Dividend Watch List

I list companies on the Dividend Watch List for basically three reasons.

• The underlying business is weakening enough for the dividend to be at risk. This is typically due to profits lagging the payout, but may also be caused if debt becomes too high to service or roll over;
• A closed-end mutual fund is paying out significantly more in distributions than it’s making with investment income, meaning dividends are being paid with leverage, sales of assets or by returning fund capital to investors.
• Companies are organized to pay distributions as “staple shares,” which are now targeted by the Canadian government for potential new taxes.

The three Canadian Edge How They Rate companies that cut dividends last month were all on the list for reason one, i.e. business weakness: former CE Portfolio Aggressive Holding Perpetual Energy Inc (TSX: PMT, OTC: PMGYF), current Aggressive Holding Daylight Energy Ltd (TSX: DAY, OTC: DAYYF) and Superior Plus Corp (TSX: SPB, OTC: SUUIF).

Of the three Daylight’s cut was the most benign. That’s because it wasn’t actually due to a weak business but was one of the terms of the company’s merger agreement with state-supported Super Oil China Petroleum & Chemical Corp Ltd, better known as Sinopec (NYSE: SNP). Daylight shareholders will receive CAD10.08 per share in cash from the deal, which is expected to close by the end of December.

At this point there’s little apparent risk to the deal from the Canadian government or the Alberta provincial authorities. And approval from shareholders seems a no-brainer, as the offer was more than twice Daylight’s pre-deal share price.

The good news is, even if the deal does fail Daylight’s third-quarter earnings clearly indicate the company can thrive on its own. (See Portfolio Update.) The worst that can happen is it remains independent, in which case management would almost certainly resume paying dividends.

Even with sharply lower output and lower realized selling prices, the company still covered its dividend with distributable cash flow by better than a 2-to-1 margin. Daylight also has an estimated value of reserves in the CAD15 to CAD16 per share range, a value that would almost surely attract another suitor in short order if Sinopec walks away.

My advice is to hold Daylight Energy for now. The stock trades roughly CAD0.20 below the takeover price, about 2 percent. That’s an effective annualized “yield” to the close of around 15 percent. US investors can also get a lift from appreciation in the Canadian dollar between now and early December. Note I don’t intend to recommend holding through the consummation of this deal. Look for a Flash Alert sometime in December with a “sell” recommendation for Daylight Energy.

I cut Perpetual Energy from the Aggressive Holdings in an Oct. 20 Flash Alert, Sell Perpetual Energy. As I pointed out, I still have a great deal of respect for management, and I fully believe the company will survive. But as long as natural gas prices are so far under USD5 per million British thermal units, Perpetual has no choice but to plough all available cash flow into developing its liquids production and servicing its debt.

As long as the company avoids bankruptcy, it’s hard to see a lot more downside in the stock. It does face a CAD75 million debt maturity on Jun. 30, 2012, in the form of a 6.5 percent convertible bond that would only be “in the money” if Perpetual were trading at CAD14.20. As the common stock currently sells at just CAD1.64, it’s likely it will have to come up with the cash to pay off the bond, or else roll investors over into a much higher yielding note.

A third alternative is for the company to use its CAD210 million credit line, on which only CAD88.97 million is drawn. Doing that, however, depends on being able to roll over this agreement when it expires May 29, 2012. And even if that effort is successful, it will only be a stopgap measure until the company finds permanent financing.

Eliminating the dividend will free up about CAD25 million a year in cash flow, which can be applied to reduce that debt. If the company is successful increasing liquids output and oil prices continue to inch higher, it may be able to pay down enough debt to make such a rollover a non-event. That, in turn, will bring the day closer when management–which has increased its holdings of the stock by 55.55 percent over the past six months–will be able to restore the dividend.

On the other hand, if energy prices should weaken from here it will become progressively more difficult for Perpetual to service its debt, let alone roll over upcoming maturities. That could incite more pressure from lenders to pay down debt, shrink credit lines and/or swap debt for equity on horribly dilutive terms.

The bottom line: There’s no certainty here and no dividend to reward us for taking the risk of hanging around. The bar of expectations is very low, meaning even a little good news would likely send the stock a lot higher. But until the company is able to provide more clarity on its 2012 debt maturities and cash flow, I’m out. My advice to those who still own Perpetual Energy is to sell it.

Superior Plus halved its monthly dividend to CAD0.05 per share this week. That follows a 26 percent cut in March 2011, or a total reduction of about 63 percent this year.

