Dividend Watch List

Two companies in the Canadian Edge How They Rate universe announced distribution cuts this week. The good news is both were modest and long expected by investors, and they left generous yields solidly protected by cash flow.

Conservative Holding CML Healthcare Income Fund’s (TSX: CLC-U, OTC: CMHIF) roughly 29.5 percent distribution cut is part of its plan to convert to a corporation on Jan. 1, 2011. For the rest of 2010, it will continue to pay its current monthly CAD0.08927 per unit rate. The new rate will be CAD0.0629 per month, a level CEO Paul Bristow affirmed in the second-quarter conference call will give CML “sufficient retained capital to fund operations and enough financial flexibility to pursue strategic accretive tuck-in acquisitions.”

Read another way, management is confident it can continue growing after taxes at the new dividend level–without accessing capital markets–which ultimately opens the door to resumption of dividend growth. I discuss the reduction–which was far less than expectations and triggered a sharp surge in CML units–and the company’s prospects in September’s High Yield of the Month. CML Healthcare Income Fund is a buy up to USD12.

The other cutter last month was Manitoba Telecom Services (TSX: MBT, OTC: MOBAF), a traditional telecom organized as a corporation and covered under Information Technology in How They Rate. The company will cut its quarterly distribution from the current rate of CAD0.65 per share to CAD0.425.

As with CML, cutting its dividend triggered a surge in Manitoba shares last month. More important for the longer haul, it still leaves a solid yield of 6 percent-plus and limits the company’s need to rely on capital markets to fund ambitious plans to roll out broadband service to underserved areas of rural Canada. The fiber-to-the-home build-out is expected to cost CAD125 million over five years and connect some 120,000 homes.

By the time its network is completed in 2015, the company will have a broadband connection to 65 percent of households in Manitoba, via either fiber or other high-capacity lines. And it will be able to offer a triple play of entertainment, broadband Internet and voice service to its base that’s superior to cable television competitors, who continue to pick off its traditional phone customers though at a declining rate.

On the negative side, the dividend cut is also in response to loss of revenue due to continued weak conditions in the enterprise market and lowered management guidance for full-year 2010 earnings. The original outlook of CAD2 to CAD2.50 per share is now CAD1.80 to CAD2.15 per share. Free cash flow, meanwhile, is now expected to tally between CAD175 million and CAD225 million, down from an earlier projection of CAD160 million to CAD190 million.

Second-quarter results reflected this weakness, as not even an expectation-beating CAD11.6 million annualized cost savings could prevent a 6.4 percent drop in cash flow and an 18.2 percent dip in earnings per share. Aggressive promotional advertising from a cable television competitor forced the company to temper pricing, though it was able to post 5.3 percent, 3.1 percent and 7 percent growth in wireless, high-speed Internet and television customers, respectively. The company also enjoyed a 58 percent surge in wireless data revenues, as more of its base moves to smart phones and their myriad applications.

Looking ahead, business-to-business revenues are likely to remain sluggish even as cable competition remains fierce. As the leader in Manitoba for every telecommunications market segment, however, the company does enjoy certain advantages in scale, financing and reach. Also, management is targeting an additional CAD30 million to CAD40 million in annualized cost reductions this year, which will continue to offset these pressures.

When management adjusts its guidance lower, it’s important to pay attention. And in my view, Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) is a much better choice for secure yield in this sector. Note that Bell Aliant, too, has slated a distribution reduction beginning Jan. 1, 2011, when it converts to a corporation. Its monthly rate, however, will be CAD0.158 an annualized yield of about 7.5 percent on the current price.

Happily, the worst now appears out for Manitoba Telecom, and the stock appears to good candidate to revisit at the least the low 30s over the next several months. I continue to rate Manitoba Telecom a buy up to USD28 for income and modest growth.

Here’s the rest of the Watch List along with my current advice for all of the companies on it. As was the case in the previous issue, I’ve divided the list in two. The first is comprised of companies that have endangered dividends because of weak operations. The second lists the handful of trusts yet to set a dividend rate for 2011 when the new taxes kick in.

