Dividend Watch List

Four companies in the Canadian Edge How They Rate coverage universe announced distribution cuts this week. All four cuts were directly related to planned conversions to corporations, though one was also at least partly attributable to ongoing business weakness.

As reported in a Sept. 9 Flash Alert, Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) won’t officially convert to a corporation until Jan. 1, 2011. But the company is reducing its distribution with the Oct. 15 payment, to reflect the new taxes as well as to ready for ambitious capital spending plans over the next couple years.

Despite a relatively low payout ratio and progress reducing debt over the past year, Penn West management had long made clear its intention to reduce distributions when it converted. The 40 percent cut was pretty much in line with what most investors had expected, and buyers quickly filled in for what sellers there were in the wake of the announcement. Units currently sit about 10 percent above pre-conversion levels.

The new payout level provides a baseline yield of roughly 5 percent, based on current prices. The monthly rate of CAD0.09 is likely to be increased over time, however, as Penn West develops its vast inventory of properties and as oil prices continue to strengthen with global demand.

The company’s deal with Mitsubishi Corp (Tokyo: 8058, OTC: MSBHY) will provide sufficient financing to unlock a massive reserve of shale gas it might not have otherwise developed. Similarly, its Peace River oil sands project is moving ahead full steam with financing from Penn West’s 5 percent owner China Investment Corp, the Middle Kingdom’s largest sovereign wealth fund.

For the past several months, I’ve maintained that where Penn West management set its post-conversion dividend wasn’t really important to its long-term wealth-building potential. The dividend reduction has reduced the annual yield part of the equation by roughly 4 percentage points. Just eliminating the uncertainty surrounding future dividends, however, has already produced a capital gain for investors of more than twice that much. And there’s a lot more to come as the company boosts profitability, and oil prices strengthen.

The dividend cut will cause some investors to move on. But Penn West is now one of the lowest-risk ways to bet on energy. Buy it up to USD22.

That also goes for Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), which announced it will cut its distribution even deeper, 50 percent, when it converts to a corporation in January. As noted in the Oct. 1 Flash Alert, Peyto’s play is due in part to abysmally low natural gas prices, which have again plunged to less than USD4 per million British thermal units. More than 80 percent of the company’s energy production is gas, though a growing amount also contains more valuable liquids.

More important, however, management decided to convert the successful reserve development of the past several years into a quantum leap ahead in production. That’s been the history of Peyto for the first dozen years of its life, as reserves per share and production per share have grown at compound annual rates of 54 and 43 percent, respectively.

The recent growth spurt is due in part to the advent of horizontal drilling techniques on its lands and results are already showing up.

Daily production is up to 25,000 barrels of oil equivalent per day (boe/d) from 18,000 a year ago. Output is expected to rise to 28,000 boe/d by the end of 2010 and to the 33,000 to 37,000 range by the end of 2011.

Production gains are profitable mainly because of a 50 percent cut in the cost of bringing new output on line. And with a proven reserve life (90 percent or better chance of development) of more than 20 years, there’s even more room to ramp things up, even with gas prices at these low levels. Throw in the fact that the market value of the company is well less than the assessed value of its reserves in the ground and there’s an air-tight case for sticking with Peyto.

I continue to rate Peyto Energy Trust a buy up to USD16 for those who don’t already own it. Note Peyto’s unit price is also up about 10 percent since the conversion/dividend cut announcement. That’s roughly twice the cut in its annual yield that will take place in January.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX) will reduce its distribution by 25 percent when it converts to a corporation Jan. 1. That still leaves a generous yield of about 7.5 percent based on the current unit price. More importantly, it removes all remaining uncertainty regarding the company’s multi-year restructuring and sets the stage for solid long-term total returns.

The conversion to a corporation is the last major move for Provident, following the divestiture of its US operations and spinoff on July 9 of its oil and gas production arm to form Pace Oil & Gas (TSX: PCE, OTC: MDOEF). The surviving company is the largest pure play on natural gas liquids (NGL) infrastructure and related services in North America. That’s mostly a fee-generating business, but Provident also has an opportunity to capitalize on stronger energy prices through its marketing arm.

As I pointed out in the Oct. 7 Flash Alert, reducing the distribution will bring the payout ratio back to a manageable level after an uncomfortable period where it had been well over 100 percent. It will absorb any new taxes, aided by the company’s estimated CAD900 million in tax pools related to asset development. And it will provide a greater amount of cash flow to fund future organic growth projects and strengthen the balance sheet.

There’s still too much commodity price exposure here to merit a swap for Provident from the Aggressive to the Conservative Holdings.

