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The Canadian Edge

By Roger Conrad on March 5, 2010

As reported in the March 4 Maple Leaf Memo Canada’s economy officially grew at a robust 5 percent rate in the fourth quarter of 2009. Considering the country barely stumbled during the downturn of the past couple years, that’s extraordinary.

It’s also reflected in the generally solid fourth-quarter and full-year 2009 earnings numbers being put up by our Canadian Edge Portfolio Holdings. As might be expected, comparisons with year-ago levels were difficult. That was especially true for companies whose fortunes are connected in some way to natural gas prices, or to the health of the US economy.

Nonetheless, every one of the 21 Canadian trusts and corporations turned in results that supported their dividends and balance sheets and laid the groundwork for a strong 2010. Coupled with the obvious strength in the overall Canadian economy–fueled in large part by the country’s growing ties to the surging economies of developing Asia–what we have is a compelling case for growth for our favorites. And it’s an edge that’s by no means shared by the majority of US companies.

The broad-based S&P/Toronto Stock Exchange Income Trust Index has continued to outperform the S&P 500 in 2010, just as it did so convincingly in 2009. The Canadian dollar, meanwhile, has been equally strong, adding to US investors’ gains and raising the value of distributions paid as well.

Despite these gains, however, many Canadian trusts and high-yielding corporations–including most CE Portfolio picks–continue to trade well below their levels of just a few years ago. That may lead some to wonder just when the Canadian edge is going to truly be reflected in share prices, if ever.

As I explain in the Feature Article, trust conversions to corporations have been overwhelmingly bullish for investors thus far. The 26 companies that have already completed their conversions are up an average of 63 percent from where they stood prior to announcing the move. Meanwhile, the 19 companies that have announced conversions and set post-conversion dividends are up an average of 23 percent and are likely headed for gains similar to the already converted.

Ironically, the conversion process is still viewed with grave suspicion by investors. That’s not surprising, given that the public has been told again and again by so-called experts that trusts’ conversions to corporations would be a doomsday of steep dividend cuts and crashing share prices. And it’s why playing conversions has been so lucrative to date and will be going forward–as it’s all too easy for converting trusts to beat expectations.

Until the conversion process winds up, however, it’s likely 2011 will remain a point of insecurity for investors. That means unit prices of trusts that don’t declare their intentions on post-conversion dividends will continue to labor under a cloud, i.e. remain at lower levels than they otherwise would.

This will be only a temporary state of affairs for trusts backed by strong underlying businesses. Only long-distance mind-readers or investors with a seat on a trust’s board can know for certain in advance what a post-conversion dividend policy will be.

Some managements will surprise on the upside, as High Yield of the Month Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) and Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) did last month. But others will come in lower than we expect, as Davis + Henderson Income Fund (TSX: DHF-U, OTC: DHIFF) has apparently done. Prospects for Yellow and Davis are reviewed in Dividend Watch List, including their fourth-quarter and full-year earnings results.

Regardless, however, setting a clear post-conversion dividend policy will remove the uncertainty that’s built up over the three years-plus since Finance Minister Jim Flaherty made his infamous Halloween night 2006 announcement that trusts would be taxed. Some investors may sell if a dividend cut is more than they bargained for. But the record of the 45 trust conversion and dividend-setting announcements thus far is it won’t be long before buyers come back to well-run businesses.

The key to unlocking those post-conversion gains is strong underlying businesses. Consequently, careful monitoring of Canadian Edge Portfolio holdings’ earnings is as important this year as it was the last two, when recession and credit concerns were a perpetual threat to crater companies’ prospects.

We now have earnings in for 21 CE Portfolio holdings, including Bell Aliant Regional Communications Income Fund’s (TSX: BA-U, OTC: BLIAF), which were reviewed in the February High Yield of the Month. Below, I review the results, starting with the Conservative Holdings that have turned in numbers. Note some of these were also reviewed in the February 19 Flash Alert, though I’ve tried not to duplicate the information.

For trusts and corporations not in the Portfolio, see How They Rate for payout ratios, CE Safety Ratings, information on fourth-quarter earnings and debt, and my most current buy-hold-sell advice. The Portfolio table runs down total returns for all Portfolio picks, or capital gains/losses plus distributions since the original recommendation.

Again, results for Davis + Henderson and Yellow Pages are reviewed in Dividend Watch List. Enerplus’ numbers are highlighted in High Yield of the Month, as are the prospects of Mutual Fund Alternative EnerVest Diversified Income Trust (TSX: EIT-U, OTC: ENDTF).

Conservative Holdings

AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) management is still sticking to its forecast for a post-conversion dividend of CAD1.10 to CAD1.40 per share. That’s a big step-down from the current rate of CAD2.16 per share. But it’s also a powerful statement about management: Despite stellar growth prospects–which are reflected in strong fourth-quarter numbers–it won’t launch a post-conversion dividend that it’s not absolutely certain the company can build off of in coming years.

The move has obviously cost AltaGas shares some near-term upside, as the units trade for just 1.4 times book value and with a yield of nearly 12 percent. But the projection does leave room for quite a bit of upside as well going forward, thanks to the company’s powerful long-term business fundamentals.

Excluding the impact of unrealized gains and losses on risk management contracts, cash flow rose 7.8 percent in the fourth quarter, triggering a 17.3 percent boost in net income.