Weak companies cut dividends due to business reasons mandated by subpar operating performance. When cuts are made, share prices typically fall hard and often never get back up. Damage can be particularly nasty if the reduction is largely unexpected, or is made after prior management assurances that no cut is imminent.

In stark contrast, conversion-related cuts are entirely at management’s discretion. More than half the trusts to either complete or announce conversions thus far have elected to do so without reducing distributions, a clear upside surprise. Most of the rest have cut only enough to cover their new tax liability, in order to preserve their ability to grow. This, too, has created upside in the converting trusts’ units.

Of course, a particularly sharp cut can take a stock down hard as yield-focused investors bail out. But as we’ve seen again and again, as long as the underlying business is solid, it won’t be long before bargain hunters and growth-oriented investors pick up the slack, reversing the damage.

The upshot: There’s not much risk to investors holding and even buying shares of strong trusts that have yet to announce post-conversion dividends. Discretionary cuts are virtually impossible to forecast with accuracy. That’s why companies that haven’t announced a post-2010 dividend still trade at a discount to those that have. But even in the worst-cases for lost income, patient investors are ultimately being made whole. And when the current extremely low expectations are exceeded–not too difficult given the level of fear in this market–upside potential is substantial.

The key to your returns as an investor is always a strong underlying business. That’s why the companies in the list “Business Concerns” are typically sells and holds at best. Meanwhile, the “Conversion Cut Candidates” are often buys, despite the remaining uncertainty about their future plans for paying dividends.

Note that Primaris Retail REIT (TSX: PMZ-U, OTC: PMZFF) is now off the first Dividend Watch List, thanks to strong second-quarter numbers that demonstrate the success of recent investments and the overall health of its portfolio. The payout ratio of just 87 percent matches the prior quarter, and reflects solid 96.6 percent occupancy of its malls as well as a successful run of acquisitions. Primaris Retail REIT is a buy up to USD19.

I continue to prefer its rival RioCan REIT (TSX: REI-U, OTC: RIOCF) in the shopping center REIT space, at least when it trades under USD20.

Meanwhile, CML Healthcare and Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF) are both off the second list this month. September’s High Yield of the Month selections announced post-corporate-conversion dividend policies, Phoenix without reducing distributions and CML cutting only modestly.

I expect most of the rest of the companies on List #2 to announce their intentions along with third quarter earnings. That includes Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) as well as Parkland Income Fund (TSX: PKI-U, OTC: PKIUF), which continues to state dividends will fall within a range of 75 to 110 percent of the current monthly rate of CAD0.105.

List 1: Business Concerns

• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–Sell
• Consumers Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)–Sell
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)—Hold
• InterRent Properties REIT (TSX: IIP-U, OTC: IIPZF)–Sell
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)–Hold
• Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Hold
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)–Hold
• The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Hold

List 2: Conversion Cut Candidates

• ARC Energy Trust (TSX: AET-U, OTC: AETUF)–Buy @ 22
• Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF)–Hold
• Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)–Buy @ 22
• Brookfield Real Estate Services (TSX: BRE-U, OTC: BREUF)–Buy @ 12
• Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF)–Buy @ 15
• Chartwell REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• Freehold Royalty Trust (TSX: FRH-U, OTC: FRHLF)–Hold
• IBI Income Fund (TSX: IBG-U, OTC: IBIBF)–Buy @ 15
• Liquor Stores Income Fund (TSX: LIQ-U, OTC: LQSIF)–Buy @ 16
• NAL Oil and Gas (TSX: NAE-U, OTC: NOIGF)–Buy @ 15
• Parkland Income Fund (TSX: PKI-U, OTC: PKIUF)–Buy @ 13
• Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)–Buy @ 22
• Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)–Buy @ 15
• Provident Energy Trust (TSX: PVE-U, NYSE: PVX)–Buy @ 8
• Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF)–Buy @ 16

Bay Street Beat

Potash Corp of Saskatchewan (TSX: POT, NYSE: POT) board of directors announced on Aug. 17 that it had received and rejected an unsolicited, USD130 per share buyout offer from Australia-based BHP Billiton (NYSE: BHP), the world’s largest mining company. Potash Corp shares, which we rated a buy up to USD100 prior to the offer, shot from USD112 to USD140 when it opened on Tuesday, Aug. 17. The stock was above USD148 as of Friday morning, Sept. 3.

