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Why EPS And Share Price Don’t Predict Future Performance

Most analysts, and especially “chartists,” put a lot of emphasis on earnings per share (EPS) and stock price movements when determining whether to buy a stock. Unfortunately, these are not good predictors of company performance, and investors should beware. Most analysts are focused on short-term – meaning quarter-to-quarter – performance. Their idea of long term is looking back 1 year, comparing this quarter to the same quarter last year. As a result, they fixate on how EPS has done and will talk about whether improvements in EPS will cause the “multiple” (meaning stock price divided by EPS) to “expand.” They forecast stock price based upon future EPS times the industry multiple. If EPS is growing, they expect the stock to trade at the industry multiple, or possibly somewhat better. Grow EPS, hope to grow the multiple, and project a higher valuation. Analysts will also discuss the “momentum” (meaning direction and volume) of a stock. They look at charts, usually less than one year, and if price is going up, they will say the momentum is good for a higher price. They determine the “strength of momentum” by looking at trading volume. Movements up or down on high volume are considered more meaningful than those on low volume. But unfortunately, these indicators are purely short-term, and are easily manipulated so that they do not reflect the actual performance of the company. At any given time, a CEO can decide to sell assets and use that cash to buy shares. For example, McDonald’s (NYSE: MCD ) sold Chipotle and Boston Market. Then, the leadership took a big chunk of that money and repurchased company shares. That meant McDonald’s took its two fastest-growing and highest-value assets and sold them for short-term cash. They traded growth for cash. Then leadership spent that cash to buy shares, rather than invest in another growth vehicle. This is where short-term manipulation happens. Say a company is earning $1,000 and has 1,000 shares outstanding – so its EPS is $1. The industry multiple is 10, so the share price is $10. The company sells assets for $1,000 (for the purpose of this exercise, let’s assume the book value on those assets is $1,000 – so there is no gain, no earnings impact and no tax impact.) Company leadership says its shares are undervalued, so to help out shareholders it will “return the money to shareholders via a share repurchase” (Note, it is not giving money to shareholders, just buying shares.) $1,000 buys 100 shares. The number of shares outstanding now falls to 900. Earnings are still $1,000 (flat, no gain), but dividing $1,000 by 900 now creates an EPS of $1.11 – a greater than 10% gain! Using the same industry multiple, analysts now say the stock is worth $1.11 x 10 = $11.10! Even though the company is smaller has weaker growth prospects, somehow this “refocusing” of the company on its “core” business and cutting extraneous noise (and growth opportunities) has led to a price increase. Worse, the company hires a very good investment banker to manage this share repurchase. The investment banker watches stock buys and sells, and any time he sees the stock starting to soften, he jumps in and buys some shares so that momentum remains strong. As time goes by and the repurchase program is not completed, he will selectively make large purchases on light trading days, thus adding to the stock’s price momentum. The analysts look at these momentum indicators, now driven by the share repurchase program, and deem the momentum to be strong. “Investors love the stock”, the analysts say (even though the marginal investors making the momentum strong are really company management), and start recommending to investors that they should anticipate this company achieving a multiple of 11 based on earnings and stock momentum. The price now goes to $1.11 x 11 = $12.21. Yet, the underlying company is no stronger. In fact, one could make the case it is weaker. But due to the higher EPS, better multiples and higher share price, the CEO and her team are rewarded with outsized multi-million dollar bonuses. But over the last several years companies did not even have to sell assets to undertake this kind of manipulation. They could just spend cash from earnings. Earnings have been at record highs – and growing – for several years. Yet, most company leaders have not reinvested those earnings in plant, equipment or even people to drive further growth. Instead, they have built huge cash hoards , and then spent that cash on share buybacks, creating the EPS/multiple expansion – and higher valuations – described above. This has been so successful that in the last quarter, untethered corporations have spent $238B on buybacks, while earning only $228B . The short-term benefits are like corporate crack, and companies are spending all the money they have on buybacks rather than reinvesting in growth. Where does the extra money originate? Many companies have borrowed money to undertake buybacks. Corporate interest rates have been at generational (if not multi-generational) lows for several years. Interest rates were kept low by the Federal Reserve hoping to spur borrowing and reinvestment in new products, plant, etc. to drive economic growth, more jobs and higher