Three Canadian trusts and one closed-end fund under How They Rate coverage cut distributions last month.

Cathedral Energy Services Income Trust’s (TSX: CET-U, OTC: CEUNF) was the deepest at 50 percent. The move was part of management’s plan to convert the energy services provider from a trust to a corporation by Dec. 31, 2009.

The new rate of CAD0.06 will be paid quarterly in place of the current monthly rate of CAD0.04. Management views the new rate as “sustainable,” despite the worst operating environment in many years.

The cut will free up capital to grow the business, which will be immeasurably easier without the burden of the “undue expansion” restrictions that trusts have faced since late 2006. The first payment at the new rate will be for the fourth quarter of 2009 and will be disbursed in January 2010.

Since hitting a peak in 2005, energy services have been a very tough business in North America. Falling natural gas prices hit activity hard in the latter part of 2006 and well into 2007. The province of Alberta’s short-lived attempt to jack up taxes on energy producers–dubbed “Our Fair Share”–further discouraged drilling and crimped services companies.

There was a brief renaissance in early 2008, as energy prices took off and drilling picked up, particularly in the US. But when energy prices started falling in earnest last year, activity went into a power dive.

Today, despite a massive effort by Alberta to actually cut taxes on drilling, by some estimates drilling activity is 70 percent off last year’s levels in Canada and more than 50 percent in the US.

Cathedral’s focus on unconventional “directional” drilling and related services and geographic diversification in the US has kept its business in better shape than many rivals. Activity in the US has consistently been more robust than in Canada, primarily thanks to the discovery of rich deposits of shale gas and new technology that enables companies to get it out more cheaply than ever before. And Cathedral has been right in the middle of the action.

That remains the case today, with management announcing major new initiatives in the up-and-coming Marcellus Shale region, as well as in the Fayetteville and Haynesville shale plays. Assuming any kind of recovery in natural gas prices, that should translate into a solid business rebound for Cathedral in coming quarters.

Meanwhile, trimming the distribution will free up cash flow, limiting reliance on debt and ensuring survival as long as the market remains slack.

The bad news is Cathedral’s second quarter results offer little indication of when we can expect a recovery to start. Neither do those of any other energy services trust.

Given the magnitude of the dividend cut and the current tough conditions, this is not a time to buy, particularly if you already have. Hold Cathedral Energy Services Income Trust.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF) reported some good news with its second quarter numbers.

The REIT’s holdings in Quebec, for example, saw occupancies rise 6.9 percent. That enabled same property net operating income to record a relatively flat performance (down 0.4 percent). Ontario occupancy held in at 92.5 percent, a healthy level though below last year’s 93.3 percent. And western Canada occupancy came in at 92.5 percent, paced by near full levels in Alberta.

On the other hand, US occupancies were just 89.5 percent, as the soft economy hurt business. Controllable operating expenses rose as a percentage of revenue and management fees fell by more than half. The REIT was also forced to write down CAD30.7 million of the value of accounts receivable and mezzanine loans, essentially bad debt.

The upshot was a 27 percent distribution cut to a monthly rate of CAD0.045. That’s an amount that second quarter distributable cash flow did cover, excluding the writedown. And management has expressed confidence it can be maintained going forward despite challenges from the economy.

To be sure, the long-term fundamentals of senior housing in North America do appear solid, given the aging of the population. And with the REIT selling for little more than book value, it’s hardly expensive. Until we get some sense numbers are stabilizing, however, there’s not much attractive about Chartwell, which also faces some unanswered questions about how it will be taxed starting in 2011.

That leaves Chartwell Seniors Housing REIT a hold.

Wajax Income Fund (TSX: WJX-U, OTC: WJXFF) had already reduced its distribution once in 2009, a cut from a monthly rate of CAD0.36 to CAD0.20 cents with the April payment.

That, coupled with the fact that second quarter cash flows did cover dividends at CAD0.20, make this month’s cut to CAD0.15 (beginning with the September 21 payment) somewhat disturbing, particularly for conservative investors.

The diversified equipment maker has felt pain from Canada’s economic slump at each of its major divisions. Mobile equipment revenue sank 33 percent in the second quarter versus year earlier levels. Division earnings slid 43 percent, as profit margin also declined from 8.4 to 7.1 percent.

