Dividend Watch List

Dividend cuts picked up steam in December in the Canadian Edge universe of income trusts and high-yielding corporations. Some 19 trusts trimmed distributions, including 10 energy producers and a closed-end mutual fund.

Cuts at energy producer trusts are to be expected anytime oil and natural gas fall as precipitously as they did from mid-summer to early December. And judging from the general lack of reaction to them in the market place, the latest batch was more than priced in.

There are still a handful of producer trusts that are likely to cut distributions in 2009, even if oil and gas continue to rally. These include Harvest Energy Trust (TSX:  HTE, NYSE: HTE) and possibly Penn West Energy Trust (TSX: PWT, NYSE: PWE), neither of which have cut dividends to date. Both, however, currently yield in the 30 percent area. That makes it very hard to argue they aren’t already pricing in far larger cuts than are likely.

The most important thing to remember about energy trusts is revenue follows energy prices. We’ve seen the dark side of that relationship in the months since the mid-summer peak in oil and gas. But as I discuss in the Feature Article, energy prices will ultimately rally again, quite possibly to an even higher level than before. And under those circumstances, even the very weakest trusts, such as True Energy Trust (TSX: TUI-U, OTC: TUIJF), would ramp up distributions again.

As I’ve said since the very first issue of Canadian Edge, energy producer trusts are not utilities. Rather, they’re a high-yielding way to play energy prices. And when energy prices are volatile, so are they. The good news is, from today’s low prices the risk/reward relationship is squarely in our favor. That’s why so many producers rate buys in How They Rate, including those on the Dividend Watch List.

That also goes for many of the energy services trusts, which have arguably suffered an even more brutal beating in the markets. The energy services business is doubly leveraged to energy prices, as companies rely on the go/no-go decisions made by producers, which in turn are dictated mainly by energy prices.

The steep drop in energy prices over the past few months has already triggered a record wave of cancelled projects. That comes directly off the bottom line for energy services outfits, as it cuts into both capacity usage and fees.

The only comfort is these trusts and companies have been living under tough conditions for more than two years now and have learned to adapt, cutting debt levels to nothing and reducing distributions and capital spending to very conservative levels.

Last month, Precision Drilling Trust (TSX: PD-U, NYSE: PDS) became the latest to trim its distribution, taking the monthly rate down to just CAD0.04 per unit from CAD0.13. As has been the case in prior years, the trust will pay a special “in kind” dividend of CAD0.04 a unit on Jan. 15.

The move comes as part of Precision’s debt reduction program accompanying its successful takeover of rival Grey Wolf. The Grey Wolf deal extends the trust’s reach to every significant reserve area in North America, positioning it for explosive growth when energy prices and drilling economics rebound.

The new yield of roughly 6 percent will disappoint income seekers. But again, energy service plays are energy bets, not utility-safe income bets. With Grey Wolf in tow, marginal debt and selling for just 85 percent of book value, Precision Drilling Trust is a buy up to USD12.

As badly as oil and gas have been hit, damage to other commodities has been even worse. Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF) slashed its monthly payout by two-thirds to CAD0.04, effective with the Jan. 15 payment. The trust remains under pressure from tough conditions in the global softwood pulp market, which has forced it to curb output.

The bright spot here is a big pickup in insider buying over the past month, which is matched by overwhelmingly bullish opinion on Bay Street. Canfor remains strong in its industry and both the shares and the distribution will ramp up when industry conditions improve. That might be some time, however. Hold Canfor Pulp Income Fund.

Weak demand for forestry products has also forced drastic measures at PRT Forest Regeneration Income Fund (TSX: PRT-U, OTC: PFSRF), which has now suspended distributions for 2009. The primary culprit is the demise of new home construction in North America, which has pulverized demand for timber and hence reforestation services. The trust expects order volumes to decline this year and is anxious to shepherd its cash flow.

On the plus side, PRT has been able to make a number of low-cost acquisitions in recent months that dramatically enhance its ability to take advantage of better market conditions. There’s been some insider buying, Bay Street is bullish and the shares sell for 36 percent of book value and 34 percent of sales. But there’s no longer a yield, and no one should expect the situation to improve any time soon. Hold PRT Forest Regeneration Income Fund.

As reported last issue, TimberWest Forest Corp (TSX: TWF-U, OTC: TWTUF) has suspended its distribution indefinitely. Last month, the company won approval for a change in its note agreements, replacing the fixed rate on the bond portion of its stapled units with a variable rate ranging from 2 to 12 percent, depending on the trust’s profitability.

