The Highest Yield
In my view, it’s still critical to always look at Canadian income trusts first based on their businesses. High monthly dividends are nice but only if they can be sustained. If a sweet yield is cut, it’s not only your income stream that sours; you can lose a significant chunk of your principal as well.
All the biggest losers thus far in 2007 are trusts that at one time offered sky-high yields and were decimated by dividend cuts. Enterra Energy Trust (ENT.UN, NYSE: ENT), for example, suspended its distribution entirely after a series of cuts, en route to losing 69 percent this year. Outside of oil and gas, Primary Energy Recycling’s (PRI.UN, PYGYF) suspension of its distribution lopped more than a quarter off its share price.
Not all dividend cutters have lost ground. Fording Canadian Coal (FDG.UN, NYSE: FDG) has more than doubled off its lows, despite cutting its distribution virtually every quarter during the past year. But it’s more the exception that proves the rule as investors bid it up on the future value of its metallurgical coal reserves.
There are times, however, where shopping for a huge yield is a distinctly lower risk proposition than usual. That’s the case in late 2007 for one major reason: Trusts have just endured a massive stress test. The survivors have passed this test, including several with very high yields.
Not every high-yielding trust now rates a buy. Small natural gas producer trust True Energy Trust (TUI.UN, TUIJF), for example, currently yields more than 20 percent. But it’s almost certain to have to reduce its distribution again with gas prices stalling.
Energy services trusts such as Peak Energy Services Trust (PES.UN, PKGFF) aren’t earning their distributions in what’s now the weakest drilling market in a generation in Canada. And some nonenergy business trusts, such as Cinram International Income Fund (CRW.UN, CRWFF), are also imploding.
But with nearly half the trusts in the CE coverage universe yielding double digits, we can afford to be very choosey. Below I highlight 10 of the trust universe’s “highest yields” worth buying. I’m adding one from this group, TransForce Income Fund (TIF.UN, TIFUF), to the Aggressive Portfolio. It’s discussed in detail in High Yield of the Month.
Stress Test
Access to capital is the lifeblood of companies. If they can’t raise money on the equity and bond markets, companies are forced to fall back on their own resources and to rely on bank loans to meet liquidity needs. Growth is next to impossible, and only a very solid business will be able to survive, let alone grow.
For roughly a year, Canadian income trusts have suffered a more severe stress test than US corporations have in nearly a century. It began with the Conservative Party government’s Halloween announcement that trusts would be taxed as corporations beginning in 2011.
That announcement triggered an immediate 20 percent haircut in trust prices, immediately increasing their cost of capital by 20 percent. Moreover, as a part of that ruling, the creation of new trusts was suspended, and existing trusts were placed under strict limits for how many new shares they could issue.
Specifically, the ruling forbade trusts from increasing their total share counts by more than 100 percent before 2011. Share issues were limited to 40 percent of the base in 2007, followed by a limit of 20 percent for 2008, 2009 and 2010. Mergers between trusts were exempted from the ruling.
Before the Halloween ruling, there were basically no limits on the number of shares a trust could issue. Management took full advantage; some trusts routinely doubled and tripled their share counts each year. Activity accelerated further after the Liberal government pulled its 2005 plan to tax trusts, reaching a crescendo by mid-2006 with BCE, Telus and even Encana announcing potential conversions to trusts.
When I first launched Canadian Edge, many frequently charged trusts were basically “ponzi schemes.” Management, it was alleged, was taking advantage of high-yield mania to issue shares at will to finance everything from ordinary corporate expenses to dividends, debt interest and management bonuses.
In my view, the situation was closer to that of a homeowner who borrows heavily against equity on the supposition that the value of his or her property will grow. Whatever the case, there were a large number of trusts that depended on access to cheap, plentiful capital.
When the door was slammed on them, they were forced back on their own resources. Many have never recovered.
Trusts involved in the natural gas sector—both producers and service companies—have been hit with a second stress factor as well: falling gas prices. Beginning in early 2006, a mild winter began boosting gas inventories and prices started falling from the post-2005 hurricane highs. The decline continued as mild season followed mild season into 2007.
Before the gas drop began, many trusts had built their growth around buying more gas reserves. Some paid extremely high prices in late 2005 and early 2006, a luxury they could afford in the days of cheap, plentiful capital.
Since then, however, falling gas prices have sapped their cash flow. And coupled with rising operating costs, the result has been two-dozen distribution cuts in the natural gas patch. Each cut has depressed share prices further, making it even more difficult to raise capital.
The third stress factor for trusts kicked in this past summer. The broad-based S&P Toronto Stock Exchange Trust Composite had just regained its pre-Halloween levels when the subprime crisis began to hit the US financial sector with a vengeance.
