Dividend Watch List

Four companies in the Canadian Edge How They Rate universe announced distribution cuts last month:

• Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF)
• Liquor Stores Income Fund (TSX: LIQ-U, OTC: LQSIF)
• NAL Oil and Gas Trust (TSX: NAE-U, OTC: NOIGF)
• Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF).

All four reductions were a part of plans to convert from income trusts to corporations. All four companies will maintain current distribution levels until they actually convert.

Big Rock Brewery Income Trust (TSX: BR-U, OTC: BRBMF), like many Canadian food and beverage companies, has been dealing with soft markets and tough competition the past couple years. What’s been remarkable is the former CE Portfolio holding has been able to expand market share against much larger rivals, even while controlling debt and maintaining a modest payout ratio consistently in the neighborhood of 80 percent. Third-quarter results again affirmed these strengths, as the company successfully added new brands to its existing line-up.

The announced 33 percent reduction will take the current monthly rate of CAD0.10 per unit to a quarterly payout of CAD0.20. That will absorb the taxes faced by the beer and beverage company as a corporation, while maintaining the same 70 to 80 percent payout ratio. The plan will be voted on by unitholders sometime in December, following what should be easy approval by Alberta regulatory authorities.

The biggest negative for unitholders is the conversion reduction takes Big Rock’s yield down to little more than 5 percent, based on its recent unit price. The company did bump up the trust’s yield in Sept. 2009, but the new rate takes the payout back to where it was in 2004.

Given how tough this business is and the limited potential for growth with taxes now due, that makes Big Rock Brewery Income Trust a hold.

Liquor Stores Income Fund (TSX: LIQ-U, OTC: LQSIF) will trim its distribution to a monthly rate of CAD0.09 when it converts to a corporation, also on or about Jan. 1. That represents a reduction of about 30.8 percent for the franchiser of retail liquor stores in Alberta, British Columbia, Alaska and Kentucky, from its current monthly rate of CAD0.13.

As with Big Rock’s reduction, this cut looks tailored to absorb the full impact of the company’s prospective taxes as a corporation. Investors apparently anticipated a reduction of at least that size, as they’ve pushed up Liquor Stores’ unit price slightly since. It still leaves a yield of roughly 7 percent post-conversion, very competitive for any company in this sector anywhere in the world.

Finally, post-conversion Liquor Stores still has considerable room to grow. Regulation in Alberta has crimped profits there in recently. But there’s still considerable room to grow in British Columbia and particularly the US, where retail liquor remains a highly fragmented market.

Potential opportunity looms in states, particularly Virginia, considering opening hitherto government monopolies by selling off franchises. Liquor Stores is a likely candidate for such a purpose, as it’s already a player in neighboring Kentucky, where it acquired operations in the fourth quarter of 2009.

The bottom line: Despite the dividend cut, Liquor Stores is still an attractive bet for modest growth and safe, high income, backed by an industry that’s proven itself recession proof yet again the past several years. Buy Liquor Stores Income Fund up to USD16.

NAL Oil & Gas Trust (TSX: NAE-U, OTC: NOIGF) will convert to a corporation on or about Dec. 31, 2010. Upon conversion the producer of oil and gas will reduce its monthly payout from the current rate of CAD0.09 per unit to a new rate of CAD0.07, a reduction of about 22.2 percent.

The reduction was roughly in line with market expectations, as the stock has scarcely budged since. It leaves a post-conversion yield of a little less than 7 percent based on the company’s current unit price, which is roughly in line with yields on other converting oil and gas trusts.

In my view, barring a steep drop in oil prices, NAL could have maintained its current dividend rate after taxation. But there is a major potential long-term benefit for shareholders: The cut will allow the company to really ramp up its light oil drilling projects in the Mississippian and Cardium regions of northeast Saskatchewan and central Alberta. Management currently anticipates devoting as much as 85 percent of a CAD200 million to CAD230 million 2011 capital spending budget to these light oil properties, with the target of producing 30,000 to 31,500 barrels of oil equivalent per day.

As it’s done every year, NAL will release more detail about its plans for the year ahead at the end of January. The key takeaways from this move, however, are, one, that paying out a substantial dividend is still a central management objective and, two, that the company’s post-conversion ability to substantially boost its output of extremely valuable light oil over the next couple years has the potential to increase cash flow and by a sizeable amount as well.

That means a return to dividend growth, especially if oil prices continue to rise in 2011 and beyond. The upshot is NAL Oil & Gas Trust remains attractive for a high, secure yield and growth. I am lowering my “buy up to” target to USD14, however, to account for the lower initial post-conversion yield.

Zargon Energy Trust (TSX: ZAR-U, OTC: ZARFF) had long warned it would reduce its payout upon conversion, with a target range of 35 percent of distributable cash flow after taxes. That seemed to imply a fairly steep cut from the CAD0.18 per month rate, which the company had maintained throughout the financial crisis as one of three producer trusts not to cut payouts.

As it turned out, however, the scheduled reduction–effective with the Jan. 1 conversion–will be only to CAD0.14, or a drop of 22.2 percent. And given management’s notoriously ultra-conservative financial policies, the company should have no problems at all maintaining that rate going forward, with the possibility of increases in coming years as it gets used to paying taxes.