That measure will help immensely with the company’s cash drain, which has become particularly acute in the face of very weak timber market conditions. Unfortunately, management now faces a growing risk that it won’t be able to realize cash from developing real estate parcels, due to growing local opposition.

Coupled with concerns it may be delisted from the Toronto Stock Exchange, that raises serious questions about solvency. Shares have bounced back some in recent weeks but my advice is once again to sell TimberWest Forest Corp, at least until there’s some clarity on the timber market.

Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF) is holding its regular quarterly distribution for now at CAD0.50 a unit. The fund won’t, however, pay a special distribution this quarter, resulting in a sizeable cut to its total payout. That’s the result of weakening global demand and prices for iron ore, and therefore profitability at the Iron Ore Company of Canada (IOC) facility that provides substantially all of Labrador’s cash flow.

As the primary ingredient for steel, iron ore is in a bullish position over the next two to three years, particularly if infrastructure spending is increased as governments now promise. The IOC facility has a great market position and primary operator Rio Tinto (NYSE: RTP) is still one of the world’s most dominant mining companies.

The near term looks rocky, to be sure. IOC has suspended a planned CD800 million expansion of mining and production facilities at Labrador City, and it expects to run at only 80 percent of capacity in 2009, with the first quarter “much slower” than usual.

But for those willing to hold on through the current weakness, Labrador is certainly capable of moving to its former highs and beyond. I’m bullish, and so is Bay Street. Those who already own this one should hang on. All others can buy up Labrador Iron Ore Royalty Income Fund to USD30.

In stark contrast to US real estate investment trusts (REIT), most Canadian REITs are in great shape to weather a downturn in their country, thanks to very conservative management, high portfolio quality and only judicious use of debt. There are some exceptions, however.

H&R REIT (TSX: HR-U, OTC: HRREF), for example, began building The Bow, a major office building for giant energy producer EnCana (TSX: ECA, NYSE: ECA) just before credit market conditions began to tighten.

As pointed out last issue, despite the creditworthiness of EnCana as a prospective tenant–as well as HR’s demonstrated skill managing projects and overall profitability–management has nonetheless been challenged to come up with the capital to keep the CAD1.4 billion project going. That, in turn, has threatened its solvency and dividend.

The good news is the REIT has taken a giant step toward securing all the financing it needs by inking a CAD200 private bond sale to investment firm Fairfax Capital. That should ensure it will get the additional CAD400 to CAD550 million that it’s projected to need to finish the job.

The bad news is the deal came at the cost of a 50 percent cut in H&R’s distribution. With the building 100 percent pre-leased for 25 years to EnCana, however, the REIT’s profitability should rise sharply when the project is completed. As a result, shareholders can likely look forward to much higher distributions over the next few years. Meanwhile, trading at just 72 percent of book value, H&R REIT is a buy up to USD7.

Financing and credit concerns were also behind Interrent REIT’s (TSX: IIP-U, OTC: INREF) move last month to cut its monthly distribution by 54 percent to a penny Canadian a share. The new level will allow the residential landlord REIT to cover all cash requirements with internally generated funds, including all capital improvements to the portfolio. That will essentially eliminate the need for both additional borrowing and share sales while the current tight capital market conditions last.

On the plus side, Interrent’s apartment portfolio is healthy, and management expects to boost margins further in 2009 with energy conservation and a planned 15 percent trimming of general and administrative (G&A) costs. The REIT also plans to cut interest costs with a 10 percent buyback of certain convertible debt.

Those measures should ensure the current 10 percent plus distribution level holds. There has been some insider buying at slightly higher prices and the REIT trades at just 31 percent of book value. Hold Interrent REIT.

InStorage REIT (TSX: IS-U, OTC: INREF) has suspended its monthly distribution after agreeing to be bought out by Canadian Storage Partners for CAD4 per share in cash. The takeout price is slightly above the buyer’s prior offer of CAD3.75 and with the support of the REIT’s board of trustees its success appears assured. It should be substantially completed well before Feb. 7, the apparent date when the 60-day offer expires.

Trading within a few percentage points of its takeout price, InStorage REIT is a sell for US investors, mainly for the sake of avoiding any mistaken withholding taxes.

