After an early-year swoon to less than USD70 a barrel, oil prices have snapped back to more than USD80. Black gold’s resilience has also catalyzed a recovery in the Canadian dollar and stock market, both of which are now well ahead for the year.

The strength in oil and other commodities is almost entirely thanks to surging growth in Asia, which has offset still-sluggish demand in the US. It further underscores the benefits of Canada’s growing economic ties to the resource-starved Far East, particularly China, which we highlighted last month. And it’s a very big reason why every American’s portfolio needs northern exposure.

Stronger commodity prices should keep all things Canadian on the upside in 2010. The approaching end game on trust conversions to corporations, however, will likely have the greatest influence on share prices in the near term. And fortunately–based on what we’ve seen so far at least–that’s another huge positive.

The primary reason is still a very low bar of expectations for post-conversion dividends. Shortly after the trust tax was first announced Halloween night 2006, a major Canadian accounting firm noted there were as many potential conversion strategies as there were trusts. Their point: Post-conversion dividend policies wouldn’t be determined by the Canadian government or the amount of the trust tax, but by management decisions on where they wanted their companies to go.

All 45 How They Rate companies to announce so far have beaten expectations for where they’ll stand after converting. That’s the clear message from the average gain of 65 percent for companies that have completed conversions and the nearly 24 percent for those still going through the process.

Post-conversion dividends, however, have definitely been a mixed bag. The ratio of cutters to holders is still breaking down close to 50-50. We’ve even seen a pair of companies–Baytex Energy Trust (TSX: BTE-U, NYSE: BTE) and Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)–announce dividend increases along with conversions.

On the other hand, it’s proving very difficult to predict just what individual management teams will do. Last week, for example, Enerplus Resources Fund (TSX; ERF, NYSE: ERF) CEO Gordon Kerr asserted in the trust’s fourth-quarter conference call that “we do not expect to adjust our monthly cash distributions as a result of a conversion to a corporation.” That’s despite an oft-stated strategy of moving “from the traditional income trust business model to a hybrid growth and income business model.”

As expected, Just Energy Income Fund (TSX: JE-U, OTC: JUSTF) also affirmed it would convert to a corporation, “maintaining the current payout.” But fellow Conservative Portfolio holding Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) this week announced it would cut its payout from the current annual rate of CAD1.84 to CAD1.20 per share, effective with a Jan. 1, 2011 conversion.

That leaves a yield of more than 7 percent and–judging from share-price action following the announcement–the cut appears to have been priced in already. But given the company’s strong balance sheet and growing, recession-resistant business, such a big move can only be viewed as extremely conservative. In fact, CEO Bob Cronin was repeatedly questioned on that point in a rather testy exchange during the company’s conference call.

The good news is–lower 2010 dividend rate or no–Davis + Henderson is still attractive as a conservative, high-yielding growth play on the Canadian banking sector. The country’s financial institutions posted robust fourth-quarter results, keyed by rising business volume and falling charge-offs. That’s a formula for solid profit growth for companies like Davis + Henderson that do business with them. And ultimately, it’s that kind of growth that will drive shareholder returns, despite the ultra-cautious 2011 dividend policy.

The trick for getting through this season of many conversions is being sure of the underlying businesses of the trusts that you own. And we have another golden opportunity to make those assessments as fourth-quarter earnings results come in.

The winter reporting season is different from the spring, summer and fall because regulators require far more numbers and declarative statements. That stretches out the reporting period more than a month longer. In fact, my last pick to turn in fourth-quarter numbers–Atlantic Power Corp (TSX: ATP, OTC: ATLIF)–won’t do so until March 30, the next-to-last day of first quarter 2010.

Happily, what we have seen thus far has been very encouraging indeed for Canadian Edge Portfolio picks. Distributions were generally well covered–including for companies like Davis + Henderson that announced post-conversion cuts–and balance sheets continued to strengthen. More important, management is positioning our picks’ core businesses to capitalize on growth opportunities and avoid remaining pitfalls from US economic weakness. That’s the key to their long-term success–and strong shareholder returns.

