Dividend Watch List

Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) has cut its monthly dividend in half to CAD0.015. The announcement was made concurrent with management’s release of first-quarter 2011 earnings numbers and is effective with the Jun. 15 payment.

As I pointed out in a May 18 Flash Alert, the company is redeploying the cash into a 50 percent boost in capital spending. Specifically, the goal is to lift production of liquids (light and heavy oil, natural gas liquids) up to at least 12.5 percent by the end of 2011, from virtually nil in recent years.

Oil and natural gas liquids (NGL) volumes rose 57 percent in the first three months of the year, as the company enjoyed positive drilling results. The decision to raise capital spending is in equal parts due to the more favorable pricing environment for liquids over dry natural gas, as well as the company’s own drilling successes.

Efforts to develop light oil in the Cardium and Elmworth Montney areas continue to be very successful, and heavy oil output in the Mannville area of Alberta is increasing. The company’s tests of its bitumen and shale gas also continue to be promising. Recompletions on its legacy natural gas asset base have mitigated decline rates, and construction of natural gas storage is also on track.

All of this, of course, is only partially offsetting the negative impact of continued price weakness in North American natural gas (93 percent of output). Perpetual has been fortunate in recent years to have a large number of price hedges in place, limiting the draining effect of consistently falling spot market prices. Now, however, many of those hedges are coming off and the new ones available are at much lower prices.

The company’s realized selling price for gas slipped 56 percent in the first quarter of 2011 to just CAD4.21 per thousand cubic foot. The good news is that’s now basically back to spot, which averaged CAD4.12. That means potential for further erosion is limited as long as gas prices don’t weaken significantly.

Moreover, despite its many trials and travails, Perpetual has maintained a relatively solid financial position. This year, the company has already spent CAD56.6 million of the targeted CAD135 million on development, meaning it will begin realizing the benefits of improved output this year even as its remaining financial obligations are conservative. The next significant debt maturity is a convertible security with about CAD75 million in face value outstanding, due Jun. 30, 2012. The coupon of 6.5 percent, however, is on the high side, which should limit the cost of rolling it over.

One factor that’s kept me in Perpetual despite its travails is the extraordinary level of transparency afforded by management with regard to projected output, dividends and debt under various scenarios for natural gas prices. And management provided another guidance window with its first-quarter results that suggests further downside in both share price and dividend is very limited–at least for the rest of 2011.

Specifically, if natural gas prices on the AECO hub in Alberta average CAD3 per gigajoule the rest of the year, the company will have a realized selling price of roughly CAD4.53 and a payout ratio of 41 percent. End-year bank debt will be CAD128 million, or 1.7 times annualized cash flow. That’s an AECO price about 20 percent below what prevailed when management released numbers in mid-May, a figure that’s risen since.

A slightly better price of CAD4 per gigajoule will yield a sharply better result: nearly 50 percent higher cash flow, a drop in the payout ratio to 30 percent and end-year bank debt of just CAD94 million, or 0.6 times annualized cash flow. Finally, a move back to CAD5 gas will nearly double cash flow, bring the payout ratio down to 24 percent and slash bank debt in half to just 0.2 times annualized cash flow.

A bet on Perpetual is essentially that sooner or later gas prices will improve, unlocking this company’s massive leverage to them. In the meantime management continues to take the steps that seem to be necessary to its survival, i.e. preserving cash flow and at least slightly reducing exposure to natural gas prices while they remain weak.

The rollover of the Jun. 30, 2012, convertible looms as a challenge. But it should be manageable, given that it’s only about 13 percent Perpetual’s currently depressed market capitalization.

As I pointed out in the May 18 Flash Alert, only two of the 11 Bay Street analysts covering the stock actually changed their recommendations following the mid-May earnings report and dividend cut. And both of them actually raised their rating from sell to hold.

Understandably, sentiment on Perpetual remains as gloomy as it is for natural gas prices. That’s as it should be. Gas prices have strengthened remarkably in recent weeks as we near summer cooling season. But there’s still an awful lot of production in North America with little or no opportunity for export, and usage is only creeping up.