But the company has now put all of its 2011 risk behind it and looks set to deliver annual total returns of at least 10 to 15 percent–much more if energy prices pick up steam or the company attracts a takeover offer.

As Provident only made its move on Wednesday evening after the market close, there’s not enough post-announcement trading history to declare it will follow the positive example of Peyto and Penn West units.

That’s my bet, however, after what was almost surely a lighter dividend cut than most were expecting. Buy Provident Energy Trust up to USD8.

Like the three Portfolio companies announcing cuts last month and highlighted above, Swiss Water Decaf Coffee Income Fund (TSX: SWS-U, OTC: SWSSF) also couched its distribution cut as necessary in light of its planned conversion to a corporation Jan. 1, 2011. And the 30.6 percent reduction to a quarterly rate of CAD0.0625 per share will certainly absorb any new taxes it would have to pay and then some.

Unfortunately, conversion is far from the company’s only problem in a fiercely competitive industry where a stronger Canadian dollar puts it at an increasing disadvantage. The January cut, for example, will be the third in company history from the rate of CAD0.1085 per month that it paid at its initial public offering in 2002, representing a more than 80 percent haircut.

Second-quarter and first-half 2010 results showed slightly improved sales and cash flow over year earlier levels. That was due largely to a 13 percent increase in processing volumes for the first half. But those gains were offset in large part due to the strong loonie, as 77 percent of overall company sales were generated in the US.

The company advertises a unique process, which it’s tied in a marketing sense to the public’s desire for “green” products. In reality, however, a rising Canadian dollar’s negative impact on profits will trump everything the company does to manage costs or improve sales, due to a declining value of US dollar revenue. And processes that do take place in Canada are less competitive as well, as a rising Canadian dollar boosts costs relative to those of competitors outside Canada.

The bottom line is there’s little reason to expect Swiss Water’s long-term decline–which began only shortly after its units came to market–is about to reverse, or even has come to an end. And the post-conversion yield of about 6 percent based on current prices won’t compensate new buyers for the risk.

Here’s the rest of the Watch List along with my current advice for all of the companies on it. The first list is comprised of companies that have endangered dividends because of weak operations. The second list shows the handful of trusts yet to set a dividend rate for 2011 when the new taxes kick in. I’ll continue to show it as long as there are trusts that haven’t yet declared post-conversion dividend policies.

Companies on List 1 are weak. If they cut, their share prices are likely to fall hard. List 2, in contrast, is comprised of trusts that may cut to shepherd cash flow when they convert to corporations but ultimately are backed by strong businesses. Dividend cuts may trigger selloffs if they’re greater than expected. But the damage won’t last long, as value hunters snap them up.

In effect, there’s little risk holding them to see what management does. In fact, as the examples of Penn West and Peyto show, even dividend cutters can rally strongly. Just the elimination of uncertainty that’s hung around since 2006 is enough to trigger a rally.

As always, the difference between winners and losers is always a strong underlying business. That’s why the companies in List 1: Business Concerns are typically “sells” and “holds” at best. Companies on List 2: Conversion Cut Candidates are often buys. They’re not only strong bets for the long haul but are likely to rally short term as well, just by telling us what their future dividends will be.

I expect most of the rest of the companies on List 2 to announce their intentions along with third-quarter earnings, if not before. That includes both ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Parkland Income Fund (TSX: PKI-U, OTC: PKIUF). Parkland continues to state dividends will fall within a range of 75 to 110 percent of the current monthly rate of CAD0.105 per unit.

Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF) is off the Watch List after announcing it will convert to a corporation Jan. 1, 2011 without a dividend cut. Instead, the company will trade as a staple share, combining notes with a face value of CAD5 per unit that mature in 2040 with an equity component. The debt will shelter income from taxes, allowing the company to continue paying out a robust amount.

Of course, that amount can vary with the company’s margins on storing and loading metallurgical coal for export, as recent fluctuations in Westshore’s distribution can attest. Those margins fluctuate with energy prices as well as demand, particularly in Asian markets. For more on Westshore Terminals Income Fund, a buy up to USD20, see this month’s Feature Article.

Finally, two companies are now much more likely to cut distributions by the end of the year after last month’s developments. Currently on List 2, Brookfield Real Estate Services Fund (TSX: BRE-U, OTC: BREUF) management now states its dividend could be cut at conversion, though it still isn’t saying by how much.

The company’s dominant position in the real estate agent franchising sector (22 percent market share), backing of parent Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) and lack of capital expenditures are huge positives for a consistent high payout, however. And the current yield of 10.6 percent is clearly pricing in a cut greater than the likely added tax burden. Brookfield Real Estate Services Fund is still a buy up to USD12.

