BMO Equity Research Presents Best of BMO Equity Ideas

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Welcome to Markets Plus, where leading experts from across BMO discuss factors shaping the markets, economy, industry sectors and much more. Visit bmo.com/marketsplus for more episodes.

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The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates, or subsidiaries.

Camilla Sutton:

Every quarter our Equity Research team releases the Best of BMO, which is a compilation of our broad macro views as well as our best North American stock ideas for the next 12 months. Essentially, it's an idea book. I'm Camilla Sutton, MD in Equity Research, and today we run you through six of those ideas. Accordingly, I'm really pleased to be joined by six of our Equity Research analysts, including Rufus Hone for asset managers, Jackie Przybylowski for metals and mining, Jim Thalacker, utilities power and renewables, Randy Ollenberger for oil and gas, Kelly Bania for food retailers, and Fadi Chamoun for transportation. They will each run us through their Best of BMO idea for the next 12 months. Rufus, Let's kick it off with you. What is your Best of BMO idea in the asset management sector?

Rufus Hone:

Thanks Camilla. Our Best of BMO recommendations in the U.S. financial sector a Nuvei, a digital merchant acquirer, Ally Financial and auto lender, and Apollo, an alternative asset manager. In this podcast I want to focus on Apollo, which is one of our best investment ideas in U.S. financials, and there are three key points I'd like to make. Firstly, we think consensus earnings estimates for Apollo are too low. Following its transformational merger with life insurance company Athene at the beginning of this year, Apollo is the only alternative asset manager that's currently seeing an earnings benefit from the rise in interest rates and the widening of credit spreads. Currently, a theme is reporting record organic volume growth, while its profitability is also expanding, as its spread-based business model benefits from higher rates and wider credit spreads. And we expect investors to revise their earnings expectations up through next year as they are currently underestimating the upside from higher rates in this business. Secondly, Apollo's valuation is extremely compelling, shares trade at less than eight times next year's earnings versus an average in more benign periods in the low teens. So, investors can buy Apollo at a trough valuation multiple, right before a period where earnings growth is poised to accelerate meaningfully. Apollo has just concluded a significant hiring phase, which has held back margin expansion until now. Meanwhile, better-than-expected fundraising this year, should provide additional operating leverage through 2023. Taken together, we expect Apollo's earnings to grow at a 25% compounded rate through 2024 with even greater potential upside from M&A and more aggressive share repurchases. Thirdly, the sentiment around private markets and Apollo has been broadly negative year to date, and longer term, we expect it to improve from here. To give you a sense of how negative it's been, Apollo's shares have fallen over 20% year to date. And this decline has happened despite earnings estimates for Apollo increasing by 20% year to date. And investors remain concerned that rising interest rates, higher inflation, and the uptick in volatility will be a headwind for demand for alternative assets, and for companies like Apollo. However, what we're actually seeing in the data is that while industry overall fundraising is experiencing headwinds, this hasn't been the case for the very large managers like Apollo, which have seen their fundraising rise year over year, while capital deployment has also been very strong. And as these market share gains become more apparent, this should help prepare some of the negative sentiment around the stock. Zooming out, we expect over time investors will refocus on the long-term secular growth of private markets and, in particular, on the resiliency of asset managers like Apollo versus the industry overall. We see Apollo as a core all weather holding within U.S. financials, and it's one of our top ideas in the sector today. Thank you.

Camilla Sutton:

Rufus, that's an interesting one to watch. Thanks for joining us today. Jackie, moving to mining. Can you walk us through your Best of BMO idea?

