Closed-End Funds and Return of Capital

By David Dittman • September 9, 2011 • Dividend Watch List

Dividend Watch List

No companies under How They Rate coverage cut dividends last month. Consequently, this month’s focus is on dividends to watch, which currently fall into three broad categories:

  • individual companies with weakening underlying businesses;
  • closed-end mutual funds paying out significantly more in distributions than they make in investment income or with capital gains from sales; and
  • companies that currently pay distributions as “staple shares,” which are now targeted by the Canadian government for potential new taxes.

Starting with the first group, the list remains about as long as it was last month. On the positive side, that means companies that were covering their distributions by solid margins before generally did so again in the second quarter of 2011 and look set to do so in the second half of the year as well.

On the negative side, where there was improvement in weaker companies, it wasn’t enough to earn an exit from the Watch List. There was, however, generally some improvement in most that could see them come off the List later this year.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Advice: Hold. The REIT stated encouragingly last month that changes in Medicare payments wouldn’t appreciably impact its earnings or ability to pay dividends. Then it posted generally solid second-quarter results that took its quarterly payout ratio down to 90 percent from 96 percent in the first quarter.

Funds from operations still weakened by 5.6 percent, in part because of a weaker US dollar. But if new management contracts for US operations and other initiatives can improve margins, Chartwell will earn an exit from the Watch List.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Advice: SELL. The payout ratio came down to 81 percent from 118 percent in the first quarter. But the bleeding from US operations continues unchecked, with cash flow tumbling 33.8 percent. The key test for this dividend is whether generally stable Canadian operations and cost-cutting south of the border can hold the line.

Management’s last word was that it expected to hold the current dividend. But the margin for error is very thin indeed.

FP Newspapers Inc (TSX: FPI, OTC: FPNUF)–Advice: Buy @ 5. The payout ratio in the second quarter came in at just 79 percent. That’s good coverage, particularly considering the 12 percent plus yield is already pricing in a cut. But the results also included a 7.6 percent drop in advertising revenue, excluding newly acquired operations.

That’s a trend that must reverse in coming quarters for this dividend to hold, and it’s why this stock is for aggressive investors only.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Advice: Hold. I’m encouraged by this oil-weighted producer’s second-quarter payout ratio of just 74 percent. I was less excited about how it got to that number: higher realized selling prices for oil drilled on its lands rather than more activity and output. Freehold depends on others to produce on its lands and generate royalty income.

Lower realized selling prices for oil in the second half of 2011 would ramp up pressure on the payout once again.

Interrent REIT (TSX: IIP-U, OTC: IIPZF)–Advice: Hold. This one has been a positive surprise, as it continues to recover from what appeared just a few months ago to be a death spiral. The second-quarter payout ratio dipped to 75 percent in what is a seasonally strong period for apartment REITs, due to low heating costs. Encouragingly, occupancy improved sharply to 95.1 percent, from 86.7 percent a year ago.

That’s a good indication the quality of the portfolio is improving and the REIT is able to take advantage of what’s a growing shortage of apartment properties in many parts of Canada.

Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Advice: Buy @ 5. Second-quarter numbers support the dividend, and the third quarter seems in line with management expectations as well. The company published an operational update on Aug. 29 that indicates continued progress increasing its production of natural gas liquids (NGLs). That’s a strategic initiative meant to capture some of the growth of the robust market for NGLs as well as to reduce dependence on low-priced natural gas.

The company is also developing heavy oil and light oil properties and expects liquids to be about 12 percent of its total output by the end of the year. Natural gas prices appear to be averaging out in the mid-range of guidance set by management at the beginning of the year. That’s encouraging for Perpetual’s long-run survival.

But this stock is likely to stay weak as long as natural gas prices are under USD5 per million British thermal units.

