Dividend Watch List

The US dollar has fallen more than 20 percent against the Canadian loonie in 2007. That’s created an economic shock for trusts doing business here and a trigger for dividend cuts.

Last month, otherwise strong trust Canfor Pulp Income Fund (CFX.UN) trimmed its distribution from 18 cents Canadian to 14 cents Canadian a share. The reason: A weak US dollar crimped margins on sales south of the border and heightened competition.

The good news is, unlike smaller rival SFK Pulp Fund (SFK.UN, SFKUF), Canfor has no serious operating problems at its mills. Rather, productivity improved in the third quarter and costs fell, offsetting an increase in raw material costs.

Rising pulp prices in the US are offsetting the falling US dollar to some degree. And provided the trust continues to operate its assets well, cash flows should improve in coming quarters.

Canfor shares are as cheap as they’ve been in some time, selling for 1.5 times book value and 30 percent off their high in Canadian dollars. There’s still potential for more erosion here if the US dollar continues to plunge. But for those willing to take on that risk, Canfor Pulp Income Fund looks like a bargain up to USD13.

In contrast, it looks like much rockier times lie ahead for multimedia products distributor Cinram International Income Fund (CRW.UN, CRWFF). The trust, which sells virtually all of its DVDs and compact discs outside Canada, was already struggling under the burden of rising competition, high costs and heavy debt. But the plunge in the US dollar has made all three challenges measurably worse.

This month, management elected to completely suspend its distribution, blaming US dollar weakness. The greater worry, however, is the trust’s crushing interest expense, which reached 79 percent of third quarter earnings before interest and taxes (EBIT). That’s more than double last year’s 36.7 percent and points to an unsustainable trend.

The trust has likely bought itself some time by suspending the distribution indefinitely. But there’s little attraction for holding this trust, which could easily slide into Chapter 11 if conditions worsen further. Sell Cinram International Income Fund.

Note that the weak US dollar will likely shave income for many trusts in the second half of 2007. But a handful of them are more vulnerable than others. Two are seafood trusts Clearwater Seafoods Income Fund (CLR.UN, CWFOF) and Connors Brothers Income Fund (CBF.UN, CBICF).

The latter appears to be putting its potential botulism liability behind it. But with US dollar receivables off sharply on the exchange rate change, it’s hard to see how the trust can avoid another dividend cut. Steer clear of both Clearwater Seafoods Income Fund and Connors Brothers Income Fund.

Investors should also be increasingly cautious again about Sun Gro Horticulture Income Fund (GRO.UN, SGHRF), which is back on the Watch List after a brief escape. Management has done a solid job of using the strength of the Canadian dollar to build a growing business in the US. The problem is the falling greenback is crimping near-term cash flow, pushing the third quarter payout ratio to 118 percent.

The trust is hedging its exposure aggressively and has contracts in place for 70 percent of its US dollar receivables through 2008. That should allow enough time for the currency to at least stabilize. And the trust’s basic business remains very healthy. But Sun Gro Horticulture Income Fund is a hold for the more aggressive only.

Ironically, the biggest distribution cut last month had more to do with management miscues than the falling US dollar. Priszm Income Fund (QSR.UN, PSZMF) announced it would reduce its monthly payout to just 3 cents Canadian a share for the remainder of 2007, down from a prior level of 10.67 cents Canadian. The trust intends to restore a 10-cent-Canadian distribution beginning in 2008, if certain business projections are met.

The fast-food franchise trust is still feeling the aftershocks from a disastrous marketing campaign earlier this year emphasizing limiting trans fats. Third quarter sales fell 4 percent from year-earlier levels, while same store growth (from restaurants owned more than one year) fell even further at 4.7 percent.

The trust’s cost of sales rose to 59.9 percent of revenue from 58.7 percent. That, coupled with the impact of the US dollar’s decline on US sales, clipped cash flow and triggered the distribution cut, along with a CAD5 million restructuring charge.

