High Yield of the Month
ARC Energy Trust (AET.UN, AETUF) and Yellow Pages Income Fund (YLO.UN, YLWPF) are two charter members of the Canadian Edge Portfolio that continue to prove themselves. And as long as they do, I intend to keep recommending them.
Of the pair, Yellow Pages is the more secure. As an energy producer trust, ARC’s cash flows depend heavily on the price of oil and natural gas. Management can make all the right moves regarding production, financing, hedging output, cost controls and acquiring and developing new reserves. But if energy prices move against them too quickly, its shareholders will feel some pain.
Even Yellow can be affected by the ups and downs of the economy. But in contrast to energy production, the basic business it’s in is very steady. In fact, it’s quite utility-like: It publishes and distributes print telephone directories.
The trust first went public in 2002, following an initial public offering/spinoff by a private-capital consortium, which had purchased the directory assets of phone giant BCE. Since then, it’s steadily acquired the directory businesses owned by Canada’s former phone monopolies to build a coast-to-coast empire.
The trust’s latest move was to acquire the directory business operated by Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) in a deal that was completed in late April. The buyout gave Yellow sole control of these territories, which it had operated as managing partner for a decade. And the territories’ rural, Atlantic Canada geography gives the trust a true nationwide footprint, with only an operation run by the Nunavit outside its control.
With no print directory rivals in Canada, Yellow is now turning its full attention on its other key strategic goal: migrating its business to the Internet. That move is being driven partly by necessity.
Just as North Americans are slowly swapping copper phone connections for higher-speed Internet and wireless ones, so are we gradually moving to the Internet to navigate communications. The beauty here is Yellow continues to enjoy strong, steady cash flow from its print directory business, even as it’s realizing rapid growth from moving to the Internet.
Advertising is the driver of both operations. Advertising has always been the raison d’etre for print directories. And while some have postulated the business is in decline, the numbers say otherwise. Yellow’s second quarter directories adjusted revenue (excluding acquisitions) rose 5.1 percent, while cash flow surged 6.6 percent as margins reached a lofty 58.8 percent.
Part of those strong results is because of last year’s acquisition of Trader Corp, which added a wide array of specialty print advertising publications to Yellow’s mix. The trust has also introduced more specialized directories throughout its territory, including lighter, more-portable versions of its standard model.
Print growth numbers pale, of course, in relation to the trust’s Internet-based growth. From basically nil a couple years ago, Yellow’s network of sites drew nearly 10 million visitors in the month of April, and growth has continued to accelerate. The network is currently the seventh most-visited site by Canadians and reaches an estimated 43 percent of the country’s Internet users.
More important, that rapid growth of penetration is already adding to the bottom line in a big way. Online revenue rose 43 percent in the first half of 2007 and is expected to sustain at least a 30 percent rate of growth through 2008. Important, Yellow seems to be leading its traditional print pages customers to the Internet, which should ensure directory advertising dominance for some time to come. And it’s succeeding both in bundled products—such as its Directory Plus offer—as well as stand-alone online services.
It all adds up to a formidable combination of robust, reliable growth and very strong finances. Adjusted for the past year’s acquisitions, second quarter sales and cash flow surged 21.3 percent and 19.2 percent, respectively. Distributable cash flow per share rose 10 percent, despite a 5 percent jump in outstanding shares to finance growth. And that rate is expected to continue into the foreseeable future.
As for the balance sheet, the Dominion Bond Rating Service continues to rate Yellow the same as it has since it first became a CE Portfolio holding: STA-1 (low), the highest of any trust. And Yellow’s fixed income offerings also get high marks in the BBB category.
With all of its operations in Canada, Yellow stands to be fully taxed as a corporation beginning in 2011 under current law. Future liability will be at least partly mitigated by hefty noncash expenses generated from the chief legacy asset, i.e., the print directory business. But Yellow’s management has also promised something no other trust has: to literally outgrow its future tax burden to maintain its current distribution.
Whether it succeeds depends on keeping its current business growth going. In my view, that’s something definitely worth betting on. Buy Yellow Pages Income Fund up to USD15.
As I said above, ARC Energy’s basic business is far less stable than Yellow’s. However, it’s one of the most secure in the oil and gas production business. Its 68 months without a distribution cut is the longest streak in the sector. And with a balanced mix of long-life, low-cost oil, natural gas and gas liquids production—backed by a powerful balance sheet—it figures to add to that record for some time to come.
“Sustainability” is a word that’s often repeated in conversations with ARC management. And, in fact, virtually every move it makes can be interpreted as designed to further that goal.
