Tracking Yellow’s Flameout

By David Dittman • October 7, 2011 • Dividend Watch List

Dividend Watch List

Two companies under Canadian Edge How They Rate coverage cut dividends last month: Yellow Media Inc (TSX: YLO, OTC: YLWPF) and Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF).

Yellow’s move is basically a final coup de grâce in a long saga of decline. The company essentially faced a margin call from its lenders, who are understandably worried that the transition to Internet directory advertising isn’t happening fast enough to compensate for the decline of the print business.

Yellow is more dependent than ever on its banks to survive, as the sharp drop in its stocks and bonds has all but shut off access to capital markets. To keep them happy, the company eliminated its dividend and wrote off $2.9 billion in goodwill. It also repaid CAD500 million in debt and reduced the size of a revolving term loan from CAD750 million to CAD250 million–the price of amending terms of a CAD1 billion loan.

The question now is, will that be enough to keep money flowing for the company as it battles to grow its web-based offerings as maintain its print business. There are no bonds coming due before 2013, but there is still some CAD2.3 billion in debt outstanding that must be serviced. And there’s what one banker described as a “wall of maturities” coming due in 2013, which will be harder to cope with after the reduction of the term loan.

Eliminating the dividend will save the company roughly CAD75 million a year, which will help. Management, however, has provided little visibility on future earnings since early August, when it largely abandoned years of guidance regarding its paper-to-Internet transition.

That breaking with guidance was the major reason I finally threw in the towel on Yellow last August. These developments do nothing to fill that information void.

Assuming nothing else catastrophic happens beforehand, we’ll presumably get our next read on this on Nov. 3, when Yellow is projected to announce its third-quarter numbers. At that point we may get a better read on the company’s prospects for survival. That will no doubt be of interest to anyone who owns its bonds and preferred stocks, which have also been battered. Stockholders, however, look increasingly unlikely to retain any value, even if the company does find some way to survive.

As is always the case when a stock becomes valued in pennies rather than dollars, there will be opportunities for speculators to trade Yellow. A nickel move in the stock at this point, for example, is worth nearly 30 percent.

That’s a not a game I’ll be playing, however, and as far as income investors are concerned, Yellow has been dead money for a while. If you still haven’t sold Yellow, my advice is to take what you can now. As the de-listing of Priszm Income Fund showed once again, these stocks can literally vanish, and it’s always better to get out some money before they do.

Zargon Oil & Gas isn’t likely to follow Yellow down the rat hole for a couple of reasons. First, its primary asset–oil and gas reserves–isn’t vanishing before its eyes. And despite the recent decline in energy prices, its value is likely to increase over time.

The company is also enjoying some success expanding its production and reserves, particularly of oil and other liquids. That’s in part coming from the “redevelopment” of existing wells using horizontal drilling, an avenue that wasn’t open to producers until recently.

Zargon’s capital budget remains robust at CAD65 million for 2011. And CAPEX is expected to remain at similar levels in 2012, as the company continues to expand its development areas. A projected exit rate for oil production of 5,600 barrels per day is a sizeable jump from the current rate of 5,200 to 5,400.  Natural gas production guidance has also been raised.

The other reason is financial strength. The company’s debt-to-capital ratio is just 24 percent, and it’s been successful selling non-core assets–mainly undeveloped land–to offset the cost of its capital program, as well as acquisitions that have increased scale in key areas.

The company is less than half drawn on its loan facility of CAD180 million, and the dividend cut will further limit need to access outside capital. The immediate result of the dividend cut, in fact, was an upgrade to “buy” at three of the seven analysts who rate the stock.

Zargon avoided a dividend cut in 2008, despite a drop in oil prices from over USD150 to less than USD30. Since the beginning of 2011, however, it’s now cut its payout twice: the first a drop from a monthly rate of CAD0.18 cents to CAD0.14, the second a dip to CAD0.10.

The first cut was an adjustment to new taxes as Zargon converted to a corporation. That in itself was a bit of a surprise, given that the other two oil and gas producers that didn’t cut in 2008–Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF)–were able to pull off cut-less conversions.

Zargon had reported difficulties with its drilling program in the first half of 2011, due to wet weather and related surface access problems. That was a major factor pushing its second-quarter payout ratio up to 89 percent, though output had appeared to stabilize over the summer, pushing up cash flow and taking the payout ratio lower. As a result the cut last month took most of us somewhat by surprise, resulting in a slide in the stock.

