Beating expectations is the key for growing, healthy trusts converting to corporations as they set their future dividends.

The good news is expectations have basically been abysmal since Halloween night 2006, when Finance Minister Jim Flaherty announced trusts would be taxed beginning in 2011. That means converters have had little trouble beating them–once they’ve replaced uncertainty with clarity.

A case in point is Conservative Holding Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF). I added the trust to the Conservative Holdings more than a year ago and have been very pleased with its performance; the company continues to grow operations, maintain a healthy balance sheet and pay a generous distribution, all the while throwing off a total return of more than 50 percent.

This week Innergex gave me more reasons to like it, as it announced its strategy to convert from trust to corporation. First, the trust will merge with Innergex Renewable Energy (TSX: INE, OTC: INGXF), its 16 percent owner and the manager of its assets.

The deal cuts costs and creates an independent pure play on carbon neutral power with 326 megawatts (MW) of installed generation and another 128 MW ready to come on line by the end of 2011.

The deal is expected to close by the end of March, following needed regulatory and unitholder approvals. At that point Innergex will convert to a taxpaying corporation under the “reverse takeover” arrangement, which is expected to make the entire event non-taxable.

Third, Innergex will continue to pay its current distribution for the months of February and March, until the closing. Innergex Power unitholders will see their distributions cut 15 percent. That’s based on an exchange of 1.46 shares of the post-merger company per income fund unit, and an effective annualized dividend of CAD0.58.

Merging with the company that manages its assets and owns 16 percent of its units will require no cash while adding needed scale to Innergex. That, in turn, should increase its access to capital and enable the post-merger company to expand its credit agreements up to CAD210 million. The additional liquidity and stronger balance sheet will be key to developing an estimated 1,800 MW of prospective wind and hydro capacity throughout Canada already identified by Innergex Renewable.

The current portfolio is geographically diversified, which is a key strength given that both hydro (73 percent of output) and wind (27 percent) can be impacted by weather conditions. No individual project accounts for more than 15 percent of revenue, protecting overall cash flows from potential mechanical problems.

Moreover, all output is sold under long-term power purchase agreements (PPA) to investment-grade companies and government entities; these deals, which include built-in rate increase, average 17 years in length.

The transaction alone is expected to increase the post-merger Innergex’ distributable cash flow by 20 percent in its first year of operations alone, as it brings new assets on line and continues to run older ones well. And investors’ payoff may come even faster, should the company attract takeover interest from other North American power producers who need to offset carbon dioxide emissions from other plants.

Converting to a corporation in March will instantly free Innergex to access equity market in a way it’s been barred from since Halloween 2006. Moreover, it will start off with CAD750 million in tax pools–non-cash expenses from development that can be used to shelter income–the same tax shelter enjoyed by oil and gas producers.

Like most investors, I would have preferred if Innergex hadn’t reduced distributions a penny. But with the units soaring to a new 52-week high the day after the announcement, it’s clear the market was expecting considerably worse. And the result has been an immediate gain for investors.

Innergex’ yield is still quite generous at around 8.5 percent. In fact, it’s about 6 percent above what the trust paid at its inception in July 2003. Equally important, the new rate is sustainable as a corporation, which eliminates all 2011 risk. And management expects to begin ramping it up again after 2013, when a major project now under construction is wrapped up.

CEO Michel Letellier had this to say during this week’s conference call: “If you look at the theory behind evaluation of a corporation, raising the dividend slowly but steadily is probably the surest thing to create value for shareholders.” He went on to say that the company’s business is “so capital-intensive that it’s very, very difficult to finance completely our acquisition or development through internal cash flow. So hence, (Innergex) better have a good currency (the stock) and a good cost of capital to tap the financial market.”

That’s about as strong a statement in defense of paying a high dividend as you’re likely to hear. Coupled with the innate security of Innergex’ underlying assets and operations, my near-term outlook is for a return visit to the units’ early 2008 highs in the USD13 to USD14 range. That should be followed by a gradual push to much higher levels, as management grows the business and boosts the distribution.

Coupled with the current dividend, that adds up to annual total returns of 15 percent in one of the safest businesses around. And any reasonable takeover offer would fetch at least a double from here. Buy Innergex Power Income Fund all the way up to USD12.

While Innergex has established certainty regarding its post-conversion dividend, Bell Atlantic Regional Communications Income Fund’s (TSX: BA-U, OTC: BLIAF) future payout is still in doubt. That’s the main reason why it yields more than 11 percent and sells for just 81 percent of book value.