Like all trusts, ARC has been hedging a generous portion of its future output, locking in selling prices with a combination of forward contracts, futures and other instruments. The trust, however, also has a built-in natural hedge, namely natural gas liquids (NGLS) sales. Natural gas is the primary feedstock for gas liquids, which can be sold for oil-like prices. With oil high and natural gas low, that’s translated into huge margins on NGLs, offsetting lower margins on gas.
ARC’s current strategy seems to be to hold production and reserves steady by continuing to develop its lands, rather than make acquisitions. As a result, it’s been able to cover both capital spending and distributions with internally generated cash flow, plus the proceeds from its successful dividend reinvestment plan. That, in turn, has held down the trust’s need to access capital markets, except on its own terms.
Like all oil producing trusts, ARC’s revenue from oil sales is being negatively impacted by the sharp decline in the US dollar because oil is priced in greenbacks. Here, too, however, management has put a natural hedge in place by holding a major portion of its subsidiaries’ debt in US dollars. The declining buck reduces the Canadian dollar value of the interest paid.
As of the end of the second quarter, the trust had CD380 million in US dollar debt, or 58 percent of its total net obligations. That was CD40.5 million less than at the beginning of the year, solely because of the appreciation of the Canadian dollar. And third quarter numbers will show a similar cut in debt when they’re released in the coming weeks.
At last count, ARC had an inventory of ongoing internal development projects that alone are projected to sustain production at current levels in the next two years. In the oil and gas sector, that’s an eternity for management to make another major move to ensure long-run sustainability, such as a merger with a like-minded trust or another big acquisition. And although there’s no guarantee it will do the right thing, the management’s track record is hard to bet against.
A recovery in natural gas prices would, of course, be a major upside catalyst for ARC cash flows and shares. And although management isn’t saying, it’s likely a big cash flow increase would lead to a substantial dividend boost, as the trust attempted to maximize its tax pools for 2011.
A potential takeover is another possibility, though ARC’s price-to-book value of 2.21 is above that of other trusts, as is its market capitalization of about CD4.56 billion. And as is the case with all trusts, ARC shares would realize a windfall if there’s any change to the law imposing corporate taxes in 2011, though it should pick up some ground as its ability to dodge the full 31.5 percent rate becomes clear.
On the negative side, the Alberta provincial government is studying raising royalty rates on oil and gas production, per the recommendations of a report it had commissioned. And, although Prime Minister Harper remains opposed to the Kyoto Protocol on global warming, there’s also the possibility of a carbon tax on oil and gas producers.
We won’t know the details of future Alberta royalties until mid-month at the earliest. On the other hand, however, one of the report’s recommendations was for a lower royalty rate on mature reserves, the bread and butter of most oil and gas producer trusts including ARC. Moreover, the bulk of recommendations for higher royalties fall on the oil sands, in which ARC hasn’t yet elected to play a role.
Uncertainty about a prospective carbon tax is likely to hang around for a while to come. But as long as energy markets remain tight, any tax will be borne by the consumer in the form of higher prices.
ARC shares have recovered from their lows earlier this year. But they’re still yielding more than 11 percent and are well off their old highs in the upper 20s. More than anything else, how they fare will depend on oil and gas prices. But the trust’s unerring focus on sustainability nonetheless makes them suitable for more conservative investors as well. Buy ARC Energy Trust up to USD23.
Note that the Canadian government withholds 15 percent of distributions paid by both ARC and Yellow Pages before they cross the border. That’s standard practice for most foreign governments; in fact, Canada’s rate is lower than most. And it can be recovered by filing a Form 1115 with your US taxes. Distributions of both trusts are considered “qualified dividends” in the US, taxable at a maximum rate of 15 percent.
For more information on both trusts, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner MPL Communications for press releases, charts and other data. Note these are huge companies, so any broker should be able to buy them, either with their Toronto or over-the-counter (OTC) symbols. Ask which way is cheapest.
| ARC Energy Trust & Yellow Pages Income Fund | ||
| Toronto Symbol | AET.UN | YLO.UN |
| US Symbol |
AETUF
|
YLWPF
|
| Recent USD Price* |
21.10
|
13.75
|
| Yield |
11.4%
|
8.0%
|
| Price/Book Value |
2.21
|
1.25
|
| Market Capitalization (bil) |
CD4.394
|
CD7.074
|
| DBRS Stability Rating |
STA-5 (high)
|
STA-1 (low)
|
| Canadian Edge Rating |
4
|
1
|