This is truly a bet for the patient. But with management ensuring solvency in all but the worst circumstances and the stock selling well below net asset value of its reserves in the ground–even valued at currently low gas prices–this still seems like a solid speculation, at least for anyone who wants to bet aggressively on gas with limited risk while garnering a decent dividend. And that payout will be ratcheted higher if and when the company’s fortunes improve.

My buy target for Perpetual Energy remains up to USD5 for those who don’t already own it.

The Dividend Watch List highlights companies with dividend-threatening challenges at their core businesses. Not all of those listed below are sells, and they can be buys if the price is right.

Also note that several companies in How They Rate with high payout ratios for the first quarter of 2011 aren’t on this list. That’s because their shortfalls are due to seasonal factors. If numbers don’t improve going forward, they may wind up on the List. But at this point, results are well within management guidance and there’s no immediate risk to their payouts.

Here’s the June Watch List, with highlights of the past month’s developments for each following.

• Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF)–Hold
• Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Hold
• CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–SELL
• Colabor Group Inc (TSX: GCL, OTC: COLFF)–Hold
• FP Newspapers Inc (TSX: FPI, OTC: FPNUF)–Hold
• Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Hold
• Interrent REIT (TSX: IIP-U, OTC: IIPZF)–SELL
• Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Buy @ 5
• Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Hold

Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF) remains on the List this month, mainly because it still looks like management will have to make an adjustment in its distribution to reflect trust conversions.

The fund at one time held a great many Canadian Edge Portfolio recommendations but has recently focused on a broad mix of equities, including some paying little or no dividend. That may work. But it’s a departure from what’s made the fund successful historically, even as the high current yield continues to send out its siren call to unwary income investors.

Sell Brompton Stable Income Fund and switch to Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF), a longtime Portfolio member.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF) actually saw its first-quarter payout ratio drop to about 96 percent. The keys were successful acquisitions, improved facility occupancy (90.2 percent) and cost cutting. The per-share bottom line was a bit below last year’s tally. But the distribution should hold, and the payout ratio should come down as the company continues to look for ways to streamline its portfolio.

This month, for example, management announced a deal to simplify and restructure its relationship with Horizon Bay Realty LLC in the US, which is expected to close August 1. I prefer Portfolio pick Extendicare REIT (TSX: EXE-U, OTC: EXETF), a buy up to USD12, but Chartwell Seniors Housing REIT is a solid hold.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF) pretty much posted the kind of results I was worried it would in the first quarter. Canadian operations were stable, which seemed to encourage at least some investors. The US business, however, continued to shrink rapidly and, combined with new post-corporate conversion taxes, pulled down earnings 30.4 percent and pushed the payout ratio up to 118 percent.

That number should come down going forward, as management looks for ways to match cost cuts in the US with ongoing revenue losses. And no one is talking about a dividend cut here, at least for the moment. But my view remains to avoid CML Healthcare until there’s more clarity on what will happen to the US operation.

Colabor Group Inc (TSX: GCL, OTC: COLFF) disappointed with its first-quarter earnings because it was forced to eat costs to keep customers in the competitive and slumping food services industry.

Management gave every indication during its conference call that the situation would be temporary and it continues to advance acquisition plans that will add significantly to market share, revenue and cash flow stability. But given the jump in the first-quarter payout ratio, the stock will remain on the Watch List until the numbers prove their case. Colabor Group is a hold, though the stock remains in the CE Portfolio.

FP Newspapers Inc (TSX: FPI, OTC: FPNUF) won’t announce its first-quarter earnings until Jun. 8. At that point, we’ll get a much clearer view of how secure its distribution is and what the stock itself is worth.

With a yield of more than 11 percent and a price of just 62 percent of book value, my view is the risk of holding is limited at this point. This is, however, another print media company trying to adapt to a digital/Internet age and so faces a huge amount of investor skepticism. We’ll let the numbers be our guide. Hold FP Newspapers for now.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF) earns money in two ways. First, it produces primarily natural gas from its lands. Second, it collects royalties on what others produce, which is also primarily natural gas. Both have been extremely tough businesses of late, with first-quarter cash flow from operations dipping 11 percent and the company’s payout ratio surging to over 90 percent.

