Dividend Watch List

FutureMed Healthcare Income Fund (TSX: FMD-U, OTC: FMDHF) will reduce its distribution by roughly 27 percent–roughly the amount management expects to incur in taxes–when it converts to a corporation on Jan. 1, 2011. The real story, however, is that at the same time nine trusts stated their intentions to convert to corporations without cutting distributions.

The group includes Canadian Edge Portfolio members Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) and Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF)–the April High Yield of the Month selections–and Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), whose earnings are analyzed in Portfolio Update.

It also includes A&W Revenue Royalties Income Fund (TSX: AW-U, OTC: AWRRF), Enbridge Income Fund (TSX: ENF-U, OTC: EBGUF), Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF), Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF), Northland Power Income Fund (TSX: NPI-U, OTC: NPIFF) and North West Company Fund (TSX: NWF-U, OTC: NWTUF).

That 9-to-1 margin of cut-less converters to cutters clearly signals trust management teams are taking the approach that preserving more dividends after conversion is best. That means more expectations-beating conversions and resulting windfall gains–as well as more attractive post-conversion income stocks.

Turning first to FutureMed, the trust also posted solid fourth-quarter results, fueled by the explosive growth of its disposable nursing supplies business. Distributable cash flow rose 18.3 percent in 2009, knocking its full-year payout ratio down to 82 percent from 92 percent a year ago. Sales rose by more than a third from year-earlier tallies, thanks to the contribution from the Dismed acquisition that ignited a 39.2 percent boost in sales of consumable nursing supplies.

With few debt needs and management guiding to another solid year in 2010, setting a dividend policy that absorbs the entire tax increase is a conservative policy. Like Conservative Holding Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) a month ago, FutureMed is holding the current rate until the conversion takes place, which won’t be until trusts’ tax advantages run out in January 2011. Also like Davis + Henderson, management has apparently taken the approach of low-balling the initial rate to maximize the potential for future growth surprises.

Unlike Davis + Henderson, investors have been cool to management’s moves thus far; the units are down roughly 6.5 percent (4.2 percent in US dollar terms) from the day before the March 9 announcement. That may be in parts due to disappointment with the scale of the distribution cut and/or the fact that other trusts elected not to make cuts.

The good news is Davis + Henderson units followed the same pattern initially following the company’s March 2 announcement of an even deeper 2011 distribution cut before surging to a price nearly 10 percent above its pre-announcement level. That’s been the profitable course followed by nearly every converting trust over the past couple years, provided they were backed by a solid underlying business, as FutureMed is. The only losers were investors who panicked in the face of the distribution cuts and sold at post-cut lows.

Despite the units’ recent tailspin, the thing to keep in mind is what almost surely lies in store for well-managed, well-positioned FutureMed. Although I would have preferred management hold more of the distribution, the company still trades at just 1.13 times book value and 68 percent of fast-growing sales.

Even after the dividend cut, it will still yield nearly 7.5 percent at current prices, one of the most attractive payouts for any health care stock. And the benefit of being so conservative with the future payout is the company is more disaster proof than ever. FutureMed Healthcare Income Fund is a buy up to USD10.

As for the trusts that elected to hold payouts in the face of new taxes, Jazz Air’s tentative decision is by far the most aggressive. Speaking at an investor conference last month, CEO Joseph Randell stated he sees “no compelling reason to convert to a trust until late this year, in order to take full advantage of the tax holiday.” He then went on to assert the company’s 60 cent per unit distribution was sustainable even if Jazz switched to a corporation later this year.

Jazz’ official policy will be decided at a shareholders’ meeting in the fall. And the company’s underlying business certainly faces challenges from the weak economy, particularly as it has affected the fortunes of its major partner Air Canada, which currently accounts of 99 percent of Jazz’ sales. The company is currently trying to diversify its customer base, with an eye toward Latin American and Asian markets. But as the 10.6 percent drop in fourth-quarter sales and 28.6 percent decline in distributable cash demonstrate, there are still considerable headwinds.