Industrial components sales were roughly flat but earnings plunged 71 percent on a drop in margins to 1.7 percent, from the year-ago 5.3 percent. Finally, power systems earnings and margins dropped nearly in half.

That added up to an overall revenue decline of 23 percent, a 51 percent slide in earnings per share and a 40 percent fall in distributable cash flow per share, the account from which dividends are paid. Net debt was reduced by 22 percent and the labor force was slashed 15 percent. But it simply wasn’t enough to offset the hits to underlying revenue.

On its face, the reduced distribution looks set to hold. The second quarter payout ratio, for example, is just 66 percent at that level. Management has made progress in cutting inventories, and there are pockets of strength in its customer base, notably in the oil sands and mining industry. The balance sheet is strong, and there are also opportunities for further cost-cutting and even business expansion.

On the other hand, these results indicate conditions haven’t yet hit bottom for Wajax, no matter how optimistically management is trying to paint its situation. I like this trust’s position in its markets and long-run growth potential. The price of 1.34 times book value and a still-generous yield of over 11 percent aren’t expensive, and I see a lot of upside as the Canadian economy comes back to life.

Unfortunately, I can’t say when that is going to happen. And as long as the economy remains weak, Wajax is vulnerable to future setbacks like this one.
Then there’s the question of 2011 taxation, which management has yet to fully address. I don’t see any compelling reason to sell Wajax now, but neither do I see one to buy. Hold Wajax Income Fund.

CE Portfolio Fund Alternative EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF) trimmed its distribution back in March as part of a major strategic initiative, including buying back shares, a 1-for-3 reverse stock split and a dramatic reorientation of the portfolio to a more conservative and lower debt focus.

Effective with the September 15 payment, it will cut its monthly payout again to a rate of CAD0.10, bringing total percentage reductions this year to 52 percent.

What makes EnerVest’s payout reductions quantitatively and qualitatively different from cuts at individual trusts is simply that it’s a mutual fund. A dividend cut at an individual trust–including the trio highlighted above–is almost always a sign of weakness at the underlying business. The key question for investors following such reductions is whether or not all the bad news is out.

In other words, does the cut reflect all the bad news that’s likely to occur, or simply what has already? In the case of Wajax, for example, the fact that dividends have been cut twice this year is a pretty clear indication that management didn’t foresee that business conditions would again worsen and has therefore been forced to reduce its guidance again.

That’s an apparent contrast from Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF). That trust’s management cut its distribution in early 2008 in anticipation of worsening conditions at its biomass operations and has not reduced the payout since, despite the bankruptcy of its partner in that venture, a division of AbitibiBowater.

There may still be a dividend cut and, in fact, one is arguably priced in with the trust yielding nearly 18 percent. But cash flow did improve in the second quarter of 2008, meaning dividends were covered, and there was money left over to build reserves, make needed capital expenditures and even cut debt. That’s why Boralex Power Income Fund remains a buy for aggressive investors up to USD4.

When it comes to mutual funds, however, dividend-cut calculus is wholly different. Mainly, a change in distributions isn’t a function of an underlying business strengthening or unraveling. Rather, it’s determined by the distributions paid by the holdings, how far management is willing to leverage that income by taking on debt, and how much the fund relies on capital gains.

The more a fund relies solely on income from its holdings to pay distributions–and less on debt leverage or capital gains–the safer its distributions are. That’s why I’ve always presented payout ratios for funds based solely on distributions of holdings in How They Rate. Having a payout over 100 percent doesn’t necessarily doom a dividend, and relying on debt isn’t necessarily a bad thing. But it does mean a fund is more vulnerable to weak market and economic conditions.

One reason I unloaded EnerVest from the Portfolio last year was management’s continued heavy reliance on debt leverage to maintain a monthly payout of CAD0.075, which it had done from late 2003. I was also turned off by escalating fund expenses billed by the fund’s previous management, and its penchant for swapping its units at a discount for units of individual trusts in order to build assets and therefore management fees.

The reason I added the fund back earlier this year was that new management had begun writing these wrongs. First to go were the discounted unit swaps to build assets, replaced by unit buybacks to try to close the monstrous gap between EnerVest’s market price and net asset value.

