Dividend Watch List

For the first time in quite a while, no How They Rate companies were forced to cut distributions due to weakening businesses. Two Conservative Holdings, however, did announce they would cut their current payouts beginning Jan. 1, 2011, when they plan to convert to corporations: Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

These weren’t the first 2011-related dividend cuts for converting trusts, and they won’t be the last. I don’t like dividend cuts any more than the next investor. But the points of decision are whether the remaining payouts are still attractive and if the underlying businesses of the companies will be healthy and growing after converting. If the answers to both question is “no,” it’s time to sell. If “yes,” the best course is definitely to hold on.

Happily, the word for both companies for both questions is “yes.” An addition to the Watch List last month, Yellow Pages had long been rumored to be considering a reduction. The company had maintained its current monthly payout of 6.67 cents Canadian since May 2009, when it suffered the first cut in its history from a prior rate of 9.75 cents. That marked a sharp break from earlier management statements that it would be able to “outgrow” any 2011 tax liability without cutting distributions.

The second cut will take the payout to a new monthly rate of 5.42 cents starting with the Jan. 31, 2011 dividend record date, which will be received in February by shareholders of the then-converted Yellow. It represents a payout ratio of 60 to 70 percent of anticipated cash earnings per share, which have remained stable over the past year despite a rough economic environment for directory advertisement both online and in print.

Until that point, Yellow will continue to pay out at 6.67 cents a month, a rate that’s been roughly equivalent to 50 to 60 percent of distributable cash flow. Shareholders will vote on the conversion at a special meeting held May 6; two-thirds approval is needed for passage.

My advice for Yellow shareholders is two-fold. First, plan to vote yes on the conversion. Second, stick with your shares through the conversion.

Yellow shares have rallied sharply since the conversion announcement for a reason: For the first time, long-term dividend policy has been confirmed, and it’s better than most analysts expected.

That’s mainly the result of solid fourth-quarter earnings that not only show stability in operations. They also suggest that the worst is behind and recovery is ahead for the company’s core business, where it remains dominant in Canada.

As I pointed out in a February 19 Flash Alert, Yellow’s fourth-quarter numbers were very welcome news. Even after all the economic turmoil of the past couple years, the company remains dominant in Canada’s directory advertising business in all its forms. 

Online organic growth of 24 percent, excluding acquisitions, is pretty clear proof the company is holding market share against the same competition that took down the now bankrupt US directory companies. In fact, it continues to take advantage of the explosion in smart phone applications for Blackberrys, Google’s Android and the iPhone.

This month the company purchased RedFlagDeals.com and acquired the 411.ca brand, uniting it with its Canada411.ca and YellowPages.ca brands into an unmatched combined local search engine. 411.ca has currently attracted close to 10 percent of the country’s online users, generating some 1 million queries for local Canadian businesses each month. Financial risk is reduced by the fact that Yellow will purchase shares of owner 411 Local Search Corp over a three- to five- year period, though the revenue should start to show up right away.

As for the full year, overall revenue and income from operations before goodwill impairment were basically flat from 2008, though cash flow from operating activities ticked up 8.4 percent. Fourth-quarter results, however, marked a sharp acceleration from 2008. Revenue surged 24 percent, while income from operations ticked up 10.2 percent and cash flow from operating activities rose 11.8 percent. Excluding acquisitions such as RedFlagDeals, online revenue rose 19 percent over the same period of 2008. Cash flow margins actually rose slightly to 58.8 percent from 58.7 percent a year ago.

Not surprisingly, Yellow’s biggest weakness remains its Trader business and its exposure to the highly cyclical automobile and real estate industries. These were the operations that were supposed to ensure Yellow’s dividend would outgrow 2011 taxation. Instead, management has been locked in a constant battle to cut costs to match falling sales.

The bad news is Trader is still declining, with fourth-quarter revenue falling 14.8 percent. The good news is that’s far less of a decline than the full year’s 22.7 percent and, taking into account the sale of US operations, the decline was only 12.3 percent. As a result, Trader will be much less of a drain on cash flow in 2010 than it was in 2009, even if the economy remains sluggish.

