Like Wall Street, Bay Street Canada always produces to demand. With the public clamoring for high-yielding income trusts in mid-2006, the country’s investment houses were all too happy to oblige with a deluge of new offerings.

I’m all for choice. Unfortunately, much of what was issued was simply garbage. Worse, many investors didn’t distinguish quality from hype. And when falling energy prices and changing Canadian tax policy brought the hammer down, they were left holding the bag.

Today, despite a strong recovery, pessimism is the prevailing market emotion when it comes to Canadian income trusts. Many investors are still swallowing wild-eyed stories of a future doomsday, complete with gutted trust dividends and share prices.

The irony is risks are far lower now than a year ago. The 2011 tax changes are more than priced in. And future effective tax rates are going to be a lot closer to what the average Canadian corporation pays (roughly 6.7 percent) than to the official rate of 31.5 percent.

Even more important, Canadian income trusts are growing up as an asset class. Even as the weakest have fallen apart and faded away, the survivors are focused as never before on long-term sustainability, both as businesses and as payers of generous dividends.

Hype is out. Straight talk is in, even from those whose job is promotion.

Last week, I hosted a question-and-answer panel at the San Francisco Money Show, featuring top executives from Canetic Resources (CNE.UN, NYSE: CNE) and True Energy (TUI.UN, TUIJF). As Canadian Edge readers know, I’ve not been a fan of either trust this year.

My view since late 2006 has been that both trusts made overly aggressive acquisitions, which left them at risk to even a minor pullback in energy prices. And unfortunately, that’s how things have turned out. True even attempted to convert to a low-dividend corporation earlier this year, only to have shareholders reject its plan.

What I heard on the panel was very encouraging for these trusts and the rest of the sector as well. Both affirmed a will to pay big distributions well past 2011, whether they’re ultimately organized as trusts, corporations or limited partnerships. Second, both declared a long-term target of covering both capital expenditures and distributions with operating cash flow, thereby eliminating the need to issue debt or equity unless it spurs growth.

These strategic goals certainly don’t eliminate either trust’s leverage to energy prices, which is shared by all in their sector. But coupled with new uniform trust accounting standards—distributable cash flow is now a consistent metric, as are oil and gas reserves—it does greatly improve my comfort level that they’ll survive well past 2011 and become more valuable along the way.
 
To be sure, there’s still plenty of deadwood out there. And it’s always been my primary goal at Canadian Edge to point it out in advance, so it won’t come crashing down on you. But with even Canetic and True talking about sustainability—and backing up their words with deeds—the risks of trust investing have clearly fallen dramatically in the past year. And low prices and high growth potential spell opportunity.

As I pointed out in the July 27 Flash Alert, there are two near-term risks that can hurt us. One is the extreme weakness in natural gas prices, though that’s mostly limited to the riskiest plays in the Aggressive Portfolio.

The other is that the US subprime mortgage crisis engulfs the high-yield markets, thereby making it much more difficult for private equity firms to borrow to make acquisitions. That could slow the current feverish pace of trust buyouts, now at 37 deals.

Private capital, however, isn’t the only buyer of trusts. Moreover, the high premiums on these deals are a pretty good indication trust prices aren’t running up on takeover speculation.

However these risks break out, the bottom line is business quality is still king. As long as our picks have it, we’ll stick with them, no matter how stormy the markets get this summer. We’ll get a pretty good indication of how Canadian Edge favorites and the rest of the trust universe are stacking up, as second quarter earnings are announced in the next few weeks. We’ll be reviewing them in the weekly Maple Leaf Memo.

Portfolio Action

Despite very volatile market conditions, there are no changes to the Canadian Edge portfolios this month. Conservative Portfolio holdings have fared better than most income investments during the subprime-led selloff. As long as earnings hold up, they should continue that performance. Aggressive Portfolio holdings across the board have slipped in the wake of falling natural gas prices. Only the most leveraged—Advantage Energy (AVN.UN, NYSE: AAV), Paramount Energy (PMT.UN, PMGYF) and Precision Drilling (PD.UN, NYSE: PDS)—are truly at risk to dividend cuts. We’re sticking with them, however, because of their ability to double and more when gas prices recover.

High Yields of the Month

The August Conservative High Yield of the Month is Algonquin Power Income Fund (APF.UN, AGQNF), which yields close to 11 percent, runs a very steady water and power business, and is heavily shielded from post-2011 taxation, with a major part of cash flows coming from the US. The Aggressive Portfolio High Yield of the Month is Penn West Energy Trust (PWT.UN, NYSE: PWE), now cheap and one of the biggest and strongest of the oil and gas producers.