The good news is, with these reductions, the trust should be back on solid footing early next year and the 10-cent-Canadian monthly distribution should be secure. And trading at just 84 percent of book value and 21 percent of annual sales—after roughly falling by half since April—it’s extremely cheap for a trust not in any danger of Chapter 11. Accordingly, Priszm Income Fund is now a buy for aggressive investors up to USD6.50.

In contrast to recent months, there was only one announced distribution cut in the energy patch last month. As noted in the Oct. 26 Flash Alert, Fairborne Energy Trust (FEL.UN, FELNF) plans to convert to a corporation as part of an elaborate transaction involving Denham Commodity Partners Fund IV LP.

If this deal is approved by unitholders at a meeting anticipated for mid-December, Fairborne will eliminate its distribution after the Dec. 17 payment. It will then effectively become a nondividend-paying junior producer.

Unitholders’ interest will be diluted by a little more than 25 percent from the issuance of 13.4 million shares to Denham. In return, management will have roughly CAD100 million in proceeds, which it plans to invest completely into developing its reserve inventory.

Fairborne has couched this move as a way to grow its business and has blamed the 2011 trust taxation plan as effectively giving it no choice. In my view, that’s only half the story at best.

Rather, the trust has been increasingly squeezed by the combination of weak gas prices (75 percent of output is gas), a relatively low proved reserve life of just 6.4 years and rising costs as a small trust. That’s a nearly impossible situation in which to go it alone for long.

The real question is, of course, whether converting to a corporation three years before the taxation picture changes is really in the unitholders’ interest or if it’s just a job guarantee for management—which essentially gets the cash to stay with its business plan. Either way, I don’t think this is a situation we want to be involved with.

But confirmed unitholders may want to kill this deal, as owners of True Energy Trust (TUI.UN, TUIJF) did to a similar management-inspired deal. A prospective merger with a more powerful trust would be an infinitely better alternative, at least for income investors.

Below is the rest of the Watch List. I’ve added Harvest Energy Trust (HTE.UN, NYSE: HTE) back to the list. The trust’s energy production business is thriving amid high oil prices.

But its refining business was already headed for trouble, with sector margins collapsing before it elected to perform maintenance on its facility. Hold Harvest Energy Trust.

Note I’ve also added two Aggressive Portfolio picks to the Watch List for slightly different reasons. Advantage Energy Income Fund (AVN.UN, NYSE: AAV) remains a strong buy but only for those willing to tolerate potential volatility if further weakness in gas prices triggers a distribution cut.

TimberWest Forest Corp (TWF.UN, TWTUF), meanwhile, has superb assets in both timber and real estate. But it’s being hit now by a combination of a production interruptions and weak timber prices. I’m moving TimberWest Forest Corp to the Aggressive Portfolio as a hold.

Advantage Energy Income Fund (AVN.UN, NYSE: AAV)
Chartwell Seniors Housing (CSH.UN, CWSRF)
Clearwater Seafoods Income Fund (CLR.UN, CWFOF)
Connors Brothers Income Fund (CBF.UN, CBICF)
Daylight Resources Trust (DAY.UN, DAYFF)
Enterra Energy Trust (ENT.UN, NYSE: ENT)
Essential Energy Services Trust (ESN.UN, EEYUF)
Fording Canadian Coal (FDG.UN, NYSE: FDG)
Freehold Royalty Trust (FRU.UN, FRHLF)
Harvest Energy Trust (HTE.UN, NYSE: HTE)
Newalta Income Fund (NAL.UN, NALUF)
Newport Partners Income Fund (NPF.UN, NWPIF)
Noranda Income Fund (NIF.UN, NNDIF)
Paramount Energy Trust (PMT.UN, PMGYF)
Peak Energy Services Trust (PES.UN, PKGFF)
Precision Drilling (PD.UN, NYSE: PDS)
Primary Energy Recycling (PRI.UN, PYGYF)
Priszm Income Fund (QSR.UN, PSZMF)
Sun Gro Horticulture Income Fund (GRO.UN, SGHRF)
Swiss Water Decaf Coffee Income Fund (SWS.UN, SWSSF)
TimberWest Forest Corp (TWF.UN, TWTUF)
Trilogy Energy (TET.UN, TETFF)
True Energy Trust (TUI.UN, TUIJF)
Wellco Energy Services Trust (WLL.UN, WLLUF)
Westshore Terminals Income Fund (WTE.UN, WTSHF)

Buy the Business

Buy the business, never the tax dodge: That’s a critical distinction, whether you’re talking about Canadian income trusts, stapled shares that combine debt and equity into a single security, or limited partnerships (LP).