The results reflect the successful completion of new capital projects, adding to the company’s base of fee-generating assets in electric power, energy extraction and transmission, field gathering and processing and utility distribution.

AltaGas currently has another CAD2 billion in “organic” projects under development, i.e. new fee-generating assets tied into existing ones.

It’s also acquiring a major gas storage project in Nova Scotia, further taking its reach beyond its traditional Western Canada territory. In its fourth-quarter conference call, management affirmed it will provide full information on its planned conversion in May, with a vote on its plans scheduled for June 3. We’ll see then just how much if any management has been low-balling its prospective dividend. Until then, shares are likely to lag on the uncertainty.

But with its business prospects bright and very low expectations priced in, there’s little risk to buying AltaGas Income Trust up to USD20 if you haven’t already.

Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) reported a 120 percent jump in its fourth-quarter revenue on a 47 percent increase in generation, the result of the drop-down of power assets from parent Brookfield Asset Management (TSX: BAM/A, NYSE: BAM) last year. That induced management to go one better on its previously announced plan to maintain its entire distribution after converting to a corporation later this year–by increasing its existing payout a solid 4 percent to an annual rate of CAD1.30 per unit.

One of the benefits of having a much larger portfolio now is the company’s ability to post steady numbers even when a particular asset underperforms. That was the case in the fourth quarter, as the company maintained 98 percent availability at its wind plants overall despite lower generation at the Prince Wind Farm. The next big cash-generating asset to come on line will be the Gosfield Wind Project, with an additional capital cost of CAD147 million to be spent in 2010.

It’s expected to add CAD0.06 per share to distributable cash flow, which will remain the primary metric for determining dividends after Brookfield Renewable (formerly Great Lakes Hydro Income Fund) converts to a corporation later this year. It’s also the kind of project that avoids the risks of “greenfield” development, which, in turn, would add variability to capital costs, cash flow and, potentially, dividends.

The only thing wrong with buying Brookfield Renewable now is that its share price is much higher than it was just a few months ago before it announced its cut-less conversion to a corporation.

But with virtually all of its power locked into long-term contracts with the strongest possible entities, a strong balance sheet and more dividend growth ahead, Brookfield Renewable Power Fund is still a worthy buy up to USD20 for those not lucky enough to own it already.

Canadian Apartment Properties REIT’s (TSX: CAR-U, OTC: CDPYF) earnings remain some of the most delightfully boring reading available, just as they were during the recession and credit crunch of the past two years. Net operating income margin rose to 53.5 percent from 52.7 percent a year ago, knocking the payout ratio down to 91.9 percent in the fourth quarter–typically light because of heating costs landlords must absorb in Canada–and 88.5 percent for the full year.

Despite a generally weak market, particularly in Western Canada, average monthly rents rose 1 percent portfolio-wide. That was despite a slight drop in occupancy to 98 percent from 98.5 percent a year ago.

Of course, 98 percent is a number US apartment REITs can only dream about, but it’s standard fare for CAP REIT, whose stable bad-debt levels are also a sharp contrast to rivals south of the border.

In fact, the REIT has now posted 16 consecutive quarters of stable or improved year-over-year net operating income growth at its core portfolio.

Debt leverage was reduced to 62.75 percent of gross book value from 62.97 percent in the third quarter.

Moreover, the REIT was able to refinance CAD304.6 million of property mortgages at a weighted average interest rate of just 3.95 percent, well below the 5.22 average rate of mortgages maturing in 2009. That’s a testament to sound financial management, demonstrated skill at raising capital and a high-quality property portfolio, all of which ensure continued steady results and safe dividends for investors.

Amazingly, CAP REIT continues to yield 7.6 percent, some two and a half percentage points more than rival Home Properties (NYSE: HME) in the US despite the latter’s recent dividend cut and inferior operating metrics. If you’re looking for high-quality property cheap, you won’t do better than buying Canadian Apartment Properties REIT up to USD15.

CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) units took a one-day hit of roughly 5 percent on March 4–the day management announced fourth-quarter and full-year earnings.

Full-year numbers were strongly up from 2008; fourth-quarter revenue, however, slipped 4.1 percent and was only partly offset by a 2 percent cut in expenses. As a result, cash flow slipped 9.4 percent, though cash provided by operating activities rose 9.8 percent and adjusted net earnings–excluding a CAD50 million goodwill impairment charge–rose 20.4 percent. Distributable cash flow rose 2.3 percent, and the payout ratio for the quarter came down to 94.4 percent from 96.6 percent a year ago.

Analysts on the trust’s fourth-quarter conference call seemed chiefly concerned about the company’s US medical imaging business, profits from which were hurt by the drop in the US dollar, but mainly by less traffic. On the plus side, the CML isn’t waiting around for the situation to improve and has acted quickly to shake up the management of the unit. The writeoff of goodwill reflects a forecast for lower Medicare reimbursement reductions and volume growth. The company remains in prime position to benefit from health care reform, particularly if its diagnostic services become available to 30 million more insured Americans.

That’s offset, however, by continued pressures to control costs, which could reduce demand. What seemed to trigger the selling in the stock was the fact that US operations performed so much worse in the fourth quarter than they had previously in 2009. Management addressed several questions on that issue during the conference call, stressing its moves to improve sales and margins.