The immediate impact was on private capital, as the pace of new takeovers slowed amid concerns about funding acquisition-related debt. Other worries surfaced that Canadian banks were overly exposed to troubled asset-backed debt and would tighten credit agreements inked with trusts.
Both concerns proved unfounded. Trust after trust has since reached new credit deals on equal or better terms. Every trust takeover has been completed because buyers have secured financing. And we’ve even heard new deals announced, such as a soon-to-be-completed bid for Oceanex Income Fund (OAX.UN, OCNXF).
Banks on both sides of the border, however, are now more cautious than they were a few months ago. That’s a good sign for the ultimate health of the financial system. But it’s yet another challenge to raising capital for trusts.
The upshot has been a year-long stress test for trusts. Even the strongest have had to pull in their horns. The weakest, meanwhile, have entered a death spiral, with low-priced takeovers the only escape.
But the stress test has been enormously beneficial for investors in one respect. Rather than having to guess which trusts are vulnerable, we’ve seen first hand those that are and those that are basically impervious to it.
The first group is still a screaming sell. But the latter group is ripe with potential buys that are suddenly more secure than ever. That goes for the entire CE Conservative Portfolio, as well as most of the Aggressive Portfolio.
We still may see some fallout for some smaller gas producers and trusts reliant on energy services. Even the weak are proving their ability to survive an unimaginably tough climate. That radically ups the odds they’ll be hugely profitable investments when overall conditions inevitably improve.
Big Yields Cheap
By definition, a superior yield always indicates high risk. None of the 10 trusts highlighted below should be assumed as safe and sustainable as trusts highlighted in the Portfolios.
However, well-chosen fare can be very attractive additions to an already balanced portfolio. In fact, if they continue to hold their own, these 10 are likely to be among the sector’s biggest winners in the next year.
My first screen for these picks was yield, with 12 percent as the cutoff point. Next, I considered payout ratios—distributions as a percentage of distributable cash flow—and the basic nature of the underlying business.
Power generation and pipelines, for example, pay utility-quality yields and can sustain higher payout ratios. Oil and gas, however, are inherently volatile, and a lower payout ratio is required for sustainability.
Debt is another key criterion. As I’ve pointed out, when trusts’ cash flows fall, they have three choices: curtail business activity, pile on debt or cut the distribution. A low level of debt makes the range of choices a lot easier to swallow and thereby adds considerably to dividend safety.
I no longer look so closely at share issues for gauging distribution stability because trusts have been largely prevented from mass issues. I am, however, looking very closely at book value as a gauge of value and potential takeover appeal.
The metric varies from sector to sector. But generally, the lower the price-to-book value, the cheaper the trust and the more likely it is to be taken over. Also, lower investor expectations leave more room for upside surprises and less for downside disappointment.
The table “High Yields Cheap” features 10 trusts that measure up. Oil and gas producers are the highest-yielding trusts; there are four sector entries on our list.
Penn West Energy Trust (PWT.UN, NYSE: PWE) is highlighted in this issue’s High Yield of the Month. It’s the most solid of the quartet, particularly after it completes acquisitions of Vault Energy (VNG.UN, VNGFF) and Canetic Resources (CNE.UN, NYSE: CNE). Penn West Energy Trust is a buy up to USD38; its quarry rate holds while their mergers are completed.
Fellow CE Aggressive Portfolio members Advantage Energy Income Fund (AVN.UN, NYSE: AAV) and Paramount Energy Trust (PMT.UN, PMGYF) are considerably more focused on natural gas production than Penn West—which will actually be 57 percent oil after completing its mergers. That’s the primary reason for their higher yields and greater dividend risk.
Both trusts are rapidly proving themselves to be survivors in a tough market. Advantage has completed its merger with battered Sound Energy, adding a wealth of reserves and raw land at a price of less than book value. The trust now has average production exceeding 30,000 barrels of oil equivalent per day (boe), proven reserve life of 8 years-plus and a strong drilling inventory of projects that will hold down future capital costs.
Management has also studiously acquired a large stable of “tax pools,” noncash expenses that can be carried forward to offset future tax liabilities. The current inventory would be sufficient to completely shelter current cash flow from 2011 corporate taxation for more than four years.
The bulk of its properties are located in Alberta, where the trust should be able to avoid real increases in its royalty payments to the provincial government under the new rate schedule that will take effect in 2009. It also has major properties in Saskatchewan and British Columbia.
Advantage’s biggest vulnerability is weak natural gas prices. With Sound, production is still nearly two-thirds gas weighted. In addition, debt levels are relatively heavy at 1.57 times annual cash flow. As a result, another dividend cut is still possible as long as gas prices remain weak.
