Value Library

The following is an excerpt from the ABC Perspective - July 2009 - Pg. 4-5

ABC Fund Value Favourites

COGECO INC. AND COGECO CABLE INC.

During recessions, people generally look for small comforts and little “pick-me-ups” as we cut back on more expensive luxuries. Cable TV, internet access and services such as video-on-demand are now substitutes for an expensive night out. In the current environment, we think that cable and internet providers offer a nice mix of defensiveness and growth. In the sector we like Cogeco Incorporated (TSX: CGO) and Cogeco Cable Incorporated (TSX: CCA).

To clarify, we had to purchase both CGO and the more liquid CCA to get full positions for our funds. Cogeco, the parent company, is a diversified communications company that holds cable distribution and radio broadcasting assets. Cogeco’s publicly-traded cable subsidiary, Cogeco Cable, offers analogue and digital cable, high speed internet and telephony services to residential and commercial customers. It is the second largest cable telecommunications company in Ontario, Quebec and Portugal with approximately 2.7 million revenue-generating units from over 2.4 million homes that are passed by its network.

We view the parent entity, Cogeco, as a net asset value play that trades at a discount to its sum of the parts. Cogeco holds approximately 15.7 million shares of Cogeco Cable, or 32% of the outstanding shares, in addition to some radio assets. The radio division includes the Rythme FM Network, which has four stations throughout the province of Quebec and Station 93 in Quebec City. Using the current price of Cogeco Cable, we believe that Cogeco trades at a 20% discount to its net asset value. Historically, the discount has ranged from approximately 20% to only 5% so we could see some upside in CGO should this discount narrow.

Further, we think that Cogeco Cable is itself a cheap stock. Management recently updated financial guidance for fiscal 2009 and forecasted $500 million in operating income and $80 million of free cash flow for the cable division. Today, Cogeco Cable trades at a discount to Rogers Communications (EV/EBITDA of 5.5x compared to 6.4x trailing and 5.7x compared to 6.5x forward) despite a higher consensus EBITDA growth rate (12.5% compared to 5.1% in 2009). Narrowing the valuation discount relative to Rogers should be a two pronged-approach for management.

First, there is plenty of room for Cogeco Cable to improve its penetration rates relative to its peers. Penetration rates are used to measure and compare the number of subscribers relative to homes passed by the Company’s installed network. Currently, Cogeco Cable lags Rogers Communications in several key categories: basic video at 56% compared to 65%, digital video at 31% compared to 44% and internet at 32% compared to 45%, respectively. Increased penetration will come over time, as marketing initiatives and service bundling gain traction.

Second, the resolution of Cogeco Cable’s difficulties with its Portuguese cable operations, known as Cabovisao, could be a major catalyst for trading-multiple expansion. Cogeco Cable originally bought Cabovisao in 2006 for approximately EUR465.7 million or roughly $660 million. Although lower cable and internet penetration rates in Portugal originally presented a growth opportunity, competition from the two largest incumbents has intensified. In the first half of fiscal 2009 the segment lost almost 35,000 revenue generating units. In response, management wrote down their investment in Cabovisao by $399.6 million. Tellingly, although Portugal accounted for only 14% of Cogeco Cable’s EBITDA in the second quarter of fiscal 2009, an inordinate number of questions on the quarterly conference call had to do with Cabovisao. We believe that turning around these operations or even selling them entirely would provide a lift to CCA.

In summary, we bought Cogeco Inc. because it trades at a historically large discount to its sum of the parts. The largest component of Cogeco’s net asset value is its holding of Cogeco Cable, which is itself a cheap stock. We think that upside to the story comes from narrowing the penetration rates relative to Rogers and either turning around or selling Cabovisao. One other potential catalyst exists, but whether this ultimate scenario actually plays out is unknown. Rogers actually owns approximately 23% of Cogeco and 20% of Cogeco Cable. Perhaps one day Roger’s management will pull the trigger and buy the balance of Cogeco and Cogeco Cable that they don’t already own. In any event, we believe that both Cogeco Inc. and Cogeco Cable are relatively undervalued and that, over time, investors will be rewarded.