At this point, the current payout rate doesn’t appear to be threatened by these developments, as the US operations remain profitable and the much larger Canadian operation is healthy. But success at turning around the US operation will be critical to CML retaining its current payout rate after it converts to a corporation later this year.

Also on the plus side, CML has put an inter-company financing structure in place that effectively zeros out any tax liability in the US, which has a major impact on cash available to grow that business without compromising overall company financial strength. On the negative side, regulation appears to be a negative for 2010, with lower rates only partly offset by projected utilization growth. I’m willing to ride with CML Healthcare Income despite these earnings, mainly because of its conservative financial management; it remains a buy up to USD13 for those who don’t already own it. But I’ll be watching future earnings closely to ensure it’s executing its plans. Note than management expects to issue more guidance on its post-conversion dividend in May.

Colabor Group (TSX: GCL, OTC: COLFF) posted a 25 basis point improvement in its fourth-quarter 2009 margins, a major achievement considering the weakness in the North American food service market. Earnings were in line with what Bay Street analysts expected, and demand for food and food related products–the company’s mainstays–remain solid.

Fiscal 2009 sales rose 3.2 percent, cash flow picked up 6.3 percent and net earnings nearly doubled. The cash flow payout ratio, meanwhile, dipped to 60 percent. For the quarter, results were less favorable, as sales slipped 8.5 percent and cash flow fell 2.6 percent. Fortunately, that was more than offset by a steep 21.2 percent cut in financial expenses, leading to a 10.7 percent jump in earnings before income taxes, a 108 percent increase in net earnings and a 60.6 percent jump in headline earnings per share to CAD0.53.

The company’s operations are basically divided into wholesale–which services food distributors primarily in Quebec and Atlantic Canada–and distribution, which serves a range of customers in Ontario. Both divisions saw a drop in sales but distribution had the worst of it, due mainly to worse economic conditions in Ontario. The good news here is, even in this environment, Colabor generated more than enough cash to strengthen its balance sheet, pay its generous quarterly distribution of CAD0.27 per share and continue its strategy of growth through acquisitions.

Management has routinely demonstrated its ability to control costs, taking the step of freezing management salaries last year. That pushed up margins to 4.13 percent in the fourth quarter from 3.88 percent a year ago, offsetting the revenue losses impact on cash flow. Those are solid reasons to own this stock, which completed its conversion to a corporation last year. Buy Colabor Group up to USD12.

Just Energy Income Fund (TSX: JE-U, OTC: JUSTF) will convert to a corporation in the fourth quarter of calendar 2010. It will also maintain its current monthly distribution of 10.33 cents Canadian after converting, as management has indicated for some weeks.

The company also reported very solid numbers for its fiscal 2010 third quarter (ended December 31). The most important were a 7 percent increase in seasonally adjusted sales and an 11 percent jump in average margin per customer, boosting gross margin by 17 percent.

The company’s Just Green energy offering remained fabulously successful, generating 37 percent of all new customer volumes, and it continued to successfully integrate the operations of former competitor Universal Energy.

The company added 28.5 percent more customers under long-term contracts year over year, despite what continues to be a weak market for its operations on both sides of the border. That spurred distributable cash flow growth of 27 percent after marketing expenses to add customers, taking the payout ratio down to just 67 percent, before the special dividend of CAD0.20 per share.

Encouragingly, the company continues to exceed management’s targets for growth, which remains 5 to 10 percent for fiscal year 2010 distributable cash flow. That’s partly because of a close focus on costs, as well as skillful hedging against volatility in energy prices, interest rates, currency swings and even economic hardship.

The company currently expects to earn at the low end of its 5 to 10 percent growth target, largely because of the impact of continued economic weakness at its US operations. That leaves room to beat the bar on the earnings front, even as the stock continues to yield nearly 9 percent despite putting 2011 uncertainty behind it. Just Energy Income Fund remains a strong buy up to USD14.

Keyera Facilities Income Fund’s (TSX: KEY-U, OTC: KEYUF)  most important news last month, ironically, wasn’t its blockbuster fourth-quarter earnings report or even the affirmation that it will hold its dividend steady when it converts to a corporation later this year. Rather, it was its release of plans for a major enhancement to its natural gas liquids (NGL) transportation network.

As my colleague Elliott Gue has pointed out in The Energy Strategist, demand for NGLs has surged recently, the result of the massive pricing differential between their feedstock, natural gas, and their chief end-use competitor, oil. And with shale gas in abundance and demand for oil surging globally, that differential looks likely to endure, driving demand for NGLs to replace far more expensive oil for plastics and other refined goods.

Keyera’s build will focus on extending and enhancing its network in central Alberta, adding storage facilities, converting an existing pipeline to NGL service and constructing a new 6 kilometer connection (roughly 3.7 miles) at a total cost of CAD11 million. This is precisely the kind of fee-based infrastructure that Keyera has become known for, and it promises to keep cash flows–and eventually distributions–rising well into the future, even as the company absorbs corporate taxation.

As for fourth-quarter results the steady performance of existing assets and the addition of valuable new ones lifted distributable cash flow per unit to CAD0.66. That was a gain of 15.8 percent from last year’s fourth quarter.