The move was widely expected: The stock was yielding north of 17 percent before the announcement, and after an initial dip it’s now basically trading where it was last week. It’s also the latest proof of the general rule that when a company cuts its payout once, another reduction is often on the way.

The key question now is if there’s yet another dividend cut or possibly an elimination to come. In conjunction with the reduction, Superior also announced its third-quarter profit numbers. The company pays its dividend out of adjusted operating cash flow (AOCF), an accounting measure that factors in the unique nature of its diversified businesses. Third-quarter AOCF came in at CAD0.21 per share, down from CAD0.25 a year ago, producing a payout ratio of 142.9 percent based on the old dividend rate.

Because Superior’s propane and heating oil distribution franchise is seasonal, the summer quarter typically produces a shortfall in profits. And the company did affirm its prior full-year AOCF forecast of CAD1.55 to CAD1.90 per share, a rate that would have covered the former annual dividend rate of CAD1.20 per share.

Rather, the dividend cut seems to be more based on the company’s guidance for 2012, which is identical to 2011 at CAD1.55 to CAD1.90. Management had previously implied that it expected higher profits next year, which would have made handling upcoming debt maturities considerably easier. Instead, in the words of CEO Grant Billing, the company was forced to consider “the market value of Superior’s equity and debt securities, the ongoing uncertainty with respect to the European and US sovereign debt issues and recently reduced growth expectations for Canada and the US.”

Several of Superior’s businesses are highly cyclical and depend heavily on the health of the economy, particularly Specialty Chemicals, Construction Products Distribution and US refined fuels distribution. That’s a contrast with the generally steady Canadian propane business, where sales margins rose to CAD0.19 per liter versus CAD0.184 a year ago.

Despite its obvious dependence on heavy industry, Specialty Chemicals has to date been a bright spot. In fact, management has raised its expected cash flow from the division to CAD105 million to CAD120 million from a prior CAD100 million to CAD115 million. That’s largely due to strong conditions in the pulp market that have pushed up chloralkali sales volumes and pricing.

Unfortunately, Construction Products remain a drag, despite management’s efforts to slash operating expenses (down CAD2 million). The reason is a very weak market for gypsum and commercial and industrial insulation, due to weakness in North American residential and commercial construction markets. Management now expects annual cash flow from this division to come in between CAD15 million and CAD25 million for 2011, down from guidance of CAD27 million to CAD37 million issued with second-quarter results.

Superior’s total debt-to-cash flow was reduced to a 5.2-to-1 ratio from 6.1-to-1 at the beginning of the year. With underlying weakness likely to persist in key operating areas, however, further meaningful reductions were looking increasingly problematic. That left management no real choice but to free up more cash by cutting the dividend. The latest move will provide another CAD70 million to CAD75 million for debt reduction, including repayment of what’s still outstanding of the December 2012 5.75 percent convertible debenture.

Assuming it does meet 2011 and 2012 guidance, Superior will be left in a far better financial position than it is now. Assumptions behind guidance appear conservative enough to hold up even if the North American economy slips into recession. And there’s still some CAD300 million outstanding under a credit agreement that won’t expire until Jun. 27, 2014.

That’s likely enough reason for those who own Superior Plus to keep holding. I strongly advise, however, against trying to average down in this or any other challenged company. Superior has already proven once this year that one dividend cut can easily be followed by another. And while management’s strategy appears conservative now, so did its statements this spring after the previous dividend cut.

If Superior can indeed meet this round of guidance numbers and reduce its debt meaningfully, there’s no reason why in a year its stock can’t be trading in double-digits. On the other hand, if there’s another cut in the dividend, this one is headed to low single-digits in a hurry, possibly worse. Again, holding the stock is fine if you don’t mind taking that risk. But to buy more risks turning a losing stock into a full-on debacle.

Here’s a roundup of the past month’s news and general prognosis for the rest of the Dividend Watch List, including when to expect third-quarter earnings if they haven’t yet been reported. Note that I’m keeping Superior Plus on the List for next issue. If anything, the company is as deep in the woods as ever.

Aston Hill VIP Income Fund (TSX: VIP-U, OTC: BVPIF)–Advice: SELL. A closed-end fund with a dividend that vastly exceeds its investment income should never be considered safe.

Management is holding the payout, but it’s doing so with smoke and mirrors.

Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy @ 7. We’ll know how safe this small oil and gas producer’s dividend is when it releases third quarter numbers, which is expected to be on or about November 15. Rising oil prices in recent weeks should be a plus and management has a history of being able to weather tough times.