The payout ratio of 68 percent of distributable cash flow is low mainly because of the 40.3 percent dividend cut last summer. And until overall conditions improve–or management scares up business outside Canada–the dividend should be considered under some pressure.

At a yield of more than 13 percent, however, that risk is well priced into the units, and Jazz also trades at just 70 percent of book value and 38 percent of sales. There are easier ways to earn a dividend. But with its post-2010 dividend policy now in better relief, Jazz Air Income Fund rates a hold for aggressive investors.

A&W is basically a royalty stream from a chain of profitable restaurants rather than a real operating company. As a result, there have been real questions about how and even whether it can restructure to avoid taxes and preserve what’s been a generous dividend.

In late March the company answered at least some of these questions with an innovative move to change the way it recognizes royalties. Under the plan, A&W will remain a specialized investment flow-through (SIFT) entity rather than actually convert to a corporation. As a result, it will face the punitive tax scheme enacted by the minority Conservative government in order to encourage conversions to corporations.

To deal with this the trust will replace subordinated notes from which it now receives income with non-voting common shares of an entity called Trade Marks. Trade Marks earnings are the royalty paid by A&W Food Services of Canada, less administrative expenses and interest on a term loan.

The switch will essentially eliminate taxes on this income, thereby cutting the effective tax rate on the trust’s income to 18 percent versus the 25 percent without the switch. As a result, 82 percent of trust’s net income will be available for dividends.

That still means additional taxes and lower royalty income for unitholders. But coupled with rising income from the growing portfolio of restaurants–and the excess earnings A&W routinely generates and pays out to investors via a special year-end distribution–the switch will enable management to hold its distribution level “for the remainder of 2010 and 2011.”

What happens after that will depend on the performance of the restaurant portfolio. That’s why we have to look at the numbers from quarter to quarter. For now, however, A&W has given investors a blue print not only for its own future, but for what other restaurant royalty trusts can do. My buy target for A&W Revenue Royalties Income Fund remains USD15.

Enbridge Income Fund’s board has approved a restructuring to be approved at a unitholder meeting on May 3. Under the plan, all publicly held units will be swapped for a new taxable corporation dubbed Enbridge Income Fund Holdings, which will continue to be managed by parent Enbridge (TSX: ENB, NYSE: ENB).

Combined with the basic nature of depreciable energy infrastructure assets and related tax benefits, the new structure will allow the company to hold down its corporate tax rate. The switch won’t involve a one-time cash payout to investors, a move the board had debated, and the payout will move from a monthly to a quarterly basis.

Most importantly, however, Enbridge Income Fund Holdings will “initially pay an annualized dividend of approximately CAD1.15 per common share, the same as the annualized distribution per trust unit currently paid by the fund.” The conversion will likely take place in late 2010 in order to maximize tax benefits of remaining a trust.

Enbridge’s move follows similar no-cut conversions of other Energy Infrastructure trusts and further underscores the stability of its basic business of green power and pipelines. Enbridge Income Fund units are slightly above my buy target of USD12 but would be a strong buy should they revisit that level.

Labrador Iron Ore is another trust whose income is based on royalties. In its case, the cash comes from a 7 percent share of gross sales generated by the Iron Ore Company of Canada, a facility operated by global mining giant Rio Tinto (NYSE: RTP).

Cash flow depends on the output from the plant, which is essentially basic elements used in steel production, as well as the global price of iron ore. Understandably, both demand and pricing for iron ore have been extremely volatile over the past couple years, given the recession in the US and hardball negotiating of major buyers like China. The result has been a drop in Labrador distributions to the current quarterly level of CAD0.50 per unit.

Happily, the outlook for the next 12 months is considerably brighter, with the trust already announcing a special distribution of CAD0.25 to be paid April 25 along with the regular rate. And management has hinted it will continue that rate as market conditions further brighten.

