Eye on Earnings
Here in early September, the broad-based S&P/TSX Composite Index is back within a few percentage points of the early July highs. And it’s even closer to where it stood on Halloween 2006, the night the Conservative government announced a surprise plan to tax income trusts as corporations beginning in 2011.
The key is earnings. As I point out in this month’s Feature Article, the Canadian economy is surging, even as huge segments of the US are slumping. The root is the natural resource boom, but the resulting prosperity has spread to virtually all sectors.
That’s the clear upshot from second quarter earnings season, which I review for our Portfolio picks below. Trust after trust reported solid results, including the two real estate investment trusts I’m adding to the Conservative Portfolio this month: Artis REIT (AX.UN, no US symbol) and Canadian Apartment REIT (CAR.UN, CDPYF).
Artis is reviewed along with AltaGas Income Fund (ALA.UN, ATGUF) in this month’s High Yield of the Month section. Canadian Apartment is spotlighted in the Feature Article, along with fellow REIT picks RioCan REIT (REI.UN, RIOCF) and Northern Property REIT (NPR.UN, NPRUF).
Keeping an eye on earnings is, of course, our most important job at Canadian Edge. The good news is none of our picks disappointed us this season, and indications are they’ll continue to post good returns for the rest of the year and beyond.
I’ve said it before and I’ll say it again. Healthy, growing businesses will do well, no matter how they’re taxed. Ottawa did its worst to the trusts by voting to eliminate their dividend-encouraging tax incentives. Their move is now fully reflected in prices of income trusts, as it’s been for some months.
What’s not priced in is the growth of good businesses and management’s ability to shelter future income after 2011, either as income trusts or corporations. Neither is management’s stated desire to keep paying big dividends long after 2011. Nor is the fact that top trusts have absolutely no economic incentive under current law to stop paying their big current distributions right up until Dec. 31, 2010.
What that adds up to is simply this: A strong trust backed by a healthy, growing business paying an 8 percent yield is going to pay us more than 25 percent of our investment back in cash by 2011. And as it continues to become more valuable as a business, it should give us at least that much in capital gains.
There are several other factors that could lift trust returns further still in the coming months. There’s still a strong possibility that Canada will change its tax laws concerning income trusts before 2011. That could involve reducing the 2011 tax rate on all trusts to 10 percent, as the main opposition Liberal Party advocates.
It could mean throwing the tax out entirely for oil and gas producer trusts. Should that happen, trusts across the board would rally strongly to new highs, and quite possibly well beyond given the fact that no alternative investment yields anywhere close to as much.
Second, liquidity is returning to global markets. And the US government has as good as committed to doing whatever it takes to ensure there’s no across-the-board credit crunch. As a result, trust takeover activity is already resuming. Last month, deals for Countryside Power and Versacold Income Fund were completed on schedule and other deals pushed forward. Meanwhile, new offers were launched for two troubled REITs: IPC REIT (IUR.UN, IPCUF) and Legacy Hotels (LGY.UN, LEGYF).
The long and the short of it is the recent pause in trust takeover activity looks as good as over. US mortgage market risks are no longer influencing decisions and more deals are likely, if not certain. Even the trusts themselves have stepped up acquisition activity.
Third, the Canadian dollar held its gains during the worst of the US subprime crisis, when investors cashed in their yen, euros and other paper for the world’s traditional safe haven. Now that the fear level is dropping, the Looney looks poised for its next stop–parity with the greenback–a move that will boost share prices and dividends for US investors with each uptick.
Finally, interest rates are likely to remain low as long as the world’s central banks are concerned about the US mortgage market. Low rates mean even better borrowing terms for strong trusts–several announced improvements in credit terms from banks this month. And they enhance the value of dividend-paying investments overall, which trusts certainly are.
All of these factors, however, have one inconvenient truth in common: They’re beyond the control of trusts’ managements, as well as ours as investors.
If even half of these wild cards come down in our favor, they’ll multiply the returns from good trusts in coming years. But the real key is always going to be the health of the trust’s business. If trusts’ operations are healthy and growing, we don’t need these factors to make our gains.
