Dividend Watch List

Four How They Rate entries announced distribution cuts last month: Cathedral Energy Services Trust (TSX: CET-U, OTC: CEUNF), Contrans Income Fund (TSX: CSS-U, OTC: CSIUF), Keystone North America (TSX: KNA, OTC: KNAIF) and Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF).

Unlike in prior months, all but one of these moves was the result of a strategic move by management rather than direct business weakness. Cathedral and Contrans have announced conversions to corporations that should take place by the end of the years. Both have stated they intend to pay dividends in 2010, but for now have suspended all payouts at least until conversions are completed.

For Contrans, the last payment is the CAD0.44 per share distributed October 30 to unitholders of record October 15. That in turn was the first distribution paid since March 13, at which time payouts were suspended due to the tough economic environment’s impact on the trucking and transport industry.

Cathedral’s stated reason for its move, meanwhile, is “the cash requirements to complete the Conversion.”

The good news for investors is both companies intend to pay dividends next year, once their conversions to corporations are completed. The bad news is the new payouts aren’t likely to match their pre-conversion levels.

Both companies have stated they intend to operate as “growth-oriented” enterprises. That implies a larger percentage of cash flow reinvested in growth, rather than divested in distributions. Contrans, for example, states: “While no final decision can be made concerning dividend policy, management believes that a payout of 30 percent of free cash flow of the new public corporation paid quarterly, would satisfy the goals of yield-seeking investors.”

Based on recent results, that would equate to a quarterly dividend somewhere in the neighborhood of a nickel a share. Again, however, there are a lot of dots to connect before a hard figure is possible, which could be significantly higher or lower. And judging from statements made by management, we’re not likely to have anything hard anytime soon.

As for Cathedral, management is saying nothing beyond the company “will become a dividend paying corporation” and that taxes paid by Canadian investors should be less.

The larger concern is the pair’s still considerable exposure to financial pressures from the weak North American economy. Cathedral’s focus on horizontal drilling rigs and long-term contracts spared it for many months from the worst of the energy services’ industry depression. And the strategy continues to serve it well, with North American drilling apparently showing some signs of life.

On the other hand, distributable cash flow was sharply negative in the second quarter of 2009. And while third quarter is seasonally stronger, activity isn’t likely to really ramp up in Canada and the US until natural gas prices show some real staying power, which could be some months off. Add in the “wait and see” attitude management is taking here with regard to dividends and no one should expect much of a yield for some time.

On the plus side, Cathedral is a solid trust with excellent geographical diversification (nearly half of income is from the US), great assets and a basically solid balance sheet, with debt just 25 percent of total capital. There are no outstanding debt maturities for the next few years, and the units trade at just 1.47 times book value.

Like the rest of its sector, Cathedral is going to take patience to pay off. Shares, for example, are down more than 30 percent in US dollar terms this year, largely because of uncertainty about the dividend. That’s a stark contrast to already converted corporation and Aggressive Holding Trinidad Drilling (TSX: TDG, OTC: TDGCF), which is up more than 75 percent.

The good news is Cathedral, like Trinidad, has proven its ability to survive the worst of conditions and is in prime position to profit richly when North American drilling does pick up. As a result, I continue to rate Cathedral Energy Services Trust a buy up to USD5 for very aggressive investors who don’t need the income.

Plan to vote for the conversion at the still-to-be-set meeting, or via proxy materials slated to be mailed to investors in November. Cathedral plans to complete the conversion on December 21. It will be a non-taxable event, and unitholders will own one share in the new corporation for every Cathedral unit they now own.

Contrans unitholders will get a chance to vote on the trust’s conversion plans at a meeting slated for November 26, or beforehand using mailed proxy materials. The deal will also be on a one-share-per-one-unit basis with no tax consequences for those who hold on through. It must still win regulatory and court approvals, which are expected by the end of the month.

After that, however, everything will depend on how quickly the trucking and transport business rebounds, which in turn will determine just how much 30 percent of free cash flow is. Conditions have been progressively more difficult over the past two years, not only from diminishing cross-border traffic but within Canada itself.