Below is the executive summary of the March issue. If you have questions about anything related to Canadian Edge, please drop us a line by clicking on the “Contact Us” item at the top of the page.

Portfolio Action

There are no changes to the Portfolio this month. Roughly a third of recommended companies have yet to report fourth-quarter and full-year 2009 earnings. The good news is, from what we’ve seen so far, it’s clear that our holdings are still backed by healthy and growing underlying businesses. That’s going to prove essential in 2010, with North America’s economic recovery likely to remain sluggish and uneven and trusts’ conversions to corporations starting to accelerate.

This month, I review earnings for the following Conservative Holdings:

• Altagas Income Trust (TSX: ALA-U, ATGFF)
• Brookfield Renewable Power Fund (TSX: BRC-U, BRPFF)
• Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)
• CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF)
• Colabor Group (TSX: GCL, OTC: COLFF)
• Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF)
• Just Energy Income Fund (TSX: JE-U, OTC: JUSTF)
• Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF)
• Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF)
• Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF)
• RioCan REIT (TSX: REI-U, OTC: RIOCF)
• TransForce (TSX: TFI, OTC: TFIFF)
• Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

I also review the following Aggressive Holdings:

• ARC Energy Trust (TSX: AET-U, OTC: AETUF)
• Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF)
• Newalta Corp (TSX: NAL, OTC: NWLTF)
• Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)
• Trinidad Drilling (TSX: TDG, OTC: TDGCF)
• Vermilion Energy Trust (TSX: VET-U, OTC: VETMF).

Note that Enerplus is reviewed in High Yield of the Month. Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), an early reporter, was a February HYotM selection. All other Portfolio picks will be reviewed in Flash Alerts this month as they release results.

High Yield of the Month

The March High Yield of the Month picks are Aggressive Holding Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) and Mutual Fund Alternative EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF). Both are primarily conservative, high-yielding bets on the continuing recovery in energy prices and their positive impact on Canadian producers. Both are also pro-dividend.

Enerplus stated with its fourth-quarter and full-year earnings that “we do not expect to adjust our monthly cash distributions as a result of conversion to a corporation. It’s a great play on several prolific oil and gas producing regions and a buy up to USD25.

EnerVest, meanwhile, is a closed-end fund that’s dramatically improved the safety of its 9 percent-plus distributions over the past year. Its broadly diversified portfolio stands to benefit from the strength of Canada and the Canadian dollar and it trades at a discount of nearly 15 percent to the value of its assets. Buy up to USD13.

How They Rate

How They Rate has automatically updated US dollar unit/share prices, dividend payment rates in US dollars, yields, most recent dividend dates, dividend frequency and debt-to-capital ratios. Note that information on trust conversions is now included in the Income Trust Tax Guide. We’ll be updating this information regularly as new conversions are announced. Information on US taxation of How They Rate companies will now be included in the table on a regular basis.

CE Safety Ratings are based on six operating and financial criteria. Companies meeting all six criteria are rated my highest rating of “6.” “0” is the lowest rating, indicating companies that meet no safety criteria. Safety criteria are described in the text below the How They Rate table and are as follows:

• One point if the payout ratio meets “very safe” criteria for the sector.
• One point if the payout ratio is not “at risk” based on the criteria for its sector.
• One point if the debt-to-assets ratio meets “very safe” criteria for the sector.
• One point if the company is already organized as a corporation, a qualifying REIT (no change to tax status in 2011) or has clarified its dividend policy for when it converts to a corporation.
• One point if the company’s primary business is recession resistant. Qualifying varies from company to company, though virtually all Electric Power and Energy Infrastructure companies qualify, while no Energy Services companies do.
• One point if the company’s profitability is not directly affected by changes in commodity prices.

I list 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.