This latest dividend cut is part and parcel of what should be the final step in the transition, involving a dramatic cut in leverage and a shift in fund assets to other investments with more stability. Some 55 percent of the current portfolio is now in assets where income won’t be affected by 2011 tax changes.

At its core, a mutual fund is the sum of its parts. No fund can indefinitely pay more in distributions than its holdings pay out in dividends and interest. EnerVest–as well as the other funds covered in How They Rate–are in as much a state of adjustment as the rest of the Canadian investment markets, and they continue to share their fate.

EnerVest, for example, is up more than 60 percent this year in US dollar terms, as most other Canadian funds have generally done as well. It was also down nearly 50 percent last year, which was an exceedingly bad year for the Canadian markets.

The most recent moves should stabilize EnerVest’s returns and distributions going forward as much as is possible. But they certainly won’t eliminate the fund’s exposure to the Canadian market, or the volatility we’re likely to see for some time particularly in sectors involved with natural resources.

I fully intend to stick with EnerVest for a long time to come as a way for investors to get broad-based exposure to a large number of high-yielding Canadian securities. And, as it’s priced in and pays dividends in Canadian dollars, this fund is still a solid inflation hedge, despite making its portfolio more conservative.

But make no mistake. My preference is still to buy and hold individual trusts. Buy EnerVest Diversified Income Trust up to USD12, but only if you want a fund, i.e. to play the averages.

Here’s the rest of the Dividend Watch List. See How They Rate for buy/hold/sell advice. Note I don’t include energy producer trusts. As this month’s feature article makes clear, investors should consider these high-cash-flow bets on energy prices that ebb and flow with what happens to oil and gas.

Note Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF) came off the list this month, thanks to posting very strong second quarter earnings. The trust’s payout ratio for the quarter fell to 68 percent, thanks to a combination of cost controls and successful new brands. Hold Big Rock Brewery Income Trust.

In contrast, conditions seemed to worsen for InnVest REIT (TSX: INN-U, OTC: IVRVF) and Royal Host REIT (TSX: RYL-U, OTC: ROYHF), and both could see their dividends on the chopping block later this year. InnVest’s hotel revenue declined 11.9 percent, while Royal Host suffered a 13 percent decline in hospitality revenue, the lifeblood of its business. Both occupancies and revenue per available room fell for the pair.

Royal Host’s cash flow failed to cover its distribution in a quarter that’s historically a money maker. If there’s a positive here it’s that both trusts are not going broke and their shares are deeply depressed.

Until the other shoe falls on distributions, however, both InnVest REIT and Royal Host REIT are sells.

• Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF)
• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)
• Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF)
• Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)
• Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• InnVest REIT (TSX:  INN-U, OTC: IVRVF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Primaris REIT (TSX: PMZ-U, OTC: PMZFF)
• Primary Energy Recycling (TSX: PRI-U, OTC: PYGYF)
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)

New Additions

We’re adding two new companies to How They Rate coverage this month. Liquor Stores Income Fund (TSX: LIQ-U, OTC: LQSIF), a Business Trust, owns 82.1 percent of Liquor Stores LP, the top operator of private liquor stores in Canada with an expanding presence in the US. Canadian National Railway (TSX: CNR, NYSE: CNI), which we discussed in the May Canadian Currents, is now a member of the CE Transports group.

Liquor Stores has an interest in 206 stores in Alberta and British Columbia, 19 in Alaska, and will close on the acquisition of an eight-outlet Kentucky chain in December, a transaction that will be funded from available credit facilities. The Kentucky acquisition is forecast to approximately double its US revenue.

The deal illustrates Liquor Stores expansion strategy: The eight stores operate under established brand names in solid markets and further a plan to diversify geographically.

The fund buys independent stores and lets them stay that way. The recently acquired Liquor Barn chain, for example, will continue to carry Kentucky-made products at its eight stores in Louisville and Lexington. Liquor Barn and its predecessors have been in the liquor retailing business in the region since 1967; Liquor Stores seeks to leverage the chain’s strong customer recognition and deep connection to Kentucky culture. Financial terms of the sale were not disclosed.