Below, I briefly analyze the earnings report of each recommended trust. Note that we’ve reviewed all of them previously in Maple Leaf Memo, which provides complimentary weekly updates for CE readers.
Conservative Holdings
The hallmark of the Conservative Holdings is good businesses with little, if any, involvement in the energy business. I’ve also looked for trusts with the desire to pay big dividends well after 2011 as well as potential tax advantages, were they to be taxed as corporations.
Each earnings season, I look for good distribution coverage along with debt and cost control. I also want to see focus and growth that ensures those big cash flows will continue. Happily, I wasn’t disappointed by what came out in the second quarter.
Algonquin Power Income Fund (APF.UN, AGQNF) reported a loss for the second quarter, reflecting a one-time accounting charge required by the passage of the Tax Fairness Plan (see Canadian Currents). That masked a solid operating performance, including a solid 10.6 percent jump in recurring revenue and boost in cash available for distribution to 25 cents Canadian per unit, up from 23 cents a year ago. The key was acquisitions, chiefly the St. Leon Wind Energy Facility, along with better production at the Windsor Locks and Sanger facilities.
Running its existing operations well and positioned to capitalize on the drive for carbon-neutral power generation, Algonquin Power Income Fund is a buy up to USD9.
Arctic Glacier Income Fund (AG.UN, AGUNF) chalked up a 32 percent jump in second quarter sales as it continued to integrate acquisitions, most of which are in the US. The trust also enjoyed higher output at its previously owned sites, offsetting the impact of a higher US dollar. Distributable cash–the best bottom line measure of trust profitability–rose a solid 14 percent, though it dipped slightly on a per share basis because of new issues to fund growth. The trust’s payout ratio of just 58.3 percent holds the door open to further increases, especially considering the large US operations are shielded from 2011 taxation.
Arctic Glacier Income Fund is a buy up to USD14.
Atlantic Power Corp (ATP.UN, ATPWF) reported a headline loss of 39 cents Canadian per unit on non-cash mark-to-market losses, offset by a noncash gain at the Onondaga plant. More important, however, distributable cash flow continued to cover the dividend–which is part debt interest, part equity–by a healthy margin, despite expansion-related dilution from issuing 58.9 percent more shares in the past year. Cash flow from operations rose 9 percent as all projects performed and management controlled expenses.
That’s the formula for more growth ahead, and Atlantic’s structure shields its dividend completely from 2011 taxation. Buy Atlantic Power Corp up to USD12.
Bell Aliant Regional Communications Income Fund’s (BA.UN, BLIAF) second quarter results illustrate two things. First, revenues continue to shift from traditional telephone to broadband services: High-speed Internet subscriptions were up 21 percent year-over-year, while local access lines declined slightly. More important, however, revenue rose 1.3 percent and fueled a 4.1 percent jump in cash flow.
That’s the same formula used by US rural telecoms to pay big distributions. As long as it follows it, Bell will be able to do the same well past 2011. Buy Bell Aliant Regional Communications Income Fund up to USD32.
Boralex Power Income Trust’s (BPT.UN, BLXJF) revenue and earnings slipped in the second quarter, largely because of a shortfall in hydrological conditions. The seven hydroelectric power stations generated 137,553 megawatt hours (MWh), 11 percent below historical averages and down 19.6 percent from 171,006 MWh a year ago.
Fluctuations in hydrology come with the territory with most power trusts. But while the second quarter payout ratio jumped to 116.9 percent of distributable cash flow, dividends for the first half of the year were still well covered, even without tapping into Boralex’s ample reserves. Wood residue and cogeneration segments posted strong performance.
Boralex’s strategic review is still in progress, and I’m still looking for a takeover deal this year. But even if nothing happens, Boralex will continue to pay its ample dividend, and would be able to pay richly even if taxed in 2011. Buy Boralex Power Income Trust up to USD10.
