On December 1, Baytex Energy Trust (TSX: BTE-U, NYSE: BTE) became the first trust to actually raise distributions at the same time it announced plans to convert to a corporation. The key: a strong underlying business fueled by low debt and expanding oil production.

In contrast, Acadian Timber Income Fund (TSX: ADN-U, OTC: ATBUF) and Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF) slashed their distributions as they announced their conversions in mid-November. Their common denominator: core businesses severely punished by a weak overall environment.

This trio of conversions tracked the same pattern as the 23 announced before them. For one thing, where underlying businesses have remained strong, converting trusts have elected to avoid cutting distributions. Conversely, trusts bashed by the recession have basically used the excuse of converting to slash their payouts.

Investors have definitely made it clear which fork in the road they prefer management take. Baytex units, for example, surged 5 percent the day of its conversion announcement. In contrast, Acadian is off about 5 percent and Essential is down 16 percent since their respective November 13 and November 10 announcements.

Neither has the sharp outperformance of cut-less conversions been lost on management. Third-quarter earnings statements implied a clear preference to maintain current distribution levels, and executives I’ve spoken to directly have conveyed similar sentiments.

The real question is what’s possible, given the bite of 2011 taxes in the context of future business conditions.

At this point, trusts have a pretty good idea what their prospective tax rates will be as corporations. Far less certain is how much they’ll be earning in 2011 and beyond.

That’s a particularly large sticking point for energy producers, whose cash flows rise and fall in tandem with perpetually volatile oil and gas.

But even trusts in stable businesses like electric power face some uncertainty if they’re counting on growth ventures to lift cash flows above a specific threshold.

The good news is the bar of expectations for future trust conversions remains extremely low, even for strong businesses. Canadian Edge Portfolio holdings have returned roughly 60 percent on average this year, and the broad-based S&P/Toronto Stock Exchange Income Trust Index (SPRTCM) is close behind. But most trusts are still well below their pre-Halloween 2006 levels, when the new taxes were announced.

Oil and gas producers sell at sharp discounts to the value of their assets in the ground, while non-producer trusts trade for low price-to-book values. Yields reflect expectations for big dividend cuts.

That’s why the mere act of eliminating uncertainty regarding post-conversion dividends continues to push up share prices, even when dividend cuts are involved. And when dividends are held–or in Baytex’ case increased 50 percent–the result is a windfall gain for long-depressed shares.

The ability to meet and beat expectations for post-conversion dividends depends on business performance. Even the backing of powerful parent Brookfield Asset Management (TSX: BAM-A, NYSE: BAM) wasn’t enough to prevent abysmal timber market conditions from taking a big bite out of Acadian’s dividend.

And with North American drilling running at less than a third of capacity, it was hardly a surprise that Essential followed the lead of other drillers and eliminated its distribution.

On the other hand, Portfolio picks posted solid third-quarter results up and down the line, including the nine Aggressive Holdings that make their living in the oil and gas business. Maintaining and improving those numbers is the best assurance we can have that post-conversion dividends will beat expectations. And their task will become increasingly easier as the global economy finds its way back to health.

Strong underlying businesses are the biggest reason I’m long-term bullish on Canada in general and the CE Portfolio in particular. But rock-bottom investor expectations are the best reason I can think of for upside surprises in 2010, a year when excessive leverage remains as deadly as ever and a still-weak economy can cause even the strongest to stumble.

We’ll be keeping our eyes on both as we look to add to this year’s gains, and continue recovering from 2008’s losses.

If you have questions about anything related to Canadian Edge, please drop us a line at canadianedge@kci-com.com.

Portfolio Action

Solid earnings in lean times: That’s been the hallmark of the Portfolio’s Conservative Holdings since the economic downturn began back in mid-2007. And it was once again the case in third quarter 2009, as all of our holdings reported numbers supportive of distributions and credit quality as well as long-term growth.

The commodity price-sensitive Aggressive Holdings held their own in the face of sharp drops in product prices. In fact, with payout and debt ratios generally low and third-quarter realized selling prices for oil and natural gas well below current spot prices, prospects for maintaining and even increasing distributions are better than they’ve been in many months.

This month’s Portfolio Update highlights the results of the 17 trusts reporting after the November issue was published.

December is traditionally a time for dumping losers and loading up on fresher horses. But despite an average return of nearly 60 percent for CE holdings this year and the continuing stress tests to underlying businesses, all recommendations remain buys going into the last month of 2009.

In fact, the only Portfolio action is an addition: IBI Income Fund (TSX: IBG-U, OTC: IBIBF) a new Conservative Holding. Yielding nearly 10 percent, IBI is spotlighted in High Yield of the Month.

High Yield of the Month

December High Yield of the Month and new Conservative Portfolio addition IBI Income Fund (TSX: IBG-U, OTC: IBIBF), like Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), is a contractor for infrastructure projects. The focus, however, is on planning, design and consulting services rather than actual building.