In contrast, Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF) remains a sell after effectively doubling down on its investment in sub-metering. The company last week completed its takeover of Enbridge Inc’s (TSX: ENB, NYSE: ENB) Electric Connections (EECI) unit for approximately CAD23.2 million in cash. The deal represents a combination of the two largest independent players in Canada.

Unfortunately, right now that holds about the same appeal as monopoly on making telegraph machines. EECI’s operations complement those of Consumers’ Stratacon unit. But the combination will still face the same steep challenges, mainly regulatory uncertainty in the midst of a popular revolt among apartment dwellers against landlords installing sub-meters.

Apartment owners are, of course, incentivized to install anything that would save energy, and thereby reduce the steep heating bills most cover for their tenants. Their eagerness was the main spur to the torrid growth of sub-metering up until last year, when Ontario regulators clamped down by suspending new installations and requiring tenant approval of existing company-landlord agreement.

By purchasing EECI, Consumers’ Waterheater is clearly making a bet that the Ontario government will live up to its statements that it will create a long-term regulatory solution, and that new opportunities for growth in condominiums will offset weaker growth in straight apartment buildings. The ability to cut costs from EECI will also play a major role, questionable given its different operating areas from Stratacon.

Another risk: Despite doubling in size thanks to the merger, the company’s share of this market will still lag well behind that of Canada’s giant utilities. And if there is a price war of sorts, the results would be a disaster for Consumers’ cash flow and therefore distribution, particularly as CAD605 million in debt comes due over the next four years. That’s an amount more than twice Consumers’ current market capitalization of CAD267 million.

Judging from the reader mail I’ve received, Consumers’ Waterheater continues to draw investor notice for its hefty yield, which is still well over 13 percent. If you fall into that category, just remember the current payout ratio is low only because management cut the distribution in half a year ago. And there are two possible catalysts to take it down at least that far again: converting to a corporation in Jan. 2011 (management hasn’t yet set a dividend rate) and a potential disappointment in sub-metering. Sell Consumers’ Waterheater Income Fund.

List 1: Business Concerns

• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–SELL
• Consumers Waterheater (TSX: CWI-U, OTC: CSUWF)–SELL
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)–Hold
• Interrent REIT (TSX: IIP-U, OTC: IIPZF)–SELL
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)–Hold
• Superior Plus Corp (TSX: SPB, OTC: SUUIF)–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 (TSX: BR-U, OTC: BRBMF)–Hold
• Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)–Buy @ 22
• Brookfield Real Estate (TSX: BRE-U, OTC: BREUF)–Buy @ 12
• Canfor Pulp Income (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 Trust (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

Bay Street Beat

Canadian Edge Portfolio Aggressive Holding Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) has done nothing but run since announcing its intent to convert to a corporation on Dec. 31, 2010. The stock seems poised to push its 52-week high after rallying more than 8 percent since Tuesday evening’s announcement.

The conversion will include a 50 percent reduction in the monthly payout, from CAD0.12 per unit to CAD0.06 per share, beginning with the January 2011 distribution, “as part of a plan,” in management’s words, “to deliver more return to investors through growth.” Management’s plan that the loss in regular cash income for investors will be more than made up for by capital appreciation seems to have been validated by the market, at least over the first couple days post-announcement. The cash saved with the dividend reduction will be used to fund to boost capital spending.

Bay Street is certainly bullish on the Peyto’s conversion; of the nine analysts covering the stock, eight rate it a “buy” based on Bloomberg’s standardized system, while one says it’s a “hold.” (And the “hold” rating is, in the words of the analyst, “sector perform,” with a CAD16.50 price target. Bloomberg attempts to standardize the aggregate ratings nomenclature derived from a number of Bay Street and Wall Street houses. The analyst reiterated the “sector perform” rating and a CAD16.50 target with the stock priced at CAD14.35, Tuesday’s close. From where the analyst was sitting, he still saw 15 percent upside in the stock.) FirstEnergy Capital upgraded Peyto to “outperform” with a CAD17.50 target.

Management pointed out in its statement that Peyto’s reserves and production per share or unit have grown at a compound annual rate of 54 percent and 43 percent, respectively, over the past 12 years, growth that’s been reflected in the share and unit price. (Peyto became an income trust in 2003.) Average daily production in 2010 is up to 25,000 barrels of oil equivalent per day, a 39 percent increase from September 2009. Already a low-cost, high-output producer, Peyto has employed technological advances such as horizontal multi-stage fracturing to reduce costs even further while also boosting returns. The company continues to add horizontal drilling locations to its inventory, the production of which, based on an expanded capital program, should push the 2011 exit rate to between 33,000 and 37,000 barrels of oil equivalent per day.