The rising Canadian dollar has added a further impediment to the country’s exports to the US, hence hampering transport volumes. And, while fuel costs are automatically passed along to customers, they remain quite high and a competitive disadvantage for trucking versus alternatives for freight like railroads.

We’ll get a much better idea of how Contrans is doing in coming quarters as it releases numbers. And management’s plan to resume paying a dividend is encouraging. The company faces no significant debt maturities until December 2013, and there’s ample cash on the books.

The key question is whether there are better alternatives to play a recovery in this industry. And the answer is most decidedly yes, mainly Conservative Holding and already-converted corporation TransForce (TSX: TFI, OTC: TFIFF), which did support its distribution by a solid margin in the third quarter as it has throughout this recession (See Portfolio Update).

Accordingly, my advice in the sector remains to buy TransForce up to USD8 if you haven’t already. Contrans Income Fund remains a sell until it hammers out a solid post-conversion distribution policy.

Keystone North America’s elimination of its distribution is actually part of a very happy event for shareholders. Service Corp International (NYSE: SCI) is offering CAD8 per share in cash to buy all outstanding shares. That’s a significant 34 percent premium to Keystone’s average market price for the 20 days prior to the offer. And it pushes the shares back to a price they last held in early 2008, or nearly three times the low point hit in early December.

The deadline for the offer according to the “Management Circular” to be mailed to shareholders is Jan. 31, 2010. But there’s little or nothing to be gained from hanging on at this point. That also goes for anyone who still owns the subordinated notes that were at one point attached to the income participating securities.

The acquirer is obligated to continue paying interest on these, which have a par value of CAD25.716 per note and a coupon rate of 14 percent, just as they must all other debt of Keystone when the acquisition is completed. And the cash flows of the company remain very steady, as they’re backed by revenue from one of the surest of all businesses, namely funeral homes and cemeteries.

On the other hand, this takeover combined with the splitting of the original Income Participating Security’s (IPS) debt and equity portion has made the original IPS and the related note very derivative. Consequently, they’ll almost surely be a lot less liquid. This one traded a lot higher at one point, but it has also sold for considerably less. It’s time to cash out and move on to less complicated and far more potentially profitable alternatives. Sell Keystone North America.

In contrast to the trio of trusts highlighted above, Phoenix Technologies roughly halved its distribution strictly because of very difficult business conditions in the drilling industry. Phoenix–which specializes in horizontal drilling used in developing shale gas deposits–had maintained its monthly payout of CAD0.085 per unit since June 2008, when it raised it from 6.5 cents. In fact, it had never once cut since converting to a trust in 2004.

One reason for this staying power is the long-term nature of its contracts and the resiliency of shale projects. Not even Phoenix, however, is able to shrug off a 76 percent drop in third quarter distributable cash flow, or a ballooning of its payout ratio of 210 percent. At the root was a 47 percent decline in revenue versus last year’s tally, triggered by a 42 percent drop in consolidated rig operating days.

On the plus side, Phoenix’ management cites a “strengthening of oil and natural gas commodity prices, drilling activity within the Canadian and US industries” that “showed modest increases from second quarter levels. It’s also seeing signs that activity in the Bakken region “will increase in the fourth quarter,” a major plus given its heavy presence in the region. The trust is also expanding its efforts outside North America, which will reduce future dependence on the continent’s hyper-volatile natural gas drilling market.

In the long term, Phoenix appears to be operating in the right places with the best technology, competitive costs and a top-drawer rolodex of customers that among the industry’s most reliable. It also has virtually no credit or debt concerns, with overall debt at just 8 percent of total equity.

As stated above, my favorite pick in this industry is already converted corporation Trinidad. Phoenix has yet to make that move and remains non-committal about its future distribution, stating only that it “has begun to explore the possibility of converting its trust structure to that of a corporation.” The payout is higher than Trinidad’s. But until it does make a move, Phoenix’ distribution and its share price will remain under a cloud of uncertainty.