Gathering and processing throughput was up 0.8 percent from year-ago levels, while net processing throughput rose 11.2 percent, despite a crushing depression in the Canadian natural gas drilling industry.

That’s a clear testament to the value of the trust’s assets and their ability to withstand even the worst overall industry conditions. And despite acquisitions and construction of new fee-generating assets last year, the company actually managed to cut its debt load.

Well positioned for growth as energy prices rise–and well protected if they slide again–Keyera Facilities Income Fund is a super buy for USD25 for those who don’t already own it.

Macquarie Power & Infrastructure Income Fund (TSX: MPT-U, OTC: MCQPF) also had bigger news last month to report than its quarterly and full-year earnings. The trust’s partner in the Leisureworld long-term care facility has agreed to buy out Macquarie’s interest in the facility following an initial public offering of its own shares.

The trust currently owns a 45 percent equity interest in Leisureworld Senior Care LP, which provided it CAD10.35 million of distributions in 2009. Terms of sale have not been disclosed but promise to provide considerable cash for the company to pursue further acquisitions closer to its core business in combination with other cash flow and credit lines.

Meanwhile, existing power assets continued to perform well during the quarter. That plus cost cutting was the key factor pushing up distributable cash flow per share by 9.9 percent. Management has also been successful meeting two of the key goals it outlined last year when it announced its plans to convert to a corporation in late 2010, namely debt refinancing and upgrading its power plants.

These will remain key challenges going forward for management. But with a payout ratio of only about 50 percent of distributable cash flow–projected to rise to 70 to 75 percent after taxes kick in Jan. 1, 2011–it has a lot of flexibility to continue making improvements and holding the 9 percent-plus dividend. It may take Macquarie’s eventual conversion to a corporation to bring the share price to full value.

In the meantime, however, the stock is cheap at just 1.2 times book value and, with the divestiture of Leisureworld, is suddenly more attractive as a takeover target as well. Buy Macquarie Power & Infrastructure Income Fund up to USD8 if you haven’t yet.

Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) came in with another rock-steady quarter, gains in revenue, cash flow and distributable cash flow largely offset by an increase in outstanding units to finance ongoing construction of fee-generating assets. That’s a formula the trust has followed successfully for many years in good and bad times, and as long as management executes it efficiently investors will see strong returns for years to come.

Pembina invested CAD423.7 million in new capital in 2009, a 90 percent increase from 2008 levels. A good chunk of that went towards acquiring the Cutbank Complex in June (CAD23 million in additional net operating income) and keeping construction of the Nipisi and Mitsue Pipelines on track for a scheduled mid-2011 opening. These new facilities are expected to generate an additional CAD45 million in annual income.

Cash flow gains were largely offset by dilution from the CAD800 million in new debt and equity raised in 2009. In reality, however, raising capital–particularly by issuing stock–is the most conservative way to finance new assets and to ensure they’re ultimately profitable. Expenditures and dilution are all upfront, while the payoff comes only after the asset is completed and brought on line. But having the expense out of the way at the beginning means investors can look forward to a substantial payoff.

Moreover, Pembina’s cost of capital is very low now, thanks to low interest rates and a high unit price, ensuring it’s getting the most bang for its buck. Breaking down the divisions, oil sands and heavy oil investments remain the driver of growth, with net operating income surging 43.9 percent last year on solid operations at the Syncrude network and the opening of the Horizon system. That offset flat performance at the conventional pipelines, which were hurt by the weak economy in the energy patch. Midstream and Marketing income was up 10.5 percent, thanks to management’s ability to maximize profitability of its assets.

Management’s strategy for 2011 taxation is to convert to a corporation in late 2010, holding its current dividend rate at least through 2013. At that point, the payout will likely be determined by the success of new projects and what tax rate the company pays, which will be reduced by the company’s tax advantages inherent in infrastructure construction.

Time will tell. But management is conservative, the trust’s assets are solid, and there are plenty of growth opportunities, particularly in the oil sands region, where the company is the premier player thanks to its exclusive arrangement with the Exxon Mobil (NYSE: XOM)-run Syncrude partnership. That adds up to an exceptionally solid company that still yields nearly 9 percent. Pembina Pipeline is a solid buy up to USD18 for those who don’t already own it.     

RioCan REIT (TSX: REI-U, OTC: RIOCF) was also reviewed in the February 19 Flash Alert. As reported there, Canada’s largest REIT and a specialist in high-quality shopping centers posted fourth-quarter numbers that lagged some estimates and triggered a sharp decline in its units. Units have since recovered from those lows, but the REIT’s latest shortfall in distributable cash flow–the fourth quarter payout ratio was 123 percent–nonetheless merits some scrutiny.

As was the case throughout 2009, the primary reason for the high payout ratio was again the huge amount of capital RioCan raised last year, mainly to finance acquisitions of high-quality properties with distressed owners. As it turned out, the REIT acquired 20 properties in Canada and the US with an aggregate capacity of 1.8 million square feet. Of the four US properties, three were part of a joint venture platform inked with Cedar Shopping Centers (NYSE: CDR) to purchase seven grocery store-anchored shopping centers in the Northeast. The total investment was CAD348 million.