A good set of numbers will earn the stock an exit from the Dividend Watch List.

Canfor Pulp Products Inc (TSX: CFX, OTC: CFPUF)–Advice: Hold. The company had a tough third quarter, as softer pulp prices and the planned outage of a facility for maintenance depressed sales. The restart of the facility should help in the fourth quarter, as will solid results at the paper unit. The real worry is Chinese demand, and whether the recent drop is due to temporary de-stocking or something deeper.

Meanwhile, the payout ratio moved over 108 percent, which is unsustainable unless it drops in coming quarters, though management remains outwardly supportive of the payout.

Chartwell Seniors Housing REIT (TSX: CSH-U, OTC: CWSRF)–Advice: Hold. The company expects to release its third quarter numbers on or about Nov. 11. The acquisition of a 50 percent interest in a US seniors housing portfolio and a settlement agreement with Spectrum LP should improve the company’s fortunes, providing needed cash and boosting revenue. Management reduced the amount outstanding on a CAD85 million credit line to CAD49 million. That must be whittled down further, however, before it matures Jun. 23, 2012.

I expect to see progress on this front, as well as strong enough operating numbers to earn an exit from the Watch List. Until that happens, however, I’m keeping it here.

Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF)–Advice: Buy @ 5. The airline is almost certain to post another solid quarter when it releases numbers on Nov. 8. And management is likely to be upbeat about its future prospects as well. All of that, however, is likely to be irrelevant to the stock price, which rises or falls on the perceived health of parent Air Canada (TSX: AC/A, OTC: AIDIF).

With the yield at nearly 16 percent, many investors seem to be betting that the deal between Chorus and parent will have to be altered, forcing a dividend cut. We’ll know more next week. But at this price there doesn’t appear to be much risk.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF)–Advice: SELL. The company will release quarterly results on or about Nov. 8. At that point we’ll see just how bad things are in the US, where cuts in government health care payouts and weak economy have hammered sales in recent quarters.

A new rate deal in Canada is a big plus, but it will be tough for management to hold the dividend if the US is coming to pieces.

Enervest Energy & Oil Sands Total Return (TSX: EOS, OTC: EOSOF)–Advice: SELL. The closed end fund apparently owns few stocks that actually pay dividends, yet it continues to pay out a hefty sum each month. Funds are often black boxes in how they’re run and pay dividends, and management has plenty of levers to pull to hold the payout in the near term.

But that’s no basis for making an income investment, and there are plenty of higher-yielding and more reliable ways to score in aggressive energy.

FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Advice: Buy @ 5. This is a stock to hold quarter by quarter, as there are many questions about its transition from print to Internet. Third-quarter earnings are due Nov. 10, and so far at least management has been able to maintain enough cash flow to provide decent payout coverage.

But its traditional newspaper business is in decline, and investors aren’t likely to cut the company any slack as long as macro conditions are so uncertain.

Freehold Royalties Ltd (TSX: FRU, OTC: FRHLF)–Advice: Hold. I expect to see generally solid third-quarter earnings when the company makes its now confirmed Nov. 10 announcement. However, it relies heavily on others to produce from its lands to generate royalties, which makes returns less certain than if it were producing for itself.

The October rebound in oil prices may induce management to hold the distribution, even if there were a spike in the payout ratio. But until the numbers are in, uncertainty will make other energy plays more attractive, despite this stock’s 9 percent-plus yield.

Interrent REIT (TSX: IIP-U, OTC: IIPZF)–Advice: Hold. Third-quarter earnings due on or about Nov. 11 should show enough improvement to take the apartment owner off the Watch List. That’s my view given the apparent robust health of the Canadian apartment rental market and the REIT’s recent results. We’ll see if that’s case next week.

NAL Energy Corp (TSX: NAE, OTC: NOIGF)–Advice: Hold. Speculation in the market that this company is about to cut its dividend has risen in recent months. Management tried to quell them with an “update” of its activities in mid-October. But the yield is still north of 9 percent, as fears have persisted. I suspect the company will deliver another solid quarter, proving its dividend level as actually quite conservative.

If that happens, I’ll take it off the Watch List and make it a buy. Until then, it’s a hold for risk-takers only.

PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–Advice: Buy @ 10. This company’s problem in a word is execution. It’s simply been unable, at least to date, to deliver on the hype that accompanied its launch in late 2009. The company has consistently maintained its monthly dividend of CAD0.08  per share and actually covered it with distributable cash flow by nearly a 2-to-1 margin in the second quarter.