Stapled share and former CE Portfolio recommendation Primary Energy Recycling (PRI.UN, PYGYF), for example, has yet to restore its distribution, which it suspended in the wake of operating problems at several of its facilities. Debt coverage concerns triggered a cut in Primary’s Dominion Bond Rating Service stability rating last month to STA-4 (middle), and it remains on negative review.

With the timing of a resumption of the dividend still in doubt, there’s no reason to stick with Primary. Sell Primary Energy Recycling.

Note I’m initiating coverage of three more stapled shares in the How They Rate Table this issue: Keystone North America Trust (KNA.UN, KYSNF), Medical Facilities Corp (DR.UN, MFCIF) and New Flier Industries (NFI.UN, NFYIF). All three are holds pending full review.

Note that crematory specialist Keystone posted a 125 percent third quarter payout ratio, indicating some distribution risk. We’ll get a better idea of the other two as earnings are released in coming weeks.

In the past, I’ve devoted only light coverage to Canadian LPs for two reasons. First, they can be very difficult to buy. In fact, most Canadian LPs operate under charters that restrict, if not forbid, foreign ownership. You can sometimes find a broker who will buy for you on the US over-the-counter (OTC) market, but many refuse to do so.

Second, Canadian LPs have no real yield advantage over income trusts. And they’re also subject to the same 2011 corporate taxation law as trusts. Exposure to taxation was the key reason Translata Power LP (TPW.UN) accepted a CAD629 million cash takeover offer from Cheung King Infrastructure Holdings of Hong Kong last month.

Virtually all the three dozen-plus income trusts taken over since Halloween 2006 have commanded a strong premium to their pre-deal price. So did the Transalta: CAD8.38 per share in cash versus a recent trading range of around CAD7 per share.

But given the problems for American investors buying and selling Canadian LPs, it makes a lot more sense to look at power trusts instead as takeover bets. The Conservative Portfolio lists several, as does the How They Rate Table.

The Word on Royalties

Alberta Premier Ed Stelmach has spoken, and it’s official: Royalty levies are going up for most producers of oil and natural gas in Alberta.

The government’s response to the commissioned report released last month was only 19 pages, a fraction of the size of the report itself. The boost in royalty rates fell well short of what the panel had initially proposed and proponents wanted. And the boost was somewhat more than what the industry would have preferred as well.

Here are the essential details in brief.

First of all, as is the case now, mature reserves or those with lower well productivity rates are assessed at a far lower rate than rich reserves. This has been considered essential to assure mature fields continue to have the economics to be developed. Mr. Stelmach’s ruling actually reduces royalty rates on mature fields, even as it raises rates on richer wells.

Natural gas royalties will range from a low rate of 5 percent to a top rate of 50 percent, up from a current high level of 35 percent. The rate will be capped when gas prices hit CAD16.59 per gigajoule. Rates won’t begin rising until gas hits CAD7 per gigajoule, rather than the CAD6 per gigajoule recommended by the panel.

The government projects additional revenue of CAD470 million for the province in 2010 versus CAD740 million recommended in the panel’s report. However, royalties will only increase if natural gas prices rise considerably from here–in other words, if there’s a recovery in the gas patch. Put another way, until there’s a recovery, there won’t be any additional burden on gas producers.

The top royalty rate on conventional oil will also rise from 35 percent to 50 percent, though with oil at close to $90 a barrel, producers are likely to see higher rates sooner. As for oil sands development, the 1 percent royalty assessed until projects are paid out will rise to more than 4 percent and could hit 9 percent if oil reaches $120 a barrel. Meanwhile, the 25 percent royalty rate for projects that are already paid out will rise to a cap of 40 percent, again if oil reaches $120 a barrel.