Bay Street has issued 18 coverage updates in the aftermath of BHP’s bid, which seems likely to set off an auction fraught with political uncertainty, on top of questions about the fate of what is clearly a very valuable company. Eight analysts maintained “buy” ratings (or their semantic equivalents), seven kept their “hold” advice, while three downgraded the stock to “hold.” As we noted in this week’s Maple Leaf Memo, we aren’t long-distance mind-readers:

There’s no telling for sure whether BHP does indeed have the will and the wherewithal to push its bid to USD180 per share. Potash Corp has soared well past its Canadian Edge How They Rate buy target; for conservative, income-oriented investors it’s probably time to lock in a substantial capital gain.

These types of winners come few and far between; better to build wealth over the long term by building a collection of solid, sustainable dividend-payers back by strong businesses.

In other Bay Street action, not including adjustments made to Potash Corp perspectives, analysts issued a total of 22 upgrades and 30 downgrades. The Oil and Gas group saw the most action, as Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF), EnCana Corp (TSX: ECA, NYSE: ECA), NAL Oil & Gas (TSX: NAE-U, OTC: NOIGF) and Progress Energy Resources (TSX: PRQ, OTC: PRQNF), which received two positive endorsements, were the subject of upgrades. We rate Bonterra Oil & Gas a buy up to USD35, EnCana Corp a buy up to USD40, NAL Oil & Gas a buy up to USD15 and Progress Energy Resources a hold.

Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF) was downgraded by two houses, though both analysts cut to “neutral,” the functional equivalent of “hold.” Canadian Oil Sands, the only pure play on the oil sands, is particularly sensitive to crude prices among oil and gas producers. Because costs for oil sands extraction and processing are so high, Canadian Oil Sands needs crude to stay elevated–as in above USD60 per barrel, at the very minimum–for its operations to be economic. Oil prices declined by more than 11 percent during August, suggesting, too, that Canadian Oil Sands’ forecast that it will likely cut its dividend by year’s end is a nice case of dead-on expectations management.

Over the long term Canadian Oil Sands will benefit from the fact that global production has begun to plateau, while demand for oil will continue to rise. In other words, we’ve entered a period where the new range for the per-barrel price of oil will be much higher than that to which we grew accustomed during the 1980s and ’90s. Nevertheless, the only pure oil sands play will trade erratically, and, as even management acknowledges–forthrightly and in an investor-friendly way–the dividend will be volatile, too.

The CE way to play the oil sands is through Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF), which holds the exclusive contract to move production from the Syncrude consortium, of which Canadian Oil Sands is the trading entity. Pembina Pipeline’s cash flow is locked in by contracts based on throughput; it’s less sensitive to oil-price fluctuations. Expansion plans slated for completion in 2011 will only bolster Pembina’s ability to serve producers in the oil sands region.

Pembina Pipeline Income Fund–a sure way to build wealth in the Canadian oil sands–is a buy up to USD18. Canadian Oil Sands Trust is a buy for aggressive investors up to USD30.

Top Banks

The October issue of Global Finance includes the magazine’s ranking of the world’s 500 largest banks. Canada comes off extremely well in the poll.

Royal Bank of Canada (TSX: RY, NYSE: RY) is No. 10 in the world, according to Global Finance, which is compiling its rankings for the 19th year. The magazine compares long-term credit ratings from Moody’s, Standard & Poor’s and Fitch as well as total assets to measure safety.

Toronto-Dominion (TSX: TD, NYSE: TD) is 15th, while Bank of Nova Scotia (TSX: BNS, NYSE: BNS) is 22nd, Bank of Montreal (TSX: BMO, NYSE: BMO) is 36th and Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) is 37th. All five ranked among North America’s 10 safest banks.

JPMorgan Chase (NYSE: JPM) was the highest-ranked US bank at No. 40. Wells Fargo & Company (NYSE: WFC) ranked 43rd, US Bancorp (NYSE: USB) 48th.

We’ll take a look at fiscal third-quarter earnings for Canada’s Big Five banks in next week’s Maple Leaf Memo.

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.