Cutting debt has been a major company goal since the North American recession took hold in 2008, and credit markets tightened. Much of management’s effort has been a successful push to refinance its short-term maturities. But Yellow also cut its net debt by CAD451 from June through December 2009, while fully paying down bank lines. As a result, its balance sheet is in better health than in some years.

That puts the company in line for a substantial earnings recovery in 2010 and particularly by 2011, as Canada’s economic recovery continues. Meanwhile, the 2011 annualized dividend rate is still more than 11 percent, and the current rate of 13 percent-plus is good through the January payment. Coupled with Yellow’s low price of just 58 percent of book value, that’s a very good reason for investors to stay with the company.

Although the shares have rallied solidly since the conversion announcement, Yellow Pages Income Fund is a buy for those who don’t already own it up to USD8.

Unlike Yellow, Davis + Henderson basically sailed through the recent recession and credit crunch, thanks to the robust health of its primary customers, Canada’s banks. Fourth-quarter 2009 earnings further affirmed the provider of business forms’ good health. Revenue surged 74.8 percent, cash flow soared 35.6 percent, income adjusted for one-time items soared 33.4 percent, and income per unit zoomed up 51.7 percent.

Those fabulously bullish numbers are in large part due to management’s concerted investment strategy over the past couple years, including strategic acquisitions and product development. And further gains are expected in 2010 as the company integrates last year’s acquisitions and pursues new ones.

The growth resulting from that strategy, however, stands in stark contrast to management’s oft-stated low growth target of just 3 to 5 percent a year for earnings and dividends. And unfortunately, it looks like the company has applied that almost absurdly conservative projection–rather than its recently successful actual growth rate–to setting a baseline dividend for Jan. 1, 2011, when it plans to convert from an income trust to a corporation.

In its conference call this week, management defended its decision to slash the payout from the current annualized rate of CAD1.84 to CAD1.20 per share upon conversion. The explanation given by CEO Bob Cronin was “the proposed level of distribution reflects the fact that our business is subject to taxes commencing in 2011.”

The company cited an anticipated 60 to 66 cents a share in taxes as the gauge for setting the new rate of CAD1.20 a share, stating it would have been the equivalent of a 72 to 75 percent payout ratio had Davis been a tax-paying corporation in 2009.

That certainly sounds reasonable, and no one knows Davis + Henderson better than its proven, experienced management team. On the other hand, the trust’s earnings for 2010 are likely to be a bit higher than 2009’s, given the acceleration of fourth-quarter growth over full-year tallies. That seemed confirmed by CEO Cronin’s conference call statement that a major acquisition would “cause revenue to exceed our long-term revenue growth target of 3 to 5 percent” in the first two quarters of 2010.

There’s also the fact that no converting trust will face a tax as high as 35 percent, particularly with corporate tax rates slated to slide under 20 percent in coming years. The company doesn’t face onerous near-term debt maturities–virtually nothing this year–has little need for capital spending other than for acquisitions, and it operates in a business that’s proven its ability to generate free cash flow even during a deep recession.

The seeming incongruity was certainly noted during the conference call, and CEO Bob Cronin seemed to get a little testy when repeatedly queried about it, as well as whether or not recent capital expenditures had truly been accretive for shareholders. That’s the sort of stuff that might lead one to suspect some kind of hidden weakness in the underlying business, hence the question about capital spending.

Time will tell, of course, but looking at the numbers, the underlying business, and the fact that this is high season for corporate disclosure, this just doesn’t seem to be the case here. Rather, what we have is extremely conservative management that would rather take a near-term share-price hit by keeping its post-conversion dividends very low than take a chance on setting them too high. That’s in spite of basing the company’s growth on what appear to be very high percentage business moves.

One thing that might wipe away some of this caution could be a successful refinancing this year of CAD260 million in debt in 2011, basically Davis’ entire long-term debt. Another could be continued growth of the business due to mergers and other initiatives. Either way, management has left the door open for plenty of upside surprises in the months to come. And while the units were volatile the first trading day after the announcement (March 3), they finished down just 1.7 percent and are still up for the year in US dollar terms.