Finding those accretive acquisitions, however, appears to have taken longer than management had hoped when it raised CAD871 million in debt and equity last year. The cost of that capital was very low, thanks to RioCan’s high unit price and low borrowing rates. But the result was the REIT had large cash balances earning very little interest on its books for much of 2009–and in fact still had CAD147 million at the end of the year. Coupled with the cost of carrying the debt and dilution from the additional units, that pushed down distributable cash flow per share and pushed up the payout ratio. That was despite a rise in rental revenue, high occupancy of 96.4 percent and management’s continued ability to re-lease space vacated by financially strapped tenants.

The REIT’s fourth-quarter retention rate for expiring leases was 93 percent, a sharp improvement over last year’s 88 percent and a particularly solid showing in such a weak environment. Further, renewals were carried out with an average rent increase of 9 percent overall and 11 percent excluding fixed rent leasing options.

The good news is operating statistics like these confirm both high portfolio quality and growing sector stabilization. By waiting for the right kind of purchases, RioCan sacrificed near-term cash flow but has ensured it will get the most for its money in the long haul, in the form of good properties financed with low-cost capital. Moreover, as the REIT has proven, it has the wherewithal to fund the dividend despite the distributable cash flow shortfall and is fully committed to doing so.

Ultimately, no company can indefinitely pay out more in dividends than it earns. RioCan will also likely have to alter some of its activities in 2011 to avoid facing new taxes, such as “property trading.” Management, however, now expects “recently and completed Q1 2010 Canadian and US acquisitions [to] begin to positively impact funds from operations [FFO]” even as it avoids some of the costs it faced last year. The REIT still projects at least CAD500 million in additional acquisitions for 2010, a clear sign of management’s ambition but also the formidable financial means at its disposal.

In the words of CEO Edward Sonshine during the fourth-quarter conference call: “The velocity of our FFO over the course of 2010…will be quite interesting and maybe even dramatic to some of you…That is a way of saying that any rumors out there either [about] debt or an impending cut in distributions…are extremely exaggerated.”

Those are bold words for a CEO for a REIT with such a high payout ratio. But this is one management team that’s consistently matched words with deeds, and RioCan is no over-leveraged, shoot-from-the-hip US REIT ready to collapse like a house of cards. I’ll breath easier when distribution coverage improves and there’s still cash for management to deploy. But for now, there aren’t many real estate investments in North America yielding over 7 percent with RioCan’s potential. Buy up to USD20.

TransForce (TSX: TFI, OTF: TFIFF) suffered another quarter of declining year-over-year revenue comparisons, with sales excluding the fuel surcharge slipping 6.8 percent. The numbers once again reflected a crop in volume of shipments due to economic weakness in North America. The company also recorded a CAD45 million goodwill impairment charge, related to its operations in oilfield services.

Beneath the surface, however, there were some major positives in the numbers. Management continued to be successful finding ways to cut costs without undermining its long-term strategy of growth through acquisitions in Canada’s still quite diffuse transportation industry.

Operating expenses, fixed costs and general and administrative costs were trimmed 9.1 percent in the fourth quarter from year-earlier levels. Interest expense, meanwhile, was slashed 31 percent, as the company significantly reduced its debt. At the same time, the company purchased a rival generating CAD120 million in additional revenue in November, and last month announced the purchase of a landfill and environmental complex, expanding operations of its waste management unit.

Debt-to-capital was cut to 57 percent from 61 percent a year ago, as the company paid off CD100 million in debt. Meanwhile, its payout ratio remained well covered at 53 percent. The upshot: Despite, in the words of CEO Alain Bedard, “the worst [year] that anyone in the industry can remember,” TransForce is still a solid bet for conservative growth and income while the economy remains weak–and a bet for explosive growth as conditions improve. This is one we’ve stuck with for a long time and is finally starting to pay off. Buy TransForce up to USD9.

Aggressive Holdings

ARC Energy Trust (TSX: AET-U, OTC: AETUF) management still isn’t talking specifics about its plans for a dividend after converting to a corporation later this year.

Management’s statement that “current plans would see a dividend policy similar to the existing distribution policy with dividends being paid monthly” is encouraging. But it looks like they’re going to wait to set an amount until after we see where oil and gas prices are when conversion occurs. That’s certainly reasonable for a business as volatile as this one. And there’s every reason for optimism when the time comes.

ARC’s fourth-quarter payout ratio dropped to just 50 percent, even as the company cut debt to just CAD902.4 million from CAD961.9 million a year ago. Operating costs per barrel of oil equivalent (boe) produced were also reduced, from CAD9.91 from CAD10.09 a year ago.

Headline profit numbers were lower, largely because of average realized selling prices of USD72.61 per barrel for oil and just USD4.58 per thousand cubic feet for natural gas.

That, however, leaves plenty of room for improvement in 2010, as prices have already risen substantially above those levels this year, and management has locked in above-market prices for 34 percent of expected output.

Meanwhile, ARC has added substantially to its long-term asset value by replacing 347 percent of its 2009 output with new proven reserves. Finding, development and acquisition costs (FD&A) fell to only CAD6.44 per boe, a testament to the value of the company’s property in the Montney Shale area as well as use of new technology.

Proved reserve life now stands at 10.3 years after the company boosted proved reserves 11 percent and proved plus probable reserves by 18 percent. ARC’s proved plus probable reserve acquisition cost is now the lowest in decade, making good on management’s prior assertion that Montney would dramatically extend its reserve life and production capacity–and ability to generate steady long-term cash flows to finance generous dividends.