In all, only 13 of the panel’s 26 recommendations were taken. Among the more important rulings, there will be no new tax on oil sands production. Finally, the changes will be delayed 14 months–until 2009–rather than beginning next summer as the panel had recommended.

Bay Street Beat

Cineplex Galaxy Income Fund (CGX.UN, CPXGF), a new addition to How They Rate coverage, is the one income trust to earn a perfect 5.00 average rating in the Oct. 31 Bloomberg compilation of Bay Street analyst ratings.

The units closed at a 52-week high on All Hallows Eve. We’ve tracked its 2007 run, touting its strong summer-blockbuster-season-driven second quarter results and the big-box-office prospects dotting the fall and holiday release season calendars.

Theater operators depend heavily on the monetary value of cinematic art; Hollywood seems to be in a strong formula phase, but early signs this fall are that the good times won’t roll as smoothly. Box office has been slow, a string of critically acclaimed dramas seeming to suck the air out of the summer party balloon.

Cineplex Entertainment LP, the largest movie exhibitor in Canada, owns, leases or has a joint-venture interest in 129 theaters with 1,297 screens serving approximately 60 million moviegoers a year. Its brands include Cineplex Odeon, Galaxy, Famous Players (including Coliseum, Colossus and SilverCity) and Scotiabank Theatres. Cineplex Galaxy Income Fund owns approximately 75.7 percent of Cineplex Entertainment LP.

As long as the creative types continue to satisfy the demands of the money types, enough seats will be filled and plenty of soda, popcorn and candy will be consumed.

Calloway REIT (CWT.UN, CWYUF) drew a 4.778 average rating. The REIT plans to sell eight to 12 shopping centers, which could be worth CAD150 million to CAD170 and generate about CAD100 million in cash to fund further development. Calloway currently has about 6.8 million square feet of development in the pipeline.

Energy Savings Income Fund (SIF.UN, ESIUF) matched Calloway REIT’s average rating, while Crescent Point Energy Trust (CPG.UN, CPGCF), Trinidad Energy Services Income Trust (TDG.UN, TDGNF), BFI Canada Income Fund (BFC.UN, BFICF), H&R REIT (HR.UN, HRREF), Provident Energy Trust (PVE.UN, NYSE: PVX) and Primaris REIT (PMZ.UN, PMZFF) also cracked the top echelon.

Advantage Energy Income Fund (AVN.UN, NYSE: AAV) was the second-lowest rated company in Bloomberg’s regular survey, drawing a 1.571 average.

Weak gas prices continue to weigh on the fund’s performance, and the integration of the Sound Energy Trust also presents challenges. But Advantage is yielding more than 15 percent, and the New Yrok Stock Exchange-traded units are up about 17 percent in 2007. That rise has a lot to do with the Canadian dollar’s run, so the upside story here is more about a currency bet than anything else.

Advantage sits on considerable tax pools, which would allow it to shelter cash well beyond 2011. It’s still vulnerable to natural gas prices, and another distribution cut is possible. But it’s a solid long-term play on a rebound in that market.

Fellow Conservative Portfolio recommendation Algonquin Power Income Fund (APF.UN, AGQNF) earned a 2.667 average rating. Algonquin reported that its profit more than doubled in the third quarter on net earnings of CAD12.2 million (17 cents Canadian per unit), compared to CAD5 million (7 cents Canadian per unit) a year ago. Revenue for the quarter ended Sept. 30 was CAD46.5 million, down from CAD49.4 million on lower production in the cogeneration division combined with lower reported revenue from its US facilities thanks to the stronger loonie.

Connors Brothers Income Fund, Fording Canadian Coal (FDG.UN, NYSE: FDG), Pengrowth Energy Trust (PGX.UN, NYSE: PGH), PrimeWest Energy Trust (PWI.UN, NYSE: PWI), Westshore Terminals Income Fund (WTE.UN, WTSHF), Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF), Harvest Energy Trust and Superior Plus Income Fund (SPF.UN, SPIJF) also fell on the low end of average ratings.