But with growing production and strong management, the long-term outlook looks bright. Advantage Energy Income Fund remains a buy up to USD14.
Seasoned management is also the forte of fellow Aggressive Portfolio holding Paramount Energy. With basically all its income coming from natural gas production and sales, there’s only so much CEO Susan Riddell Rose and her capable team can do, other than hedge future output as advantageously as possible and try to keep operating costs down.
For most of the past year, the trust has been reduced to reassessing its distribution on pretty much a monthly basis. The prognosis in a press release last month was generally hopeful for the rest of the year. Management cited “stronger” natural gas prices “than those realized through much of the third quarter of 2007” and affirmed its November dividend at the same rate of 10 cents Canadian per share.
On the other hand, the trust also “remained cautious in its outlook with respect to natural gas prices.” And it restated focus on a “sustainable distribution model that balances short-term cash returns to our unitholders and long-term value creation through capital spending programs.”
Read between the lines: If gas prices remain weak, Paramount will cut its dividend yet again to maintain its long-run sustainability. And with debt nearly three times annual cash flow, management doesn’t have much room to maneuver.
That’s the nature of leverage, and Paramount has it aplenty on natural gas prices. I continue to hold it as a bet on a comeback for gas prices, which will assuredly trigger a major boost in the distribution as well as the share price. A recovery to CAD10 per million British thermal units for gas should easily trigger a double in the shares.
Continued weakness spells another dividend cut and another dip in the shares, though management’s skill and willingness to act fast should ensure survival. Paramount Energy Trust is still a buy up to USD10.
My fourth high-yielding oil and gas producer’s main flaw is its small size. Even after its recent purchase of Seneca Energy Canada from US utility National Fuel Gas, NAL Oil & Gas (NAE.UN, NOIGF) still produces only about 23,500 to 24,500 boe a day. Moreover, proven reserve life is less than 7 years, which will force it to make substantial capital expenditures in coming years, difficult for any small trust.
The good news is, after cutting its distribution for the first time in a decade last year, the trust’s payout ratio is relatively under control and debt is roughly equal to cash flow. Coupled with relatively low operating costs and a heavy reliance on oil production rather than natural gas, that adds up to a pretty stable picture, despite the volatility in price of the oil and gas it produces. Management has further steadied returns with an aggressive hedging plan.
You can never completely rule out dividend cuts for any oil and gas producer trust. But after this year’s moves, NAL again appears on target to sustain itself for years to come.
A strong position in natural gas liquids has gone a long way to offset lower returns in natural gas itself. It should do better under Alberta’s new royalty rates, and geographical diversification into Saskatchewan and Ontario is a solid plus for sustainability. More aggressive investors can buy NAL Oil & Gas up to USD14.
A fifth trust on our list is also from the energy patch, Trinidad Energy Services Income Trust (TDG.UN, TDGNF). If any trust sector has been battered as badly as oil and gas producers, it’s the trusts that provide field services to them.
The combination of foul weather, low natural gas prices and uncertain taxation has combined to trigger a mass exodus from Canada’s shallow gas energy patch. Rig counts are at a fraction of the levels of just a year ago because producers have dramatically curtailed production. Worse, until there’s a real recovery in gas prices, there’s little hope of improvement.
We’ve already seen distribution cuts for most oil and gas driller trusts. The exception thus far is Trinidad. The primary reason is its focus on deep drilling rigs—which remain in high demand—and the fact that most of its rigs are operating in the US (87.4 percent of second quarter gross margin), a market that continues to grow even as Canada’s market seems to shrink.
The trust’s second quarter numbers were far superior to its rivals. So should the results for the rest of the year, particularly considering rival Precision Drilling’s (PD.UN, NYSE: PDS) prognosis for the US market.
In a market with this much volatility historically, dividend cuts can never be completely ruled out. We’ll get a better idea of what’s in store for Trinidad as it reports results for the next few quarters.
But with net debt still just 63.8 percent of equity, rig rates among the sector’s strongest and expansion universally backed by long-term contracts from users, this one is in it for the long haul, whatever short-term ups and downs it may face. And trading at just 1.45 times book value, a fraction of the industry giants, it’s a potential takeover target as well. Trinidad Energy Services Income Trust is a buy all the way up to USD18.
Beyond Energy
The other half of my list of bargain yields is outside the energy patch. Provided they keep their act together, they’ll hold their distributions no matter what oil and gas prices do.
That’s also the premise of my Conservative Portfolio holdings. The difference is these five high yielders must still face down problems in their individual businesses to sustain their distributions. And with one exception noted below, it’s still unclear how they’ll deal with 2011 taxation in order to remain high-dividend payers.
