Dividend Watch List

With earnings stabilized, post-corporate conversions remain the primary reason for dividend cuts in the Canadian Edge coverage universe.

These cuts are entirely at the discretion of management. And, as I’ve pointed out many times, I’m no long-distance mind-reader. All I can really offer you is a best guess at what they might do.

The good news: Strong businesses always build wealth, no matter how they’re organized or taxed. Strong trusts, including those that have reduced post-conversion dividends further than I expected, have universally rallied after making their moves. Investors who weren’t happy with the new dividend rate have had plenty of opportunity to cash out at a higher price.

The upshot is you don’t have to guess what management will do. As long as the underlying business remains strong, the removal of four years of 2011 uncertainty will be enough to carry the shares higher. All you have to do is monitor your picks’ health, and first-quarter earnings season presents another ideal opportunity to do so.

Last month, four Canadian Edge trusts clarified their plans paying dividends after converting to corporations. AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF), Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), North West Company Fund (TSX: NWF-U, OTC: NWTUF) and Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).

All four are very strong companies. Two are Conservative Holdings; AltaGas is reviewed as a High Yield of the Month, while Bell Aliant is highlighted in Portfolio Update. All four weathered the 2008 market crash/credit crunch and subsequent recession well and have solid long-term prospects.

All four companies, however, have elected to reduce their distributions when they convert to corporations. That’s July 1 for AltaGas and the end of 2010 for the other three.

Why cut when their businesses could support a higher rate? The main reason is a desire to maintain very conservative financial policies at a time of mounting uncertainty in the global economy. The numbers indicate that all four could absorb new taxes in 2011, either as corporations or by remaining trusts. Reducing payouts now, however, amounts to reducing financial leverage in dangerous times.

This is the policy that’s enabled these companies to ride out the horrific shocks of the past few years, and it will continue to benefit investors in the years ahead. In fact, it actually puts these companies in position to grow faster and pay fatter distributions in coming years, despite the reduction of current income now.

When North West Company Fund released its fourth-quarter and full-year 2009 earnings in late March, CEO Edward Kennedy stated with the company would “maintain the dividend policy similar to our distribution policy in terms of the pre-tax amount that we’d be allocating to dividends.” That seemed to indicate North West would be holding its post-conversion payout at the current level at least initially.

Last month, however, Kennedy provided more clarity, affirming only that the company would pay a dividend in 2011 “equivalent on an annual basis to the after-tax equivalent of the Fund’s current distribution.” Specifically, management “currently anticipates” a post-conversion quarterly dividend of CAD0.24, 29.4 percent below the current rate.

To put it mildly, this new rate is based on conservative assumptions. For one thing, the company uses a corporate tax rate of 31 percent in making its calculation. That’s well above the statutory rate and even above the “SIFT” tax rate of 28 percent. Moreover, North West had been consistently paying out less than 80 percent of distributable cash flow, even with the recession taking a bite out of its business.

Based on the imputed annualized dividend rate of CAD0.96 per share, North West still yields well over 5 percent. And the CAD0.24 a quarter is actually about halfway between the CAD0.22 paid in April 2007 and the CAD0.27 paid in July 2007. That was the first of three distribution hikes made after the trust tax was announced, in addition to four “special cash” payments.

In other words, it’s pretty clear that North West is setting a very conservative initial distribution policy. And judging from the muted reaction to the announced reduction, which will take place at conversion in late 2010, investors seemed to have expected it, as the units still trade slightly above my buy target of USD18.

In my view, High Yield of the Month Colabor Group (TSX: GCL, OTC: COLFF) is a more attractive play in the food distribution sector, as it converted last year and didn’t cut. In fact, it pays a dividend nearly twice what North West will pay when it converts. But North West’s planned cut, though painful, is not a sign of business weakness. This is still the same extremely solid company. North West Company continues to rate a buy on dips to USD18 or lower.

The same goes for Zargon Energy Trust, which last month also provided more detail on its future payout policy at the CIBC Energy & Infrastructure Conference. CEO Craig Hansen spent the first portion of the conference detailing the small oil and gas trust’s success in growing its oil-weighted reserves and output, despite a difficult environment. More interesting, however, were his comments about the company’s dividend when it converts to a corporation in late 2010.

For some months, management’s mantra has been that it will retarget its payout ratio from the current 50 percent to 35 percent of cash flow. The thinking is that Zargon will be able to use the additional cash to “exploit” the proven and potential reserves it has acquired through a recent spate of acquisitions.

Like CEOs of many Canadian companies, Hansen is clearly uncomfortable relying on capital markets to fund business growth. The company has largely eschewed large equity issues as well as taking on debt, even in one of the most hospitable environments for raising capital in decades. That’s the same capital C conservatism that enabled Zargon to avoid cutting its dividend following the 2008 crash in energy prices.

Next week, Zargon will release its first quarter earnings, which should push its payout ratio below the 50 percent it’s held recently. The main reason is more than 80 percent of cash flow is from producing oil, and oil prices generally trended higher in the first quarter.

