The Final Cut

By David Dittman • August 5, 2011 • Dividend Watch List

Dividend Watch List

Only one company under How They Rate coverage has announced a dividend cut since we published the July issue: Yellow Media Inc (TSX: YLO, OTC: YLWPF).

The company will pay its previously declared monthly dividend of CAD0.0542 on Aug. 15 to shareholders of record Jul. 29. It will not pay a dividend in September but will pay out CAD0.025 per share on Oct. 17, to shareholders of record Sept. 30. The next dividend after that will be a quarterly payout of CAD0.0375 per share, with the first installment on Jan. 16, 2012, to shareholders of record Dec. 30.

The cuts come after months of management assurances that the previous monthly rate of CAD0.0542 was sustainable and that the company is successfully transitioning its print directory business to the Internet. They also fall after Yellow completed the sale of a portion of its Trader business for proceeds of roughly CAD708 million, a move some critics doubted but which management assured investors would shore up its financial strength when it closed.

So why did the company make such a drastic change? For one thing, second-quarter adjusted earnings per share–the account to which management has been pegging the dividend–took a tumble to CAD0.17 per share from CAD0.27 in the prior quarter. That was after several quarters of relatively stable numbers.

Revenue, meanwhile, dropped 4.8 percent, also after several quarters of being relatively stable. Online sales did grow a robust 33 percent and now represent 25 percent of overall sales. Management’s new target is for online sales to be 50 percent of the overall top line by 2014, as it continues to develop its product line. The problem is the numbers show the online business, for the first time, didn’t grow fast enough to offset erosion of print business revenue.

That suggests a changing business dynamic that either management didn’t anticipate or else didn’t want to inform shareholders of. Either way, the implications are not good.

Following today’s news, Yellow’s stock price dropped by roughly half. Relative to what’s happened over the past five years (the stock traded in the mid-teens then), this last move is relatively insignificant for those who’ve hung on as I have. And in my view the only way we go significantly lower from here is bankruptcy.

That at least appears to be a relatively low probability at this time. S&P has cut Yellow’s credit rating to BB+ junk from BBB, responding to the earnings news. That may put some additional pressure on the company vís a vís creditors. But CAD700 million in cash from the Trader sale and another CAD68 million a quarter to apply to debt reduction should be plenty to keep the doors open. Dominion Bond Ratings Service, meanwhile, is still rating the company investment grade BBB (despite a recent cut), which may carry more weight with Canadian lenders.

For me, however, the question isn’t whether or not Yellow can cut debt enough to avoid filing for bankruptcy protection, as its US counterparts were forced to in earlier years. It’s not even at this point whether or not the company can succeed on the Internet as it claims. Rather, it’s the fact that the premise on which I was holding the stock as an Aggressive Holding no longer exists. For the first time Yellow’s numbers clearly show management has missed its operating and financial targets. And even the company’s worst critics didn’t anticipate the magnitude of the miss.

The initial reaction to the news announced Thursday morning is likely to wind up being at least partly reversed in the coming days. In fact, some of the losses were that same day. And at least some bargain hunters are likely to be attracted by the fact that, if Yellow is able to maintain the new quarterly dividend rate of CAD0.0375 per share, the current yield is still well in double digits after today’s drop.

When you gamble, you sometimes get burned. And as I’ve said repeatedly the past few months, betting on Yellow management to be right and its critics wrong was an increasingly risky proposition. Yellow has also been on the Watch List for some months.

As long as the numbers were still behind management, I was willing to hold on. Unfortunately, they aren’t any longer. Consequently, despite the losses we’re going to sustain, it’s time to sell Yellow Media.

Some who’ve hung on to Yellow this long may well be tempted to hold on. I will continue to cover the company in How They Rate under Information Technology, with best wishes for its survival. But for me the basis of sticking with this position is no more, and it’s time to move on to something else.

As for lessons learned, I fault myself most for not selling Yellow way back in May 2009, when it made its first dividend cut from a monthly rate of CAD0.0975 to CAD0.0667. At the time the stock had already given up a lot of ground in the market crash. But the cut was the first admission by management that its plans weren’t panning out as expected.

Of course, some companies that cut dividends do wind up recovering and rewarding those who stuck around. That in fact has been the rule for essential service companies like regulated utilities and pipelines.

In an unforgiving environment like this one, however, companies that cut once will more often than not do so again. Selling on cuts or the threat of a cut is generally the right course for investors, rather than sticking around to see if management can pull a rabbit out of a hat.