I expect third-quarter earnings, due Nov. 9, to show a solid improvement in output, which would go a long way toward proving the dividend is secure and earning the company an exit from the Dividend Watch List. But until then, however, it’s a speculation.

Precious Metals & Mining Trust (TSX: MMP-U, OTC: PMMTF)–Advice: Hold. The fund’s gold and silver mining stocks should help results in the second half of the year. But the dividend isn’t paid from its holdings’ dividends. In fact, most of them pay no dividends at all.

This is not an income investment. It’s a precious metals investment that returns cash when times are good, as they are now.

Ten Peaks Coffee Company Inc (TSX: TPK, OTCL SWSSF)–Advice: SELL. Ten Peaks enjoyed a 65.9 percent boost in third-quarter sales over last year’s levels. Gross profit, however, slipped 2.1 percent, while cash flow skidded 33.3 percent and net income went into the red. The latter figure is less relevant. But cash flow per share of CAD0.087 was 33.6 percent below last year’s tally.

CEO Frank Dennis pronounced management “satisfied with the results achieved during the first three quarter of 2011,” citing “modest” growth in processing volumes as the company has ramped up sales and marketing. Volume sales to specialty regional customers rose 27 percent and relevant coffee prices surged 71.7 percent. That, however, was offset by an 80 percent jump in cost of sales.

In its statement of outlook, management noted it expects “external market factors” to “continue to create challenging market conditions into at least 2012. That suggests covering the dividend will remain a struggle, despite management’s encouraging words.

Bay Street Beat

Recent data on North American rail traffic supports the proposition that growth on the continent, although jagged and too slow to absorb the unemployed and new job-market entrants in the US, continues.

The Association of American Railroads (AAR) reported gains in October 2011 rail traffic compared to year-ago levels, as US railroads originated 1,215,627 carloads, up 1.7 percent, and 975,566 trailers and containers, up 3.6 percent. October 2011 saw the highest weekly carload average of any month since October 2008, as well as the highest weekly intermodal average since October 2006.

For the first 43 weeks of 2011 US railroads reported cumulative volume of 12,544,777 carloads, up 1.8 percent from the same point last year, and 9,856,792 trailers and containers, up 5.3 percent.

Canadian railroads reported 80,569 carloads for the week, up 5.1 percent year over year, and 51,670 trailers and containers, up 3.4 percent compared to the same week in October 2010. Canadian railroads reported cumulative volume of 3,242,656 carloads over the first 43 weeks of 2011, up 3 percent year over year, and 2,074,568 trailers and containers, up 1.5 percent.

Because services account for an ever-greater share of overall economic activity the predictive value of rail traffic has been somewhat reduced in recent years. Nevertheless the movement of goods and commodities over rail remains at least a key variable in the macro equation.

There are two “Class I” railroads in the Canadian Edge How They Rate coverage universe, Canadian National Railway Company (TSX: CNR, NYSE: CNI) and Canadian Pacific Railway Ltd (TSX: CP, NYSE: CP), which together draw rather mixed reviews from the crowd of Bay Street analysts who cover them. CN Rail sports a seven-18-zero buy-hold-sell line, while CP checks in with a seven-14-three.

CP has drawn a great deal of attention in recent days because of the 12.2 percent stake taken by activist investor William Ackman’s Pershing Capital Management LP and his subsequent entry into talks with management, directors and shareholders about the future of the company. CP shares rallied 38 percent in the six weeks that Pershing was accumulating its position, which makes it the railroad’s biggest shareholder.

Speculation has focused on Mr. Ackman’s desire to engineer a sale of Canada’s No. 2 railroad, which is burdened by relatively inefficient operations but trades at one of the highest earnings multiples of all the North American Class I railroads. Mr. Ackman himself has denied “pushing” for a sale. “We don’t think the company should be sold,” he said in a Nov. 2 interview with Bloomberg.

CP has reliably held and grown its dividend over the past half-decade, boosting its payout nearly 10 percent during a time when the economy around it seemed to be crumbling. Upside from here will be determined by its ability to improve its network operations. A lighter-than-forecast load from pension and incentive compensation costs would also help. The company is locked into long-term sales contracts, and the location of its tracks is something that can’t be fixed by any wunderkind capitalist. If the global economy picks up quicker than current conditions suggest, CP will benefit from stronger bulk commodities exports.