Again, we won’t know what those will be until management tells us. But there’s every reason to expect good thing from resurgent ARC in coming years, particularly if energy prices rise from here as looks likely. Buy ARC Energy Trust up to USD22 if you haven’t yet.

Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) may or may not wind up converting to a corporation after Jan. 1, 2011. But whatever the case, the company will face at worst a tax rate of less than 10 percent, thanks to deriving 80 percent of income outside Canada. That means distributions will continue to be well covered under its conservative financial management plan.

Distributable cash flow after maintenance capital expenditures came in at CAD0.41 a share in the fourth quarter. That pushed the payout ratio down to just 73 percent, the lowest level since the financial crisis hit. Amazingly, that coverage was achieved despite difficult conditions for all of the company’s major business lines.

Sulphur Products & Chemicals revenue, for example, fell 53.8 percent from year-earlier levels, as prices of the company’s sulfur and sulphuric acid output dropped and production volumes dropped, due to the work stoppage at a Vale Inco plant, the company’s largest supplier of sulphur products. International revenues, meanwhile, nosedived from CAD134.2 million in the 2008 fourth quarter to just CAD50.7 million. That was only partly offset by a 31.4 percent improvement in profits at the Pulp Chemicals division.

As was the case throughout 2009, however, management was very adept at cost controls. In fact, Sulphur Products’ cash flow–revenues less expenses–actually rose 25.4 percent during the quarter. Pulp and Chemicals saw a 52.9 percent gain, while International’s was up 54.2 percent. The upshot was a strong sequential as well as year-over-year gain in profitability, with distributable cash flow per share up 17.1 percent year over year and 8 percent from the third quarter.

Better, management looks for conditions to continue improving in 2010. For one thing, Vale Inco has now resumed operations. Chemtrade was also able to take advantage of slack market conditions to improve efficiency of its own operations, including advancing some maintenance projects previously planned for 2010.

Net debt to cash flow is now well under the 2-to-1 ratio mandated in the credit agreement, which doesn’t mature until August 2011, and the company has USD65 million left on that agreement as well as USD20 million in the bank. That leaves the company in good shape to ramp up output and conditions improve, and it may not have that long to wait.

In the words of CEO Mark Davis during the fourth-quarter conference call, “Supply/demand characteristics for many of our products are stronger than they were at the start of 2009” as industrial demand has improved. Chemtrade weathered the worst possible conditions for anyone operating in its industry over the past year and a half. Now it’s rewarding investors’ patience with solid gains, including a 15 percent return so far this year. Buy Chemtrade Logistics Income Fund up to USD12.

Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) practically made a point of not saying what its post-conversion dividend will be, despite announcing it plans to convert following a vote at its annual meeting in May.

Encouragingly, management has affirmed it has tax pools to zero out taxes for several years and has also stated it intends to become a “dividend paying corporation.” As for the amount of future payout, based on its fourth-quarter and full-year 2009 numbers, the producer of oil and gas certainly has the underlying business strength to sustain the current rate well past conversion.

Daylight replaced some 600 percent of 2009 production with new reserves, as its diversified development strategy continues to pay off. Drilling on existing properties alone took proved plus probable reserves up 58.8 percent over the last 12 months, even as the trust used its recovering unit price to complete high potential strategic acquisitions.

In management’s words, the company has a true “multi-billion dollar growth opportunity” thanks to a potential drilling inventory of up to 1,800 locations, with a projected exit rate of 42,000 barrels of oil equivalent per day. At 58 percent, the fourth-quarter payout ratio remains modest, though with capital expenditures added in it moves up to 133 percent. That plus management’s stated desire to ramp up capital spending may indeed induce a dividend cut when Daylight converts to a corporation, particularly if natural gas prices remain weak. Gas is nearly two-thirds of total production.

On the other hand, realized gas prices in the fourth quarter averaged just CAD4.76 per thousand cubic feet. That’s a number the company should have no trouble exceeding in 2010 and, coupled with cost controls, should lead to better cash flow coverage of capital costs.

Meanwhile, debt is low at just 0.8 times annualized cash flow, giving the trust considerable financial flexibility. We’re almost surely going to have to wait until May to see what management does with the dividend.

But in any case, Daylight Resources Trust remains a high-quality producer with a growing production profile. More aggressive investors can buy up to USD11.

Newalta’s (TSX: NAL, OTC: NWLTF) road to redemption has been a long one since a late 2008 share price crash in the face of the credit crunch/recession and its conversion to a corporation. In retrospect, however, conversion and the sharp reduction in the distribution likely saved the company, laying the groundwork for the recovery that now appears to be unfolding.

Fourth-quarter 2009 earnings still paint a picture of a company dealing with extreme market weakness in several key operations. Chief among these is the traditional oilfield services operations, which specialize in cleaning up drilling sites and recycling waste into usable products. Overall revenue fell 6 percent from the year-earlier quarter, while cash flow slipped 8 percent. Margins in the western division fell on lower drilling activity and crude oil prices.

