues

Despite the unexpected hit from pension obligations, the real blow is the higher taxes, which have flown under the radar of many investors.

Bell Aliant could also suffer an additional one-time tax payment in late 2013 or early 2014 of $60 million to $70 million.

This is the result of a government budget that eliminated the recognition deferral of corporate partnership income for tax purposes. If this one-time payment occurs in late 2013, the expected payout ratio for Bell Aliant could be even worse next year.

Government subsidies

In the case of CML Healthcare, the risk is not higher taxes, but rather the potential for shrinking government subsidies.

CML already suffered a blow earlier this year when the government announced reductions to the reimbursement fees it pays to physicians for certain services, including diagnostic, eye care, and anesthesia. These cuts are expected to save the Ontario government approximately $338 million annually.

Pertaining to CML, reductions were made to reimbursements for services that included diagnostic imaging, such as X-rays, MRI, and CT scans. It’s possible the government, which has been stretched fiscally the last several years, may look at further reducing subsidies.

The federal budget deficit is also set to negatively impact the future of healthcare funding. The government announced it will change the provincial healthcare transfer payment structure.

Beginning in 2017, the structure will be lowered from the current 6% annual increase to a rate tied to economic growth, but with a minimum guaranteed increase of 3% per year. Canada’s real GDP growth from 2006 to 2010 averaged just 1.2%.

CML’s major contract with the Ontario Ministry of Health and Long Term Care, which is negotiated every two years, is up for renegotiation in April. The Drummond report, which looked at ways to cut costs across Ontario earlier this year, argued for serious restraint in the healthcare sector—the province’s largest fiscal mandate.

Advisors will recall the Ontario government surprised many analysts and investors in the spring of 2010, when it cut pharmacy reimbursement rates, torpedoing the stock of several companies. Shoppers Drug Mart, in particular, has never fully recovered in share price.

Even before considering further cuts to CML’s top line, the company is paying out close to 100% of its adjusted EBITDA as dividends. While investors are hoping the company’s recently announced strategic turnaround plan might drive revenue to higher levels, the attention should be on possible negative catalysts instead.

Taking everything into consideration, when it comes to a potential investment in either Bell Aliant or CML Healthcare, sometimes it just doesn’t pay to wait around.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.