Advice Changes

Here are advice changes. See How They Rate for other changes in buy targets.

Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM)–Hold to Buy @ 65. Fiscal 2010 first-quarter earnings were up sharply primarily due to trading fees, but all business lines are healthy, and the 5 percent-plus dividend looks a lot more secure.

Fort Chicago Energy Partners LP (TSX: FCE-U, OTC: FCGYF)–Hold to Buy @ 11. Solid results from its natural gas liquids business point to further upside in 2010. Management plans a cut-less transition to 2011.

IESI-BFC (TSX: BIN, NYSE: BIN)–Buy @ 15 to Hold. Fourth-quarter earnings were decent, but the shares have run up, and the good is more than priced in already. The yield is not attractive.

Manitoba Telecom (TSX: MBT, OTC: MOBAF)–Hold to Buy @ 28. Cost-cutting and sales of broadband and wireless services offset a decline in its legacy business, and management affirmed the dividend.

Progress Energy Resources (TSX: PRQ, OTC: PRQNF)–Buy @ 15 to Hold. This converted trust still has impressive reserves, but costs are rising, natural gas prices (86 percent of output) are still in a slump, and the paltry dividend is not well covered.

Rogers Communications (TSX: RCI.B, NYSE: RCI)–Hold to Buy @ 32. The company boosted its dividend 10.2 percent in the wake of posting a 14 percent jump in operating profit and a drop in its payout ratio to just 52 percent.

Royal Bank of Canada (TSX: RY, NYSE: RY)–Hold to Buy @ 55. Fourth-quarter 2009 earnings were up 35 percent, as return on equity and capital ratios improved on more business and fewer writeoffs.

Telus (TSX: T, NYSE: TU)–Buy @ 30 to Hold. Fourth-quarter cash flow was steady but not outstanding, and the payout ratio has risen to 97 percent, even as the share price has moved 10 percent beyond my buy target.

Wajax Income Fund (TSX: WJX-U, OTC: WJKFF)–Hold to Buy @ 22. Fourth-quarter distributable cash flow per share was off by half from last year, but the dividend has already been adjusted downward. Moreover, management sees business recovering and expects to hold the current dividend after converting to a corporation in 2011.

Ratings Changes

There are more CE Safety Rating changes than usual this month, owing to the number of conversion announcements and earnings reports. Most months will see far fewer changes.

ARC Energy Trust (TSX: AET-U, OTC: AETUF)–2 to 3. The payout ratio fell to 50 percent in the fourth quarter of 2009 on higher production and lower costs.

Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–1 to 0. The payout ratio ballooned to 115 percent, and management reduced its stake in the trust to 14.51 percent from 22.31 percent.

Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM)–3 to 4. Strong fourth-quarter results led to a reduced payout ratio.

Cenovus Energy (TSX: CVE, NYSE: CVE)–2 to 3. The payout ratio fell to just 24 percent in the fourth quarter.

CI Financial (TSX: CIX, OTC: CIFAF)–3 to 4. The payout ratio fell to 42 percent as the company boosted assets 20 percent in 2009.

Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)–2 to 1. The rentals portfolio fell -6.2 percent, competition is eating away at its base, and distributable cash flow fells 39.4 percent.

Crombie REIT (TSX: CRR-U, none)–3 to 4. Strong fourth-quarter earnings brought the payout ratio down to a more secure level.

Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF)–5 to 6. Strong fourth-quarters earnings were no surprise and management clarified its post-conversion dividend policy–though with an ultra-conservative dividend reduction.

Just Energy Income Fund (TSX; JE-U, OTC: JUSTF)–5 to 6. The payout ratio fell again and management announced a conversion to a corporation without cutting the distribution.

Menu Foods Income Fund (TSX: MEW-U, OTC: MNUFF)–0 to 1. Fourth-quarter results indicate a company that’s turning the corner.

Northland Power Income Fund (TSX: NPI-U, OTC: NPIFF)–3 to 5. The payout ratio fell to 92 percent, and management announced a cut-less conversion.

