September’s High Yield of the Month selections–CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) and Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)–won’t convert to corporations until Jan. 1, 2011. Both, however, have now eliminated their 2011 risk by declaring what their dividends will be after converting.

In Phoenix’ case, conversion will not affect dividends, period. The provider of horizontal and directional drilling technologies to oil and gas producers in western Canada and the US will continue paying its monthly dividend of CAD0.04 per share up to and past conversion. That ensures it will remain by far the highest yielding company in its sector, even as it gears up for a return to growth.

Energy services companies like Phoenix are doubly leveraged to energy prices. Rising oil and gas prices stimulate demand for rigs and services by producing companies, pushing up usage rates. And rising demand also means competition for existing rigs and services, which enables companies like Phoenix to increase rents and fees.

That at least was the situation in the Canadian energy patch in late 2005, as hurricanes Katrina and Rita in the Gulf of Mexico drove oil and especially natural gas prices to new levels. Then came the protracted decline in gas prices, temporarily interrupted by a first half 2008 spike, taking the fuel’s spot price down to its current level under USD4 per million British thermal units. Producers pulled in their horns and rig utilization and fees plunged.

Energy services companies saw their profits evaporate. Half of the trusts and companies in the Canadian Edge coverage universe eliminated their dividends entirely in late 2008 and 2009, and several industry players were driven into bankruptcy. Even Phoenix was forced to reverse a practice of annual distribution increases that dated back to its inception as a trust in 2004, trimming its payout from a monthly rate of CAD0.085 in October 2009 to the current level of CAD0.04.

Utilization levels are still a long way from the halcyon days of five years ago. For several quarters, however, there have been clear signs of recovering activity in the energy patch, particularly in the kind of shale gas development Phoenix specializes in.

The company’s third- and fourth-quarter 2009 rig utilization was below 2008 levels but markedly better than activity in the first half of that year. Then first-quarter 2010 operating days saw the recovery’s first year-over-year gains, with utilization up 38 percent over 2009 levels. Finally, second-quarter 2010 results showed a 117 percent jump in operating days, fueling a 114 percent increase in revenue and swinging operating cash flow solidly into the black from last year’s bleed.

Better, this favorable trend looks set to continue for the rest of 2010 and beyond. The company reported the highest drilling activity for any calendar second quarter in its history. Now management anticipates it will achieve a 29 percent boost in job capacity in 2010, fueled in part by a ramp up in capital spending to a record CAD42 million. Rising activity is expected to boost day rates in both the US and Canada the rest of the year. And the company has begun tapping into high potential opportunities outside North America, including Albania, Peru and Russia.

Some 57 percent of Phoenix’ second-quarter 2010 revenue came from its shale-focused US unit, which it operates as Nevis Energy Services. Another 7 percent was garnered outside North America. That’s roughly in line with the 64 percent US and 3 percent international recorded in 2009. But the company’s biggest emerging opportunity is actually in its home country of Canada, where producers are tapping into the light oil Cardium trend of central Alberta.

Some 80 percent of Canadian wells are now drilled directionally, up from 64 percent last year, and the proportion is still increasing. Phoenix’ focus gives it considerable advantages for grabbing a lion’s share of that emerging activity, through ownership of both “positive pulse measurement while drilling” systems and “resistivity while drilling” systems. And the same move to shale is being seen in the US and elsewhere as well. Aside from the Cardium trend, Phoenix’ most active drilling areas are the Bakken in Saskatchewan, the Pekisko in southern Alberta and the Montney in British Columbia.

The gross profit-to-revenue ratio was 23 percent in the second quarter 2010, up from 13 percent a year ago, demonstrating the company is managing growth well. Margins will continue to improve going forward, thanks to targeted capital spending and research and development efforts. And the company continues to live within its means, boosting units outstanding by just 1 percent this year and paying off CAD4 million in long-term debt during the quarter.

These developments are bullish for the future of Phoenix’ 5 percent-plus distribution and the company’s ability to grow it by adding new business. The conversion is structured as a non-taxable event, as it triggers no change in control and is on a one share-per-one unit basis. A special shareholders’ meeting is slated for November to vote on the conversion. But investors can buy Phoenix Technology Income Fund with confidence now up to my new target of USD10.