The good news is if you followed my advice to never, ever double up on a falling stock, Yellow is going to hurt, but not fatally. That’s probably the most important lesson to take from the experience.

Below is the current Dividend Watch List, highlighting companies with dividend-threatening challenges at their core businesses. In the past my attitude has generally been to look at them individually to pick out which have the better odds of avoiding a cut. As a result I’ve even listed some of them as buys.

My view now is that we’re almost surely better off out of most if not all of them. The only exception is Perpetual Energy Inc (TSX: PMT, OTC: PMGYF), which we own as a very high-risk bet on natural gas. Also, as I reported last issue, closely held FP Newspapers Inc (TSX: FP, OTC: FPNUF) appears to have locked in enough cash flows to hold its dividend, which may attract some high-risk income seekers. As for the rest, let discretion be the better part of valor and avoid them.

Here’s the Watch List along with my current buy/hold/sell advice, when second-quarter earnings are due out and what the chief risks are to the payout. Note this list will change as always as numbers come in.

Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF)–Fund, no report. Advice: SELL. This closed-end mutual fund can maintain its dividend as long as management can keep paying from other sources besides dividends of its holdings. But sooner or later it will have to adjust to reflect post-conversion dividend cuts.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Aug. 12 (confirmed). Advice: Hold. The company doesn’t see “a material effect” form the cut in Medicare payments to nursing facilities, as none of its properties are apparently affected. That’s a big plus but the dividend remains very thinly covered.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Aug. 11 (confirmed). Advice: SELL. The stock has stabilized after the management shakeup but with the US uncertain and dividend coverage light, the dividend is still definitely at risks.

FP Newspapers Inc (TSX: FPI, OTC: FPNUF)–Aug. 10 (confirmed). Advice: Hold. With the demise of Yellow Media, all print-to-Internet businesses should be considered suspect. This one is still performing on its numbers, however. Until it doesn’t, it’s OK for risk takers.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Aug. 11 (estimate). Advice: Hold. Thin dividend coverage in the first quarter may improve in the second. But this company depends on others to drill its lands and is walking on egg shells in this environment.

InterRent REIT (TSX: IIP-U, OTC: IIPZF)–Aug. 12 (estimate). Advice: SELL. Based on recent results and what appears to be emerging Bay Street bullishness, this apartment REIT may indeed be making it back. The 5.7 percent yield, however, is less than several REITs of higher quality, begging the question, why own it?

Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Aug. 10 (estimate). Advice: Buy @ 5. This one is all about natural gas prices. If you’re not willing to make that bet, don’t come near it.

Ten Peaks Coffee Company Inc (TSX: TPK, OTCL SWSSF)–Aug. 5 (confirmed). Advice: SELL. This company routinely doesn’t cover its payout and faces some severe competitive pressures.

Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Aug. 4 (see above). Advice: SELL. Dividends have been cut back to the bone. But with management missing its targets in the numbers for the first time, no one should count on the new level to hold, either.

Bay Street Beat

Reaction on Bay Street to Yellow Media Inc’s (TSX: YLO, OTC: YLWPF) dramatic reversal on its dividend policy left management disappointed, as it continues to hold out hope that its vision of its transition to the Internet will prevail. The dividend cut, the sale of Trader and free cash flow over the next three years should add up to about CAD2 billion, much of which Yellow management says it will devote to paying down its CAD2.4 billion debt load.

But, according to S&P, Yellow’s “balance sheet improvement does not sufficiently mitigate rising business risks” and is unworthy of an investment-grade credit rating. DBRS also downgraded the company to “adequate credit quality,” with negative trends. Its medium-term notes have been stepped down within the adequate BBB range, and its commercial paper is now considered on the high end of adequate compared to the low end of good credit quality after a downgrade to R-2 (high) from R-1 (low).

During a conference call to discuss results CEO Marc Tellier stuck to his guns. “We continue to make progress on [Yellow’s] digital transformation,” said Mr. Tellier. Second-quarter numbers, however, suggest that growth in the digital business won’t happen fast enough to compensate for losses on the print side.

This is a dynamic that DBRS highlighted in its statement about the company: “The downgrade reflects DBRS’s concern that the business risk of Yellow Media continues to increase as it accelerates its transition from print to digital, even though there is an expectation of a strengthened financial risk profile going forward.”

As for the Bay Street stock analyst community, there are currently zero “buy” recommendations, six “holds” and six “sells.” Cormark Securities downgraded the stock from “market perform” to “reduce” with a price target of CAD1, just two days after reiterating its opinion that the stock would perform in line with the broader market with a CAD2.35 target.