wages. The goal was to encourage companies to take on more debt, and its associated risk, in order to generate higher future revenues. Many companies have chosen to borrow money, but rather than investing in growth projects, they have bought shares. They borrow money at 2-3%, then buy shares – which can have a much higher immediate impact on valuation – and drive up executive compensation. This has been wildly prevalent. Since the Fed started its low-interest policy, it has added $2.37 trillion in cash to the economy. Corporate buybacks have totaled $2.41 trillion. This is why a company can actually have a crummy business and look ill-positioned for the future, yet have growing EPS and stock price. For example, McDonald’s has gone through rounds of store closures since 2005, sold major assets, now has more stores closing than opening and has its largest franchisees despondent over future prospects . Yet, the stock has tripled since 2005! Leadership has greatly weakened the company and put it into a growth stall (since 2012), and yet, its value has gone up! Microsoft (NASDAQ: MSFT ) has seen its “core” PC market shrink, had terrible new product launches of Vista and Windows 8, wholly failed to succeed with a successful mobile device, has written off billions in failed acquisitions, and consistently lost money in its gaming division. Yet, in the last 10 years, it has seen EPS grow and its share price double through the power of share buybacks from its enormous cash hoard and ability to grow debt. While it is undoubtedly true that 10 years ago Microsoft was far stronger as a PC monopolist than it is today, its value today is now higher. Share buybacks can go on for several years. Especially in big companies. But they add no value to a company, and if not exceeded by re-investments in growth markets, they weaken the company. Long term, a company’s value will relate to its ability to grow revenues and real profits. If a company does not have a viable, competitive business model with real revenue growth prospects, it cannot survive. Look no further than HP (NYSE: HPQ ), which has had massive buybacks, but is today worth only what it was worth 10 years ago as it prepares to split. Or Sears Holdings (NASDAQ: SHLD ), which is now worth 15% of its value a decade ago. Short-term manipulative actions can fool any investor and keep stock prices artificially high, so make sure you understand the long-term revenue trends and prospects of any investment, regardless of analyst recommendations.

GLD: Capitulation Time?

Summary Given what’s occurring in the gold stocks, it seems only a matter of time before GLD breaks down. When it’s all said and done, the 2011-? bear in gold stocks might be the worst on record, one that will most likely never be beaten. For the first time, I see the finality of this bear market in GLD. The reason I’m bullish on GLD for the long-term is continued strong money supply growth, flat to declining gold production, increasing interest payments on US debt, and low valuations. Most gold companies will be able to survive a lower price environment. It’s been a few weeks since I gave an update on the SPDR Gold Trust ETF (NYSEARCA: GLD ). In my previous article, I discussed the move in GLD after the Federal Reserve meeting concluded: GLD has risen to the 115 level, as it rocketed higher after the Fed meeting this past Wednesday. So just more of the same indecisiveness; however, the gold stocks aren’t really following GLD’s move to the upside. From the beginning of this bear market, it’s the gold stocks that have been leading the way lower. GLD’s strength might just be temporary due to a knee jerk reaction to the Fed statement. In the past, these initial moves turn out to be incorrect in terms of which way GLD is ultimately going to go. Since that time, GLD has weakened considerably and actually temporarily moved below the 110 level today (Wednesday), which is major support that held in November 2014 and March 2015. If this is the final sell-off of this bear market, then that 90-100 target that I have been talking about since last year comes into play – and fast too. The weekly MACD also shows another negative crossover, which could portend new lows are ahead. (Source: Schwab) Given what’s occurring in the gold stocks, it seems only a matter of time before GLD breaks hard to the downside. The NYSE ARCA Gold Bugs Index ($HUI) is comprised of 16 gold companies and it includes the biggest names in the sector. The index has been incredibly weak as of late, and when you see the gold producers selling off like this, usually GLD isn’t too far behind. This looks like capitulation, which I have been waiting many months for. So without question, if GLD breaks aggressively lower, this will be the final sell-off for this bear market. I wasn’t sure if it was going to happen but now the likelihood grows everyday the more gold stocks collapse. This would be a most welcome turn of events as this bear market is very long in the tooth. When it’s all said and done, the 2011-? bear in gold stocks might be the worst on record, one that will most likely never be beaten. The HUI hit an all-time high of 630 in late Summer of 2011, which means it has declined 78% from that point to today’s levels. If GLD enters that final leg lower, you could get some major panic selling in