That said, all of them are certainly capable of reaching that high level of quality. And in the meantime, they’re all solid buys for those willing to take on a bit more risk in return for substantial reward.
Avenir Diversified Income Fund (AVF.UN, AVNDF) was a Canadian Edge Portfolio member until the Canadian government dropped its Halloween tax bomb last year. At that point, the shares plummeted and I recommended investors take the tax loss, shifting into higher-quality fare until the trust’s business showed it could survive the suddenly adverse environment.
As it turned out, management has proven up to the task more quickly than I expected. The oil and gas production business (35 percent of income) is still too small to make it long term on its own. Rather, the best course is for management to sell it to a larger player and focus on its more profitable businesses, namely finance/investment and real estate.
The finance business is mostly concerned with the EnerVest closed-end mutual fund family. Management continues to expand these by a method unique to Canada of offering its own shares for those of a range of individual trusts. By this method, it can increase fund size and, therefore, management fees without a significant cash outlay.
In general, I advise strongly against any individual investor opting for this type of exchange. Though the EnerVest funds are solid, you’d have to cash in a trust you want to own for a stake in a broad-based fund, focused on trusts you don’t want to own as well as those you do. From Avenir and EnerVest’s point of view, however, these exchanges boost profits. And that’s what the fund has been able to do consistently. Buy Avenir Diversified Income Fund up to my new target of USD8.50.
Superior Plus Income Fund (SPF.UN, SPIJF) is another former CE Portfolio holding that’s again worthy of a look. I originally dumped Superior at a much higher price after the fund trimmed its distribution for the first time ever. My fear was the cut was only the tip of the iceberg of trouble for a trust that had expanded too rapidly into too many different business lines, piling up too much debt in the process.
As it turned out, within a few months, management seemed to reach the same conclusion. The result was a second distribution cut and dip in the share price but also a major restructuring that’s since been carried out in a very disciplined and effective way.
The remaining business lines of propane distribution, chemicals and construction products all face challenges. The latter two are also vulnerable to a further slowdown in the US. But costs and debt are coming down, and sales appear to have stabilized.
For its part, management looks committed to maintaining the distribution at its current level and moving it higher as its businesses turn around. This one has been all over the map. But selling for just 47 percent of sales, it’s certainly cheap. Buy Superior Plus Income Fund up to USD15.
Chemtrade Logistics Income Fund (CHE.UN, CGIFF) put itself on the market soon after 2011 trust taxation was announced, and for a while, it appeared to have several willing bidders. None of the offers measured up, and management took off the “for sale” sign. That triggered an initial dip in the shares, but solid results have triggered a rebound.
Third quarter distributable cash flow ticked up to 42 cents per share Canadian from last year’s 40 cents Canadian, as operating cash flow rose 20.5 percent. Results included expenses for the failed sale attempt and reflected strong performance at the Sulphur Products & Performance Chemicals group.
The trust also benefited from business additions and the reorganization of certain divisions, cutting costs and better capitalizing on new opportunities globally. Pulp chemicals also realized strong results, bucking weakness in certain segments of that sector.
Encouraging, management has concluded that the trust’s effective tax rate in 2011 will be only about 10 percent, based in large part on its substantial foreign operations. Trading at just 1.5 times book value and 57 percent of sales, Chemtrade Logistics Income Fund is a buy up to USD11.
Jazz Airline Income Fund (JAZ.UN, JAARF) shares have lately behaved as if they’re the victim of the same sickness affecting other airlines: high fuel prices, fierce competition and employee unrest that’s only begun to squeeze margins. Ironically, the trust—which now trades at just 98 percent of book value—is virtually immune from such forces, thanks to a lucrative deal with Air Canada, that country’s leading airline.
Jazz’s agreement with its parent basically enables it to pass along fuel costs. In addition, Air Canada currently purchases substantially all of Air Canada Jazz’s fleet capacity at predetermined rates and accounts for virtually the trust’s entire business. And with the western half of Canada booming, Jazz is having no trouble filling its flights either.
Part of the trust shares’ recent weakness can be traced to its late August announcement that it held USD5.5 million in asset-backed commercial paper. That’s only a fraction of its overall CAD146 million in cash holdings, however, and no threat to Jazz’ financial health.
And even if a US recession triggers a tapering off of traffic in Canada, the airline would be protected by its deal with Air Canada. That leaves the risk of an ongoing lawsuit attempting to break up the Air Canada deal. Barring that extreme, however, the trust should hold its distribution for a long time to come. Jazz Airline Income Fund remains a buy up to USD10.