That said, and last month’s dividend cut notwithstanding, the company has remained strongly profitable amid the worst possible market conditions. That’s enough reason for it to be my second-favorite pick in this sector. And with a market capitalization of less than CAD200 million, it’s a perpetual takeover target in this battered industry as well. Accordingly, Phoenix Technology Income Fund is a buy up to USD8.

Here’s the rest of the dividend watch list. See How They Rate for buy/hold/sell advice. I don’t include energy producer trusts, which should always be considered at risk since dividends depend on energy prices.

Finally, expect to see some of these names change in the December issue, as we get the full raft of third quarter earnings reports.

• 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)

Bay Street Beat

Last year Warren Buffett authored an op-ed piece published in the New York Times under the headline Buy American. I am. Had you snapped to, called your broker or logged into your online account and picked up an S&P 500 index fund you’d be about 19 percent to the positive right now, on a strictly price appreciation basis.

The Sage of Omaha made his call almost five months ahead of what’s endured as “the bottom,” the lows plumbed in early March. The rally since March 4 is now greater than 50 percent on the S&P 500. Nevertheless, 19 percent is a nice return.

Buffett has once again made his sentiments known, spending USD34 billion for the existing shares of Burlington Northern Santa Fe (NYSE: BNS) he doesn’t already control. Buffett himself described it as an “an all-in bet on the economic future of the United States,” adding, “There is no way you can move a railroad to Asia.” (It’s also a bet that US reliance on coal will continue for the foreseeable future.)

“The great moves are usually greeted by yawns,” Buffett noted in his 2008 letter to Berkshire Hathaway (NYSE: BRK-A, BRK-B) shareholders. It’s difficult for Buffett to do anything without arousing some reaction, impossible when he pushes USD34 billion to the center of the table; the richest guy in the world (give or take) can’t do soporific. Of course Buffett, Berkshire and Burlington made waves across the global financial pool. So what’s the reaction on Bay Street?

Here’s Jonathan Ratner in an FP Trading Post entry, Not Impressed with Burlington Northern Deal:

Christmas may have come early for Burlington Northern Santa Fe Corp shareholders, but the company’s board came up short in extracting maximum value for this transcontinental railway franchise….

…Yes, the 8.6x lagging 12-month EV/EBITDA multiple falls within the historical 8-9x industry range, but the range is generally reflective of pre-secular pricing strength, according to UBS analysts.

They also noted that the multiple paid is on cyclically depressed EBITDA. It shrinks to 8.1x on next 12-month earnings and 7.8x based on estimated 2010 and 2008 numbers.

Ratner is saying that Buffett got a deal.

Ratner’s colleague Richard Beales notes elements familiar and unfamiliar in this Buffett deal:

Warren Buffett has a name for buying dollar bills for 50 cents. The famed value investor’s biggest-ever deal — valuing the Burlington Northern railway group at US$34-billion — doesn’t appear to fall into that category. True, Buffett is going big in a company and industry he likes. But it is a bet on growth rather than on value….

…Berkshire is buying the 77.4% of Burlington it doesn’t already own on a price-to-estimated 2010 earnings ratio of about 18 times. That’s about the level where Berkshire itself trades.

Combine that with the hefty 31% premium to Monday’s closing price, and it’s hard to see how Buffett could have justified paying more. That said, the round US$100 a share he is forking over for Burlington is indicative of the Nebraskan billionaire’s disinclination to quibble over the nickels and dimes when he thinks he has found a good business.

Only time will tell whether this move pays off as nicely as the NYT appearance has for those who follow Buffett at every turn.

If you ever thought about owning some Buffett, this might be a good opportunity–not by buying Berkshire, but by picking up Burlington Northern while it’s trading below the USD100 per share offer price. As of Friday morning, November 6, the railroad is priced at USD97.12. If the deal closes as scheduled during the first quarter, you can earn about 8 percent to as high as about 20 percent on an arbitrage trade. You’ll get cashed out with Berkshire B shares.

A final word on Buffett and his USD40 billion and you and your relative pittance. True, Buffett has, even on a relative basis, much greater room for error. But, as he noted in his 2008 letter to Berkshire shareholders, “I have pledged–to you, the rating agencies and myself–to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Arguably the most successful individual investor of the financial age knows the value of a prudent reserve, and he’ll never make a single bet he thinks could bring down his whole house. Sounds pretty simple: Keep some cash, and don’t do anything stupid.