The key, however, is the success of a productivity and efficiency campaign across its operations in Canada and the US. This effort follows severe winter weather in 2010-11 and extensive spring flooding. Fiscal 2012 second-quarter earnings showed a drop in profits from a year ago, as operating expenses jumped on nearly 90 weather-related outages during the three-month period ended Jun. 30.

CEO Fred Green said during a quarterly conference call that the railway is taking steps to ensure that equipment and personnel are in place to limit future impacts from inclement weather. CP’s goal is to improve its operating ratio–a measure of expenses relative to revenue–to the low 70 percent range from the 76.9 it posted during the three months ended Sept. 30, 2011, over the next two to four years.

CP reported net income of CAD186.8 million and diluted earnings per share of CAD1.10 on total revenue of CAD1.3 billion. Operating income was CAD324.6 million, a decrease of CAD13.1 million. The question is whether Mr. Ackman or anyone else can do better.

CN Rail, on the other hand, is among the most efficient North American Class I operators. It’s hard to understand the Bay Street’s inability to distinguish the stock, though it is notable that zero analysts rate it a “sell” under the standardized Bloomberg rating system, versus the three who are basically saying to unload CP.

CN faces similar macro headwinds, but its operation has proven resilient in the face of the same weather that felled CP in 2011. The company reported a 19 percent increase in net income for the three months ended Sept. 30 to CAD659 million, as earnings per share (EPS) rose 23 percent to CAD1.46. Excluding the gain on the sale  of the RailMarine Terminal Company adjusted net income increased 12 percent over the year-earlier quarter to CAD621 million.

Revenues for third quarter 2011 rose 9 percent to CAD2.31 billion, while carloadings grew 4 percent and revenue ton-miles increased 6 percent. Operating income increased 12 percent to CAD938 million, while CN’s operating ratio was 59.3 percent, a 1.4 point improvement over 60.7 percent for the third quarter of 2010.

CN has boosted its dividend by 15.24 percent over the past five years, CP 9.86 percent. Back in September 2006 CN paid CAD0.1625 per share per quarter, while in October 2006 CP paid CAD0.1875.

Tips on DRIPs

In January 2011 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):

• Bank of Montreal (TSX: BMO, NYSE: BMO)–www2.bmo.com/content/0,1089,divId-3_langId-1_navCode-4993,00.html
• Bank of Nova Scotia (TSX: BNS, NYSE: BNS)–https://www-us.computershare.com/investor/plans/planslist.asp?planid=81&state=eStateDisplayPlanSummary
• BCE Inc (TSX: BCE, NYSE: BCE)–http://bce.ca/en/investors/dividendinfo/drp/#enroll
• Enbridge Inc (TSX: ENB, NYSE: ENB)–www.enbridge.com/InvestorRelations/StockInformation/DividendReinvestmentandSharePurchasePlan.aspx
• EnCana Corp (TSX: ECA, NYSE: ECA)–www.encana.com/investors/shareholder/drip/
• Nexen Corp (TSX: NXY, NYSE: NXY)–www.nexeninc.com/en/Investors/Shareholders/GeneralInformation.aspx)
• Pengrowth Energy Corp (TSX: PGF, NYSE: PGH)–www.pengrowth.com/investors/drip_information/
• Potash Corp of Saskatchewan (TSX: POT, NYSE: POT)–www.potashcorp.com/investors/stock_information/dividend_history/drip/
• Rogers Communications (TSX: RCI/B, NYSE: RCI)–https://www-us.computershare.com/investor/plans/planslist.asp?planid=773&state=eStateDisplayPlanSummary)
• Royal Bank of Canada (TSX: RY, NYSE: RY)–http://www.rbc.com/investorrelations/ir_dividends.html
• Suncor Energy (TSX: SU, NYSE: SU)–https://www-us.computershare.com/investor/default.asp?bhjs=1&fla=1&cc=CA&issuerid=scussunq&landing=y&showinvestorcontact=y
• Telus Corp (TSX: T, NYSE: TU)–https://www-us.computershare.com/investor/plans/planslist.asp?planid=121&state=eStateDisplayPlanSummary
• Toronto-Dominion Bank (TSX: TD, NYSE: TD)– http://www.td.com/investor/drip.jsp
• TransCanada Corp (TSX: TRP, NYSE: TRP)–https://www-us.computershare.com/investor/plans/planslist.asp?planid=124&state=eStateDisplayPlanSummary