CML has actually increased its distribution twice since the trust tax announcement Halloween night 2006, most recently in May 2008. However, beginning Jan. 1, 2001–as it converts to a corporation–the company will cut its payout from a monthly rate of CAD0.08927 to CAD0.0629.

The reason is simply 2011 taxation and management’s desire to maintain its growth strategy despite the needed cash outlay. The provider of medical imaging and laboratory services basically has two business lines. One is a quasi-utility operation that provides services at rates prescribed in large part by the Ontario Ministry of Health funding agreement.

Under Canada’s government-sponsored system, there’s relatively little fluctuation in revenue due to the economic ups and downs, as no one ever loses his or her health insurance to unemployment. Under this environment, CML has been able to reliably grow revenue by adding services and facilities, both organically and through acquisitions. The key to profitability is keeping regulators happy by providing a high level of service and keeping costs under control.

The numbers bear out the stability of these operations. First-half revenue in Canada, for example, was up 1.7 percent. One-time expenses kept cash flow flat, but should result in higher margins in the second half of 2010. And the company posted its eighth consecutive quarter of imaging services growth in Canada, even excluding acquisitions.

CML’s other line of business is a growing diagnostic business in the US. Here, the opportunity for growth is massive from growing insurance rolls, a general dearth of testing facilities relative to demand/need and an extremely dispersed market. Risks, however, are also considerably higher than in Canada, as the negative impact of general system dysfunction has been magnified by the recession.

Despite a growing portfolio of facilities, CML’s second-quarter 2010 US revenue slid 26.4 percent from year-earlier levels. Cash flow margin fell from 15.3 percent to just 11.1 percent. On the plus side, margins were sharply improved from first-quarter levels, thanks to the efforts of a new management team. On the minus side, the challenges in the US continue, not least of which is US Medicare’s decision to cut reimbursement rates for diagnostic testing.

Looking ahead to the rest of 2010, profitability at the US operations is going to depend heavily on management’s ability to keep controlling its costs. Revenue will remain challenged by the economy. Office visits to referring physicians were off 4.6 percent in the second quarter from 2009, for example.

Further, under the US system, even testing for life-threatening conditions is often considered “elective” unless it meets strict criteria laid out by health insurance companies. Consequently, it’s hardly surprisingly that in a weak economy, patients would put off such procedures as mammography despite the risks of not detecting cancer in time for effective treatment.

The good news is second-quarter numbers show business even in the US has vastly improved from earlier this year. The company has made great strides to orient its business more towards fees with less exposure on the cost side. And coupled with the solid Canada performance and strong overall balance sheet, that ensures the company will continue to generate the cash to fund the current distribution through the end of 2010, and the new lower payout rate in 2011 and beyond.

CML units were relatively stable during the 2008 debacle but have underperformed badly since, hitting a low of a little over USD9 at the end of July. The primary concerns for investors have been the US business and what the dividend would be post-corporate conversion.

The double-digit gain in the unit price since the Aug. 12 earnings and conversion announcement is largely because of management’s progress addressing these concerns. But at a price a third less than its early 2008 all-time high, there’s still a lot of room for hefty capital gains, in addition to the still generous yield. Buy CML Healthcare Income Fund up to my target of USD12 if you haven’t yet.

What can go wrong for CML and Phoenix? CML’s pole position in medical diagnostics in Canada largely insulated it from its home country’s brief recession. The more the company has expanded in the US, however, the greater its exposure has become to economic hard times, as doctors, patients and insurance companies have sometimes delayed or even avoided needed testing.

The passage of comprehensive health care legislation in the US adds a huge pool of potential customers and it could potentially eliminate the disincentive to test under the current system. But there’s still enormous uncertainty surrounding what that legislation will actually mean to the industry. And that’s leaving aside the political uncertainty with Republicans now heavily favored to come to Washington, DC, in greater numbers next year, many with designs to repeal the legislation.