EQUITABLE GROUP INC.

Equitable Group, (TSX: ETC), through its wholly owned subsidiary Equitable Trust, is a federally incorporated trust company that specializes in first mortgage financing. The Company serves single-family, small to large commercial borrowers and mortgage brokers primarily in Ontario and Alberta. Importantly, total assets of $3.9 billion and mortgage assets of $2.8 billion are funded by issuing guaranteed investment certificates as opposed to asset-backed commercial paper.

The financial services industry has been in turmoil since the middle of 2007. A collapse in certain segments of the US housing market resulted in a breakdown in the asset-backed commercial paper market. In a vicious cycle, credit markets tightened, assets declined in value and lenders were forced to raise dilutive capital during a crisis of confidence. Central banks responded by injecting liquidity and lowering interest rates. The failure of several financial institutions struck fear in investors. However, it is clear that Equitable Group avoided the three major pitfalls of the current crisis: excessive leverage, unsound lending practices and asset-backed commercial paper as a source of funding.

We purchased our position in this relatively thin stock by participating in a bought deal at $21.50 on June 25, 2008. The Company was looking to raise some equity capital in order to meet its 2008 growth objectives while maintaining a conservative total capital to assets ratio. With the stock priced at 8.7 times 2007 earnings, 1.3 times book value and yielding 1.86% we felt Equitable was excellent value.

Unfortunately, the markets continued to deteriorate dramatically. The shares fell from the secondary issue price of $21.50 to a low of $11.05 on November 3, a decline of almost 50%. Thankfully, the shares rebounded to $13.75, or almost 25%, by the end of the week. But nervous investors, fearing that Canadian home prices would decline in a similar fashion as American home prices again punished the stock. The stock declined to reach a low of $8.66 in early December 2008. Management’s tone was quite cautious throughout the slide. However, economic data began showing signs of stabilization and the shares started to recover.

We believed that the upward momentum could continue given the solid fiscal 2008 and first quarter 2009 results. Net income for fiscal 2008 increased 23.9% to $38.6 million or $2.78 per fully diluted share. Return on equity was 16.6%, in line with Company objectives. In the first quarter of 2009, net income increased 23.3% to $11.9 million or $0.80 per fully diluted share compared to $9.7 million or $0.74 per fully diluted share a year ago. Return on equity was an impressive 17.8% in the quarter and book value increased from $17.75 per share at year end to $18.90 per share. Management’s tone was noticeably better on the quarterly conference call and the shares responded positively.

Looking forward, the net interest margin, and therefore profitability, should expand in the coming quarters for two key reasons. First, the single-family mortgage division is the fastest growing segment of all the Company’s business lines. Remember that single-family mortgages are more profitable than commercial mortgages yet require only a third of the capital. Second, the prime rate is expected to stabilize and the mortgage spread over prime should increase due to more normalized credit pricing. GIC’s will roll over at lower rates, new and renewing mortgages should be priced more favourably and interest rate floors were implemented on variable rate mortgages.

Finally, we need to examine the credit quality of the Company’s mortgage book. Net impaired mortgages were 0.94% of total mortgage assets at the end of the first quarter of 2009 compared to 1.21% at the end of the fourth quarter of 2008. The improvement stemmed from successfully dealing with one problem borrower in Western Canada. Management took over several key properties that were subsequently sold for losses of approximately $2.5 million, though the majority of the loan was recovered. As they stated in the press release, “the level of defaults and losses that the Company has experienced in the last few quarters has been manageable and reflect management’s focus on protecting its portfolio”.

We believe that the solid financial results should give investors greater confidence. In fact, Bay Street analysts were quick to upgrade their earnings estimates and price targets for the stock. Annualizing the first quarter results, the shares are trading at only five times expected earnings. We need to monitor the credit quality carefully, but it is safe to say that the Canadian home-owner is typically much more conservative than his or her American counterpart. We therefore don’t expect to be surprised by a spike in defaults or loss losses. As investors look past the worst case scenario and management continues to under-promise and over-deliver, the P/E multiple should continue to expand.

Irwin A. Michael, CFA