To be sure, there’s going to be distribution volatility at Labrador. But it’s going to be due to iron ore prices, as the company will remain essentially the same dividend-paying entity after conversion. It’s not for conservative investors. But Labrador Iron Ore Royalty Income Fund is a buy up to USD45.

Northland Power, like other power-generating trusts, has traditionally maintained a high payout ratio that many analysts and investors–including myself–had long assumed would have to be cut after corporate conversion.

Management, however, not only surprised investors with strong fourth-quarter results. But it’s now also stated it will be able to hold its distribution at the current rate after converting in late 2010. That will be achieved chiefly by the addition of two large European wind farms to the power plant portfolio as well as the expected impact of two new Saskatchewan plants slated to start up later this year. Together, these projects will provide some $1.5 billion in “capital cost allowance tax pools,” which directly shield income from corporate taxes, in addition to new cash flows.

The fourth-quarter payout ratio was down to 92 percent–a marked improvement from prior periods and a clear sign that asset additions are boosting profits as management expected. That adds up to reliable distributions over the long term and, ultimately, dividend growth. Northland Power Income Fund is a buy up to USD13.

Finally, North West Company Fund came in with solid fourth-quarter results, including a 3 percent boost in overall revenue and a 1.6 percent jump in “same store sales,” from facilities owned for more than a year. Management continued to control expenses and rely on robust sales of food in Canada, overcoming weakness in general merchandise sales that fell short of projections despite a slight lift in same-store sales.

The results were consistent with what North West has put up over the past couple years, a tough time in several of its key resource-producing operating regions. And they added up to a conservative fourth-quarter payout ratio of 81 percent. Coupled with improving markets this year across the board, management has all the flexibility it needs, in the words of CEO Edward Kennedy, to “move forward with the conversion at year end to a corporate structure and maintain the dividend policy similar to our distribution policy in terms of the pre-tax amount that we’d be allocating to dividends.”

In other words, dividends will ultimately depend on how profitable North West is and how successfully it implements its growth plans. But conversion to a corporation in late 2010 won’t take a bite. And that’s pretty much what we expected to see from this company. Buy North West Company Fund up to USD18.

Here’s the rest of the Dividend Watch List. Later this month, we’ll begin seeing first-quarter earnings that may earn some of these trusts and high-yielding corporations exits, even as others are added.

Energy-producer trusts should always be considered at risk to dividend cuts, as cash flows follow often volatile energy prices, though the momentum seems to be for higher dividends now particularly for oil producers.

The List 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.

Again, I’m no long-distance mind-reader. Trusts with strong businesses seem less likely now to cut distributions when they convert to corporations–at least if they can avoid it. But as FutureMed showed again last month, that’s no guarantee managements won’t take a more conservative route and make deeper post-conversion cuts.

The good news is even trusts that have cut dividends when converting have eventually scored windfall gains. That means our task is still to identify and buy good businesses and avoid the weaklings.

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)
• 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

Bay Street loves a growth story, and income stream story, not so much. That’s the easy takeaway from a comparison of analyst reaction to Advantage Oil & Gas (TSX: AAV, NYSE: AAV) in the wake of its corporate conversion and to Atlantic Power Corp’s (TSX: ATP, OTC: ATLIF) recent announcement of fourth-quarter and full-year 2009 results.

Advantage, as a growth-oriented exploration and production (E&P) company, is now a darling of the Bay Street crowd; its average rating among analysts (according to Bloomberg’s system) wallowed around 3.000 for years leading up to its mid-2009 conversion announcement.

Now that it no longer pays a dividend and is focusing all its free cash to exploring the potential of its Montney shale assets, Advantage earns a 4.750 average–seven Bay Streeters say “buy,” while one rates it a hold. All eight who cover it maintained their ratings following Advantage’s recent earnings announcement.