Jackie Przybylowski:

Thanks, Camilla. Yes, we published two ideas in our Best of BMO report; our top base metals idea Teck Resources and our top precious metals idea Agnico Eagle. In this podcast we want to highlight our investment thesis for Agnico Eagle, rated Outperform, we have a US$68 per share one-year target price, which implies a 60% return as of August 30. This is a high-quality name. It's not inexpensive but it is a reasonable value today. Since we first highlighted Agnico Eagle in our March Best of BMO podcast its value has appreciated from a 5.5 times consensus, EV/EBITDA on multiple then to 6.5 times today. We see opportunity for Agnico to continue to re-rate further both along with its peers as the gold commodity improves and to outperform its peers as well. There are reasons to be optimistic in gold and gold equities. And we're definitely hearing that investors are looking for reasons to be optimistic. There's capital on the sidelines waiting to be reinvested in the sector, which appears to be overall well valued today. However, investors are cautious about being too early and are looking for the right entry point. If we do continue to see the conditions that are supportive of gold prices, we would expect meaningful and increasing funds inflow back into the sector. Fundamentals are supportive of a strong gold price environment. The mining industry's attention will turn to gold in September major industry conferences including the Gold Forums Americas will give gold companies and industry leaders a platform to showcase growth and value creation. And beyond the catalysts highlighted at conferences, we're expecting macro-economic tailwinds, which support will support the commodity price through the second half of this year. The U.S. dollar could be weakened by expectations of less hawkish U.S. monetary policy environment. A weaker U.S. dollar could support sustained stronger gold prices as U.S. dollar is historically inversely correlated to gold price. Broadly, gold equities should also show signs of improvement. High operating costs were a major challenge in the first half of the year. But we're expecting unit operating costs to level off in the second half because of flat or modest declines to input prices, including fuel, explosives, steel, as well as naturally higher grades and production levels at many of the operations in the second half versus first half. With operating costs inflation expected to flatten, we could be seeing a rotation out of the inflation insulated royalty streamers and into mining operators; most specifically the large cap mining operators, such as Agnico Eagle. We're increasingly positive gold, but we're keeping our bias to lower beta names. Investors are still cautious particularly on the higher-risk growth stocks. This rally hasn't really even started yet, so, it's early days and it's not yet clear whether positive momentum can be maintained. Hurdles to overcome include the continued geopolitical uncertainty in many jurisdictions, costs inflation, on growth projects, and unpopular M&A beginning to creep back into the sector. It's a smaller scale of the challenges that this sector has seen in the past. So even though the market may turn bullish gold, we continue to recommend the larger, more liquid, safer and more stable equities at this point in the cycle. Agnico Eagle checks all the boxes. In addition to tailwinds for the sector overall, we believe that Agnico Eagle offers company-specific features and catalysts, which will contribute to outperformance. It balances low-risk growth catalysts with positive momentum. Agnico's portfolio of assets has been thoughtfully assembled with a focus on relatively safe jurisdictions. We believe that this is appreciated in the current risk-off yet long-term bullish environment. It has projects which create value, including the meaningful Odyssey South Underground Project, which was approved prior to the industry's major cost inflation pressures. Future growth and optimization are expected to be incremental in terms of cost and risk. And finally, the merger with Kirkland Lake has generated long-term value-creating opportunities, which we're sure to continue to hear about in the coming months. Agnico has best-in-class cost control. Agnico has also managed his operating costs extremely well this year, it has been helped by hedges on input costs and currencies, as well as through synergies achieved to date from the merger with Kirkland Lake. We expect that this cost leadership will continue. Agnico Eagle has already protected some of its 2023 costs with hedges and it continues to realize merger synergies beyond its initial targets. And capital returns, last but not least, a share buyback program, which was launched in June has created a new mechanism for Agnico to return cash to shareholders beyond the company's regular dividend, providing a potential further benefit to shareholders. Agnico Eagle is our top precious metals name and a Best of BMO pick. Camilla, back to you.

Camilla Sutton:

Jackie, Thanks for walking us through all of that. Jim, in the equities power and renewable space, what is your Best of BMO idea?