Broker Watch

Please note that the following list is intended as a primer only and shouldn’t be construed as an endorsement; only make the decision to use these services after investigating the fee structures and requirements.

Canada’s economy has remained resilient despite the malaise south of the border and select Canadian royalty trusts are poised to grow dividends. Aside from growth and income, investing in international stocks diversifies your portfolio and limits its exposure to a single economy.

But just as watching a travel show on TV isn’t as rewarding as actually visiting a foreign land, investing in foreign stocks that trade on the US over-the-counter (OTC) market is vastly inferior to buying these securities on the local exchange.

Not only does direct investment avoid the headaches that invariably arise from a lack of liquidity in OTC markets (especially when you want to sell a position), but purchasing stocks on their native exchanges also hedges against a weaker US dollar–some would say an eventuality given the Federal Reserve’s current monetary policy. These transactions typically involve higher fees and commissions than one would incur when purchasing a New York Stock Exchange-listed stock.

Although the biggest discount brokers such as Charles Schwab (800-992-4685) usually offer access to foreign markets, investors oftentimes must call in their orders rather than placing them online. Even worse, the list of available securities is often limited.

Pennaluna & Company is an Idaho-based brokerage that’s specialized in cross-border trading since its founding in 1926. Its online platform, PennTrade, provides trade executions on both sides of the US-Canada border for USD29.95, “no exceptions, no fine print.”

Popular online broker E*Trade allows clients to trade online in six of the largest international markets: the UK, Canada, France, Germany, Hong Kong and Japan.

Because of their size and liquidity, these exchanges typically include securities issued by companies in surrounding countries; the Hong Kong market, in particular, features stocks from companies throughout Asia.

Unfortunately, access to many local markets remains spotty, but readers seeking international exposure should consider opening an account with one of several firms that offer robust foreign trading capabilities.

EverTrade (888-882-3837), the direct brokerage division of EverBank, provides its clients with access to the largest overseas exchanges as well as markets in Mexico, Russia, Thailand, Singapore and South Africa. Although EverTrade doesn’t impose any account minimums or maintenance fees, the outfit does charge a USD50 fee for each foreign-equity trade–somewhat expensive, but less than many full-service brokerages.

Peter Schiff’s Euro Pacific Capital (800-727-7922) has earned high marks from many readers of Yiannis Mostrous’ Silk Road Investor, a newsletter that focuses exclusively on opportunities in emerging markets and vociferously advocates buying local. Through this service, investors can purchase stocks directly in Argentina, France, Greece, Hong Kong, Israel, Mexico, the Philippines, Singapore, Thailand and a host of other markets.

Because Euro Pacific boasts direct relationships with innumerable foreign trading desks, clients avoid the large spreads often imposed by domestic market makers of foreign securities. The firm charges a minimum commission of USD50 per trade, while additional fees vary based on the size of the order and the amount of advice given. Generally speaking, a large order that’s very specific will incur a lower fee than a small order from a customer who requires extensive advice.

Hands down, Interactive Brokers remains the best way for investors to purchase foreign stocks directly; the firm boasts the lowest fees and access to an ever-increasing list of markets that even includes South Korea and other markets.

All told, Interactive’s customers can order directly from over 70 exchanges worldwide.

That being said, this service doesn’t offer the research and handholding that many novice investors have come to expect, though its interface is relatively easy to use. Originally designed for professional traders, clients install Interactive’s trading platform on their computers rather than access the service through a website.

Once the software is installed, customers can look up a stock’s ticker on its home exchange, convert dollars to the requisite amount of foreign currency and enter the trade directly. Clients also have the option of to let Interactive handle the currency translation.

Despite the company’s low fees, those who trade only sporadically may be turned off by inactivity charges of USD10 a month for accounts that generate less than USD10 in commissions and interest paid only on cash balances exceeding USD10,000. — Peter Staas