One big reason Zargon was able to hold its distribution in 2008-09, for example, is its healthy reliance on oil production, rather than natural gas. The company, however, has increased its oil weighting further this year with a series of acquisitions and development plans. It’s also, however, been willing to shop for bargains with more gas, such as the Sept. 2010 purchase of privately held Oakmont Energy Ltd in an all-stock deal.

Oakmont is the kind of “tuck under” acquisition management prefers, bringing on existing production at a low price with upside for growth. Its reserves and output are roughly equally divided between gas and oil, providing steady and accretive cash flow on the oil side and upside on the gas side.

Ultimately, small producer companies like Zargon are more likely to end up as acquisitions for someone else rather than to stay independent indefinitely and gobble up small independents. But either way, Zargon is in good shape to produce strong returns, both through growth and with a post-conversion yield that will still be around 8.6 percent based on its current price.

Insiders have been consistent buyers all year in the upper teens. That’s a good point for total return investors to pick up Zargon Energy Trust, still a buy up to my target of USD20.

Here’s the rest of the Watch List along with my current advice for all of the companies on it. I continue to divide the list in two. List 1 comprises companies that have endangered dividends because of weak businesses writing the checks. List 2 is the dwindling number of trusts yet to set a dividend rate for 2011, when the new taxes kick in.

I expect most of the rest of the companies on List 2 to announce their intentions along with third-quarter earnings, if not before. Note that four companies announced no-cut conversions last month and are no longer on the list: ARC Energy Trust (TSX: AET-U, OTC: AETUF), Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF), Freehold Royalty Trust (TSX: FRH-U, OTC: FRHLF) and Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF).

All are strong companies, as proven by maintaining their distributions as corporations. All rank buys except for Freehold for US investors, as it pays a dividend that’s not qualified for tax purposes. Most of the rest of List 2 are also buys. Converting companies’ stocks have almost universally rallied once they do clarify dividends, even if they cut. That’s because the level of pessimism and fear about 2011 and conversions is still elevated.

In contrast, conservative investors should generally avoid the companies on List 1. That’s because the danger to their dividends is weak underlying businesses. Should conditions deteriorate enough for them to actually cut, their share prices will likely plummet, and it will be very difficult to make up that lost ground. For information on earnings, see How They Rate.

List 1: Business Concerns

• Boston Pizza Royalties Income (TSX: BPF-U, OTC: BPZZF)–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
• The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Hold

List 2: Conversion Cut Candidates

• Bonavista Energy Trust (TSX: BNP-U, OTC: BNPUF)–Buy @ 22
• Brookfield Real Estate Services Trust (TSX: BRE-U, OTC: BREUF)–Buy @ 12
• Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF)–Buy @ 15
• Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• IBI Income Fund (TSX: IBG-U, OTC: IBIBF)–Buy @ 15
• Parkland Income Fund (TSX: PKI-U, OTC: PKIUF)–Buy @ 13

Bay Street Beat

Twelve Canadian Edge Portfolio recommendations have reported earnings over the past month, and the numbers have been solid across the board. CE’s bedrock wealth-builders have shown themselves capable of sustaining consistently high dividends, maintaining clean balance sheets and growing their businesses.

At the same time they’ve been rolling out impressive third-quarter results investors have pushed share and unit prices into new-all-time-high territory. The analysts on Bay Street provided updates for CE Portfolio’s first dozen reporters that generally reflects the recent rally: As the S&P/Toronto Stock Exchange Income Trust Index (SPRTCM) and the S&P 500 have pushed out to post-March 2009 highs, so too have valuations for our favorites. The SPRTCM has actually outperformed the broader Canadian market, as In Brief details, with a picture.

The bottom line is a “buy” recommendation should be earned, and an increase in a “buy-up-to” target has to be justified by the numbers. Bay Street’s reticence to chase the market reflects the analyst community’s institutional conservatism–nobody wants to get too far out in front, nor lag too far behind–as well as it does some built-in skepticism about the durability of the current rally.

October employment numbers in the US suggest, finally, that the world’s biggest economy is adding jobs at a pace sufficient to reduce unemployment, assuming that pace continues. This news, although too late for Democrats in the US Congress, is just in time for those hungry for a real sign of economic stability. It’s the kind of thing that makes you look forward, reasonably, to new all-time highs, without qualifiers.

Nevertheless, things are still far from perfect. But that’s why we focus on businesses that have proven capable of operating during rough patches. The key to long-term wealth-building is a strong underlying business, one that holds up come hell or high water. Whether the current rally blooms into a full on long-term bull on the strength of rising employment or not, a selection of CE Portfolio recommendations, including the companies below, is a great way to stabilize your portfolio.

With Canada-based dividend payers–still the highest in the world, in fact, despite what you may have read about Finance Minister Jim Flaherty and his “Halloween Massacre”–you get exposure to a strong currency backed by the Great White North’s copious natural resources, too. Canada’s a great way to hedge against a weakening greenback, and the CE Portfolio helps you get paid at the same time.