Production activity on its lands dipped 29 percent. All of these trends could reverse with a vengeance in coming months, should natural gas prices keep moving up as they have recently. On the other hand, there’s not much margin for error at Freehold, which pays a dividend of nearly 8 percent. Hold Freehold Royalties Ltd.

Interrent REIT (TSX: IIP-U, OTC: IIPZF) still hadn’t set a date to release first-quarter results as of press time. When it does, the big questions are going to be how well the apartment REIT dealt with winter heating costs and whether it was able to bring down a payout ratio that’s basically been in the red–forcing the company to essentially pay dividends from its cash on hand.

Distributable income per unit for the 12 months ended Dec. 31, 2010, was actually a negative CAD0.05 per unit. The two Bay Street analysts covering the stock currently rate it a buy. But results must improve to save the dividend and there are plenty of other REITs without so many question marks. Sell Interrent REIT.

Yellow Media Inc (TSX: YLO, OTC: YLWPF) over the past month has basically been the victim of what’s referred to colloquially as “dog piling,” with Bay Street analysts trying to one-up each other with bearish comments. Ironically, only one of the 12 following the stock actually rates Yellow a sell. That’s pretty clear evidence of just how uncertain the verdict is on the key question facing this company: Is its Internet advertising business growing fast enough to offset the erosion in its traditional print directory business?

The downside action in the stock over the past couple of weeks has basically been due to growing speculation that the answer is “no” and that the company faces a dividend cut in the near future. The mild rebound since Tuesday is mainly a reaction to management’s response, that the dividend is safe and plans to convert the business are going swimmingly, as is an asset sale expected to garner CAD745 million in proceeds later this year to fund CAD500 million in debt reduction as well as the repurchase of up to 10 percent of common stock and preferred stock outstanding.

I highlighted all of these issues in a June 1 Flash Alert, and there’s nothing really to add now. Again, this isn’t a bet for conservative income investors to be making, and there is a risk of a dividend cut, no matter what management says, if the company fails to execute its strategy.

On the other hand, none of the comments/opinions splashing the media now on Yellow have any basis in the latest round of numbers released less than a month ago. And no intelligent investment decision regarding any dividend-paying stock should ever be made based on anything but operating numbers and how well they support or don’t support the dividend.

Anyone who can’t stand the volatility and risk of failure should stand clear of Yellow. But if you can stomach the ups and downs and are patient enough to wait on hard numbers–rather than respond to rumor and fear–this one still has promise for capital gains as well as a pretty massive dividend going forward.

My advice remains to hold Yellow Media if you own it.

Bay Street Beat

Canadian Edge Portfolio REITs have reported roundly positive first-quarter numbers thus far in reporting season. With just two left to go, Bay Street basically held ground as far as buy-hold-sell advice is concerned–at least insofar as Bloomberg’s method of simplifying the variety of terms used in lieu of those basic instructions is concerned.

Artis REIT’s (TSX: AX-U, OTC: ARESF) three-four-zero buy-hold-sell line remains entirely intact following its May 21 earnings announcement, as all seven analysts who cover the stock maintained their basic advice. All seven also boosted price targets.

• Heather Kirk, National Bank Financial, CAD14.25 to CAD15
• Shant Poladian, Canaccord Genuity Corp, CAD15.25 to CAD16.50
• Michael Smith, Macquarie Capital Markets, CAD14.50 to CAD15
• Alex Avery, CIBC World Markets, CAD14.50 to CAD15.50
• Karine Macindoe, BMO Capital Markets, CAD14 to CAD14.50
• Michael Markidis, RBC Capital Markets, CAD14 to CAD15
• Mario Saric, Scotia Capital, CAD13.75 to CAD14.50

All seven see upside from the REIT’s CAD14.27 Jun. 2 close, though BMO Capital Markets and Scotial Capital (CAD14.50) don’t see as much as Canaccord Genuity Corp (CAD16.50).