Liquor Stores reported a 46.2 percent increase in distributable cash before non-recurring items in the second quarter. The fund reported a profit of CAD8.1 million (CAD0.44 per unit), compared with a profit of CAD4.3 million (CAD0.24 per unit) a year ago. Revenue for the quarter ended June 30 was CAD140.3 million, up from CAD121.6 million. Same-store sales were down 1.7 percent year-over-year on unseasonably cool temperatures and poor weather in Alberta.

Canadian National Railway is an excellent way to play Canada’s emerging economic recovery. CN Rail, which runs 20,421 route-miles of track in Canada and the US, generated CAD8.5 billion in revenue in 2008, 51 percent from US domestic and cross-border traffic, 26 percent from international traffic and 23 percent from Canadian domestic traffic.

In recent years CN has shifted toward more long-haul business, which provides greater profit margins; profitability in the rail business is largely a function of length of haul. The further freight moves, the more money the carrier makes, so CN has been dramatically increasing its average length of haul, at the same time eliminating short-haul traffic.

Although car loadings are down 24 percent in 2009, revenue ton miles are off only 14 percent. This sort of streamlining will boost earnings when recovery takes hold.

CN Rail has one of the lowest operating ratios among Class 1 railroads based on 2007 year-end results (63.6 percent). It originates approximately 87 percent of traffic, allowing the company to capitalize on service advantages, efficient asset utilization and negotiations with other carriers on revenue division arrangements.

CN Rail has held up well during the downturn, maintaining earnings mainly by cutting costs. The rail sector is currently trading at a discount to the levels it plumbed during the 2001 recession, although volume declines have been much more precipitous during this downturn–19 percent compared with 3 percent. As volumes start to recover, however, earnings will certainly follow.

Canadian National Railway is a buy up to USD50.

Bay Street Beat

Eleven Bay Street analysts cover IESI-BFC Ltd (TSX: BIN, NYSE: BIN). Eleven rate the waste manager a buy.

The company’s solid operating results put in good position to grow in a North American industry that’s in the midst of a rapid consolidation. IESI-BFC earned CAD15.1 million (CAD0.18 a share) in the second quarter, down from CAD17.4 million (CAD0.25 a share) a year ago. Revenue totaled CAD253.7 million compared with CAD277.6 in the second quarter of 2008.

Operating income was CAD31.3 million, on par with the CAD31.3 million for the second quarter of 2008; it would have been CAD34.3 million assuming a constant foreign exchange rate, an increase of 9.5 percent over the year-ago period.

Excluding the impact of foreign currency exchange, Canadian revenue rose on core price increases and acquisition growth. US revenues declined on lower construction and demolition volumes, partially offset by contributions from acquisitions.

Organic growth for the three months ended June 30, 2009, increased 0.7 percent in Canada (consisting of a 3.3 percent core price increase, partially offset by decreases of 1.1 percent in volume, 1.1 percent in fuel surcharges and 0.4 percent in recycling and other pricing) and decreased 7.4 percent in the US (consisting of a 2.4 percent core price increase offset by decreases of 4.4 percent in volume, 3 percent in fuel surcharges and 2.4 percent in recycling and other pricing). CE agrees with Bay Street: IESI-BFC Ltd is a buy up to USD14.

CE Conservative Holding CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) is in similar company, as all six of the Bay Streeters covering the company rate it a buy.

CML’s efforts to expand into the US paid off with expectations-beating second quarter numbers. CML reported income of CAD25.9 million (CAD0.29 per unit), which was down slightly from CAD26.3 million (CAD0.29 per unit) a year ago. Revenue increased 12.9 percent to CAD133.9 million from CAD118.6 million in the second quarter of 2008; the increase is primarily the result of the acquisition of American Radiology Services, which contributed CAD7.7 million.

CML generated distributable cash of CAD24.3 million and distributed 98.6 percent of it. Management attributed the high payout ratio to the timing of working capital changes.

According to a statement accompanying its earnings announcement, “CML Healthcare will continue to evaluate its options for the post-2010 tax regime.” Management also noted, “At this time the fund does not see any compelling reasons to make changes to its structure prior to 2011.” CML Healthcare Income Fund is a buy up to USD13.