Ten Peaks Coffee Company Inc (TSX: TPK, OTC: SWSSF)–Advice: SELL. This company has been battered by the strong Canadian dollar year after year, and there’s nothing in second-quarter numbers suggesting any relief. It’s been an easy stock to bet against for many years, and I fully expect to see the fourth dividend cut in the company’s nine-year history in the next 12 to 18 months.

Yellow Media Inc (TSX: YLO, OTC: YLWPF)–Advice: SELL. The latest news from Yellow is the resignation of Christian Paupe, the longstanding executive and current chief financial officer. Paupe was vilified earlier this year in the Canadian press for selling stock ahead of Yellow’s most recent plunge and is closely associated with the company’s long-followed strategy of trying to move its print business to the Internet.

Paupe’s departure sends mixed signals, but the recent dividend cut and disappointing second quarter earnings sends a crystal one. We’re better off out, at least until this company starts posting some better numbers.

The second group of dividends I’m watching closely are those paid by the closed-end mutual funds I track in How They Rate. Funds typically cover a portion of their distributions with gains on asset sales and margin rather than 100 percent with the actual dividends of their holdings.

The disturbing trend is that for many funds the level of investment income seems increasingly to be an afterthought when management and the board set the distribution rate. Some, in fact, are now generating negative investment income after fund operating and management expenses are taken out.

Particularly dangerous, some are now paying all of their dividends as return of capital (ROC). That means the payout is neither covered by investment income or capital gains from asset sales but instead represents what’s basically a winding down of assets.

Canadian investors are, of course, compensated for this by favorable tax treatment for return of capital. For US investors, however, all dividends paid by Canadian closed-end funds are ordinary income, taxed at their regular rate if held outside an IRA. And for those who hold these funds in an IRA there’s the 15 percent withholding tax.

Such funds may still be attractive as high cash flow bets on select sectors. It’s also far from certain that an ROC-paying fund will ever cut its dividend. Closed-end funds have a great deal of latitude about what they pay and where they get the money. Management may elect to keep paying from ROC until the market turns and it can generate capital gains.

Funds also benefit from what can be described as a “yield zombie” effect, meaning that some investors will be drawn to a high yield and never question its source. Such funds can literally finance current dividends (and management compensation) by issuing more shares.

Unlike in a real pyramid scheme, investors can actually build wealth if the sector performs and increases the net asset value (NAV) of the fund. But there’s also the risk the assets won’t perform, either because they’re poorly chosen or due to tough market conditions. And if that happens distribution cuts and big capital losses are inevitable.

The key is knowing just how the funds you own are covering their dividends and whether the yield and potential upside from their investments compensate for the risks of a lack of coverage by investment income.

How They Rate now lists payout ratios for the nine closed-end funds I track, based on first-half 2011 numbers. Financials are generally available on the funds’ websites and include a list of holdings as well as a balance sheet and income statement. The payout ratios shown are basically the percentage of the distribution that’s covered by investment income after fund expenses are taken out. That’s basically dividends and interest paid by the holdings.

A brief scan of How They Rate reveals that none of these funds fully cover their payouts with investment income, other than CurrencyShares Canadian Dollar Trust (NYSE: FXC) and iShares MSCI Canada Index Fund (NYSE: EWC). Both of these are exchange-traded funds (ETF) and pay only a miniscule dividend anyway.

The key, however, isn’t 100 percent coverage of the distribution with investment income. Rather, it’s a balance that weights in that direction, building in a cushion when capital gains fall short.

Of the list, Canadian Edge Portfolio Holding Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF) has by far the best coverage. Also in the Portfolio, EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF) has historically maintained a solid coverage ratio, though its payout rose in the second quarter on a 21 percent drop in investment income from last year.

That appears to be the result of management getting a bit more conservative in anticipation of tougher market conditions. Consequently, I’m willing to live with it for now, given EnerVest’s solid performance and increased discipline the past couple years.