James Thalacker:

So, thanks so much Camilla. Our Best of BMO recommendation continues to be NextEra Energy, ticker NEE. We see NextEra as a core holding in the utility power of renewables coverage, and the anchor of our high-quality compounder side of our BMO barbell framework. The combination of the company's premium utility franchise, market leading positioning and renewable development, and innovative customer-centric energy transition solutions is unique and supporting of its premium valuation. NextEra is the first company in history committing to and having established the visible executable importantly economic framework to moving past net zero all the way to real zero by 2045. Their zero carbon blueprint relies on eliminating carbon emissions from their operations and does not rely on using carbon offsets or credits, which are expected to become increasingly more expensive as companies need to execute on their own reduction pledges. As investors’ adoption of ESG criteria in their investment process continues to accelerate, it's also becoming increasingly more sophisticated, we believe NextEra’s differentiated strategy and rule as a facilitator in enabling third parties to meet their own corporate decarbonisation goals, will reposition NextEra as a must-own exposure and diversified investment portfolios. We believe NextEra’s superior fundamentals underwrite an attractive and consistently compounding 10% total return, with a visible sector-leading 8% EPS growth that combined with a 2% dividend yield, provides investors with a premium equity market return at around 60% of the systematic risk. Additionally, and probably more important, given the current inflationary backdrop, our forecast of 10% dividend growth, which we believe is sustainable given the company's low-60% payout ratio, delivers investors with inflation-protected income that is superior to that in the broader market aggregate. We turn to the drivers that underpin NextEra’s sector-leading growth. We begin with the company’s envious Florida utility footprint, in addition to boasting some of the best top-line sales and customer growth, Florida Power & Light southeastern franchise has one of the best and most constructive regulatory frameworks in the U.S. FP&L is currently operating under a four-year regulatory agreement that incorporates an industry-leading allowed return on equity, as well as a rate-making construct and ensures the company will earn at the top end of its 9.7 to 11.7 allowed ROE band, both on a quarterly and importantly annually basis. This drives 9% regulatory asset growth, and at roughly 55% of our consolidated EPS forecasts, underwrites the visibility we have in the 8% consolidated EPS growth. Pivoting to its nonregulated operations, NextEra Energy Resources multi-decade strategy has built the foundation as the top domestic renewables developer, with 20% market share across its wind, solar, and storage platforms. We see NEE as one of the primary winners of the recently passed Inflation Reduction Act of 2022, adding a secular tailwind to the company's decarbonization products and expanding its total addressable market, including economic green hydrogen, the IRAs extension of existing wind and tax credits, and the addition of new standalone credits for storage, nuclear, and hydrogen – we believe it will further bend the renewable cost curve, making decarbonization incrementally affordable and helping accelerate the adoption of NDS customer-centric decarbonization solutions, adding additional growth opportunities. Finally, NEE prioritizes balance sheet strength with a healthy 100 basis points of cushion relative to its downgrade threshold, providing significant capacity to facilitate non-dilutive and incremental growth. With that, I'll turn it back to you.

Camilla Sutton:

It’s a really interesting story, Jim, thank you for that. Randy, what about in the energy sector? What is your Best of BMO idea?

Randy Ollenberger:

Thanks Camilla. Our Best of BMO idea is Cenovus Energy, which were rate Outperform with a target price of $33 versus a current market price in the range of $25. However, before running through our thoughts on Cenovus, I want to make a few comments on the oil market, which has been a big influence on the performance of the oil and gas equities. Oil has been volatile over the last several months and has traded lower over the last two months in particular, but we remain bullish on the oil price outlook. Despite the relative weakness we think investors need to understand that the world is in the midst of the most significant energy crisis since the 1970s. We believe that the factors weighing on oil prices are largely transitory. Firstly, demand has underperformed this year due to the global recession, rising rates, and other factors. As the recession comes to an end, we expect oil demand to resume its growth patterns that have been well established over the last decade. Second oil supply has been higher than expected as Russian oil and product exports have continued to flow into Europe despite the war in Ukraine. We expect tightening sanctions by the end of this year to start to reduce those Russian exports in 2023, which should help tighten the overall supply demand balance. Thirdly, the U.S. and other OECD countries have been releasing strategic oil reserves, and that has boosted oil supplies by as much as one and a half million barrels a day. These programs are expected to have run their course by the end of 2022, again, helping to tighten up that supply demand balance. Against that backdrop, global oil investment is not growing at a pace that's sufficient to meet future demand growth. We believe this will become increasingly evident to investors over the next several years. Now on to Cenovus. We believe Cenovus is very well positioned to benefit from a stronger oil price environment. The shares remain inexpensive relative to its peers and less than three times 2023 EBITDA while offering a free cash yield in excess of 20%. Many of the companies in the group are offering very attractive free cash yields; however, we think Cenovus could be one of the first companies to pivot to 100% distribution of that free cash flow. We think that that could happen as early as the first quarter of 2023, compared to many of its peers, which might take until the end of 2023 to reach a similar point in their distribution strategies. We also like the company's asset base. It has some of the best oil sands assets in Canada, very strong ESG performance, and a suite of downstream assets that has improved with the recent acquisition of BP’s Toledo refinery. We believe all of these factors will coalesce to drive an expansion in Cenovus’s valuation multiple relative to its peers and should drive additional share price upside. Cenovus is our top recommendation in the oil and gas group. And I'll leave it there, Camilla.

Camilla Sutton:

Terrific. Thank you, Randy. Kelly, interesting times in retailing, what is your Best of BMO idea?

Kelly Bania: Thanks, Camilla. Walmart has been our top pick since the end of 2021, and we continue to believe that the stock is very well positioned as we look into the back half of 2022 and longer term. For a little perspective, in the fall of 2021, we outlined a thesis calling for a more price-sensitive consumer environment following the in-depth analysis we did on stimulus and market share for our multi category retailers. And throughout COVID, we saw consumers really shift their spending priorities away from price at the top of their list and instead prioritizing safety and convenience in a way we had never seen before. For this reason, we analyzed the retailers in our coverage and evaluated which retailers we estimate took disproportionate margin expansion throughout this period. And with the thought process being that there could be meaningful risk to margins for those retailers when a more normalized environment returns. Walmart not only stood out to us as a retailer that did not use this environment to expand margins to unsustainable levels but should also benefit when the consumer returns to seeking value. And that's exactly what has been happening. Walmart noted with its 2Q earnings in August that both middle- and higher-income consumers are trading into Walmart while they're maintaining their core customer. And it appears this trade in consumers are disproportionately purchasing food and consumables over discretionary, which remains a challenge but an opportunity also, in our view. To put some numbers around near-term numbers, we believe Walmart's guidance assumes a very conservative second half. Their first half operating income for the U.S. alone, which is the lion's share of the company's profit, was pressured by a non-structural excess inventory situation, which is plaguing the industry. But despite that their first half EBIT was up about 15% relative to 2019, which would put it at a 5% CAGR over the past three years. Now the second half we estimate is planned down 3% relative to 2019, which seems highly conservative to us. And as we look out to 2023, we forecast 2023 up 20% from 2019 levels, which is also a 5% CAGR. So, as we get past non-structural inventory issues, we believe this will allow investors to refocus their attention on Walmart's higher-margin initiatives. And this will allow Walmart stock to behave more defensively. Retail is changing, and with that Walmart's investments to build out an omni channel infrastructure are growing. We estimate that Walmart's global e-commerce revenues are on track to reach $73 billion this year and expect them to reach $100 billion globally in the next couple of years with a goal of $200 billion just a few years after that. With this growth we believe Walmart's digital advertising business will continue to grow. Walmart disclosed late last year that its digital advertising business was a $2 billion business and is on track for 30% growth in the first half of this year. We recently published a deep dive on retail media where we sized up the company's potential relative to industry leader Amazon. Amazon's ratio of digital advertising to its gross merchandise value, we estimate this at about just shy of 5.0% at 4.9%. And we estimate Walmart is only at 2.7%. Highlighting the significant runway that the company has as it leverages this ecommerce platform. Walmart also has much potential to leverage its customer relationships in areas such as financial services and healthcare, which are earlier stage. So overall, we believe that these investments position Walmart well to continue balancing a more consistent earnings growth cadence and coming years. And despite these near-term non-structural inventory-related pressures, we believe Walmart share price remains attractive for a global retailer with difficult to replicate scale and best-in-class price positioning. I'd also add that from an ESG perspective, we believe Walmart really stands out in our analysis of ESG. It may sound surprising that Walmart stands out in this analysis because it hasn't always been the case historically. But perhaps because of that history, Walmart has been, we believe overcompensating for many years. And we believe they have accomplished many firsts, including but not limited to, the first to tie executive compensation to ESG, the first retailer to submit a GHG target to the SBTI. And Walmart is really only one of two companies in our peer group that have an approved committed SBTI target, with the goal of achieving zero emissions in 2040. So, our target price of $160 implies about 25% upside, and this is based on 23 times our fiscal 2023 EPS, which would be about a 15% to 20% rebound from this year of $581. From a valuation perspective, over the past three and five years, Walmart has traded in an average multiple of 21 to 22 with a trough of 17 and a peak of 27. So, we think this is quite reasonable.