On the other hand, the numbers did show some very real signs of improvement that point to brighter days ahead in 2010. The Eastern division’s revenue, for example, was up 14 percent year over year, while margins rose 22 percent. That’s a clear testament that the expansion policy of recent years into Canada’s industrial heartland is paying off, even though that region too remains relatively weak.

Management cut overall costs by CAD8 million and, excluding one-time restructuring costs, cash flow was actually flat year over year. The company continues to invest in growth opportunities, though at a lower rate than in years previous to 2009. And it’s adding to its technical expertise as well, for example with the recent agreement with BioteQ Environmental Technologies to devise solutions to clean up industrial wastewaters. That could potentially have implications for the company’s oil sands cleanup business, an area of explosive growth before the 2008 crash that’s likely to be very important in the future.

A depressed rig count in Canada remains a drag on operations, but there are signs this metric is improving, even as it becomes less important to Newalta’s future. Reflecting stabilizing fortunes, Newalta shares have come a long way back from the low of barely USD2 a share it hit on Mar. 27, 2009. But selling for 75 percent of book value and having preserved its niche as a premier environmental services company in a resource-rich country, the best of this recovery by far is yet to come.

Newalta’s not for everyone and its low yield will no doubt turn off the typical income seeker. But it’s a strong buy up to USD10 for patient, growth-oriented investors.

Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) at one time was rumored to be set on gutting its distribution as part of a corporate conversion. That doesn’t appear to be management’s plan at this point, if it ever was.

But the most important fact about this company now is it’s trading at roughly 75 cents per dollar value of its proven oil and gas assets in the ground.

Moreover, the value of those assets is likely to rise sharply in coming years, even in the unlikely event that energy prices stagnate, as the company continues to dispose of non-core properties for cash and to reinvest in its portfolio of extremely promising finds.

The company beat its 2009 production guidance of 177,000 boe/d , while spending CAD688 million in development capital–the midpoint of its prior guidance.

More impressive, however, was the sharp reduction in its future development capital costs from CAD18.94 in 2008 to just CAD13.75 per boe in 2009. That’s an extremely positive development that not only indicates lower industry costs but a higher quality of reserves and vastly improved management efficiencies. And with capital spending for 2010 projected to ramp up to CAD700 to CAD850 million, those hits promise to just keep on coming.

As for current operations, fourth-quarter distributable cash flow based on realized selling prices of just USD69 per boe for oil and CAD4.39 per thousand cubic feet for gas covered the current distribution by a margin of nearly 2-to-1. That provided more than enough cash for management to realize its target of cutting debt-to-cash flow to a 1.9-to-1 ratio, still high but well below the levels near 3-to-1 hit last year.

Penn West units have been trading at low multiples for many months now, mainly on fears about its distribution. In my view, the stock market success of trusts that haven’t cut distributions plus the company’s own successes at the drill bit have made more than a minor cut highly unlikely.

Even if management should go that route, however, it won’t change the fact that Penn West is a cheap resource play that will ultimately attract a lot of buyers. We would just have to wait a bit longer for that to occur. Accordingly, Penn West Energy Trust remains a buy up to USD22 for those who don’t already own it.  

Trinidad Drilling (TSX: TDG, OTC: TDGCF), like all drillers and energy services companies in North America, continues to be challenged by very weak drilling conditions.

Industry utilization in Canada, for example, was just 32 percent in the fourth quarter of 2009 and 24 percent for the full year. That compares to what were already poor rates in 2008 of 43 percent for the fourth quarter and 42 percent for the full year. Even in the US, which had been resisting Canada’s downturn due to the rapid development of shale resources, utilization has weakened markedly, with the number of rigs in service for 2009 down 42 percent from 2008.

Trinidad, too, has suffered a drop in business. Its pain, however, has been far less than that of virtually every other rival, thanks to an historic focus on deep drilling rigs and long-term contracts with creditworthy counterparties. And nearly half are on a take-or-pay basis that requires payment regardless of whether the rigs are used are not. That’s had the impact of stabilizing rig utilization rates and cash flows, enabling the company to continue paying dividends and expand its fleet, even while rivals are skating close to bankruptcy.

Even in Canada, Trinidad’s utilization rate was 44 percent in the fourth quarter, 12 percentage points above the average. US and international drilling rigs, meanwhile, saw 63 percent utilization. Again, that was well below the 80 percent rate of a year ago, but well above the averages. And the company’s barge drilling utilization came in at 75 percent despite still soft market conditions. As for day-rates, Trinidad’s were down only 2 percent for the full year in Canada versus an industry-wide drop of 14 percent.

Moreover, day-rates were up 5 percent from the third quarter in Canada and 4 percent in the US and Latin America. That’s a major reason why Trinidad’s gross margin as a percentage of revenue has remained steady year over year at 40 percent, as well as how it managed to cut net debt 18 percent in 2009 and 28 percent since the end of 2007.

To be sure, this is still a lousy time to be in the drilling business, and Trinidad’s fourth-quarter headline numbers most certainly reflect that. Adjusted for one-time items, cash flow fell 25 percent in 2009, while earnings slid by more than two-thirds. Some of the company’s traditional service areas like the Western Canada Sedimentary Basin may never fully recover. And as long as natural gas remains below USD5 per thousand cubic feet, most other regions won’t either.