the shares of these precious metal companies. It’s not out of the question for the Gold Bugs Index to be cut in half if GLD hits 90 (or about $950 for gold). That would put the HUI at 70 and change, which is an 89% sell-off from peak to trough. We have to go back to the Great Depression to see that kind of carnage in a U.S. stock index, as the Dow declined from 381 in 1929, all the way to 41 by 1932. An 89% sell-off as well. But it only took a few months for the Dow to double off of the lows, and a year later it had tripled from the bottom. I expect a similar rebound in terms of percentage and swiftness should the HUI move substantially lower over the coming weeks/months. (click to enlarge) (Source: StockCharts.com) No market index is going to lose 80%-90% of its value and just remain at those levels for years. These size percentage losses only occur in major oversold events where investors misprice assets to the extreme. At bubble tops, peak prices last for just a few days/weeks, the same goes for bear market bottoms. The lows in the Nasdaq during 2002 (after the tech/internet bubble burst) only lasted a few days. 2-3 months later the index was up 50%, a year later the Nasdaq was up 100% from the lows. If we go back and look at the previous bear market in the HUI (which ended in late 2000), the bottom was very short-lived. History will repeat here as well. These gold stocks are already at deep deep discounts to their fair values. The further they move to the downside from current levels, the tighter the rubber band is pulled, and the faster and harder it will snap back. I’m Still On The Sidelines With GLD and the gold producers acting very weak over the last few months, I have been in mostly cash. For the first time though, I see the finality of this bear market. During previous lows that have occurred over the last few years, it was questionable. While gold and precious metal share prices were cheap, they weren’t at extremes levels that would mark a final bottom. This would be more definitive now, as gold anywhere under $1,000 is simply unsustainable. I still believe that GLD is in its bottoming stage while the stock market is in its topping stage. I don’t see a market crash occurring in the next few months, rather I expect this chopping action to continue. Marginally higher highs could be hit in the major US indices, or we could just see a series of lower highs. Next year though (and maybe towards the end of this year) will not be pretty for the market. Many investors look for reasons why GLD has been performing so poorly since 2011-2012. This has nothing to do with the strength of the USD, as so many people believe. It’s simply the result of the huge bull market in stocks that has occurred. But the stock market is not attractive at the moment as valuations are extremely stretched. And with the Fed about to embark on raising rates probably sooner rather than later, it’s time to be booking profits. Why Am I A Long-term Gold Bull? I’m currently bearish on GLD’s short-term outlook, long-term though I’m pounding the table. I know for a lot of investors it’s hard to see this sector ever returning to its former glory of 2011. But this is going to be the best performing asset class over the next several years. Gold will continually move higher in price as long as we have a non-gold backed fiat currency system. You have M2 surpassing the $12 trillion level in the last few weeks. With the money supply constantly expanding at a very brisk pace, it’s only a matter of time before the gold price catches up. (Source: Federal Reserve) You also have the major gold producers showing a flat to declining production profile over the next several years. This is in stark contrast to what the landscape looked like in 2011, when many gold projects were being developed and growth in output for most gold companies was very strong. Some might worry about the Fed raising rates, which investors believe would put further downward pressure on the price of gold. But we are in a negative interest rate environment, and the Fed Funds rate would have to hit 2% for that to change. I doubt the Fed gets past 1.0-1.5% before this economy starts to buckle. That figure could move higher if inflation and GDP growth pick up in the short-term. But it’s not just the economy that will feel the pressure of rising rates, it’s the U.S. Government’s debt position that will be impacted the most. The Government is a huge beneficiary of this low interest rate environment, as it means lower interests. The second rates increase, so will interest payments. If rates “normalize” to the 4% level, interest will skyrocket. From the Congressional Budget Office’s updated projections for 2015-2025: Interest Payments. CBO expects the government’s interest payments to rise sharply during the coming decade , largely as a result of two conditions. The first is the anticipated increase in interest rates as the economy strengthens. Between 2015 and 2025, CBO projects, the average interest rate on 3-month Treasury bills will rise from 0.1 percent to 3.4 percent and the average rate on 10-year Treasury notes will rise from 2.6 percent to 4.6 percent. Second, debt held by the public is projected to increase significantly under current law….Together, the rising interest rates and federal debt are projected to more than