Artis reported impressive headline numbers in the first quarter and set the stage for further growth as the Alberta real estate market recovers. We rate Artis REIT a buy up to USD15–where it would yield 7.4 percent at the current annualized dividend rate of CAD1.09 per share–for those who don’t already own it.

Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) owns a five-five-zero buy-hold-sell line on Bay Street, where it, too, received straight “maintains” on basic advice in the aftermath of first-quarter earnings. CAP REIT closed at CAD19.17 on Jun. 2. Nine analysts issued updated advice, with five price-target boosts.

• Jonathan Kelcher, TD Newcrest, CAD21
• Karine Macindoe, BMO Capital Markets, CAD21
• Mario Saric, Scotia Capital, CAD19.25 to CAD19.50
• Brad Cutsey, Dundee Securities Corp, CAD19.50 to CAD20
• Mark Rothschild, Canaccord Genuity Corp, CAD19.10
• Heather Kirk, National Bank Financial, CAD21
• Michael Smith, Macquarie Capital Markets, CAD20.50 to CAD21
• Neil Downey, RBC Capital Markets, CAD19.75 to CAD20.50
• Alex Avery, CIBC World Markets, CAD19.25 to CAD20

Canadian Apartment Properties REIT, which pushed down its payout ratio in the first quarter and recently announced two meaningful acquisitions, is a buy up to USD20.

RioCan REIT (TSX: REI-U, OTC: RIOCF), which was trading above our USD25 buy target for new money as of press time, is a buy for two Bay Street analysts and a hold for seven more. All of them maintained their Bloomberg-simplified advice, though six raised price targets.

• Karine Macindoe, BMO Capital Markets, CAD25 to CAD26.50
• Mark Rothschild, Canaccord Genuity Corp, CAD24
• Sam Damiani, TD Newcrest, CAD26
• Heather Kirk, National Bank Financial, CAD26 to CAD26.25
• Michael Smith, Macquarie Capital Markets, CAD26 to CAD27
• Neil Downey, RBC Capital Markets, CAD25.50 to CAD26
• Pammi Bir, Scotia Capital, CAD25.75 to CAD26
• John Sheehan, Edward Jones, Hold, no price target
• Alex Avery, CIBC World Markets, CAD26.50 to CAD27

New investors shouldn’t pay more than USD25 or lower to buy, but RioCan REIT remains a cornerstone holding for those who own it.

Extendicare REIT (TSX: EXE-U, OTC: EXETF), which announces first-quarter earnings Jun.8, is covered by four analysts, according to Bloomberg’s rather thorough accounting, three of whose ratings translate to “buy” under the financial media behemoth’s standardized language. The other rates it a hold.

Douglas Loe, Versant Partners, raised his price target on the stock from CAD13.50 to CAD14.25 in early May. Sam Damiani of TD Newcrest reduced his target for Extendicare to CAD11.50 to CAD11 in late April. We’ll have an update on Extendicare following its earnings announcement next week, though the REIT is a buy up to USD12 for those who don’t own it.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) won’t announce first-quarter earnings until Jun. 14. Like RioCan, the REIT was trading well above its USD28 buy target (USD30.76 as of midday Friday). Karine Macindoe of BMO Capital Markets pushed her target to CAD32 on May 29 but pulled back to CAD31 the next day, her target for much of 2011. Mario Saric from Scotia Capital (CAD30 to CAD31.25) also boosted his target, with a little more conviction, in reaction to other REITs’ earnings and their promise for Northern Property.

We’ll also update Northern Property–a buy on dips to USD28 or lower–when it announces in mid-June.

The Long Way Home

Over the past year we’ve advised CE subscribers to use a letter from a US Treasury official explaining the legal consequences of the Fifth Protocol to the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, what we commonly refer to as the US-Canada tax treaty.

The basic principal of this and all other treaties like it is to eliminate or reduce double taxation. The US-Canada agreement is particularly clear about its aims to achieve a level of reciprocity on taxation befitting the largest bilateral trade relationship in the world. The so-called Karzon Letter explains that distributions or dividends paid by Canadian income trusts that have either become tax-paying SIFTs (specified investment flow-through) or tax-paying corporations in respect of units or shares held in US IRA accounts should no longer be subject to withholding.