The upshot is management can be generally confident about steady growth in Canada (70 percent of revenue) but will have to stay on its toes in the US. Happily, the US team put in place has already demonstrated its skill dealing with earlier underperformance of the US imaging business, upgrading information systems to improve efficiency and service quality and inking a new compensation deal with its radiologists that better aligns costs with revenue. The focus is now on sales and marketing efforts, which if successful will start to show up in the numbers in coming quarters.

On the company’s second-quarter conference call, an analyst questioned CEO Paul Bristow’s assertion that CML could fund operations, growth and the new distribution rate, given the current tough operating conditions. He answered by pointing out CML’s ability to shelter cash flow through non-cash expenses and lack of capital costs, except what’s needed for acquisitions. He also stated the new rate is set low enough to enable the company to continue doing “tuck-in” acquisitions.

That’s been management’s growth strategy since converting from a non-dividend paying corporation to a trust in 2003. In fact, essentially the same team then decided incremental deals were a better course than capital-using “transforming ones,” and that it would be better to return cash to shareholders as dividends than to hold it in a bank on the off chance such a big deal would appear.

The key is CML is a well-run company that is conservatively financed–it has no major debt maturities until 2013–and has a clear long-term strategy for growth that it has stuck to for many years. I’ll be watching quarterly numbers closely, particularly for US operations to ensure recently demonstrated progress stays on track.

As for Phoenix, what can go wrong is really pretty simple: a renewed plunge in oil and natural gas prices that once again halts drilling in North America, including now-popular shale development. There’s also the possibility that opponents of shale drilling will induce Congress to introduce new restrictions that will discourage producers.

Phoenix’ exposure to the ups and downs of energy prices, however, is precisely what makes it interesting as an investment. The units draw a CE Safety Rating of only 2 and should be considered Aggressive Holdings. But after a nearly five-year depression in the energy services sector, there’s not much froth in these stocks to say the least. And a return to the 2008 high would double investors’ money.

New regulations on shale gas development in the US are always possible. But odds of anything getting through Congress this year on that score are nil–and are likely less than zero after the November elections. Moreover, the Obama administration’s consistent policy has been to encourage gas use over coal and oil, impossible if shale development is stalled. Again, don’t buy Phoenix unless you’re willing to make a bet on energy.

Also note that a reprise of the 2008 meltdown would likely hit both stocks, in part because it would depress the Canadian dollar’s exchange value, and both stocks are priced in and pay dividends in Canadian dollars. Damage would be reversed when markets stabilized, however, and both proved beyond the shadow of a doubt their ability to survive under the worst possible conditions during the 2008 crisis.

For more information on CML and Phoenix, see How They Rate. Click on the TSX symbol to go to their Google Finance pages for a wealth of information ranging from news releases to price charts. These are substantial companies that trade frequently in both the US and Canada. Phoenix is smaller at a market cap of about CAD250 million. CML’s comes in at roughly CAD1 billion at its early September price.

Some states have “blue sky” laws that may not allow your broker to pitch these trusts to you. Those laws, however, don’t prevent you from placing the order. If your broker won’t take the trade, take your business somewhere else. US investors are generally not permitted to take part in secondary offerings, but that has nothing to do with shares that are already traded either on the Toronto Stock Exchange or over the counter (OTC) in the US.

Click on the trusts’ names to go directly to their websites. Phoenix is listed under Energy Services, while CML can be found under Health Care. Click on their US symbols to see all previous writeups in Canadian Edge and its weekly companion Maple Leaf Memo. Note CML has been in the Portfolio since December 2008, while Phoenix is a new addition to the Aggressive Holdings, replacing Trinidad Drilling (TSX: TDG, OTC: TDGCF).

Distributions paid by both companies are considered 100 percent qualified for US tax purposes. Both provide tax information to use as backup for US filing–whether or not there are errors on your 1099–on their websites. Tax information to use as backup for US filing–whether or not there are errors on your 1099–is available in the Income Trust Tax Guide.

As is customary for virtually all foreign-based companies, the host government–in this case Canada–withholds 15 percent of distributions paid to US investors at the border. If you hold these trusts outside an IRA, the tax can be recovered by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation, though unrecovered amounts can generally be carried forward to future years. Form 1116 recovery will also be possible after the trusts convert to corporations.