triple net interest costs-from $229 billion in 2015 to $808 billion in 2025. So as confirmed by the CBO, should rates normalize, the interest that the U.S. will be paying on the debt will go from $229 billion to $808 billion over the next decade (this doesn’t include interest credited to Social Security and other government trust funds). The faster the Fed raises rates, the faster these payments balloon. The simple fact is the U.S. will be running $1+ trillion deficits again in the not too distant future. Of course GDP is projected to increase as well over the next decade, so a $1 trillion deficit won’t be the same in terms of “percent of GDP” as it was say 5 years ago. But that’s also a reflection of the amount of inflation/growth in the system, so gold will respond positively to this. The U.S. is still dealing with a ever increasing debt obligation that simply can’t be repaid. This stealth inflation that has been in place since the 2008 financial crisis will remain. Gold will have its turn as it must adjust for higher levels of money supply growth. The biggest reason though to be a long-term gold bull is simply because of the extremely compelling valuations in the sector. Sure, they will get even cheaper if GLD takes one last plunge. It wouldn’t be out of the realm of possibility to have many producers/developers/explorers selling at or below cash values soon, as their businesses will be worth nothing to investors. This is exactly what occurred in tech/internet stocks in 2002, the general stock market in 2008, and housing in 2009-2010. At a certain price point, an asset becomes as close to a “sure thing” as it will ever be. What’s The Timing Of This? Should GLD break down decisively, I’m expecting this bottom/capitulation process to last 2-4 months for GLD and the gold stocks. That would mean investors should be looking to be buy sometime in the September-November timeframe. The window to acquire GLD and precious metal shares at or near the absolute lows will be small and will not hold for many days. Timing though isn’t extremely important providing investors are purchasing somewhere near the bottom. Once the bottom is reached, I expect a V-shaped recovery with GLD moving back swiftly to the 115 level. Will There Be A Mass Wave Of Bankruptcies In The Gold Stocks? Given a possible low of $950 for gold, and the debt loads for many of these companies in the sector, investors might assume that we will see a wave of bankruptcies come this Fall. But that is unlikely for a few reasons. 1. While net debt levels are high for some gold producers, much of this debt is long-term in nature. Barrick Gold (NYSE: ABX ) for instance, the most indebted company in the sector, has plenty of cash on hand to cover its debt obligations (including interest) for the next several years. The majority of companies will be able to survive a trip down below $1,000. Most of the weak ones have already perished (Allied Nevada for example), the rest have adapted to this low gold price environment and can withstand more downside. Unfortunately their stock prices will suffer. 2. As I mentioned earlier in this article, as well as in previous articles on the sector, gold under $1,000 isn’t sustainable. The simple reason is cash costs will never be able to get down to that level across the industry without a serious supply disruption. And we haven’t had a big enough increase in total gold output worldwide over the last 15 years that would warrant/necessitate a decrease in production. Gold producers have done a tremendous job with reducing their costs structures since the precious metal started to decline in 2011, but to ask them for more is too much. Everything that could be done (to reduce All-in Sustaining costs), has been done. The only other avenue would be to take offline some of this lower margin supply. I just don’t see that happening though because of the disruption this would cause to the industry. In Summary This feels like the start of capitulation in GLD, and in typical fashion it’s the gold stocks leading the way lower. Should GLD break down hard (and we don’t have some last gasp stick save event), I’m expecting the ETF to bottom out around the 90-100 region (probably closer to 90). The gold stocks have much further downside than GLD, and we could see the HUI fall as much as 90% from the 2011 peak when it’s all said and done. There is much to be bullish about when looking at the long-term for GLD. Production growth is flat to declining, M2 is still rising at a very strong pace, net interest for the U.S. will skyrocket which will cause the deficit to hit $1 trillion again, and valuations in the gold sector are extremely compelling already. If “this is it” then I expect the bottoming process to last for 2-4 months. We won’t see a mass wave of bankruptcies in the sector either during that time. Net debt levels are high for some gold producers, but much of this debt is long-term in nature. I also don’t expect gold to remain under $1,000 for long, so it won’t be an issue for most companies. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Capital Power Corp.: Weak Market Sentiment But Strong Investment Case