Management has yet to announce its plans for 2011. But its distribution will be shielded from new taxes by low debt, robust growth, a low payout rate and the fact that 40 percent of cash flows come from outside Canada and therefore won’t be taxed.

This month’s Aggressive pick is Provident Energy Trust (TSX: PVE-U, NYSE: PVX), an energy producer trust that derives more than half its income from fee-for-service midstream assets. The acquisition of Dow Chemical Canada’s Sarnia hydrocarbon storage facility announced last month should immediately add to earnings when completed in early 2010.

Coupled with recent sales of heavy oil assets to cut debt, the purchase will also shore up the 10 percent-plus distribution, though safety ultimately depends on energy prices as is the case with all energy producers.  

How They Rate

How They Rate lists trusts and high-yielding corporations by the following sectors:

• Oil and Gas–All producer trusts are included here.
• Electric Power–Power generators.
• Gas/Propane–A mixture of distributors, from propane to packaged ice.
• Business Trusts–A range of businesses involved principally with consumers.
• REITs–All qualified real estate investment trusts.
• Trust Mutual Funds–Closed-end funds holding portfolios of individual trusts.
• Natural Resources–Trusts and corporations that produce resources and raw materials other than oil and gas.
• Energy Services–Trusts and corporations whose main business is providing drilling, environmental or other services to energy producers.
• Energy Infrastructure–Trusts and corporations that own primarily pipelines, processing facilities and other fee-generating assets.
• Information Technology–Trusts and corporations that provide communications, newspaper, directory and other information services.
• Financial Services–Canada’s banks, investment houses and other trusts and corporations feeding that business.
• Food and Hospitality–Trusts and corporations that franchise restaurants, own and operate hotels and manufacture and distribute food and beverages.
• Health Care–Trusts and corporations involved in the medical care and/or supply business.
• Transports–Trusts and corporations that ship freight and move passengers by bus, truck, rail or air.

Here are advice changes. See How They Rate for other changes in buy targets. Price and yield information is updated every 15 minutes in both tables. Use this service as a reality check when errors occur with US quotes-based services.

Note that it sometimes takes several days for a dividend cut to be updated in the live feed. All dividend cuts in our coverage universe are analyzed in detail in Dividend Watch List.

Column four of the table shows dividend frequency. Note that dividend dates shown are approximate and can vary within two to three days of listed dates. This column also shows how each trust and corporation will and won’t be affected by the new taxes set to kick in Jan. 1, 2011.

“Already Taxed” indicates entries already organized as corporations and therefore already paying tax. 2011 will have no impact on them whatsoever.

“REITs Exempt” shows real estate investment trusts meeting rules to remain tax advantaged. Other data shows how entries currently organized as trusts can reduce their future tax burden and preserve cash flow for dividends once they convert to corporations.

“Foreign” indicates non-Canadian income, which is not taxed. “Pools” indicate tax pools used primarily by energy producers, which shield income dollar for dollar.

“Depreciation” indicates businesses with large non-cash expenses that can be used to shelter cash flow.

“None” indicates no visible method of avoiding 2011 taxes, though some trusts have stated their intention to simply outgrow their future liability and maintain distributions.

Algonquin Power & Utilities (TSX: AQN, OTC: AQUNF)–Buy @ 5. The power and water company has completed its conversion from income trust to corporation. The process was complex, involving a temporary “merger” with fuel cell company Hydrogenics (TSX: HYG, OTC: HYGSD). But anyone holding Algonquin trust units through the conversion should by now have received shares of the new corporation on a one-for-one basis.

Atlantic Power Corp (TSX: ATP, OTC: ATPWF)–Buy @ 10. Atlantic has completed its conversion from income participating security (IPS) to corporation. All holders of the former IPS are now owners of the corporation on a share-for-share basis. The former monthly distribution of 9.12 cents Canadian per share will now be an equity dividend, rather than approximately 60 percent debt interest. The company also plans a New York Stock Exchange listing sometime in the first half of 2010.

Bellatrix Exploration Ltd (TSX: BXE, OTC: BLLXF)–SELL. Bellatrix is the surviving company resulting from True Energy Trust’s conversion to a corporation, completed last month. The new company’s focus is on developing its primarily natural gas reserves (70 percent of output). But given its small size (7,432 barrels of oil equivalent per day), hefty debt and lack of a distribution, there are far better gas plays.

Brookfield Real Estate Services Fund (TSX: BRE-U, OTC: BREUF)–Hold to Buy @ 11. The trust’s strategy of building market share in the real estate brokerage business paid off during Canada’s property market downturn and is now generating profits as values and transaction volume turn up again. Parent Brookfield Asset Management (TSX: BAM-A, NYSE: BAM) also continues to treat its trusts in a shareholder-friendly way as 2011 taxation approaches.