Although management stated at one time that it could maintain its current payout after a conversion, we noted back in June that decision-makers might choose to pump more cash into reserve and output growth as a more “tax efficient” way to build wealth for investors. Given that natural gas, which accounts for more than 80 percent of Peyto’s production, has languished around USD4 per million British thermal units since early 2009, a cut along the lines of Daylight Energy’s (TSX: DAY, OTC: DAYYF) 37.5 percent reduction seemed a likely course. In the event Peyto’s ultra-conservative reduction allows it to redirect cash toward investments that will help the company thrive as the paradigm shifts to low prices for and high consumption of gas. The abundance of natural gas in North America and its relatively clean profile make it the perfect fuel to bridge the transition to a renewable-based future while also serving the cause of energy security for Canada and the US.

The CAD0.72 per share post-conversion annualized payout works out to a yield of 4.6 percent, based on Thursday’s closing price. But the track record suggests management will deliver on a total return model and continue to grow reserves and production. Though the dividend cut was steeper than we anticipated, Peyto has been and will continue to be a solid long-term holding for investors who seek stable income and reasonable growth–whatever form it takes. Peyto Energy Trust is still a great way to play the eventual recovery of natural gas up to USD16.

Here’s how Bay Street rates the rest of the names under Canadian Edge Oil and Gas coverage:

• Advantage Oil and Gas (TSX: AAV, NYSE: AAV)–8 Buy, 2 Hold, 0 Sell
• ARC Energy Trust (TSX: AET-U, OTC: AETUF)–10 Buy, 6 Hold, 0 Sell
• Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF)–2 Buy, 0 Hold, 0 Sell
• Baytex Energy Trust (TSX: BTE-U, NYSE: BTE)–13 Buy, 1 Hold, 1 Sell
• Bellatrix Exploration (TSX: BXE, OTC: BLLXF)–5 Buy, 2 Hold, 0 Sell
• Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)–6 Buy, 6 Hold, 0 Sell
• Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF)–5 Buy, 1 Hold, 0 Sell
• Canadian Natural Resources (TSX: CNQ, NYSE: CNQ)–20 Buy, 3 Hold, 0 Sell
• Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF)–6 Buy, 8 Hold, 3 Sell
• Cenovus Energy (TSX:  CVE, NYSE: CVE)–13 Buy, 8 Hold, 0 Sell
• Crescent Point Energy (TSX: CPG, OTC: CSCTF)–8 Buy, 4 Hold, 0 Sell
• Daylight Resources (TSX: DAY, OTC: DAYYF)–12 Buy, 4 Hold, 0 Sell
• Encana Corp (TSX: ECA, NYSE: ECA)–9 Buy, 14 Hold, 1 Sell
• Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF)–4 Buy, 9 Hold, 2 Sell
• Equal Energy (TSX: EQU, NYSE: EQU)–2 Buy, 0 Hold, 0 Sell
• Freehold Royalty Trust (TSX: FRU-U, OTC: FRHLF)–0 Buy, 5 Hold, 0 Sell
• NAL Oil & Gas Trust (TSX: NAE-U, OTC: NOIGF)–9 Buy, 4 Hold, 0 Sell
• Nexen Corp (TSX: NXY, NYSE: NXY)–9 Buy, 14 Hold, 1 Sell
• Pace Oil & Gas (TSX: PCE, OTC: MDOEF)–5 Buy, 0 Hold, 0 Sell
• Pengrowth Energy Trust (TSX: PGF-U, NYSE: PGH)–12 Buy, 3 Hold, 1 Sell
• Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)–8 Buy, 7 Hold, 0 Sell
• Perpetual Energy (TSX: PMT, OTC: PMGYF)–1 Buy, 7 Hold, 4 Sell
• Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)–8 Buy, 1 Hold, 0 Sell
• Progress Energy Resources (TSX: PRQ, OTC: PRQNF)–10 Buy, 7 Hold, 0 Sell
• Suncor Energy (TSX: SU, NYSE: SU)–18 Buy, 6 Hold, 0 Sell
• Talisman Energy (TSX: TLM, NYSE: TLM)–20 Buy, 5 Hold, 0 Sell
• Trilogy Energy (TSX: TET, OTC: TETFF)–5 Buy, 4 Hold, 1 Sell
• Vermilion Energy (TSX: VET, OTC: VEMTF)–6 Buy, 5 Hold, 0 Sell
• Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF)–0 Buy, 7 Hold, 0 Sell

Since last month’s issue was published (Sept. 3), a total of 268 actions have been taken by Bay Street, including 253 “maintains,” meaning an analyst’s opinion hasn’t changed from prior guidance. Analysts have issued a total of 10 updated recommendations on eight companies, including seven downgrades and three upgrades.