I mainly recommended Davis + Henderson last year for its strong underlying business and wealth-building potential. But I’ve also been hopeful for a potential windfall gain resulting from management announcing a lesser dividend cut with its corporate conversion than the market expected. As things have turned out, this projected cut is pretty much in line with what was priced in. As a result, we can probably forget about a near-term windfall gain, such as those I discuss in the Feature Article.

What’s still there for investors is a solid and growing company that will pay a yield of 11 percent this year and at least 7 percent next year based on current trading prices. That yield is in inflation-resistant Canadian dollars and is backed by management that’s once again proved it will always take the safe road.

I’m no fan of dividend cuts, even if they do beat expectations. But in this case, I’m sticking with Davis + Henderson in the Conservative Holdings as a buy up to USD17 for investors who don’t already own it. And I advise voting for the conversion as well, which will put 2011 taxes behind us.

Here’s the rest of the Dividend Watch List. Note that starting later this month we’ll see a new batch of quarterly results. Some of these trusts and high-yielding corporations will earn exits, and others are likely to be added. Energy producer trusts should always be considered at risk to dividend cuts, as cash flows follow often volatile energy prices.

The list below is made of up companies facing business weakness with a real possibility of triggering a distribution cut. Excluded are trusts with strong businesses that may elect to trim distribution as part of converting to corporations later this year.

One reason is such cuts are basically elective, and forecasting them would require mind-reading skills I don’t possess. The other is that trusts with strong businesses have repeatedly posted powerful share price gains after announcing conversions. Those that haven’t cut dividends have scored windfall gains almost immediately. But even the cutters have ultimately surged.

The point is strong businesses always build wealth, no matter how they’re organized or taxed. Weak ones lose value, no matter how high their current yields look or what tax advantages they enjoy. Buying the strong and selling the weak will not only save you a lot of market pain. It’s the surest road to long-term gain.

• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)
• Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• InnVest REIT (TSX: INN-U, OTC: IVRVF)
• Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)
• Primaris REIT (TSX: PMZ-U, OTC: PMZFF)
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)

Bay Street Beat

A total of 20 Canadian Edge Portfolio recommendations–14 Conservative Holdings, six Aggressive Holdings–have announced fourth-quarter and full-year 2009 results as of the close of business Thursday, March 4. Bay Street has been busy the last several weeks, churning out a total of 128 updates to outlooks on 19 of our Holdings. (Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) reported Thursday afternoon, too late for even the most eager analyst to chime in.)

Securities analysts aren’t known as a particularly aggressive bunch; a few stars have emerged–Frank Quattrone, Henry Blodget, Abby Joseph Cohen during the tech boom, Meredith Whitney before the US financial system imploded–only to end up imprisoned, disgraced and/or reviled, justly for their crimes or irrational exuberance, strangely, in some cases, for their foresight. These few exceptions suggest the rule–anonymity–is a lot more comfortable. It comes as no surprise, therefore, that of these 128 new analyses only nine resulted in ratings changes.

Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) recorded a 16th consecutive period of year-over-year same-property growth in the fourth quarter, capping what was a solid year amid a tough economy all over. Average monthly rents were up in most areas, and occupancy stood at 98 percent as of Dec. 31, 2009. Fourth-quarter FFO rose 5.1 percent, while for the year it was up 2.9 percent. The 2009 payout ratio was 88.5 percent, down from 89.8 in 2008.

This was enough for 10 Bay Streeters to maintain their ratings. One downgraded the REIT from “market perform” to “underperform.” Of the 12 total analysts who cover it two rate it a buy, six rate it a hold, four rate it a sell.

CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) hosted its fourth-quarter and full-year conference call Thursday morning, and by late Thursday night one analyst had digested enough to downgrade the stock to “neutral,” which Bloomberg considers “hold” in its straight-up buy-hold-sell framework.