How They Rate

I’m adding two business trusts—AG Growth Income Fund (AFN.UN, AGGRF), a farm equipment trust with a huge reach in the US market, and cities services trust IBI Income Fund (IBG.UN) to How They Rate coverage this month. Coming off this month’s listings are Canada Cartage (TRK.UN), Clean Energy Income Fund (CLE.UN, CEANF), Custom Direct Income Fund (CDI.UN, CUDFF), Thunder Energy (THY.UN, THYFF) and UE Waterheater (UWH.UN). Shiningbank Energy Income (SHN.UN, SBKEF) has completed its merger PrimeWest (PWI.UN, NYSE: PWI) and will be dropped from the list next month.

Here are advice changes. See the How They Rate or Portfolio tables for changes in buy targets. Price and yield information is updated every 15 minutes on both tables.

• Artis REIT (AX.UN) from a hold to a buy up to USD16. This relatively new real estate investment trust (REIT) continues to make successful acquisitions, and the sector has become a bit cheaper of late. I intend to feature Canadian REITs in the September issue.
• Canetic Resources from a hold to a buy up to USD15. Management’s affirmative answers to my questions combined with recent weakness in the shares are the main pluses. Another dividend cut is still possible if oil prices weaken, but the lesser reliance on natural gas prices will help.
• Connors Brothers Seafood (CBF.UN, CBICF) from a hold to a sell. The weak US dollar and tough competition have been a drag for some time. Throw in a food recall for botulism and there are just too many ifs for conservative investors to stick around.
• Peak Energy Services (PES.UN, PKGFF) from a buy up to USD6 to a hold. Sooner or later, the energy services market will turn, but it may be a while. Meanwhile, this one could still take another knock.
• True Energy from a hold to a buy up to USD5. Management’s plans are ambitious, and its position is still weak, given its high reliance on natural gas production. But things are moving in the right direction, and it’s a worthy speculation.

Feature Article

To date, there’s been relatively little private capital interest in buying energy producing Canadian income trusts. That’s due to the unpredictability of producer cash flows, which has limited buyers’ interest to only truly cheap deals like the now-completed buyout of Thunder Energy. Mergers between trusts, however, boost scale and long-term sustainability. Last month saw Advantage Energy ink a deal with Sound Energy Trust (SND.UN, SNDFF), and more deals are likely. I discuss the pros and cons of energy producer mergers for investor returns and highlight the best candidates for profitable deals in the next year.  

Canadian Currents

The ups and downs of the Canadian dollar have a huge impact on Canadian trust returns for US investors. The rise in the Looney in the past few years has increased the US dollar value of trust distributions and share prices, though it’s hurt cash flow for businesses operating in the US that are inadequately hedged. I’ve tapped George Kleinman—editor of the newsletter Futures Market Forecaster and a successful commodities trader for decades—to discuss his outlook for the Canadian dollar going forward and how US investors can protect against its inevitable fluctuations.  

Tips on Trusts

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide “Subscriber Tips” section.

Dividend Watch List—Trusts reliant on natural gas production are again vulnerable to distribution cuts, as gas prices have plunged in the face of rising inventories and mild summer temperatures. Paramount Energy Trust trimmed its payout again last month, and the longer prices stay at these levels, the more likely we’ll see others cut. Big, diversified energy producers should avoid trouble, thanks to rising oil prices. Outside the producers, energy service trusts should also be considered on red alert, though like the gas producers they can turn sharply higher on a dime and are still suitable aggressive bets. Away from energy, danger spots are rare. But Connors Brothers Seafood goes on the list for operating problems.

Bay Street Beat—Here’s a rundown on how the Canadian analyst community views trusts, and how to use that information.

Tax Pools Made Dry—Producers of natural resources such as miners and drillers can use a Canadian Development Expense, a type of tax pool–as another form of asset. Such pool will make it easier for those in the energy sector to levy the post-2011 tax of the Tax Fairness Plan. 

Action Update—As I’ve pointed out in prior issues, trusts aren’t the only high profit action in Canada. Here’s an update on our recommendations.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed on the How They Rate Table for US dollar prices of trusts intra-day. For other information, go directly to a trust’s website by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to the web site of our Canadian partner Toronto-based MPL Communications (133 Richmond Street West, Toronto M5H 3M8) www.adviceforinvestors.com, which has price charts and access to press trust releases. For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. The Web site www.sedar.com is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news on trusts. Dominion Bond Rating Service is the pre-eminent credit rater for trusts. The Bank of Canada Web site features a handy currency converter for Canadian dollars and US dollars into 50 other currencies around the world, and it’s a great source of free information on the Canadian economy.

Roger Conrad
Editor, Canadian Edge