All five analysts that cover AltaGas Ltd (TSX: ALA, OTC: ATGFF) maintained their ratings in the aftermath of the company’s second-quarter earnings reports, leaving it with three “buy,” two “hold” and zero “sell” calls. TD Newcrest boosted its price target from CAD26 to CAD27 in maintaining its “buy” rating, while RBC Capital Markets reiterated a “sector perform” rating but lifted its target from CAD24 to CAD27. National Bank Financial repeated its “sector perform” call and bumped its target price from CAD25.50 to CAD26.

Colabor Group Inc (TSX: GCL, OTC: COLFF) was upgraded to “buy” at Industrial Alliance Securties, leaving the stock with two “buys” and two “holds” under the Bloomberg standard. Laurentian Bank Securities reduced its target to CAD10.50 from CAD11.50 while maintaining its “hold” rating on the stock.

Keyera Corp (TSX: KEY, OTC: KEYUF) earned an upgrade from the fine analysts at Clarus Securities, from “accumulate” to “buy” with an increased price target of CAD44.50 from CAD40.50. National Bank Financial raised its target price to CAD44.50 from CAD42.50. TD Newcrest reiterated its “reduce” advice, though the new bottom is CAD34, up from CAD32. Keyera’s buy-hold-sell line is five-one-one.

Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF) was also upgraded from “accumulate” to “buy” by Clarus Securities, with a revised price target of CAD26.50, up from CAD24. National Bank Financial raised its price target to CAD25.50 from CAD24 while reiterating a “sector perform” rating. TD Newcrest has a “reduce” label on the stock but raised its price target from CAD18 to CAD18.50. Pembina has one “buy,” six “holds” and one “sell,” which is Bloomberg’s translation of the Clarus advice.

TransForce Inc (TSX: TFI, OTC: TFIFF) has a perfect mark on Bay Street, with all eight analysts who cover the stock rating it a “buy” according to the standard language employed by Bloomberg. All eight maintained their ratings in the aftermath of TransForce’s second-quarter earnings announcement. National Bank Financial, which has an “outperform” rating on the stock, reduced its price target from CAD18 to CAD17. BMO Capital Markets, which also says the stock should “outperform,” trimmed its target from CAD18.50 to CAD17.50.

Acadian Timber Corp’s (TSX: ADN, OTC: ACAZF) second-quarter earnings announcement did little to move the needle on Bay Street, as all five analysts that cover the stock maintained ratings as well as price targets for the stock. Acadian, trading right up against the average target price of the analysts that cover it, has zero “buys,” four “holds” and one “sell.”

Daylight Energy Ltd (TSX: DAY, OTC: DAYYF) has 14 “buy” ratings and seven “hold” ratings on Bay Street; nobody says “sell.” Scotia Capital reiterated its “sector perform” guidance and boosted its price target to CAD10.50 from CAD10. Salman Partners reiterated its “hold” advice but reduced its price target from CAD9.50 to CAD9.25. Raymond James, meanwhile, said again that the stock would “outperform” but cut its target from CA12 to CAD11.50.

Tips on DRIPs

Last January Baytex Energy Corp (TSX: BTE, NYSE: BTE) opened its dividend reinvestment plan (DRIP) to US investors. Baytex’s DRIP, like other plans of its kind, will allow shareholders to reinvest their monthly cash dividends in additional shares without paying commissions.

Baytex joins other New York Stock Exchange-listed Canadian companies that extend the convenience of a DRIP to US investors. US securities laws restrict participation in DRIPs sponsored by foreign 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 Petroleum Ltd (TSX: PWT, NYSE: PWE) and Provident Energy Ltd (TSX: PVE, 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. Click here for more information about Provident’s DRIP.

Penn West, Provident and now Baytex, because they’re listed on the NYSE, have therefore opted into US filing and registration requirements. It’s basically a matter of how much overhead expense trusts are willing to absorb.

Conservative Holding Atlantic Power Corp (TSX: ATP, NYSE: AT), which listed on the NYSE in July 2010, continues to “evaluat[e] options for a Dividend Reinvestment Program” and “hopes to have this option available to shareholders in the future.” NYSE-listed Aggressive Holding Enerplus Corp (TSX: ERF, NYSE: ERF) has a DRIP for Canadian investors but has not opened it to US investors.

We’ll continue to track Atlantic Power and any other Portfolio Holdings that indicate they’re considering or announce that they will sponsor DRIPs open to US investors.

Companies under How They Rate coverage that sponsor DRIPs open to US investors include (click on the links for more information):

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