Management took a proactive step to address a 4.1 percent year-over-year decline in fourth-quarter revenue, appointing a new senior VP of operations to run its US medical imaging centers. The move to Baltimore to run American Radiology Services, the outfit CML acquired two years ago, will test Kent Wentzell’s ability to translate his experience in the Canadian health-care system into success on the US side of the border.

CML reported a 2.3 percent year-over-year increase in distributable cash flow, though the full-year figure was off 3.2 percent. The fourth-quarter payout ratio was down 2.3 percent to 94.4 percent, the full-year up 5 percent to 90.2 percent. A 12.1 percent full-year gain was driven primarily by a full 12 months of ARS contribution in 2009 as opposed to 10 months in 2008 as well as the impact of seven other US acquisitions completed in October 2009. CML Healthcare now has two buy and three hold ratings on Bay Street.

Colabor Group (TSX: GCL, OTC: COLFF) inspired a symmetrical one-upgrade-three-maintains-one-downgrade response that demands a little context. Starting from the bottom, the downgrade was to “sector perform,” essentially “hold” in the lingua Bloomberga, while the upgrade was to “top pick,” which is “bullish” in any language. Colabor also has two buy and three hold ratings on Bay Street.

Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF) and TransForce (TSX: TFI, OTC: TFIFF) each received a downgrade, though six analysts maintained the energy infrastructure operator’s ratings and five held steady on the trucker. Keyera scores a tidy 5-1-1 (4.286 average) buy-hold-sell tally in Bloomberg terms, has an equally impressive 4-2-0 (4.333 average).

On the Aggressive side of the Portfolio, Daylight Resources Trust’s (TSX: DAY-U, OTC: DAYYF) fourth-quarter results triggered 10 “maintains” and two downgrades, one to “market perform,” the other to the synonymous “hold.” Daylight sports an 8-4-0 line and a 4.333 average rating.

Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), meanwhile, inspired 10 “maintains” and an upgrade, as at least one analyst had a take similar to ours on fourth-quarter results for the Canadian independent. As we noted in the February 23 Maple Leaf Memo:

For purposes of estimating a future dividend from a converted Penn West it’s important to note that the company added productive resources in recent years then worked to clean up its balance sheet. Management is of the mind that the current resource base would support the current payout level–but also wants to add a “growth component” to the story. Much will depend on costs and how efficiently existing assets can be exploited; more important, however, will be the prices of oil and natural gas. Penn West Energy Trust, laying a strong foundation for an attractive combination of yield and growth, is a buy up to USD20.

Two analysts now rate it a buy, seven say “hold,” while two aren’t buying the Penn West story right now.

The Word from the Throne

After a long layoff during which his poll numbers sagged a bit, Prime Minister Stephen Harper delivered the traditional Speech from the Throne this week, a vestige of Canada’s time as a member of the United Kingdom. Canadians weren’t happy that he prorogued Parliament at the end of December, accepting at least in part arguments made by his critics that the move was designed to distract attention from news about Canadians abusing Afghan detainees.

The story from Harper’s spokesman was that the government could not simultaneously put together a plan to address remaining weaknesses in the economy, host the Winter Olympics and debate legislative matters. Whatever the motivation, Harper returned to the stage this week to outline a program for 2010-11 that was described by Andrew Coyne of Macleans as “one of the more economically literate Speeches from the Throne in recent memory.” The most substantive proposal, at least from a short- to medium-term perspective, is to open Canada’s door to foreign ownership of its CAD40 billion telecommunications sector and repeal what have been described as some of the most restrictive investment policies in the industrialized world. Noted Coyne, “Not long ago this would have been considered a political third rail, and yet it seemed to occasion very little response from the opposition.”

This could catalyze takeovers and the consolidation of what is a much more fragmented industry than in the US. This is another sign that Canada is orienting outward from North America; attracting more foreign investment will be key to Canada improving productivity, which will be critical in coming years as it copes an aging population.

We’ll have more on Harper’s Speech from the Throne in next week’s Maple Leaf Memo.