The Stock

What to Buy: Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF) @ USD6

Why Now? The stock is currently yielding 13 percent. Management annuonced on June 23 that it Avenir will convert to a corporation in 2011, at which time the monthly dividend will be reduced from CAD0.06 per unit to CAD0.045 per share. Still, based on the new rate and today’s market price, Avenir is yielding in the neighborhood of 10 percent. Low expectations–and the fact that Avenir is trading for less than half its April 2006 all-time high–suggest impressive capital upside, too, should oil prices rise along with a steadying global economy.

The Story

The time is 4:50 am ET Wednesday morning as David eases into the lounge chair on the deck at the Mount Vernon Rec Center indoor pool, just down the street from George Washington’s house.

David’s girls are warming up for the second of what promises to be a lovely series of morning swim sessions. He gets to do this until June. The immediate dilemma, however, is this: Avenir or Armageddon? Will he break out the BlackBerry for a now-he’s-just-showing-off early morning e-mail about the top prey for September’s Big Yield Hunting, or will he crack open Max Hastings’ book about the post-Normandy phase of World War II in Europe?

Eager to impress his mentor, David whips out his PDA and gets his thumbs in gear:

I’m sitting at Mount Vernon Rec Center at 4:50 am, watching the girls swim, having a difficult time getting excited about Avenir. Is it the hour and the circumstance, or the high-cost production and the even-worse-than-expected second-quarter propane performance? What time and where shall we discuss today?

Hours later, at the much more civilized 4:50 pm, David’s BlackBerry issues a familiar rattle and hum, illuminating as well the name “Roger Conrad.” It’s time to hash out our latest high-yield building block.

David: Hey, Rog. Did you get my e-mail?

Roger: Let me back up for a moment. Being at my ninth-grader’s “Back to School Night” reminded me yet again just how out of it a lot of people are when it comes to simple mathematics. Even you, it seems, young fella. It’s really appalling. I doubt half the parents in that room could do half the things their kids can with numbers.

David: You’re not going to start talking about nuclear power again are you?

Roger: No, but that’s a classic example, of course–how few people really understand that there’s no possible way a 100 megawatt wind farm running 20 percent of the time can replace a 2,000 megawatt coal plant running 90 percent of the time. Yet you still see these people out there waving those “No Nukes” signs in one hand and “No Coal” signs in the other. Then there are the people who want to ban shale gas drilling in the US and stop global warming by shutting down coal plants and banning nuclear power. Good luck charging their iPhones.

David: Yeah, yeah, yeah, old man. I thought we were going to talk about high yields.

Roger: Sorry. I did have a point with this. And, yes it concerns that little company you’ve been bugging me about, Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF).

David: Well, my first question about Avenir is this. It’s right now yielding around 13 percent. But they will cut their dividend when they convert to a corporation in 2011. And at the new monthly dividend of 54 cents Canadian annualized, you’re getting a little less than 9 percent based on the long-standing buy price of USD6 we’ve had in Canadian Edge. Is that enough, given the risks involved?

Roger: You can actually buy Avenir somewhat below USD6 now, so the post-conversion yield is closer to 10 percent now. But OK, the point is we have a Canadian trust announcing three months ago that it will convert to a corporation at the end of the year. Management set a very conservative dividend policy, which is well covered by expected business cash flows. It has no leverage problems. In fact, it cut net debt (debt less cash on hand) by more than half in the second quarter.

Avenir’s core business is in an industry–oil and gas production and marketing–that has a lot of upside the next several years. And it’s well managed, as we’ve definitely seen from the way they held it together as a small energy company in 2008 and 2009 when so many were floundering.

Yet, the stock is still yielding 13 percent at its current rate, which will hold until Jan. 1. In fact, it’s still yielding about 10 percent based on the new lower rate it’ll be paying starting next year. How does this trade so cheaply? That seems to me a clear-cut case of not enough investors understanding zeroes.

David: Well, there are a few other numbers investors may be checking out. As you know, they’ve done a little restructuring lately, mainly involving their real estate holdings. Revenue is about a third lower in the first half of 2010 than it was in 2009. And factoring out what the company wants to sell, second-quarter funds from operations are off about 40 percent in the last quarter.

I think that’s probably scaring some people away.

Roger: Absolutely. It’s always a calculated risk with these high-yield situations. But you’re going to see these kinds of numbers anytime a company is going through a transition. But the important thing isn’t what they’re unloading, it’s what they keep.