By contrast, Atlantic Power management described during its recent earnings conference call a worst-case scenario that would still leave it able to maintain its current payout rate–that is, Atlantic has contracted cash flow that will keep investors in checks until 2015. Sustainability, however, isn’t so sexy: Bay Street gives it an average rating of 1.500 after three analysts covering the stock maintained their calls and one cut; in total, one says “hold,” while three label Atlantic Power a sell. The disparity between Advantage and Atlantic is more about Street bias than anything else. Atlantic Power, still the quintessential income stream, is a buy up to USD12.

Elsewhere, Bay Street issued 93 updated analyses on the last 13 CE Portfolio companies to report; 81 new reports maintained previous calls, while there were eight downgrades, three upgrades and one initiation of new coverage.

The eight downgrades–including Atlantic’s–had more to do with companies reaching target prices than any operational issue. Northern Property REIT (TSX: NPR-U, OTC: NPRUF) earned two upgrades; Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF), an April High Yield of the Month, also earned an upgrade.

Innergex Renewable Energy (TSX: INE, OTC: INGXF), the result of Innergex Power Income Fund’s conversion transaction, is now under coverage at RBC Capital Markets with an initial “outperform” rating.

The Last Word on Withholding and IRAs

The tax regime for specified investment flow-through (SIFT) entities passed into law in June 2007 made listed income trusts, funds, and partnerships subject to similar tax treatment as corporations. This new tax treatment was applicable in fiscal year 2007. However, SIFTs in existence on Oct. 31, 2006, the night Finance Minister Jim Flaherty made his initial trust tax announcement, were protected by transitional rules and wouldn’t be taxed at the entity level until Jan. 1, 2011, provided they steered clear of “undue expansion.” Canadian tax law at the time did not recognize “income trusts” as corporations, and their distributions were not considered “dividends.” This meant the Canadian government withheld 25 percent from trust distributions as opposed to the 15 percent withheld from dividends and interest payments.

For US unitholders, by operation of the US-Canada Income Tax Treaty (the Treaty), the withholding rate was 15 percent. Canada withheld 15 percent rather than the 25 percent domestic law dictated because the Treaty mandated that US investors be treated as US law dictates, and vice versa, on matters of income tax. This 15 percent rate is derived from the 2003 tax cuts signed into law by President George W. Bush.

Under the Canada-US income tax treaty, interest and dividends received from investments in companies held inside an IRA or 401K are exempt from Canadian withholding taxes. The nub of this problem is that, until passage of the Tax Fairness Act, Canadian law hadn’t recognized “income trusts” as “corporations,” and thus trust distributions were not considered “dividends.”

Annex B to the Fifth Protocol amending the Treaty–the Canadian explanatory notes–provides that distributions from “income trusts and royalty trusts” that are treated as dividends under Canadian tax law will be treated as dividends under the Treaty. This treatment is intended to provide relief for US investors in Canadian trusts subject to the SIFT rules. Annex B is being read to mean that only distributions paid by trusts paying entity-level tax according to the SIFT rules will be considered “dividends” in Canada and will therefore no longer be subject to withholding on the Canadian side of the border. Canada will not enforce an interpretation of the Treaty, the Fifth Protocol, and Annex B that results in it receiving essentially no tax at all from a SIFT.

Under the SIFT rules, a distribution (called a “non-deductible distribution”) made by a SIFT trust to its investors is generally deemed to be a dividend for Canadian tax purposes to the extent that it’s paid out of the trust’s earnings that have been subject to the new tax on SIFT trusts. The effect of Annex B to the Treaty is to confirm that such deemed dividend treatment also applies for Treaty purposes.

For those of you who hold trusts in your IRAs, once Jan. 1, 2011, rolls around you’re going to realize a virtual dividend increase because withholding will go away; all SIFTs that haven’t converted will be paying an entity-level tax to Canada before they distribute to unitholders, and corporate dividends are already considered exempt from withholding.

This obviously means that folks who are collecting distributions from Canadian trusts (inclusive of “income trusts,” “income funds” and “royalty trusts”) and paying withholding to Canada at 15 percent are subject to double taxation: Once they start taking distributions they’ll have to kick a little more to Uncle Sam.