Summary Strong hedges help protect Capital Power from temporary power price weakness in their key market. Strong future growth is expected as new production comes on line, and older coal assets in the province are retired. The market is penalizing Capital Power due to weak electricity prices, weakness in the oil-centric Alberta and political party changes, but all represent temporary issues. New course issuer bid, recent DRIP suspension, coming dissolution of EPCOR’s ownership and low energy prices allow purchase of a solid Canadian Independent Power Producer at a discount. Capital Power Corporation ( OTC:CPXWF ) is an independent power producer (IPP) based in Edmonton, Alberta, Canada. With more than 3,100 MW of power generation capacity through 16 facilities, 371 MW via a Purchase Power Agreement (PPA) and 620 MW of owned generation in development (mostly in Alberta and Ontario) Capital Power is one of the largest IPP’s in Canada, with one of the lowest payout ratios in the industry. Its operations and type of generational facilities are listed in the graphic below: (click to enlarge) Source: Capital Power IR Business Model Capital Power generates electricity and sells that production to local utilities, generally based on contracts with local utilities (Purchase Power Agreements, or PPAs) to lower the operating risks of the business model, and can hedge the production that is sensitive to local market conditions. They also generate and sell non-contracted electricity to drive cash flow and allow it an avenue for growth after entering contracts to cover capital costs and their dividend. Due to weaker than expected demand, warmer weather and a recent increase in supply, the market has been generally weak, allowing Capital Power to trade at levels not seen in some time. With approximately 50% of its 2016 power production hedged at relatively attractive prices, and long-term power agreements for up to 20 years for most of the required capital and dividend costs, Capital Power is suffering under the weight of headline issues, rather than in line with its impressive business fundamentals. With strong operating availability (98% in Q1) and minimal unplanned outages they have been firing on all cylinders lately. Their strong hedges have largely negated the impact of temporarily low Alberta power prices, allowing them to continue towards their FFO guidance of $365-415M. They also recently announced a 5 million share course issuer bid approval by the Toronto Stock Exchange (TSE) and cancellation of their DRIP (eliminating dilution at these low prices). So what is going on with the share price? New Democratic Party (NDP) As a resident of the neighboring province, and closet environmentalist, my siblings and I had a lively discussion regarding this recent development. The provincial NDP, a left-of-center political party, managed to win a majority in the Alberta election. This was to the dismay of almost every major Alberta-based company (and almost every rural resident), as it had long been the friendliest province in Canada (or State in all of North America) to develop oil properties. With low tax rates, strong inflows of qualified workers and lax environmental rules, it was the nearly perfect place to set up shop. This all changed on Election Day. The NDP immediately changed the game with overdue (in the author’s opinion) changes to environmental rules (increase carbon emission taxation), higher taxes on the highest income tax brackets, and a “review” of the royalty policies in Alberta. This has raised some questions regarding the future of business development in Alberta, but I feel these are overblown for a few reasons: Oil is Alberta’s bread and butter – The NDP is excited to finally begin to enact proper environmental regulations in Alberta, but even if they make aggressive moves, they are still playing catch-up to every major state in North America. They will need to push the envelope to an extreme degree to stop being the premier place in Canada (and the Americas) to do business. Taxation Changes are reasonable – The next place in Canada to do business in oil is Saskatchewan, and the effective tax rates are nowhere comparable. There is little fear of businesses relocating anytime soon. A few folks mention relocating to Texas, but Canadian corporate taxes are still very low, and Calgary remains one of the main hubs for oil companies in the Americas. Carbon Tax Fears Overblown – Capital Power, for example, is welcoming the new environmental regulations. The party line is that this is due to their being forward thinking, but when it comes down to it these regulations are going to happen sooner or later. Even the increases announced are almost comically below what is required. Capital Power is actively selling carbon tax offsets from its renewable generating plants. Using these offsets for the Alberta increases (which phase in slowly over time) is not a major business issue for the amount of cash generated by their business, allowing them to postpone any FFO impact until 2020. Perception Change is an Overreaction and Temporary – Arguably the biggest effect was the worry that the change in provincial leadership would result in a massive perception switch within the province. This might be a concern, but Alberta was growing quickly not only because it was business friendly but also because it houses all of the resources. Alberta is holding all the cards. If you want to develop, you follow the rules, and even the changes made so far