Another fund with good coverage is First Asset Pipes & Power Fund (TSX: EWP-U, OTC: FAPPF), which I’ve just added to How They Rate. Pipelines and electric power generators have proven themselves strongly resistant to recessions in prior cycles and pay solid dividends as well. The fund also trades at nearly a 5 percent discount to NAV.

Again, I prefer owning individual dividend-paying stocks to these closed-end funds.

But all three are still solid holdings for income investors. Buy Blue Ribbon up to USD12, EnerVest Diversified  up to USD14 and First Asset Pipes & Power up to USD8.

On the opposite side of the spectrum are CE Portfolio Holding Precious Minerals & Mining Trust (TSX: MMP-U, OTC: PMMTF) and EnerVest Energy & Oil Sands Total Return (TSX: EOS-U, OTC: EOSOF). Both actually posted negative investment income after expenses in the first half of 2011, including capital gains. As a result the entire payout was a return of capital for both.

Distributions are the purview of management and the board of directors, and a fund can elect to pay a return of capital dividend indefinitely. But any fund paying entirely from ROC should be considered an aggressive bet on a specific sector rather than a steady income investment. That applies to both of these funds.

I rate EnerVest Energy & Oil Sands a sell. The fund’s yield is low and many of its holdings pay no dividends in any case.

I’m sticking with Precious Minerals & Mining for now as a hold. The fund does hold a wide range of mining companies, many of which have sold off recently even though the price of what they produce has stayed strong. It’s certainly not suitable for those seeking conservative income. And a dividend cut can’t be ruled out if metals prices should head south as they did in 2008, driving down mining stocks still further.

On the other hand, all of the companies held by the fund are solid, growing and sitting on top of some very valuable resources. That’s a worthy bet for those willing to live with the risk of a lower payout if market conditions for miners don’t improve.

Finally, I continue to rate Brompton Stable Income Fund (TSX: VIP-U, OTC: BVPIF) a sell. The first-half 2011 payout ratio blew out to 302 percent, from an already high level of 233 percent in the second half of 2010. That was made possible without dipping into capital thanks to gains on sales that are unlikely to be repeated in the second half of 2011.

That does little to change my opinion that Brompton has still not adjusted its distribution to reflect the lower payout of its holdings in a post-income trust world. The monthly payout has been cut twice since early 2009. I expect another reduction in the near future. Sell Brompton Stable Income Fund.

Call it this year’s mid-summer surprise. On Jul. 20 Finance Minister Jim Flaherty proposed a special 10 percent tax on “non-qualifying income,” with the apparent goal of shutting down “staple unit” structures.

These combine debt and equity into a single distribution-paying share. Companies to date have been able to deduct the interest on the debt portion, reducing their taxes and enhancing their ability to pay a higher distribution. Mr. Flaherty’s proposal would eliminate the tax advantage of this structure, forcing affected companies to absorb higher taxes whether they converted to ordinary corporations or kept the staple-share construct.

The only Canadian Edge Portfolio company potentially affected by the proposal is Northern Property REIT (TSX: NPR-U, OTC: NPRUF). The REIT adopted a staple-share structure to shelter income from a portfolio of senior citizens properties, which is considered non-qualifying income under the Canadian government’s rules for REITs that kicked in Jan. 1.

Northern has stated it won’t “act precipitously” and instead will wait to see if the proposal is enacted. Potential actions include selling the senior citizens properties, for which it’s hired a unit of Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) to consider options, or simply folding some assets back in the REIT.

The only important factor for investors to consider, however, is that even in a worst-case Northern will incur just CAD1.5 million in additional annual taxes. That’s clearly no threat to the distribution, which was solidly covered with a 63 percent payout ratio in the second quarter. It may affect the level of the next distribution increase. But Northern Property’s solid second-quarter results make it a buy up to USD30.