Canadian Hydro Developers—Acquired. The friendly takeover by TransAlta Corp (TSX: TA, NYSE: TAC) was completed for CAD5.25 per share in cash on November 10. Former shareholders should by now have received their cash.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold to Buy @ 7. Solid third-quarter earnings and a renewed focus on growth are signs of strength for this potential beneficiary of US health care legislation.

Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)–SELL. Consumers’ is considered sold from the Conservative Holdings for a loss of approximately 40 percent. Stand aside for now.

Extendicare REIT (TSX: EXE-U, OTC: EXTEF)–Hold to Buy @ 8. Strong third-quarter revenue and a growing US presence (two-thirds of cash flows) are good signs for this REIT and its ability to pay a big distribution in 2011.

GMP Capital (TSX: GMP, OTC: GMPXF)–Sell to Hold. I was dead wrong on this one on the way down and even worse off on its recovery over the past year. The bottom line is this is a small but solid franchise with a lock on several key areas of the Toronto Stock Exchange, the fortunes of which turn rapidly on the health of the Canadian investment market. If you’re bullish on Canada for the long term, you can’t be bearish on GMP.

Noranda Income Fund (TSX; NIF-U, OTC: NNDIF)–Sell to Hold. Improved third-quarter results and a new agreement with lenders have significantly reduced default risk. But business conditions remain tough for zinc processing.

Somerset Entertainment Income Fund—Acquired. The friendly takeover by Fluid Music Canada (TSX: FMN, OTC: FDMCF) was completed November 30 for a mix of cash, Fluid shares and Fluid convertible bonds. If you didn’t sell prior to the deal per my instructions, you should receive your elected proceeds within the next couple weeks.

Student Transportation Inc (TSX: STB, OTC: STUXF)–Buy @ 7. Student has now converted from an IPS to a corporation and changed its name to Student Transportation Inc. On December 21, the company will repurchase all of the 14 percent subordinated notes–the debt portion of the former IPS–at 105 percent of face value plus accrued and unpaid interest. Financed by new debt with a much lower coupon rate of 7.5 percent, the buyback increases the bus transport company’s financial strength and growth potential.

Sun Gro Horticulture Income Fund (TSX: GRO-U, OTC: SGHRF)–Sell to Hold. Third-quarter results indicate the company is coping with very tough times, though recovery is still not in sight.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Buy @ 9 to Hold. Third-quarter erosion of same-store sales is somewhat unnerving, as is the ability of a slump in the US to push up the payout ratio.

Feature Article

Health care has emerged as Washington, DC’s signature battleground issue this year. This week, the Congressional Budget Office released its analysis of Senate Majority Leader Harry Reid’s (D-NV) bill, essentially asserting that it would make good on promises to cover 30 million more Americans, reduce the federal deficit and cut insurance premiums for most payers.

That significantly boosts the odds President Obama will sign legislation by next month’s State of the Union address, and the implications for the health care industry are massive. The good news: Several Canadian companies are in line to be major beneficiaries. I highlight the best plays, which include Conservative Holding CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF).

I also look at potential winners should the result be much higher healthcare costs for US businesses and consumers, as many fear.

Canadian Currents

As another calendar year draws to a close, so does the time when US taxpayers must report earnings to the Internal Revenue Service draw near.

CE Associate Editor David Dittman answers three key questions: how to handle trusts that have converted to corporations during 2009 and whether or not there are any tax implications; how to handle “carry forwards” for gains or losses, as well as recovery of foreign tax withholding (15 percent in Canada) on Form 1116; and the issue of qualified versus non-qualified dividends per brokerages’ filings of Form 1099s.

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–Three How They Rate companies cut their payouts last month. Two were directly related to decisions to convert to corporations ahead of 2011 trust taxation: Acadian Timber Income Fund (TSX: ADN-U, OTC: ATBUF) and Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF).

The other, Priszm Income Fund (TSX: QSR-U, OTC: PSZMF), eliminated its payout as part of a major restructuring effort to deal with very difficult business conditions.

The rest of the Dividend Watch List (excluding oil and gas producers) includes: Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF), FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF), InnVest REIT (TSX: INN-U, OTC: IVRVF), and Primaris REIT (TSX: PMZ-U, OTC: PMZFF). DWL reviews the cutters. All are tracked in How They Rate.

Note that among energy producers, those focused on natural gas are most at risk, while oil-focused trusts are likely to increase payouts in coming months.

Bay Street Beat–How the Canadian analyst community views trusts, including our favorite trusts.

Convertibles and How to Buy Them–For those in search of an effective broker, we’re again recommending old friend Pennaluna & Company (www.PennTrade.com). Note that Vanguard still hasn’t corrected its anti-investor policies vis-à-vis those who buy and hold dividend-paying foreign stocks.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed in How They Rate for intraday US dollar prices and yields for trusts and high-yielding corporations. For other information, go directly to a trust’s Web site by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to www.AdviceforInvestors.com, the website of our Canadian partner, Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8). The site features 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 website 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 the US 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 website 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.

Note the Income Trust Tax Guide has backup to file distributions as “qualified dividends.”