On the other hand, energy services are still a vital to production of oil and gas and always will be, and Trinidad has survived some of the worst conditions its industry has ever faced. Sooner or later that means the shares are going to make a full recovery to where they were before the 2008 crash, when the company was arguably smaller and less valuable. That near-triple from current levels is what we’re playing for here, though it’s going to take patience.

Trinidad Drilling shares are up 310 percent over the last 12 months in US dollar terms and I’m looking for a lot more. It’s a buy for patient and aggressive investors only up to USD8. 

Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) has officially declared what everyone already knew about its planned conversion to a corporation in late 2010: There will be no change to its monthly dividend of CAD0.19 per share.

That’s hardly surprising, given that the company has been able to sustain that rate over the past two years despite one of the greatest booms and busts in energy price history. Nor would it raise an eyebrow of anyone who has looked at the company’s sterling balance sheet (a net debt-to-cash flow ratio of just 0.3-to-1 in the fourth quarter), its conservative dividend policy (a payout ratio of 48 percent) or its hefty inventory of opportunities to expand output.

Last month, for example, Vermilion announced 100 percent success from a four-well drilling program in the Netherlands with estimated initial production volumes of 4,000 boe per day, more than twice current Netherlands production capacity of 3,200. Meanwhile, the Corrib natural gas project off the coast of Ireland is on track to boost the company’s overall output by 30 percent when it comes on-line in late 2012. That will add 40 percent to funds from operations, assuming all proceeds on schedule and on budget. Vermilion remains protected financially by the terms of its purchase agreement, which won’t require additional monies until output begins.

The company overall replaced 224 percent of 2009 production with new drilling and acquisitions, boosting debt-adjusted reserves per unit by 5.5 percent, an acceleration from Vermilion’s historic rate of 4.4 percent a year, achieved since it converted to trust in 2003. The company’s operations in Australia and Europe continue to provide a double benefit: sheltering income from the Canadian trust tax and allowing it to sell most of its output into markets where prices for oil and particularly natural gas are markedly higher than in North America. That’s a gift that will keep on giving for Vermilion for years to come.

A year ago, investors could have had all the Vermilion they wanted for less than USD20 a unit. Today the price is well over USD30. But if management is successful executing on its plans, it’s almost certain to take out the mid-2008 highs and then some in the next couple years, even if energy prices don’t rally with a global recovery as I expect them to. Vermilion Energy Trust–the very safest of the producer trusts–remains a buy up to USD33 for those who don’t already own it.

What’s to Come

Ten Canadian Edge Portfolio holdings will report their fourth-quarter and full-year 2009 earnings later this month. I’ll be updating these numbers in Flash Alerts and the weekly Maple Leaf Memo as news comes available, with a full roundup in April’s Portfolio Update.

Next month’s Feature Article will focus on oil and gas producer trusts, and the year-end compilations on their reserves.
Conservative Holdings

  • Artis REIT (TSX: AX-U, OTC: ARESF)–March 16
  • Atlantic Power Corp (TSX: ATP, OTC: ATLIF)–March 30
  • Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF)–March 19
  • IBI Income Fund (TSX: IBG-U, OTC: IBIBF)–March 17
  • Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF)–March 16
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–March 17

Aggressive Holdings

  • Ag Growth International (TSX: AG-U, OTC: AGGZF)–March 11
  • Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF)–March 10
  • Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)–March 10
  • Provident Energy Trust (TSX: PVE-U, NYSE: PVX)–March 11

Following is a list of the trusts in the Canadian Edge Portfolios that have yet to announce or implement post-conversion dividend policies. The rest have either converted, don’t have to convert, or have yet to convert but have otherwise announced plans for post-conversion dividends.

For more on trust conversions, see this month’s Feature Article.

  • Altagas Income Trust (TSX: ALA-U, OTC: ATGFF)
  • ARC Energy Trust (TSX: AET-U, OTC: AETUF)
  • Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF)
  • Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF)
  • CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF)
  • Daylight Energy Trust (TSX: DAY-U, OTC: DAYYF)
  • IBI Income Fund (TSX: IBG-U, OTC: IBIBF)
  • Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF)
  • Penn West Energy Trust (TSX: PWT-U, NYSE: PWE)
  • Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF)
  • Provident Energy Trust (TSX: PVE-U, NYSE: PVX)

Finally, some of you have asked me for a list of CE Portfolio companies that have never once cut dividends. That’s an extraordinary record, considering the tough economic times of recent years and the ongoing conversions of trusts to corporations with new taxes pending in 2011. That makes this a very special group of companies indeed. Note some have yet to convert to corporations, a process that could include a dividend cut:

  • Ag Growth International (TSX: AFN, OTC: AGGZF)
  • AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF)
  • Artis REIT (TSX: AX-U, OTC: ARESF)
  • Atlantic Power Corp (TSX: ATP, OTC: ATPWF)
  • Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF)
  • Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF)
  • Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF)
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)
  • CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF)
  • Colabor Group (TSX: GCL, OTC: COLFF)
  • IBI Income Fund (TSX: IBG-U, OTC: IBIBF)
  • Just Energy Income Fund (TSX: JE-U, OTC: JUSTF)
  • Keyera Facilities Income Fund (TSX: KEY-U, OTC: KEYUF)
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)
  • Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF)
  • Vermilion Energy Trust (TSX: VET-U, OTC: VETMF)

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