Camilla Sutton:

Sounds like a solid story. Thanks for that, Kelly. Fadi what is the Best of BMO idea in transportation in your coverage universe?

Fadi Chamoun:

Thanks, Camilla. We have two recommendations for this edition of Best of BMO. The first one is Air Canada. I note three reasons supporting our positive view on Air Canada. First, our bookings data suggest a very strong recovery in passenger revenue is under way with third quarter tracking only 10% below 2019 levels and the fourth quarter down only 2% versus 2019 levels. This is an improvement from the second quarter where revenues were down 20% versus 2019 levels. This is occurring against the backdrop of lower jet fuel costs and should deliver a strong improvement in operating margins and cash flow in the second half of the year. Second reason, we believe that Air Canada has structurally lowered operating costs by at least $500 million and is well positioned to capitalize on normalizing demand for air travel in the coming two years with a stronger competitive position versus pre-pandemic levels. The third reason, valuation at current levels. Valuation offers really significant upside, as profitability is restored and the balance sheet improves. Our second idea is CN Rail, which is amongst the few Outperform-rated stocks in our freight and logistics coverage universe. Generally, we are expecting demand for freight transportation to moderate in the coming year but believe that CN Rail should benefit from buoyancy in several end markets like grain, energy, and coal, and more importantly, its self-help improvement opportunity following recent changes to senior leadership and board of directors. Specifically, we believe that CN Rail has a margin improvement opportunity in the order of 400 to 500 basis points that should enable the company to support low double-digit EPS growth, even in the case of a mild recession in the coming year. Since the change in leadership in the spring of 2022, we have seen tangible improvement in network performance and pricing that support our constructive thesis. In fact, network performance is the best that we have seen in at least the last three years and pricing is ranging between 6% to 7%, well ahead of the cost inflation and that should be supported for margin as we move forward. Back to you, Camilla.

Camilla Sutton: Well terrific way to close out the podcast. Thank you, Rufus, Jackie, Jim, Randy, Kelly, and Fadi for joining us today. BMO Capital Markets is proud to deliver thoughtful analysis of upcoming equity research trends that will prove important to clients’ investment decisions through both this IN Tune podcast as well as their commodity specific Metal Matters hosted by Colin Hamilton. If you enjoyed today's IN Tune podcast, please do subscribe and rate it. 

Disclosure:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy, or security. This presentation may contain forward looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary. This presentation is for general information purposes only, and does not constitute investment, legal, or tax advice, and is not intended as an endorsement of any specific investment, product, or service. Individual investors should consult with an investment, tax, and/or legal professional about their personal situation. Past performance is not indicative of future results.

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