Student Transportation (TSX: STB, OTC: SUDRF)–3 to 4. Fiscal 2010 second-quarter revenue rose 18.4 percent, and cash flow surged 40 percent on robust business and reduced costs. The payout ratio was down to 36 percent.

Telus Corp (TSX; T, NYSE: TU)–5 to 4. Weakness in fourth-quarter cash flow pushed the payout ratio up to 97 percent, though this is likely temporary.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–2 to 3. Strong same-store sales in the fourth quarter indicate the company is holding up well, and the payout ratio is back under control.

Wajax Income Fund (TSX: WJX-U, OTC: WJKFF)–2 to 3. Management will hold the dividend steady after converting to a corporation, provided the business continues to recover.

Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF)–3 to 4. Management has clarified its post-conversion dividend policy, and business remains stable.

Feature Article

Conversions to corporations are accelerating. A number of companies have announced moves along with their fourth-quarter earnings. Most of the rest will likely do the same when they release first-quarter numbers in May.

Of the 45 trusts to either complete or announce conversions and post-conversion dividend policies so far, 20 have either raised payouts or held them steady. Four weren’t paying dividends at the time, and 21 have cut them.

Only four, however, sell for less than they did before announcing their conversions–and converted companies across all industries have gained an average of nearly 65 percent. The upshot: Conversions are increasingly bullish for trusts–even if they involve dividend cuts–because they eliminate uncertainty that’s hung over the group since Halloween 2006.

I wrap up the action so far and highlight yet-to-convert trusts that offer the most likely upside surprises between now and Jan. 1, 2011.

Canadian Currents

Once again, CE Associate Editor David Dittman highlights the key tax issues for US residents investing in Canadian trusts and corporations. Our view remains that Canadian equities held in IRAs should not be withheld. Note that our Income Trust Tax Guide includes information on the status of each trust regarding 2011 taxation and how its distributions should be treated in the US for tax purposes.  

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–For the first time in a very long while, no How They Rate companies cut their payouts due to business weakness last month.

Two, however, stated that they’ll reduce their payouts starting in January 2011 as part of their conversions to corporations: Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF).

We review the pre- and post-conversion prospects of both companies, which remain buys in the Conservative Holdings despite these reductions. The remaining list–excluding oil and gas producers, which are always at risk to cuts because of the volatility of energy prices–includes:

• Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF)
• 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)
• Primaris REIT (TSX: PMZ-U, OTC: PMZFF)

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

The Word from the Throne–Prime Minister Stephen Harper brought Parliament back to Ottawa this week with a Speech from the Throne that not only provided a preview of the minority Conservative government’s fiscal 2010-11 budget priorities. It also included an interesting surprise that could prove a profitable opportunity.

More Information

The following is a regular repeat from prior issues.

Whether you’re a veteran reader or a newcomer, I encourage you to take a moment to navigate the Canadian Edge website, which includes a wealth of information not included with the downloadable monthly “pdf” version. One of the most useful features is our live quote feed in How They Rate for US dollar prices, distributions and percentage yields of trusts and high-yielding corporations. Note that our quote service sometimes includes special annual distributions along with the regular monthly payments.

Clicking on the Toronto symbol (suffix “.UN”) will take you to the website of our Canadian partner, Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8), which includes price charts and access to press releases.

If you click on the US symbol you go immediately to a chronological listing of every Canadian Edge and Maple Leaf Memo article in which that trust has been featured. You can also use that page to access articles on other trusts by typing in the relevant exchange and symbol in the “Search Query” box at the top of the page.

For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site 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 our 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.

How They Rate can now be accessed several places on the home page. The Income Trust Tax Guide has backup to file distributions as qualified dividends. “Eye on Trusts” and “How They Rate” are accessible via the shaded box in the middle column.

Roger S. Conrad
Editor, Canadian Edge