The Numbers, Part II

Four more Canadian Edge Portfolio recommendations reported fourth quarter earnings this week. That leaves just Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) and Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), both of which are now scheduled to report Mar. 30.

Over the past couple of weeks, we’ve seen a number of our trusts and high-yielding corporations rally strongly off recent lows. Thursday’s close on the S&P Toronto Stock Exchange Composite, for example, was 19 percent above its Mar. 9 nadir.

Our energy trusts have done even better. ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Enerplus Resources (TSX: ERF-U, NYSE: ERF), for example, have both risen 34 percent in US dollar terms from their low points. Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) is up more than 50 percent, while Provident Energy Trust (TSX: PVE-U, NYSE: PVX) has rebounded 75 percent. Even non-energy trusts have joined the party, with Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) surging 42 percent.

When we put together the March issue of Canadian Edge, investor sentiment on global markets–including Canada–had literally never been worse. Investors were willing to dump everything, including trusts that were weathering the recession as businesses and whose double-digit dividends were in no danger. Now, I’m starting to get questions from many of those same readers asking if we’ve passed the turning point, and if they should start backing up the truck to buy.

To be sure, it’s been pretty easy to get emotional about investing since this bear market began in mid-2007, and especially since the fall of Lehman Brothers in September 2008 sent events cascading out of control. But if you’ve been holding it together these many months, maintaining a portfolio of good businesses paying solid dividends, this is no time to switch horses.

There are indications we’ve seen the worst for Canadian trusts and high-dividend-paying corporations as a group. Oil prices have stabilized, as have prices of other key commodities. Canada’s banks are no longer borrowing from the central bank’s crisis fund, a sign of growing strength. Valuations of companies with reliable earnings, stable dividends and no credit problems are at levels typical of bear market bottoms. And the Canadian dollar exchange rate has steadied.

On the other hand, energy prices are still responding to ever-shifting prospects for global economic growth. And the Canadian dollar and stock market continue to move along with them. That leaves plenty of room for more downside in coming months. And there’s always the chance one or more of our holdings will suddenly crack under the economic stress tests, despite holding up well to now.

In short, this is no time to get emotional about recent upside, any more than it was to be about the downside that came before it. The bottom line is still underlying businesses. Those that weather the ongoing upheaval are going to continue paying their big distributions. And history shows they’ll lead the recovery when this market and economy finally turn upward.

We may be in the early stages of such a rebound now. Alternatively, this may just be another bear market that takes us to fresh lows. What’s dirt cheap now may get even cheaper. Either way, we’ll fare best by remembering to stay focused on the business numbers–and riding this crisis out in an unemotional way.

Still Solid

The good news on the quartet reporting earnings this week and reviewed below is simply that their numbers confirm they’re still very solid businesses. Thanks to strong balance sheets, they’re well positioned to the weather the remainder of this global recession. Equally important, they’re still anchored in strong and growing niches, and poised to profit from the market’s eventual recovery.

From the Conservative Portfolio, Artis REIT (TSX: AX-U, OTC: ARESF) recorded a 22 percent increase in revenue, as it continued to efficiently manage its portfolio while successfully adding $116.6 million in new properties. Funds from operations (FFO) per share rose 7.7 percent, while distributable income (DI) per share ticked up 2 percent. Occupancy rates held their own portfolio-wide at 96.5 percent, and 97.4 percent including committed space. The fourth quarter payout ratio based on both FFO and DI fell to a very comfortable 64.3 percent.

Artis’ fourth quarter growth was slower than full-year rates. 2008 revenue, for example, rose 46.3 percent, while FFO and DI per share moved up 17 percent and 12.1 percent, respectively. This was largely due to a slower pace of development and acquisitions later in the year, a trend that’s continuing into 2009 as management responds conservatively to tight credit markets and Canada’s recession.

However, growth in same property net operating income–the best measure of profit margins for REITs–was basically the same for the fourth quarter and the full year, 6.9 percent versus 7.4 percent. One big reason: a 45.8 percent fourth quarter increase in rents on expiring leases. That’s also a trend that should continue, as rents portfolio wide remain more than 20 percent below current market rates.

Some 42 percent of gross leasable area is office space, 31.5 percent is retail and the rest is industrial, located in strong and less competitive areas of four western provinces. About half properties are in Alberta, where growth has slowed due to the collapse in energy prices. But nearly half of Artis’ 2009 expiring leases already have commitments, at an average rate 22 percent above current rents. Lease quality is further strengthened by the fact that over half of properties are leased to “national” tenants and 8 percent to governments.

Despite Artis’ torrid growth in recent years, management has held debt levels well in check. The ratio of total mortgages, loans and bank indebtedness to the book value of its properties stands at just 51.6 percent, versus a 70 percent limit in its charter. The REIT has a $60 million credit line that’s renewable at its option and only about half is drawn at present. Moreover, only 5.4 percent of mortgage debt expires this year, all in the second half.

The bottom line is Artis remains well positioned to continue solid growth through 2009. Yielding a whopping 16 percent, Artis REIT is a buy up to USD10.

Also in the Conservative Portfolio, Innergex Power Income Fund (TSX: IEF-U, OTC: INGRF) enjoyed a 38.7 percent increase in revenue, thanks to a 43.4 percent increase in output from its fleet of hydroelectric and wind power plants. Cash flow rose 35.8 percent while adjusted net income per share, the account from which dividends are paid, rose 37.5 percent.

Importantly, management was able to renegotiate the trust’s financial arrangements before last year’s crisis hit. As a result, 92 percent of debt is at low fixed rates. That stability is matched by an average 15.4 year life of its power sales contracts, all of which are to ultra-reliable payers like major utilities and governments. In addition, the current power plant fleet has an average projected life of 25 years.