David: Yeah, but I was checking out…

Roger: “Yeah, but” nothing. That’s you’re new nickname, by the way, “Yabbit,” as in “yeah, but.” By the way, I hauled a 100-pound canoe all over Canada for two weeks this summer, so lay off the “old man” bit.

Anyhow, I know what you were checking out. And, yes, it’s a great way to get very aggressive, but that’s why it’s NOT in the Canadian Edge Portfolio. And BIG is about recommending big yields.

David: Yeah, but…

Roger: I know, I know: Our publisher would also appreciate the logic of providing our top high-yield pick right now to folks who expect our top high-yield pick right now. Remember, however, that the point of this adventure is to step up a bit in yield and risk profile–to provide a rational way, in other words, to deploy risk capital and get paid a great dividend along the way. And right now, Avenir is a great speculative play that happens to pay a sustainable dividend that could go quite a bit higher in fact.

David: The Canadian Edge Safety Rating is 3 for Avenir; It gets one point for clarity on the post-2011 dividend, but the payout ratio isn’t “very safe” for its sector; at 96 percent it’s actually in the “at risk” zone–at least based on the second quarter of 2010. A year ago it was 63 percent, though, and the six-month ratio, to June 30, was 71 percent.

On the six-month basis it gets another point for the not “at risk” 71 percent, then. I agree the balance sheet is clean–another point for a solid debt-to-assets ratio. And they have done a very good job of keeping their debt-to-annualized cash flow rate at less than 1-to1, again superior for this industry. In fact, I don’t know a lot of companies anywhere that could theoretically pay off all of their debt and then some with one year’s cash flow. That’s a lot of comfort in a business as volatile as oil and gas production.

The projected payout ratio–based on a less-than-stellar second-quarter 2010 funds from operations, using the post-conversion monthly payout of CAD0.045 per share–that’s about USD0.53 on an annualized basis as of last night–is a much less risky 72.2 percent.

And you have to believe things will get better for natural gas prices…don’t you?

Roger: I do. But one reason I’m pretty comfortable with Avenir now is they’re not depending on a recovery in gas to execute their business plan or pay their distributions going forward, and that’s even when taxes kick in.

Oil and natural gas liquids as a percentage of total output are on the low side at 41 percent, meaning gas is 59 percent. Avenir, however, has hedged about half of its gas through March 2011 at prices greater than USD6.90 per thousand cubic feet. That’s about USD3 above what we’re seeing in the spot market now, but management has been pretty consistent about extending those hedges.

Also, the bulk of capital spending for the second half of 2010 and into 2011 is focused on oil opportunities in Saskatchewan and the Alberta Peace River arch area. So from that, we can infer oil prices are going to be a lot more important to cash flow going forward.

One other point about that debt: Much of it is mortgages attached to the real estate business, which as you know Avenir is divesting.

David: One thing that worries me some is the small size of the company. They exited the second quarter with daily production of only about 3,471 barrels of oil equivalent (boe). And even with the boost in the 2011 capital budget from CAD16 million to CAD20 million, output is only going to rise to 3,650 boe/d by the end of the year. That’s the lowest output in our Canadian Edge coverage universe. In fact, it’s about the lowest of any energy producer that pays a dividend as far as I can tell.

Roger: I agree. As you know I preach the virtues of scale in the energy business. Size means better access to capital, which is critical to development. Larger companies can also manage their vendor relationships more cost efficiently, which, in Avenir’s case, means dealing with drillers and energy services companies.

The company’s operating cost of around USD16 per boe is on the high side as well, and I don’t see it going a lot lower based on increased scale anytime soon. On the other hand, it certainly produces its oil and gas at costs that are well below current market prices, which is really the name of the game.

Also, keep in mind that this is not your typical oil and gas producer. For starters, there’s the Elbow River Marketing LP, which has a very profitable business with a niche in LPG, or liquid petroleum gases. This division actually provided 19 percent of Avenir’s funds from operations in the second quarter. That’s in a quarter where it experiences considerable seasonal weakness.

David: You mentioned their real estate division. Does it bother you that an oil and gas business would have invested in this area? Do they have a prayer of getting a decent price for their portfolio, or is this just an asset dump to make the income statement look better?

Roger: I know you know the answer to that, so thanks for playing devil’s advocate for our readers.

