Earnings: Part Two

There are still holdouts. But second quarter earnings are in for most Canadian Edge Portfolio recommendations.

In last Thursday’s flash alert and throughout the August issue of CE (e-mailed last Friday), I highlighted almost universally positive results. The one exception was GMP Capital Trust (TSX: GMP.UN, OTC: GMCPF), which I elected to hold because it continues to hold best-of-breed status in the volatile financial services industry.

The good news is the second batch of earnings—highlighted below—is also almost universally positive. The undisputed highlight came from Ag Growth Fund (TSX: AFN.UN, OTC: AGGRF), which posted a 60.3 percent jump in revenue and boosted its dividend distribution by 21.4 percent.

The provider of equipment and services to North American agriculture had just come off a couple tough quarters because of problems at certain facilities that limited its productive capacity. At the time, management maintained it was making progress correcting the problem, and these results vindicate those assertions, as production by truckload rose 47 percent and efforts to boost margins “were largely successful.”

Looking ahead, the company continues to enjoy considerable order backlog, as the North American agricultural industry remains strong. The payout ratio is now down to 55 percent, backing up the big dividend increase.

Finally, despite being more profitable than ever, the stock is still well below its levels earlier this year. That adds up to another opportunity to buy Ag Growth Fund up to USD32.

Atlantic Power Corp (TSX: ATP.UN, OTC: ATPWF) also posted welcomed results. The company—which is basically a portfolio of interests in US power plants and the Path 15 power line in California—came in with a 467 percent increase in cash available for distribution, driving its second quarter payout ratio down to just 60 percent. All of the facilities where Atlantic has interests basically performed to expectations, and management forecasted a 5 percent increase in distributions from those projects through 2008.

Looking out to coming years, Atlantic’s stapled shares won’t be subject to 2011 trust taxation, while the roughly 60 percent of the distribution that’s debt interest isn’t subject to 15 percent Canadian withholding. Cash flows aren’t directly impacted by changes in fuel costs at the plants because of customer pass-throughs and some hedging. The average length of sales contracts is 11 years, and the only noninvestment-grade off-taker is regulated power utility PNM Resources. The biggest customer is Southern Company.

Financially, substantially all the project-level debt—which accounts for basically everything but a convertible bond issue and bond portion of the income deposit security (IPS)—is designed to amortize over the life of the power sales contracts. At that point, the company will have essentially unlevered assets to sell or continue to operate.

In response to the extreme volatility in its shares and drop in share price, last month Atlantic announced a “normal course issuer bid” to buy back up to 8 percent, or 4 million, of its outstanding IPSes. As of Aug. 1, the company has repurchased and cancelled 157,280 IPSes at an average price of CAD8.44 each. That should prove immediately accretive by reducing interest expense, as well as the number of shares on which equity dividends are paid.

In a volatile market such as this one, these earnings may not satisfy everyone. And, as is the case with every other company, it will be absolutely essential to monitor every quarter for signs of weakening. But these results are a pretty good indication Atlantic’s assets, finances and strategy are sound for now—and that the wild rumors circulating over the past month are best ignored. In the meantime, Atlantic Power Corp is still a buy up to USD12 for those who don’t already own it.

Macquarie Power & Infrastructure Income Fund (TSX: MPT.UN, OTC: MCQPF) also came in with strong numbers, as income from operations rose 29.2 percent. Most of the gain was due to the power plants added with the Clean Power acquisition, but the Cardinal Power plant also turned in a solid performance.

The second quarter payout ratio was 117 percent because of the seasonal nature of earnings. But it remained on target with management expectations for a roughly 100 percent payout for the full year. In short, these results paint a picture of stability and support for this year’s dividend increase. Macquarie Power & Infrastructure Income Fund is a buy up to USD12 for those who haven’t already.

Energy infrastructure is perhaps the most stable trust sector, and Keyera Facilities Income Fund (TSX: KEY.UN, OTC: KEYUF) showed why once again by blowing the doors off its second quarter results. Distributable cash flow surged 80 percent from year-earlier levels, breaking the record set the prior quarter, spurred by an 85 percent income gain from the gathering and processing assets. Energy marketing—which attempts to leverage the trust’s physical assets—enjoyed a 50 percent income gain, while natural gas liquids infrastructure had flat results.

Ironically, Keyera posted these blockbuster results despite a weather-related drop in drilling activity for its key Alberta foothills territory, which is expected to rebound in the second half of 2008 based on planned capital spending. That’s another demonstration of just how well put together this trust is and how it can afford big dividend increases such as the 11 percent jump slated for August.

With the payout ratio at just 45 percent for the prior quarter, there’s plenty more in the tank. Keyera Facilities Income Fund is a buy up to USD23 for conservative and aggressive investors without a position.

Northern Property REIT (TSX: NPR.UN, OTC: NPRUF) had another strong quarter, turning in a 13 percent increase in distributable income per share. The payout ratio came down to 71.5 percent as the diversified property owner boosted its asset base by 30 percent.

The key again was strong growth and occupancy in the generally remote, resource-producing areas that are Northern’s specialty, including the epicenter of the oil sands boom, Fort McMurray, Alberta. The REIT’s focus on government-quality customers also remains a plus, particularly given the ups and downs of that industry. Steady Northern Property REIT remains a buy up to USD25.

Several holdings reported from the energy patch, and the news there was just as robust as from the trusts reporting last week. Natural gas-focused Paramount Energy Trust (TSX: PMT.UN, OTC: PMGYF) enjoyed a 22 percent boost in production, thanks largely to acquisitions made in the past year, as its payout ratio sank to 41 percent of distributable cash flow. The trust was able to use cash to cut bank debt 10.3 percent from year-earlier levels and remains on track for further steep reductions in the second half of 2008, thanks to strong hedging.