The trust left 2008 with no significant debt maturities until 2013, an unused credit line of CAD10 million and CAD23.7 million cash in the bank, enough to cover three quarters of distributions. That in management words, “positions the Fund to consider any investment or acquisition opportunities that might become available on the market in 2009.” And it’s solid protection for the distribution as well, as current cash flow covers virtually all capital costs and dividends.

All in all, the picture of stability Innergex showed when we added it to the Portfolio last year looks brighter than ever. Down slightly from its initial recommendation and yielding over 11 percent, Innergex Power Income Fund is a buy up to USD12.

In the Aggressive Portfolio, Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF) turned in another sensational quarter. Fourth quarter sales soared 81.6 percent, as growth actually accelerated from the full year rate of 52.9 percent. Cash flow before the impact of foreign exchange movements surged more than four-fold and was up 44.9 percent for the full year.

To a very large extent, Ag Growth’s strong results were the payoff from successful expansion of capacity for providing its grain handling equipment. But they’re also affirmation that its key drivers of grain volumes and grain storage practices in North American agriculture are robust as ever, and that market conditions remain strong despite the recession and the drop in grain prices. Order backlogs are well above levels of prior years and management reports no credit problems for its customers either.

As for Ag Growth’s own financial situation, the trust is in the process of buying back up to 10 percent of its shares, a sure sign of its strong cash position. Some 75 percent of sales come from the US and the trust has balanced its debt load to provide a natural hedge against exchange rate changes. There are two lines of credit for CAD10 million and USD2 million, neither of which have outstanding balances.

Total long-term debt is CAD52.8 million, comprised of term loans of USD37.6 million and CAD6.9 million. Effective rates are low at just 5.1 percent for the US debt and 4.8 percent for the Canadian. And there are no significant maturities this year.

Looking ahead, management states conditions are “very strong” in the portable grain handling and aeration equipment business, which comprises roughly 65 percent of sales. The stationary grain handling business is expected to be flat, while demand for the trust’s storage equipment continues to “exceed production capacity.” That’s a healthy outlook, particularly in such as weak macro environment.

There’s still some question about what Ag Growth will do in response to 2011 trust taxation. At this point, management has hinted it will convert to a corporation and that there will be an impact on distributable cash flow. Nonetheless, 75 percent of income is from the US and is therefore exempt from the tax, which leaves a lot to management’s discretion.

In any case, this is a first-rate trust with a strong niche in a rapidly growing and apparently recession resistant business, backed by a great balance sheet. That, and a 13 percent-plus yield, increased most recently in September 2008, is plenty of incentive to buy Ag Growth Income Fund up to USD20.

Another Direction

As expected, Advantage Energy Income Fund’s (TSX: AVN-U, NYSE: AAV) fourth quarter earnings showed some ill effects from the collapse of energy prices since last summer. Overall, however, they paint the picture of a business that’s maintaining its financial integrity amid tough conditions, while positioning for what could be a very rewarding future.

At the same time, however, management heaved a very large bombshell at investors: eliminating its remaining dividends and announcing Advantage will convert early from a trust to a corporation. The plan, which the company hopes to complete by June 30, needs a two-thirds affirmative vote of unitholders, who should receive proxy materials shortly from brokers.

In one sense, Advantage’s move is logical. Despite hedging, cash flows are taking a wicked hit from the meltdown of natural gas prices (67 percent of output). At the same time, however, it has hit on an extremely rich reserve at its Montney Shale play in Glacier, Alberta.

As reported in the Mar. 13 Flash Alert, 2008 drilling at Glacier allowed Advantage to replace 290 percent of its annual output of oil and gas at a ridiculously low finding and development cost of just CAD3.48 per barrel of oil equivalent. That pushed the company’s working interest ownership at the site to the equivalent of 2.9 trillion cubic feet of proved plus probable natural gas reserves, according to independent rater Sproule. And Advantage has an inventory of 440 more drilling sites that could push those numbers higher still.

The flipside of having all of these reserves is it will take considerable capital to exploit them, with CAD2.5 billion the latest estimate. Had natural gas prices not crashed from the low teens last summer to around $4 per million British thermal units now, CEO Andy Mah and the rest of the management team might have been able to take the path of developing Glacier while continuing to pay dividends. As it is, there’s simply not enough cash to do both, and management has chosen development.

Gutting the dividend entirely, of course, carries the cost of alienating Advantage’s current shareholder base. That’s apparently what’s happened this week, as a near double off the lows in the trust’s shares reversed on Thursday when the announcement was made.

As we’ve seen with other early converting companies, the market ultimately recognizes value. Once the initial selling wave has washed over Advantage, we’ll likely see a new group of shareholders come in to buy with different motivations, mainly as a bet on energy prices and a possible takeover.

No matter how you slice it, Advantage sells for barely a fifth the net asset value of reserves in the ground, as currently assessed by Sproule. That was a compelling incentive to own shares before the conversion announcement. And if anything the company’s new ability to plough all its cash into development makes it even more attractive as a growth/takeover play.

What that means in dollars and cents is Advantage shares are likely to rally sharply from these levels, once the conversion news plays itself out. The move will be particularly rewarding if energy prices turn up in a meaningful way, particularly natural gas. And there’s always the very real possibility of a takeover, given the large number of players in the Montney shale, including ARC Energy.

On the other hand, there are a large number of Canadian oil and gas producing trusts that are also selling dirt cheap despite owning valuable reserves–and which continue to pay very generous dividends. Consequently, while I’m not inclined to sell Advantage from the Portfolio at this price, I will likely move out of it at a future date. Hold Advantage Energy Income Fund for now.