Nonetheless, this is not a company about to go out of business. Rather, the dividend cuts appear to be an extension of management’s ultra-conservative financial policies–the same ones that held the payout the same in 2008 when oil was spiking up to USD150 and beyond. The goal seems to be to access the capital market as little as possible. And with oil prices backing off this fall, management obviously wants to keep more cash.

Investors shouldn’t expect a dividend increase unless oil and gas prices recover and the company is able to complete its plans for production increases. But neither does the 50 percent drop in the stock since the start of the year appear justified, unless oil really does move under USD60 a barrel.

Anything can happen in the markets, and investors need to be prepared for all oil and gas producers to raise and cut their dividends in line with energy prices. There’s also the possibility that this company hasn’t fully resolved its production troubles.

We should know the answer to the second question on or around Nov. 10, when Zargon is expected to announce its third-quarter results.

Until then, because of the uncertainty I’m rating Zargon Oil & Gas a hold. But trading at roughly 66 per dollar of reserves in the ground (as of the last assessment), this stock is definitely worth sticking with until we do get that clarification.

As noted last month, the rest of the Dividend Watch List is basically divided into three types of companies:

  • 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;
  • companies that currently pay distributions as “staple shares,” which are now targeted by the Canadian government for potential new taxes.

Here’s a roundup of the past month’s news and general prognosis for each company, starting with group one. Note their ranks have grown this month, owing to the tightening of my Safety Rating System. Some may earn an exit after third-quarter numbers are announced in the coming weeks.

AvenEx Energy Corp (TSX: AVF, OTC: AVNDF)–Advice: Buy @ 7. The company’s underlying numbers are solid, with a low payout ratio based on second-quarter cash flow and no near-term debt refinancing needs. But life gets hard for small energy producers when oil and gas prices fall and some 55 percent of production is still natural gas.

Until energy prices bounce back, this stock is only for aggressive investors.

Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF)–Advice: Hold. A weakening of Asian economies would hurt demand for pulp and crimp cash flows. The payout ratio is conservative, operating costs are the lowest in its industry, and debt is very conservative, with no near-term maturity needs. But the delay of a mill startup will limit production, and a worsening of market conditions would ratchet up the payout ratio.

That risk is why the current yield is high and investors must take note.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Advice: Hold. Operations appear to have stabilized, but there’s CAD51 million outstanding on an CAD85 million credit line that must be rolled over by Jun. 23, 2012, as well as a CAD75 million bond maturing May 1, 2012. That may be a challenge to roll over, and the payout ratio is high already. On the plus side, Chartwell doesn’t appear exposed to Medicare changes. It could be exposed to future cuts, though, and there’s not a lot of margin for error on the payout ratio.

Tread with care until these numbers get better.

Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF)–Advice: Buy @ 5. All the current numbers look good here, particularly the low payout ratio as of the second quarter and the lack of near-term refinancing needs. But maintaining strength going forward will depend on the health of Air Canada (TSX: AC/A, OTC: AIDIF), which is in doubt even with the North American economy not yet in a prolonged recession. The company has already been forced to renegotiate its deal with Air Canada, and there’s always the risk of another. One very good sign is analysts have become increasingly bullish, with six now rating “buy” versus two “holds” and no “sells.”

But as long as the economy is a question mark for Air Canada, this one is for risk takers only.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Advice: SELL. This stock hasn’t fallen much from where I sold it from the Canadian Edge Portfolio. But I still have the same concerns about the health of its business, particularly now that the executives that pushed the company into the US are now gone. The primary support for the dividend remains Canadian operations, and management’s repeated statements that it will hold.

US operations should get a boost from the better US dollar exchange rate. But going forward the payout ratio leaves little margin for error.

Daylight Energy Ltd (TSX: DAY, OTC: DAYYF)–Advice: Hold. The steep decline in natural gas prices isn’t immediately disastrous for this well managed company. The production troubles from the first half the year have now almost certainly reversed, and we’ll almost surely see a much healthier portion of cash flow coming from stronger priced liquids in the second half of 2011. The steep drop in natural gas prices the past couple months, however, is a major issue for this company, as it is for all gas-weighted producers.

I want to see third-quarter earnings, slated for Nov. 3 announcement, before getting bullish again.

FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Advice: Buy @ 5. The company was able to cut the annual costs of funding a pension shortfall nearly in half to just CAD800,000 a year–a huge benefit that will shore up the dividend that was almost completely ignored by the market. The decline in the core print and advertising business, however, mean this company will almost certainly remain a near-permanent member of the Dividend Watch List and suitable for aggressive investors only.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Advice: Hold. Higher oil prices helped bring down the payout ratio in the first half of 2011. But their reversal will only hurt in the third quarter, and there’s not a lot of margin for error.

InterRent REIT (TSX: IIP-U, OTC: IIPZF)–Advice: Hold. This one appeared about ready to come off the Watch List after reporting strong second-quarter numbers. Another good quarter will earn its exit. The numbers are due Nov. 11.

NAL Energy Corp (TSX: NAE, OTC: NOIGF)–Advice: Hold. The company is beating its production goals. The question is if profits will hold up in the face of sharply lower oil and particularly gas prices.

That’s an open question that only the aggressive should bet on.

Perpetual Energy Inc (TSX: PMT, OTC: PMGYF)–Advice: Hold. The drop in natural gas prices to the neighborhood of USD3.50 per million British thermal units was within management’s guidance range. But it will put further pressure on the company’s ability to pay down debt and continue its development of liquids assets.

The company has proven its ability to weather tough times with adept financial and operating policies. But recovery won’t happen unless gas prices do bounce up.

PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–Advice: Hold. Production appears to be recovering but lower oil prices and higher costs are a growing risk. We’ll know a lot more when earnings are announced for the third quarter, which should happen on or about November 9. But until then, discretion is advised for this very high yielding stock.

Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Advice: Hold. DBRS has now cut the company’s senior credit rating to junk. That could make debt servicing more difficult at the same time the company is experiencing tough conditions in its chemicals and construction materials businesses. All that’s reflected in a yield of more than 17 percent. The good news is there’s not a lot of pressure on the debt front, with the next scheduled maturity Dec. 31, 2012, in the amount of CAD175 million.

And management maintains the dividend is solid. We’ll know more when earnings are announced Nov. 2, with a conference call Nov. 3.

Ten Peaks Coffee Company Inc (TSX: TPK, OTCL SWSSF)–Advice: SELL. The US dollar’s recent rebound should lift second-half net income. But investors shouldn’t mistake short-term relief for long-term strength. This company’s dividend history has basically been one cut after another, and I’ve never been convinced the business model was really conducive to paying dividends. Numbers are due on or about Nov. 3.

Returning Capital

There haven’t been dividend cuts in the second group–funds paying distributions out of capital–for several months now. But the numbers in How They Rate show the vulnerability.

Basically, any closed-end fund paying distributions that are more than twice its investment income (200 percent) is doing so unsustainably. They can pay out of capital for months, or even years. But sooner or later, investment income has to rise or the payout will have to be cut, else all fund capital be extinguished.

Canadian investors are, of course, compensated somewhat 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.

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 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.

As noted last month, Canadian Edge Portfolio Holding Blue Ribbon Income Fund (TSX: RBN-U, OTC: BLUBF) has the best coverage. EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF) has historically maintained a solid coverage ratio, so I’m willing to cut it some slack. Also, the company continues to benefit from being able to offer warrants to buy stock at a 5 percent discount to net asset value and then buy back units on the market at discounts approaching 10 percent. That’s accretive to net asset value and the ability to pay dividends.

Another fund with good coverage is First Asset Pipes & Power Income Fund (TSX: EWP-U, OTC: FAPPF), added to How They Rate last month. Pipelines and electric power generators have been the strongest part of the Canadian market in recent weeks, mainly because they’re proven to resist recessions. Buy Blue Ribbon under USD12, EnerVest Diversified under USD14 and First Asset Pipes & Power under USD8.

In the danger zone are Portfolio Holding Precious Metals & Mining Trust (TSX: MMP-U, OTC: PMMTF) and EnerVest Energy & Oil Sands Total Return Fund (TSX: EOS, OTC: EOSOF). Both had negative investment income in the first half of the year. I still rate EnerVest Energy & Oil Sands a sell. The fund’s yield is low, and many of its holdings pay no dividends at all.

I’m sticking with Precious Metals & Mining for now as a hold. The fund has focused its portfolio recently on gold and silver mining companies. That’s a huge plus as these stocks continue to lag gold and silver prices, and it’s why I want to own this fund anyway.