All else equal, that would increase the pool of cash flow on which the new 35 percent target payout ratio is based, and thereby reduce the prospective dividend cut. As it stands now, however, investors can expect a reduction in their monthly dividend of roughly 30 percent, to a monthly equivalent of 12.6 cents Canadian from the current CAD0.18. That equates to a yield of roughly 7.6 percent.

Of course, the best valuation measure for any energy producing company is how its market value compares to the net asset value of what it has in the ground. At its current price, Zargon trades at about 90 cents per dollar of its growing asset base. That’s a valuation likely to attract a takeover once the conversion is complete. In the meantime, investors can rest assured they’ll own one of the most conservative energy plays in North America. My buy target for Zargon Energy Trust remains USD20.

In stark contrast is Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF), which boosted its distribution another 42.9 percent last month but with a caveat: The new quarterly rate of CAD0.50 per share may not hold after the trust converts to a corporation in late 2010/early 2011. That’s because the increase is designed to maximize tax pools in advance of taxation.

Take it from CEO Marcel Coutu: “The current level of distributions now may not be sustainable at our current future crude oil price and production levels.” That’s perfectly reasonable, given that profits from the Syncrude venture that contributes all of its profits are extremely leveraged to oil prices. And odds are by this time Oil Sands’ investors are familiar with its volatile dividend policy, which in effect tracks oil prices. Over the past five years, for example, there have been nine dividend increases and two cuts, one of which slashed the payout by 80 percent.

Things are going well now. Canadian Oil Sands quadrupled its fourth-quarter profit, and plans are underway for the Syncrude project–which is operated by ExxonMobil’s (NYSE: XOM) Canadian unit–to dramatically ramp up output in coming years. That plus higher oil prices should keep the trust’ coffers swelling in coming years.

No one, however, should buy Canadian Oil Sands if they’re relying on a steady income stream. This is at its core a powerful play on the long-term future of oil prices, but only for those who can handle some gut-wrenching ups and downs along the way. Buy Canadian Oil Sands Trust up to USD30.

Here’s the rest of the Dividend Watch List. Note we’ve now seen first-quarter earnings reported for roughly half of the companies in the How They Rate universe. We’ll have the rest over the next month with a full recap in the June issue.

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 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.

• 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)

Tips on DRIPs

US securities laws restrict participation in dividend reinvestment plans (DRIP) of foreign-based companies that don’t register their offering with the Securities and Exchange Commission (SEC).

Most plans of Canadian income and royalty trusts that do sponsor DRIPs aren’t registered under the United States Securities Act of 1933, as amended. US investors, therefore, aren’t eligible to participate.

Two CE Portfolio recommendations, Penn West Energy Trust (TSX: PWT-U, NYSE: PWT) and Provident Energy Trust (TSX: PVE-U, NYSE: PVX) do allow US investors to participate in their respective DRIP offerings, with certain limitations.

Information about Penn West’s plan is available here. Provident has a regular DRIP and a premium plan; US residents are only allowed to participate in DRIP. Click here for more information about Provident’s DRIP.

Note that Penn West and Provident are listed on the New York Stock Exchange (NYSE) and have, therefore, opted into US filing and registration requirements. It’s basically a matter of how much overhead expense trusts are willing to absorb.

Bay Street Beat

Everybody on Bay Street, it seems, loves Suncor Energy (TSX: SU, NYSE: SU). Of the 23 analysts who cover it, 20 rate it a buy; reevaluations in the wake of the company’s first-quarter earnings report include one upgrade, to “outperform.” Though the official Canadian Edge position on the stock is “hold,” clearly Suncor is doing something right.

The company did beat expectations; earnings excluding one-time items were CAD0.18 per share, 20 percent better than the CAD0.15 expected by analysts. Lower-than-expected operating costs helped Suncor’s considerable oil sands operations turn a CAD0.07 per share profit. Upstream production also bettered forecasts.

The problem with Suncor, from a CE perspective, is that it relies heavily on the notoriously high-cost oil sands, and that its recent track record there is less than bankable–again, from an income perspective.

But two separate upgrader fires during the first quarter follow similar problems in the fourth quarter. Though management says things are back on track, production has already been impacted. Even CEO Rick George admits to being “disappointed with our performance in the fourth quarter of last year and the first quarter of this year.”

Total upstream production during the first quarter averaged 564,600 barrels of oil equivalent per day (boe/d), up from 314,500 boe/d a year ago on the late 2009 merger with Petro-Canada.

Oilsands production, which doesn’t include Suncor’s interest in the Syncrude venture–contributed an average 202,300 barrels per day in the first quarter,down from 227,800 a year ago on the December 2009 and February 2010 fires at the upgraders. Both upgraders are back to full production, and Suncor achieved average oilsands production of approximately 333,000 barrels per day in April. Suncor Energy remains a hold.