There is no objection to the substance of the law. There is, however, considerable trouble when it comes to enforcement–as in, there is no institutional will to do right by US investors who hold still-standing trusts and converted corporations in IRA accounts. Certain brokerages, Fidelity, notably, are taking the extra step to help high-value clients, but these efforts have not yet resulted in a coordinated effort, for example, by Schwab, E*Trade and other biggies to work with Canadian-side clearing agents and Revenue Canada to make it easy for people to enjoy what is rightfully theirs.

The grassroots letter-writing effort has therefore achieved limited results. As a means of explaining again what remains an alternative and at the same time lighting a fire that may finally reach what should be responsible authorities, here’s a (lightly) abridged version of the process non-residents of Canada can go through to get amounts improperly withheld on the Canadian side of the border back, via the Canada Revenue Agency (CRA) Form NR7-R:

• Only you, as the “beneficial owner,” are entitled to refund, with limited exceptions.
• Where tax was remitted to the CRA in Canadian currency, you must enter the “Refund applied for” in Canadian currency. The CRA will then issue only a Canadian currency refund. You may need to contact the Canadian payer or agent to confirm the remittance currency.
• The CRA will issue refunds in a foreign currency only if the tax was remitted in that same foreign currency. If it approves a refund in foreign funds, it will use the exchange rate that applies on the date we issue the refund check. As a result, the amount refunded may be different from the amount remitted.
• You must verify the “Tax payable” rate to ensure it agrees with the rate provided under Section 212 of the Income Tax Act or with the relevant tax treaty rate provided within Information Circular 76-12R5 (or later) based on the non-resident’s country of residence at the time of payment.
• For security payments, such as dividends or interest, CRA requires one (1) NR7-R application per payable date, per income type, per beneficial owner, per CUSIP number, per Canadian payer or agent’s non-resident tax account number.
• The CRA only issues current year refunds to clients for security payments that flowed through custodians or nominees. Otherwise, you may request a current year refund directly from the Canadian payer or agent where an NR4 slip or Canadian tax slip hasn’t yet been issued.
• The CRA doesn’t issue refunds for less than $2.00.

Emphasis mine. You’re also required to provide a detailed reason for requesting the refund.

• You must provide details of payment and tax withheld.
• You must provide the appropriate “Reason for refund” and any relevant exemption number for the beneficial owner.
• Where there are third-party participants, such as a custodian, the CRA requires a notarized affidavit of beneficial ownership linking the custodian and beneficial owner. The affidavit must include: the name of the beneficial owner of the security, the name of the custodian, the number of units held by the custodian, the name of the security, the payable date of the security and the notary or lawyer’s seal and signature.
• Where there are third party participants, such as a custodian, the CRA also requires a notarized affidavit of registered ownership linking the custodian and the beneficial owner. The affidavit must include: the name of the beneficial owner of the security, the name of the custodian, the number of units held by the custodian, the name of the security, the payable date of the security and the notary or lawyer’s seal and signature.
• If the transaction flowed through the Depository Trust Company (DTC) in the US, an authorized DTC Statement, specifically a Final Detail Report, CSH SDFS Settlement Stmt Div. or Dividend Cash Settlement Items List, are mandatory substitutions for the “affidavit of registered ownership.”

Original, signed NR7-R applications with all required documentation must be sent to the CRA no later than two years after the end of the calendar year in which the non-resident tax was remitted. The address is: International Tax Services Office, Non-Resident Withholding Division, Station T, PO Box 9769, Ottawa ON K1G 3Y4 Canada.

You can reach the CRA’s International Tax Services Office at 1-800-267-3395 (within Canada and the US) or 613-952-2344 (outside North America). You can also fax your applications to 613-941-6905.

What individual investors are asked to do is enforce the law on their own, and it’s a complex, time-consuming process that many simply can’t afford. It’s a joke that they’re put in this position.