are well below the required amounts to start actually affecting business decisions. EPCOR relationship EPCOR is a utility company owned by the City of Edmonton, which previously owned Capital Power and spun it off to become its own independent power company. As EPCOR has committed to reducing its stake in the power company to focus on its own operations, it has been actively lowering its ownership in Capital Power since the IPO. Recently, they issued $225M in a secondary offering that lowered EPCOR’s stake in the company to 9% (from 18%). The entire ownership stake is now common shares. Capital Power is also no longer obligated to assist EPCOR in making secondary offerings. With the elimination of the agreement (Registered Rights Agreement) EPCOR plans on selling the remaining interest as market conditions and capital requirements apply. This eliminates a large and ongoing weight on the stock, as they have been slowly unraveling their position through selling and secondary offerings. Source: Q1 Presentation By eliminating this overhang, the public float is now maximized and there is no large third party encouraging equity issuances or selling off their position. Once this ownership is completely done, the stock will lose that unnecessary selling pressure. I feel the time to capitalize is at this moment, rather than awaiting completion, due to weakness from temporary overhangs on the stock from other areas and that the final announcement of EPCOR’s ownership stake going to zero could be a small boon for the company share price in the future, but investors need to be playing the stock first to see that benefit. Power Prices Power prices are very low at the moment, coming in below expectations in Alberta specifically. US power prices have been strong lately, but with so much of its production in Alberta this has an outsized impact on Capital Power. Power prices are being pushed from two sides. Temporarily Lower Demand Alberta has been suffering from lower oil prices, which has been reducing industrial demand. There was a stall in internal load growth in April, but that has reversed as of May, and is expected to continue growing, estimated at approximately 4.4% for the next 5 years: (click to enlarge) Source: Capital Power June Investor Meeting Temporarily High Supply With their newest power plant facility coming online, Capital Power influenced power prices with its incremental power production, though they largely hedged that production for this year. Due to the temporarily lower demand, the 1200MW of generation projects for 2015 are influencing the supply picture. However, there are legislated retirement dates for coal fired plants that will begin to ramp up over the coming years. This is detailed in the graphic produced by Capital Power: (click to enlarge) Source: Capital Power April Investor Meeting This gives a reprieve to the existing suppliers and will remove a supply overhang. The continual construction is in preparation for this eventual decrease in supply, and will result in temporary, and expected, pressures on prices. Valuation To complete this analysis I used data from YCharts and the company’s reported financials. There is a discrepancy between the reported Enterprise Value between the two. In the comparative analysis I utilized their reported values, whereas in the evaluation of Capital Power to its historical prices, I utilized YCharts (as we can assume they calculate it the same way each year). Relative to Competitors Capital Power is currently trading at an EV/EBITDA ratio of 9.98, 84% of its production locked into PPAs for 2016, and 50% of its production hedged at stronger rates and a MW growth rate of 20%. This compares to its competitors rather interestingly. Atlantic Power (NYSE: AT ), a “clean energy” producer (mostly natural gas, no coal) trades at 8.87, has 69% of 2016 production in PPAs, no active price hedging and MW growth of about 3%. Northland Power ( OTCPK:NPIFF ), a relatively clean energy producer (much heavier weight to renewables, no coal) trades at 15.83, has 100% of its production in PP’s, and a MW growth rate of an impressive 48%. Transalta (NYSE: TAC ), a relatively dirty producer (lots of renewable like Capital Power, but higher coal production of 56% versus Capital Power’s 47%) trades at 8.86, has 80% of production in PPAs in 2016, and a MW growth rate of 24%. We can presume that Capital Power should trade at some higher multiple than its low growth, highly leveraged competitor Atlantic Power, and the dirtier cousin Transalta, but is a 12% premium all that’s called for? With its better hedged production, strong growth profile and clean energy credits (allowing it to avoid negative FCF implications of NDP policy changes to 2020) there seems to be little reason to value Capital Power so closely to the listed competition. To see how much we should value Capital Power, we go to historical valuations. Relative to History Utilizing YCharts for the data, we get an average Enterprise Value (EV) of approximately 3773M (for 2015, it is 3085M, compared to a 4182M reported by Capital Power itself). We can then use the Funds from Operation (FFO) generated by the business over the last 5 years to arrive at an EV/FFO multiple of 9.76 that Capital Power historically trades at. Compare this to the existing EV/FFO multiple for 2015 