Penn West Energy Trust (NYSE: PWE, TSX: PWT.UN) demonstrated it’s successfully integrating the flurry of acquisitions that have roughly doubled its output over the past year. Funds from operations (FFO) surged 131 percent, and FFO per share surged 46 percent, driving down the payout ratio to just 51.5 percent.

Provident Energy Trust (NYSE: PVX, TSX: PVE.UN) enjoyed a 145 percent jump in second quarter FFO from year-earlier levels on sharply higher realized prices for oil and gas and a 9 percent increase in production. FFO from the energy production side of the business rose 117 percent, while cash flow from the asset-based midstream side of the business rose 72 percent.

The trust has now completed the sale of most of its US assets, freeing up considerable cash for developing its Canadian properties and retiring debt. Capital spending surged 42 percent, even as the debt-to-cash flow ratio fell to 1.4-to-1 from 3.2-to-1 last year. Coupled with a now very low payout ratio of just 43 percent, this leaves a lot of protection for the distribution at these levels. It also means potential for sizeable growth if energy prices steady and enable the trust to meet its debt-reduction goals.

All three trusts sold their oil and gas in the second quarter at prices at or slightly below current spot rates. That means there’s a risk they could wind up with lower realized prices in the third quarter. The effect, however, will be blunted by the same systematic hedging that held their realized prices (and cash flows) lower in the first half of the year. And with payout ratios this low, it would likely take a prolonged visit to $70 or lower oil and $6 gas to put current distributions under any pressure.

We’ve seen some wild action in energy trusts’ share prices, which have mostly gone lower since the beginning of July. The catalyst has been worries that the energy boom is now spent.

I can’t rule out a further dip in energy prices in the second half of the year, particularly with a US election coming up and the economy otherwise slipping. But lower demand because of high prices and recession isn’t the same thing as the permanent demand destruction needed to decisively end a bull market. In fact, the further prices fall now, the less likely we’ll see it soon.

The upshot: I’m sticking with all my energy-related trusts, and I fully expect a run to new highs in the coming months. That includes converted corporation Trinidad Drilling (TSX: TDG, OTC: TDGCF), which came in with a 14.8 percent jump in cash flow per share from operations.

Trinidad’s rig rates in the US and Canada continued to exceed industry averages by wide margins. The 31 percent utilization rate in Canada was well above the 20 percent industry benchmark for the period, a seasonally low period because of ice breakup conditions. Meanwhile, the US rig fleet rate stood at 87 percent of capacity.

Trinidad’s strong results remain because of three factors: a focus on deep drilling rigs increasingly needed to get at both new and older fields, the trust’s insistence on inking long-term contracts generally in advance of construction and continued expansion in the US, where market conditions remain better. That’s a formula that’s been stress-tested over the past two years of depression conditions in the Canadian drilling patch and shows every sign of continuing to work going forward.

The payout ratio of 48.4 percent of cash flow points to a distribution that’s sustainable, even for a company in a high-growth mode. That ensures good things for the shares, which have been all over the map this summer. Trinidad Drilling is a buy up to USD15 for growth and income in a volatile sector.

The Exception

As I mentioned at the outset, one trust didn’t meet my expectations for second quarter earnings: Arctic Glacier Income Fund (TSX: AG.UN, OTC: AGUNF).

To review, last spring the trust was hit with the news that the US Dept of Justice was investigating the North American packaged ice industry for potential price and market collusion. At the time, Arctic wasn’t named as a target in the case, and management stated it was in full cooperation with the authorities on both sides of the border.

That remains the case today. Unfortunately, these numbers indicate the investigation is starting to take a toll on the trust, and at the same time, it’s confronting a huge jump in freight costs for packaged ice as well as unexpected customer conservation in North America (with revenue down 3 percent). This week Arctic announced what it termed a “temporary” cut in its distribution by 18.2 percent because of these factors and further warned there was no end in sight to the investigation.

It’s still true that packaged ice remains a generally stable business. And it’s still very hard to see how antitrust litigation could succeed in an industry selling something every home icemaker can provide. On the other hand, lengthy investigations can be devastating to small companies, particularly if their businesses are being strained by a worsening macro environment. And it’s also true that every Tom, Dick and Harry is coming out of the woodwork to try to get their piece of Arctic.

In any case, the situation here does appear to be worse than what management expected when the investigation broke last spring. In hindsight, it would have been great to avoid our current loss by selling then or at some other point along the way. Focusing on numbers rather than rumors saves you from being whipsawed out of good positions. But occasionally, the news and numbers do get worse, and when that happens, it’s time to bail.

The bottom line: In light of the current situation and above all the dividend cut, I’m going to take the loss now and sell Arctic Glacier Income Fund from the CE Portfolio.

It’s quite possible this investigation will be resolved in a timely manner and in a way that isn’t too onerous to the company. I’ll continue to track Arctic in the How They Rate Table and won’t hesitate to upgrade it to a buy should that happen. But this is precisely the kind of situation that can really blow holes in portfolios during bear markets. And despite the loss thus far, I want to stand aside for now.

Note that Advantage Energy Income Fund (NYSE: AAV, TSX: AVN.UN), Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF), Artis REIT (TSX: AX.UN, OTC: ARESF) and Canadian Apartment Properties REIT (TSX: CAR.UN, OTC: CDPYF) will all be reporting in coming days. I’ll have a final edition of Portfolio earnings in a flash alert when we analyze those numbers. Note that earnings for other How They Rate Table-listed trusts are in the process of being posted to the CE Web site.