Approach AGF’s Juicy Yield with Caution

04/18/2012 12:00 pm EST

Focus: INCOME

John Heinzl

Reporter and Columnist, GlobeInvestor.com

The Canadian income stock has fallen amid underperforming funds and a switch by many investors from equity to less volatile vehicles, writes John Heinzl, reporter and columnist for Globe Investor.

On the surface, mutual-fund giant AGF Management (Toronto: AGF.B) would seem to be a dividend lover's dream.

The stock sports a fat 7.6% yield. The company raises its dividend every year or two. And the price-to-earnings multiple is a seemingly cheap 12 based on 2012 analyst estimates—a steep discount to its peers.

What's not to like? Let's dig a little deeper.

Why is the yield so high?
When a yield climbs north of 7%, it's often a signal that all is not well with a company. And with AGF, all is definitely not well.

At its peak five years ago, the stock traded for close to $40. It has since plunged about 65%, closing Tuesday at $14.20. So, although the dividend has been rising, the stock's downward spiral is the main reason the yield is now one of the highest on the S&P/TSX composite index.

Why is the stock getting clobbered?
AGF is facing multiple challenges in its mutual-fund business.

For one thing, it has a relatively high proportion of equity mutual funds. That's a problem, because risk-averse investors, burned by the credit crisis, have been gravitating to less volatile fixed-income and balanced funds.

What's more, many of AGF's mutual funds have underperformed, which has contributed to net redemptions by unitholders for the past several years. The growing popularity of low-cost exchange traded funds can't be helping AGF's cause, either.

Unitholders Fleeing
In the first quarter ended February 29—which includes the crucial registered retirement savings plan season—net redemptions (fund outflows minus inflows) rose to $680 million from $402 million a year earlier. Earnings per share fell 15.6%.

CIBC World Markets analyst Paul Holden said AGF lost 9% of its mutual-fund assets under management (AUM) to net redemptions in the past year. "It is very difficult to grow or even maintain earnings at this pace [of redemptions]—the treadmill is running too fast," he said in a note.

AGF's institutional business, which manages money for pension funds and other large clients, has been doing better. But the retail side has higher margins, which is why the tide of redemptions is worrisome to analysts, most of whom have a "hold" on the stock.

Managers Leaving, Too
The latest blow for AGF was the loss of star portfolio manager Patricia Perez-Coutts, whose $1.9 billion AGF Emerging Markets Fund was among the company's top performers, and accounted for more than 8% of its retail AUM. The departure of Perez-Coutts and four members of her team threatens to exacerbate AGF's redemption woes, analysts say.

"While AGF has a large international investment team with broad bench strength, we expect the announcement could result in an increase in outflows for AGF in the near term," Scotia Capital analyst Phil Hardie said in a note.

Dividend Probably Safe
Despite the company's challenges, analysts believe the 27-cent quarterly dividend is safe for now. The payout ratio is a conservative 65% of estimated free cash flow for 2012.

The company also has the option of tapping AGF Trust to support dividends or share buybacks. In the first quarter, AGF Trust—which makes mortgage and investment loans, and has a strong capital position—paid a $20 million dividend to AGF.

The Endgame
But investors who focus on the dividend alone may be asking for trouble. If AGF can't reverse the trend of redemptions, or if equity markets don't pick up, the stock could continue its descent, Canaccord Genuity analyst Scott Chan said in an interview.

Ultimately, if the company can't turn itself around, it could be taken over by a bank or other buyer, he said. As one of the few remaining independent asset managers in Canada, AGF and its $47 billion in total AUM would make an attractive takeover target, he said.

But that is probably three years away at least, Chan said.

AGF has been approached over the years, but controlling shareholder and chief executive officer Blake Goldring, 53, has been in no hurry to sell. And judging by his comments during the first-quarter conference call, that hasn't changed.

AGF has some "innovative and exciting new products that are on the shelf," he said. What's more, it has the strong free cash flow and healthy balance sheet "to take advantage of strategic opportunities as they arise."

As for the fund redemptions, Goldring put on a brave face. "I truly believe that there will be a return at the retail level to equity markets and that this will help improve investor confidence. We believe we are well positioned to grow and take advantage when this occurs," he said.

Judging by the meltdown in AGF's stock price, however, investors are running out of patience.

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