of 7.36 and we arrive at a price target of approximately $29.12, or a return of 32.6%. With a 6% dividend policy, we arrive at a 38.8% total return to year end. Note we assume that increases in the EV will translate into a proportionate increase in share price, as all other values stay constant. To evaluate possible downside, we will use a close comparable. Transalta is the closest of the comparable competitors with similar growth rates, Alberta-heavy assets, large dividend policies, large proportion of “dirty” production and they generally trade in relation to each other. Utilizing the same method of valuing Transalta, we arrive at a five-year average EV/FFO of 11.39. Currently trading at 9.10, we can see that Capital Power trades at a discount to this 5-year relationship by approximately 5%. This brings us a worst-case 5% return as Capital Power approaches parity with this relationship with Transalta. With a 6% dividend we arrive at an 11% return by year end. Again, this is assuming only matching the very low price that Transalta trades at currently, while keeping the historical relationship intact. Risk & Mitigating Factors Hedges Drop Before Prices Recover – Strong hedges are protecting earnings, but they are temporary in nature. A continued downturn in Alberta will begin to affect FFO materially in 2017. To mitigate this risk, Capital Power does have hedges out to 2017 but they believe (and I agree) that prices should show improvement as we approach the end of 2016. A strong improvement in the underlying economy of Alberta is vital to improvement of energy prices. Oil Price Weakness – Collapse in oil prices will affect Capital Power more than most energy producers due to its reliance on the province of Alberta for the majority of its revenue. Alberta is handling the crises better than most expected, but continued low oil prices will put a damper on growth in the region. Capital Power has tremendous financial resources to continue to expand to additional markets, and the capital flexibility to weather low energy prices for some time while awaiting a recovery. NDP Royalty Review – Should the political party change the oil revenue policies to something closer to market, it may further shift investor sentiment against Alberta based companies. In the author’s opinion, it is an increase that is long overdue, but even a marginal change will have an outsized impact on market sentiment. I believe it is unlikely the review results in material changes at this time, due to the extreme circumstances related to oil price weakness, but there is always the risk. Potential Catalysts EPCOR’s Ownership Stake Reduction – As their stake reduces to zero, it will remove a significant overhang on the stock as it removes a major, continual seller/diluter of stock prices. The announcement of EPCOR’s stake reducing to zero should be a boon to the equity price. NDP Policy Shift – As the NDP continue to adapt to their new role they may reduce the pressure on oil and gas companies, allowing investors and executives time to adapt to their new leadership style. There is likely to be a significant decrease in announcements related to oil and gas as most of the policy changes influencing them are currently in progress. Less noise will go a long way in easing investor anxiety regarding this new political change. Market Begins to Put Changes in Perspective – As I have mentioned in the article, there is little reason to fret about the changes made to Alberta’s energy policy changes. They are relatively weak and will do little to influence business practices. Capital Power will only begin to feel the changes in 2020, once their carbon credit offsets finally do not cover the new policies. Oil Price Recovery – Recovery in oil prices are a boon to any Alberta-based stock, regardless of their activity in the oil sands. Capital Power sells a lot of energy to the industrials within the province, so any increase or stabilization of oil prices will help boost demand in the region, strengthening current power prices. Conclusion Trading at historically low multiples, with strong PPAs, well-timed hedges, and a well-covered 6.19% dividend yield, Capital Power is sitting at a very interesting entry point. As investor sentiment overreacts to the latest news and the temporary overhangs on the industry, Capital Power gives investors access to one of the best-regulated power jurisdictions in North America. Investor sentiment may temporarily wreak havoc on the price of Capital Power, it does not influence the underlying value of the company. With solid downside protection, strong potential upside and an impressive dividend, Mr. Market is granting investors a significant margin of safety in a conservative asset class. This may represent a solid opportunity to add exposure to the Alberta energy market at a significant savings for the high-yield portion of an investor’s portfolio. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CPX over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This stock trades with narrower spreads on the Toronto Stock Exchange (TSE) those considering purchase should consider this option, if available through your broker. The author is not a financial advisor, please conduct your own due diligence and consult a trusted financial advisor before making any financial decision.