H&R REIT (TSX: HR-U, OTC: HRREF) is increasing the distribution on its stapled shares by 5 percent. Management stated in a Jul. 20 release that the finance minister’s proposal doesn’t affect its tax liability, as its payments weren’t specifically targeted. At any rate, the payout ratio is low, and second-quarter results were solid. Hold H&R REIT.

Other stapled-share companies may not fare so well. Labrador Iron Ore Royalty Corp (TSX: LIF-U, OTC: LIFZF) has only stated its directors are “studying” the announcement. Ditto Westshore Terminals Investment Corp (TSX: WTE-U, OTC: WTSHF), which remains buy up to USD24 due to the unique nature of its assets. Both Labrador and Westshore pay volatile dividends in any case that are linked to commodity prices, iron ore and metallurgical coal respectively. Hold Labrador.

New Flyer Industries Inc (TSX: NFI-U, OTC: NFYIF) got the jump on Mr. Flaherty with its Jun. 14 announcement that it will convert from an income deposit security to a common stock. The impact on investors, however, was considerably less favorable: A plan to eventually cut roughly 50 percent from the current monthly rate to just CAD0.04875 per share.

With a conversion plan already in place, New Flyer won’t be affected in the slightest by Mr. Flaherty’s proposal, as the latter calls for a year-long phase-in period. On the other hand, the company’s second-quarter numbers paint a distressing picture of fierce competition in the midst of weak market conditions.

Second-quarter revenue plunged 19.5 percent, with bus manufacturing operations’ sales dropping 23.1 percent. Bus deliveries slid 20.9 percent, and the company also saw a 2.7 percent reduction in its average selling price per unit.

This is a direct result of New Flyer’s primary customers–municipal governments–being increasingly cash-strapped. The company’s product does cut costs, particularly by improving fuel efficiency. But governments in most areas can’t place orders except for what’s absolutely needed. And that’s not likely to change anytime soon.

The lower dividend rate stands a better chance of holding and is still 9.3 percent based on the New Flyer’s current share price There’s also some improvement in trends for backlog that if sustained could signal some improvement in earnings.

On the other hand, however, management hasn’t declared a final post-conversion dividend. And it still may cut by more than half, particularly if market conditions don’t improve. Hold New Flyer only if you can take that risk.

Bay Street Beat

IBI Group Inc (TSX: IBG, OTC: IBIGF) shares took a big hit in the days leading up to its announcement of second-quarter results but have since recovered sharply. That’s no great surprise, given the very strong numbers. Bay Street was suitably impressed, as following the company’s Aug. 13 earnings release and Aug. 15 conference call two analysts have upgraded the stock to “buy.” All 11 analysts who cover the stock rate it a “buy” according to Bloomberg’s standardized terminology.

The numbers certainly back up the bullishness. Second-quarter revenue surged 17.9 percent to a new quarterly record, while cash flow and distributable cash flow rose 29.6 percent and 7.1 percent, respectively. The payout ratio came in at just 77.3 percent, down from 101.6 percent a year ago and 85.5 percent in the first quarter of 2011.

Management reported both strong progress in gaining new orders for its contract design services as well as collecting on existing accounts. That’s the result of recent global expansion both organically and via acquisitions, which has been profitably integrated into the overall company. Recent initiatives include the acquisition of a Massachusetts-based firm with extensive ties in China, a huge market for IBI’s entire range of businesses and expertise.

During the company’s second-quarter conference call CEO Philip Beinhaker affirmed a long-term cash flow growth target of 15 percent a year, stating IBI is now “back where we should be.” That’s impressive, given the world economy is still not running on all cylinders and the fact that governments and businesses have been slow to commit to both big and small infrastructure-related design contracts. And management’s conservative assessment of markets is good reason to expect more solid numbers the rest of the year and beyond.

The stock still trades with a yield well north of 8 percent. That’s a number likely to grow going forward, as cash flows continue to expand and drive down the payout ratio. And because management generally finances growth with equity and cash flow, there’s little concern about debt. Buy IBI Group up to USD15.

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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