Actually, Avenir’s diversification is one reason why I’ve resisted your enthusiasm in the past. In fact, I generally shy away from any company with such a broad strategy. But as you’ve pointed out to me over and again, they’ve streamlined quite a bit from the days when they managed the EnerVest funds and ran an energy services company. Anyway, real estate is now the only non-energy business they operate, and they’ve already downsized, as one can see from the 39 percent cut in mortgages on the balance sheet over the past year. Real estate was only 7 percent of funds from operations in the second quarter.

What they make off of the sale is a major unknown at this point, and I hate unknowns, as you know. But keep in mind that Canada’s property market never had a subprime crisis and is generally healthy. That’s even true of places like Alberta, where the market is adjusting to several years of overbuilding.

Avenir’s portfolio is also conservative, with a niche specialty in properties that are too small for REITs and too large for individual investors. Its properties are 100 percent leased and located in strong markets, namely two industrial/commercial properties in Ontario and 15 locations occupied by Landmark Theatre franchisees in Alberta and British Columbia. The theater properties are leased under 20 year deals, while the industrial/commercial facilities enjoy long-life leases and triple net fees, with the lessee paying all operating costs.

That’s not a highly leveraged, high-risk operation. In fact, I think there’s a good chance the selling price will surprise people on the upside. That’s exactly what management has been able to do with other assets it’s divested in the past and it should do even better now with the Canadian economy growing nicely. Meanwhile, these properties continue to produce solid cash returns.

Again, there are lot of moving parts here, and I think you’re right to point out that investors may be cautious on that basis. But as I read the numbers, there’s a lot of upside here with the units selling for barely book value. And even forgetting about Elbow River, they trade at a sizeable discount to conservative estimates of the value of the proven reserves they have in the ground.

David: Any upside target? This thing has been as high as USD11. Are we looking at a return journey?

Roger: Avenir’s share price as a converted corporation will fluctuate with energy prices, just as its unit price has as an income trust. But the point is expectations are very low now, with the units trading for less than half the all-time high in April 2006. That means expectations are going to be easy to beat.

And keep in mind, the biggest risk in most investors’ minds for trusts yet to complete their conversions to corporations–like Avenir right now–is still 2011 taxation. Management has committed to a number and shown in its numbers that it’s clearly sustainable, 4.5 cents Canadian per month. And the market is acting like they’re full of it, pricing it with a yield of roughly 10 percent.

Something’s going to give on this. If the market is right, Avenir will cut its dividend deeper than advertised in early 2011. That’s what I think the units are priced for now, however, which means downside is limited, even under that scenario. And if management can deliver on the 54 cents per share annual rate next year, Avenir is at least going back to a price where it yields 8 percent.

That’s a gain of more than 20 percent from here, just for following through on its business plan, and it’s in addition to the 10 percent yield. So I think a 30 percent total return on this one in a year is not only likely but is actually a very conservative projection. If the global economy can keep puttering along, we’re going to see higher oil and gas prices. That will directly benefit Avenir in both its energy production and marketing operations. It will allow management to boost distributions again and it should push the shares back towards double-digits. That would be almost a double. But in the meantime, I’m happy collecting the yield of around 13 percent through the end of 2010 and 10 percent thereafter.

Also, as you know, whenever the Canadian dollar rises, it boosts the US dollar value of Avenir’s share price and dividend. A break in the loonie above parity–which I think is almost certain over the next year or so–could turn a 10 percent return into a 20 percent return in a hurry. The Canadian currency is also likely to hold its own against a return of inflation, largely because it follows the price of oil.

David: OK, I think you know I’ve agreed with everything you’ve said and that we should take the shot. US investors may have to educate their brokers on how to buy Avenir though, particularly if they choose the over-the-counter market in the US as their way to make purchases.

Roger: You’re absolutely right. Avenir isn’t “blue-skied” in many states, so brokers won’t be able to pitch it to customers. But those customers including our readers can certainly place an order with any reputable broker. And while this isn’t a huge company at a market cap of around USD230 million, I saw 17,900 units traded this week on the over-the-counter market in the US alone, along with 39,000 plus on the Toronto Exchange.

There is supply out there. I would just make sure to buy below USD6, and preferably closer to USD5. The lower the price, the higher the initial yield, and the greater the upside.

I should mention the Canadian government withholds 15 percent of distributions paid to US investors by income trusts like Avenir. That can be recovered by filing a Form 1116 on your US taxes, same as you do for every foreign stock that pays you dividends. Once Avenir converts to a corporation, dividends paid to US investors’ IRA accounts will NOT be withheld the 15 percent. That’s a pretty good reason to buy this one through a tax-deferred retirement account, in addition to being able to shelter all the gains we’re expecting.