As part of this week’s release of fourth-quarter earnings Bell announced it will convert to a corporation in late 2010, pending a unitholder vote slated for June 16. In its conference call management repeated a prior forecast that “a reduction in the current distribution is expected,” but stated that details would have to wait until the first quarter conference call in May, saying only that the board was still determining parameters.

The continuing uncertainty about the payout overshadowed what was otherwise a very encouraging earnings report for the rural provider of communications and Internet service. As in the US, free cash flow is the name of the game for this business. Bell reduced operating and capital costs by over CAD150 million in 2009 on a permanent basis, downsizing its workforce and updating the reliability and speed of its network.

The result was a 25 percent boost in distributable cash flow over 2008’s fourth quarter, adding up to a full-year boost of 8 percent. That translated into strong distribution coverage, with a fourth quarter payout ratio of 50 percent based on free cash flow (after capital expenditures). The full-year payout ratio of distributions plus capital expenditures was just 85 percent.

The number of customers using basic telephone service dropped by 44,000, a slightly higher rate than a year ago as competition from cable providers grew and the economy remained soft. Local phone service revenue fell 4.1 percent, while long distance sales dropped 8.6 percent year-over-year and 5 percent from the end of 2008.

Encouragingly, the company did a much better job of hanging onto its enterprise customers. Internet revenue growth was a steady 7.2 percent, as an ongoing build-out extended high-speed network coverage to 77 percent of its territory. Operating margin rose four percentage points over year-earlier levels to 46.5 percent, indicating efficiencies have well outpaced line losses despite the weak economy.

Looking ahead, management’s plan remains to offset continuing losses in its traditional business by up-selling to advanced services like broadband Internet and IPTV. Government-aided construction of fiber-to-the-home networks is greatly aiding in this effort, and without weakening the company’s securely investment grade finances. The company expects to double spending on its FiberOP offering in 2010, which as a superior network has already reduced customer losses as well as enabled the company to win back former customers.

As for the distribution, Bell Aliant will retain the current annualized rate of CAD2.90 through the end of 2010. That should be covered by a margin of around 2-to-1 at the midpoint of management’s full-year distributable cash flow estimates of CAD750 million to CAD790 million, based on approximately 127 million units currently outstanding.

Sizeable debt maturities in 2011 notwithstanding, that kind of cash flow should provide the means for a fairly substantial distribution once Bell converts to a corporation.

Unfortunately, it’s unknowable at this time what the board will decide. But coupled with other statements from management about valuing a consistent dividend, that’s a pretty good sign the post-conversion payout will be attractive.

In any case, Bell’s current yield of 11 percent-plus is clearly pricing in a sizeable cut, leaving a very low bar for management to hurdle in its decision. So while we still have to wait for clarity, it should be worth our time.

Bell units have underperformed the S&P/Toronto Stock Exchange Income Trust Index by more than 8 percentage points thus far this year, so now’s a good time to get in if you’re not already. Buy Bell Aliant Regional Communications Income Fund up to USD27.

For more information on Innergex Power Income Fund and Bell Aliant Regional Communications Income Fund visit How They Rate. Click on the TSX symbol to go to the website of our Canadian partner MPL Communications for press releases, charts and other data.

These are substantial companies, so any broker should be able to buy them, either with their Toronto or US over-the-counter (OTC) symbols. Bell Aliant has a market capitalization now of nearly CAD3.4 billion. Innergex’ is now roughly CAD318 million, and will grow to nearly CAD500 million following the Innergex Renewable Energy merger. Ask which way is cheapest.

Click on the trusts’ names to go directly to their websites. And click on their US symbols to see all previous writeups in Canadian Edge and its weekly companion Maple Leaf Memo.

Both trusts’ distributions are considered 100 percent qualified for US tax purposes, and they will be after they convert to corporations. Tax information to use as backup for US filing–whether or not there are errors on your 1099–is available in the Income Trust Tax Guide.

As is customary for virtually all foreign-based companies, the host government–in this case Canada–withholds 15 percent of distributions paid to US investors at the border. If you hold these trusts outside an IRA, the tax can be recovered by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can be carried forward to future years. Form 1116 recovery will also be possible after these trusts convert to corporations.

Distributions from both trusts under certain circumstances should be exempt from 15 percent withholding, if they’re held in an IRA or other tax-deferred retirement account. That will also be true when they convert to corporations. For more information on IRAs and withholding, see Canadian Currents.