Here’s what Bay Street has to say about the 12 early reporting CE Portfolio Holdings. For our take on the numbers see Portfolio Update and this month’s Feature Article.

AltaGas Ltd (TSX: ALA, OTC: ATGFF) is rated a buy by three analysts, a hold by three, and a sell by one. National Bank Financial upgraded the stock to “sector perform” Friday morning. Seven other houses have issued updates since the company reported third-quarter results; all have maintained their postures.

AltaGas, like most of the 12 early reporters, is trading well above the analysts’ average target price. Operations continue to be strong, as third-quarter numbers reveal. For AltaGas, and all other converters, we’ll see what Bay Street does once Jan. 1, 2011, passes and the historic rhythm of dividend increases kicks in again. Then, perhaps, the group will start boosting buy targets.

Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF), trading at CAD26.54 as of midday Friday, has an average analyst target of CAD26.17; that’s why zero Bay Streeters rate it a buy right now, while 11 say to hold. Three have issued “sell” ratings. Bell Aliant is still below CE’s USD27 buy target.

Recent Aggressive Holdings addition Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF), like Bell Aliant, can find no one on Bay Street to “buy” its units; five have “hold” ratings, with three sells.

Colabor Group’s (TSX: GCL, OTC: COLFF) most recent quarterly results are dissected in last month’s Portfolio Update. Two analysts have downgraded the shares since, one (Industrial Alliance) to “buy” with a target of CAD12, the other (Scotia Capital) to “sector perform” with a CAD12.50 target. As of press time Colabor shares were changing hands at CAD11.16.

All six Bay Street analysts who cover Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) reiterated their “hold” ratings on the units since the October issue of CE. At CAD19.38 the units are above all but one analyst target. Daylight Energy (TSX: DAY, OTC: DAYYF, 12 buys, five holds, zero sells) is a new “top pick” at Desjardins Securities. It was also downgraded, to “hold,” by Stifel Nicolaus.

Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF), trading right in line with the analysts’ average target, remains a buy at four houses, a hold at three, and a sell at one. Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF, one buy, five holds, zero sells) was downgraded by Cormark Securities to “market perform” with a CAD8.20 target.

Newalta Corp (TSX: NAL, OTC: NWLTF) closed at CAD9.21, well below the average target of CAD11.91; four Bay Streeters call it a buy, while three say to hold. Five have maintained ratings since earnings were announced. Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF), on the other hand, is trading 9 percent above its analysts’ average target. One says buy (according to Bloomberg’s imperfect interpretation of myriad investment house communications styles; Clarus Securities says “accumulate,” with a CAD21 target), five say hold, five say sell.

Conservative Holding Pembina Pipeline Corp, still the best way to build wealth in the Canadian oil sands, is a buy up to USD22.

Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF) earned two upgrades in the wake of its third-quarter earnings release, to “sector outperform” with a target of CAD13.50 at CIBC World Markets and to “outperform” with a target of CAD12.50 at FirstEnergy. That’s seven buys, five holds, and zero sells in all for Phoenix Technology. CE Portfolio mainstay TransForce (TSX: TFI, OTC: TFIFF) is a buy for all four Bay Street analysts that cover the stock; the average target price is CAD14.62, while TransForce closed at CAD11.86 on Thursday, Nov. 4. All four have reiterated their ratings since the company announced third-quarter earnings.

Brookfield’s Tactical Retreat

It’s a little bit quizzical from a timing standpoint–only a couple weeks ago the company announced its plan for conversion and dealing with 2011 taxation, and it had the relevant facts that ostensibly caused the change in hand at that time–but Brookfield Renewable Power Fund’s (TSX: BRC-U, OTC: BRPUF) curious backtrack maneuver late last month (right around the fourth anniversary of the Halloween Massacre) makes sense from a cost perspective. The income fund won’t face taxation in 2011 because of tax pools, so it can enjoy the benefits of its current structure a little longer before absorbing the transaction costs (read: legal fees) involved with becoming a corporation, at least until sometime next year.

Brookfield Renewable had rolled a conversion timeline and scheduled a unitholder vote for Nov. 30. It also paid PricewaterhouseCoopers to put together a “fairness opinion” on the transaction, standard procedure for deals of this nature but still a significant cost.

The company said it would pay quarterly dividends at an annualized rate of CAD1.30 per share, maintaining the same annualized rate it now pays out on a monthly basis. It will stick with this commitment.

According to management, cash available for distributions will be unaffected by the decision to defer the conversion, as will the ability of the fund to issue equity to fund growth. Streamlined conversion rules fashioned by the federal government to encourage conversion will be available throughout 2011. Management said it will provide further details on its new conversion course “by early 2011, with the goal of recommending a structure that will best support its future growth while providing all the benefits of conversion previously outlined.”

Also, the fund is raising CAD450 million through an offering of 10-year notes, part of about USD1.3 billion Brookfield-affiliated companies have announced in recent weeks. Brookfield Renewable recently closed a secondary offering of 8 million units at CAD21.85 per unit; this transaction took Brookfield Renewable Power Inc’s ownership stake in the fund to 34 percent.