TD Newcrest accounted for much of the activity, “downgrading” Advantage Oil and Gas to “buy” (and illustrating, again, the lack of precision of Bloomberg’s shorthand for Bay Street-speak), ARC Energy Trust to “hold,” and Progress Energy Resources to “neutral.” The firm placed Penn West Energy Trust on its “active buy list” following revelation of Penn West’s plan for corporate conversion. National Bank Financial boosted Penn West to “sector perform” from “underperform” and raised its target price to CAD21.50 from CAD20.

Freehold Royalty Trust was upgraded to “sector perform” by Scotia Capital.

The fine folks at Canaccord Genuity downgraded Enerplus Resources Fund to “hold” because the unit price is scraping the firm’s target price of CAD26.50. 

How to Fix Improper Withholding

The timeline, facts and legal interpretation presented below are derived from a letter to US Representative Phil Gingrey (R-GA) signed by Elizabeth U. Karzon, Branch Chief, Branch 1, Office of Associate Chief Counsel (International), US Dept of the Treasury, Internal Revenue Service, dated June 17, 2010.

This is your first tool to use against an intransigent broker who won’t properly adjust your account to reflect the fact that Canada cannot legally withhold 15 percent at the source from distributions paid by Canadian income trusts or royalty trust that are paying tax at the entity level as “specified investment flow-throughs” (SIFT) or from dividends paid by former trusts that have converted to corporations in respect of units or shares held in a US IRA account

I am happy to provide a pdf copy of the letter to any ready who’d like one. Please e-mail me at ddittman@kci-com.com if you’d like a copy; this will be your backup tool.

It’s a general rule of US federal taxation that an individual isn’t liable for US taxes on amounts earned through an IRA until those amounts are distributed. But US tax law can only defer US tax. US tax authorities have no power to influence a foreign country’s imposition of tax on income that the IRA derives from that country.

Distributions from Canadian income and royalty trusts therefore may be subject to tax in Canada depending on Canadian tax law and the terms of the US-Canada Income Tax Treaty (the Treaty).

Certain US entities that are generally exempt from taxation in a taxable year in the US–such as IRAs–are exempt from taxation on dividend income arising in Canada in that same taxable year, according to Article XXI of the Treaty, “Exempt Organizations.”

Based on a 2005 change in Canadian tax law, Canada began imposing a 15 percent withholding tax on distributions from income and royalty trusts to US residents. Canadian tax law didn’t initially treat these distributions as dividends, however, and so they weren’t exempt from Canadian tax under Article XXI of the Treaty.

In 2007, Canada amended its domestic law again and began taxing certain of these trusts as corporations and treating distributions from these trusts as dividends for purposes of both their domestic law and their tax treaties.

Canada and the US signed an exchange of diplomatic notes in 2007, on the same day the two parties signed the Fifth Protocol to the Treaty, that include what we’ve often referred to as “Annex B.” These notes confirmed, among other things, “that distributions from Canadian income trusts and royalty trusts that are treated as dividends under the taxation laws of Canada shall be considered dividends for the purposes of [the Treaty].”

However, Canadian law–the Tax Fairness Act–provides that Canada won’t tax income and royalty trusts already in existence as of Oct. 31, 2006, as corporations until Jan. 1, 2011. Until then, Canadian tax law won’t treat distributions from such trusts as dividends. Distributions from these pre-existing trusts won’t be exempt from Canadian tax under Article XXI of the treaty until 2011–when these income and royalty trusts will become “Specified Investment Flow-Throughs,” or SIFTs, taxed at the entity level.

The IRS acknowledges that investors who hold Canadian trust units in IRAs may not claim a foreign tax credit for the Canadian taxes withheld on the income paid in respect of those units. This is consistent with a general rule that foreign tax credits may not be credited against an individual’s tax liability unless the individual is liable for the tax. Nor can the IRA make use of a foreign tax credit because it’s exempt from tax in the US.

This may ultimately result in double taxation when the IRA distributes this income to the unitholder. The 2007 Tax Fairness Act, when it and the Fifth Protocol have full effect, will generally eliminate the 15 percent Canadian withholding tax on dividends paid by income and royalty trusts in respect of units held in US IRAs.

The IRS position has been brought to the attention of at least one major brokerage, which places blame for continued incompetence on this issue at the foot of the Depository Trust & Clearing Corporation (DTCC), an old friend from the days of the qualified versus not qualified debate. Then as now DTCC was a stumbling block.