One of the bigger surprises to date has been the distribution damage in the normally recession resistant health care industry. Extendicare REIT’s (TSX: EXE-U, OTC: EXMUF) hefty payout ratio caught up with it last month, as it slashed its distribution by 24.3 percent. Management will use at least some of the saved cash to buy back a certain percentage of its shares and debt issues.

Looking ahead, the environment is challenging for Extendicare, not just for the weak economy but also because the incoming Obama administration is likely to put its stamp on the industry. Much of the REIT’s portfolio of 266 nursing and assisted living facilities is located in the US and could face intensified cost and pricing pressure. That uncertainty is the main reason why the shares remain a sell, despite selling for just 24 percent of sales.

Finally, Sentry Select Diversified Income Trust (TSX: SDT-U, OTC: SSDUF) has cut its payout for 2009 by 42.3 percent. The move is hardly a surprise, given that the closed-end fund had been dishing out nearly 2.4 times as much as it was taking in from the distributions of its holdings.

The move should both improve the balance sheet and free up more cash to invest as well. The fund still yields roughly 13 percent on the new monthly amount of CAD0.026 per share and sells for a 20 percent discount to net asset value. Hold Sentry Select Diversified Income Trust.

Here’s the rest of the Dividend Watch List. Third quarter payout ratios are shown in How They Rate for all listed trusts and corporations.

Again, note that all energy producer trusts should be considered on the Watch List if oil and gas prices resume their downward spiral of recent months.

• Acadian Timber Income Fund (TSX: ADN-U, OTC: ATBUF)
• Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF)
• Calloway REIT (TSX: CWT-U, CWYUF)
• EnerVest Diversified Income Fund (TSX: EIT-U, OTC: EVDVF)
• Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• GMP Capital Trust (TSX: GMP-U, OTC: GMCPF)
• Harvest Energy Trust (TSX: HTE, NYSE: HTE)
• Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Penn West Energy Trust (TSX: PWT, NYSE: PWE)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)
• Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF)
• Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF)

Bay Street Beat

Familiar names Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF) and CML Healthcare Income Fund (TSX: CLC-U, OTC: ) drew perfect 5.000 average scores in Bloomberg’s most recent survey of Bay Street analyst opinion.

Cineplex Galaxy continues to grab its share of entertainment-seeking eyeballs, as downbeat consumers look for distractions from everyday pressures. Medical diagnostics services provider CML Healthcare made its debut in the CE Conservative Portfolio in the December issue on the basis of the recession-resistant nature of its business as well as its ability to execute a growth strategy while paying a decent distribution.

Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF) also registered a 5.000, leading a strong contingent of oil and gas trusts in the upper echelons of stock-pickers’ esteem. Progress Energy Trust (TSX: PGX-U, OTC: PGXFF) checked in with a 4.818 average, while longtime CE Portfolio holdings Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) and Enerplus Resources (TSX: ERF-U, NYSE: ERF) also notched big numbers.

With energy trust valuations at bargain-basement levels, it’s no surprise Bay Street is shining more bullish eyes on those outfits with strong balance sheets and records of operational success.

Canada’s Tax-Free Savings Account

Although it’s a vehicle not available to US-based investors, a new savings account for Canadians could have positive implications for trust investors. As of Jan. 1, Canadians age 18 and older citizens can put up to CAD5,000 a year into a tax-free savings account (TFSA). Investment earnings in the account are tax-free and don’t affect entitlements to any federal benefit programs. Funds can be withdrawn at any time.

The new account has been widely cited in policy and financial circles as the most significant advance in Canada’s tax treatment of savings since Registered Retirement Savings Plans (RRSP), which were introduced in the 1950s. RRSPs give Canadians a tax deduction upfront and shelter investment growth until the money is withdrawn from the plan. At that point, the withdrawals are fully taxable. With the TFSA, there’s no upfront tax break. After-income-tax dollars go in, but investment growth and withdrawals are completely free of any further taxation.

The new accounts have broad appeal to potential investors with varying risk profiles and objectives; institutions offering them have reported better-than-expected application volume. Attracting new money to the market now, during what is likely to prove the buying opportunity of a generation, could have a rising tide affect for income-generating investments with strong growth prospects–things like trusts.

Tax Prep

The turn to 2009 means we’re also rapidly approaching a new tax season. Trusts will soon begin releasing guidance statements to US-based investors regarding the US tax treatment of their respective distributions.

As always, we’ll compile links to those statements as they’re released. Look for information to begin flowing with the February issue of CE.