These stocks pay little in the way of dividends as a rule. Instead, the fund will pay dividends from capital appreciation, never a sure thing but a good bet for those who want to earn cash and have a position in precious metals. This fund is only for aggressive investors who can handle a lower distribution, should gold and silver mining stocks fail to rally in coming months.

I also rate Aston Hill Income Fund (TSX: VIP-U, OTC: BVPIF) a sell. This is the former Brompton Stable Income Fund, and its payout still vastly exceeds investment income.

Staple Share Scare

Finally, there have been no new developments on this year’s mid-summer surprise. To repeat from last month, Finance Minister Jim Flaherty has 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.

Unlike the trust tax announcement of Halloween night Oct. 31, 2006, this move affects relatively few companies. The only CE Portfolio Holding with exposure is Northern Property REIT (TSX: NPR-U, OTC: NPRUF), and it anticipates just CAD1.5 million in additional annual taxes. That’s clearly no threat to the distribution, and Northern Property remains a solid buy up to USD30.

H&R REIT (TSX: HR-U, OTC: HRREF), Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LIFZF) and Westshore Terminals Investment Corp (TSX: WTE-U, OTC: WTSHF) should also only be slightly affected by the change, not enough to threaten dividends in any case.

Finally, New Flyer Industries Inc (TSX: NFI-U, OTC: NFYIF) has already announced a roughly 50 percent cut from the current monthly dividend rate as part of a conversion to a corporation. Investors should also note the company has now completed a 1-for-10 reverse stock split that’s left its shares valued near CAD60 per.

That in itself should have no real impact on the value of investor holdings in New Flyer. An investor receiving CAD500 a year in total dividends, however, will still receive that CAD500. He or she will just own fewer shares.

Instead, the primary concern here for those who still own this stock is the decline in the underlying business, a result of tough competition and shrinking budgets of the municipal governments in the US who buy its busses. That’s the real reason for New Flyer’s conversion, dividend cut and reverse split. Until that trend reverses, there’s not a lot of hope for recovery. And the dividend could still be cut again, if conditions worsen further.

Hold New Flyer only if you can take that risk. We’ll get another round of earnings numbers on or about Nov. 15.

Bay Street Beat

Former CE Portfolio Aggressive Holding Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV) is among those companies that could face trouble should, as the majority seems to anticipate, the world be gripped by another credit/financial crisis in the near future. But Bay Street is relatively bullish on the company, with six analysts who cover the stock rating it a “buy,” while three rate it “hold” and not a one says “sell.” The average target price among the analysts is CAD8.56, well above a recent price below CAD4.

The company has enjoyed a measure of operational success since converting to a corporation and killing its dividend to focus on growth in March 2009. Proven plus probable reserves at its key Montney shale gas play now stand at 1 trillion cubic feet. Advantage has managed to reduce debt from around CAD800 million to around CAD250 million. But it’s the timing of when they come due coupled with continuing low natural gas prices that make Advantage’s a formidable row to hoe. As detailed in this month’s Feature Article, Advantage Oil & Gas is likely to make it. It’s now a hold for aggressive investors only.

Elsewhere on Bay Street, analysts issued 13 “upgrades” for stocks under Canadian Edge Oil and Gas How They Rate coverage, including Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF), whose two upgrades, to “buy” at Salman Partners and “outperform” at Raymond James, bring its buy-hold-sell line to 3-4-0. The company’s ultra-conservative dividend cut seems to please analysts, who are generally more impressed by capital upside than dividend performance, particularly in the oil and gas space.

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) also earned two upgrades, to “sector outperform” at both Scotia Capital and CIBC World Markets.

Baytex Energy Corp (TSX: BTE, NYSE: BTE) drew one downgrade, by CIBC World Markets to “sector perform,” and one upgrade, by Desjardins Securities to “buy.”

Enerplus Corp (TSX: ERF, NYSE: ERF) got similar treatment, earning a downgrade to “hold” by Salman Partners but an upgrade to “outperform” by Macquarie Securities.

Vermilion Energy Inc (TSX: VET, OTC: VEMTF) also split the Street, with a downgrade by Scotia Capital to “sector perform” and an upgrade from BMO Securities to “outperform.”

Suncor Energy Inc (TSX: SU, NYSE: SU) was the subject of multiple moves, as two houses issued downgrades (to “market perform” at BMO Securities and “hold” at EVA Securities) and two issued upgrades (to “overweight/positive” at Barclay’s and “sector outperform” at Scotia Capital).

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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