Energy Savings Income Fund (SIF.UN, ESIUF) last month boosted its distribution for the 28th time since inception, a 3.9 percent boost. That was made possible by a 6 percent jump in the company’s North American customer base, which in turn fueled a 135 percent surge in profit on a 17 percent increase in sales and 15 percent increase in gross margin. Customer additions actually rose 53 percent from the first quarter, indicating growth continues to accelerate.
That’s a formula for continued growth, and management has pledged to keep paying big distributions well past 2011, no matter how it’s taxed. That could be helped by the fact that, for the first time, the fund added more customers in the US than in Canada in the second quarter. Energy Savings Income Fund is a buy up to USD16.
Keyera Facilities Income Fund (KEY.UN, KEYUF) continues to get the most out of its gas processing asset portfolio while expanding reach with acquisitions and expansion. Earnings before taxes and noncontrolling interest were up 44 percent from the second quarter of 2006. Distributable cash flow soared 31 percent to 51 cents Canadian a share, driving down the payout ratio to 72.4 percent, and setting the stage for more dividend growth.
All business segments delivered with gathering and processing income up 14 percent, natural gas liquids infrastructure up 26 percent and marketing up 83 percent. The trust was wholly unaffected by the drop in drilling activity in western Canada because of high asset quality and focus on still-growing market segments.
That looks set to continue for the rest of the year and beyond. The trust has considerable tax pools to use after 2011, which will help management maintain its pledge of paying out high income to perpetuity. Keyera Facilities Income Fund is a buy up to USD19.
Macquarie Power & Infrastructure Income Fund’s (MPT.UN, MCQPF) payout ratio ballooned out to 108.4 percent in the second quarter, largely because results reflected acquisition costs and only four days of sales from the purchase itself, Clean Power. Distributable cash per share, however, actually increased to 23.7 cents Canadian per unit.
And this month, the trust announced another acquisition, adding to the long-term care side of its business. That deal should keep earnings rising for the rest of the year. Far removed from the well-publicized and over-hyped woes of its parent Macquarie Bank, Macquarie Power & Infrastructure Income Fund is a buy up to USD12.
Northern Property REIT (NPR.UN, NPRUF) continued to add to its successful track record in the second quarter, boosting revenue 13.4 percent on strong occupancy and acquisitions. Distributable income per share rose 11.3 percent. Northern Property REIT is a buy up to USD25. For more information, see the Feature Article.
Pembina Pipeline Income Fund (PIF.UN, PMBIF) raised its distribution another 9 percent last month. And given the extremely robust results at its pipeline, processing and oil sands infrastructure businesses, there’s a lot more where that came from. More important, the trust continued to advance projects that will spur future cash flows, particularly the Horizon Pipeline for heavy oil that’s slated to be completed in mid-2008.
Long-term debt to total enterprise value remains very low for an infrastructure company at 25 percent. That leaves a lot of room for growth. Buy Pembina Pipeline Income Fund up to USD16.
RioCan REIT (REI.UN, RIOCF) continues to show why it’s the highest quality REIT in Canada. Rental revenue rose 12 percent on higher rents and occupancy as well as expense controls and timely acquisitions. High-growth markets constituted 64.6 percent of rental revenue with 83.1 percent of space that’s rented to the strongest of anchor tenants. RioCan REIT is a buy up to USD25. For more, see the Feature Article.
TimberWest Forest Corp (TWF.UN, TWTUF) faced a number of challenges in the second quarter with the result that the payout ratio surged to 158.2 percent. First, the US log and lumber market continued to be weak, while the Japanese market was oversupplied. The company also faced rising contractor costs, including a strike, and weather conditions hurt the harvest. The company relied far more on domestic sales than usual–58 percent of total volume–which hurt sales prices.
The bottom line here, however, is this company remains extremely rich in both timber and real estate, which it continues to sell profitably including a big chunk to a government agency last month. In addition, the distribution is entirely debt interest, and so represents a call on assets. That gives shareholders considerable protection, in the event that the company’s ample reserves can’t cover the payout.
The dividend is also wholly protected from 2011 taxation. The shares took a tumble on the strike news, but now discount all reasonable risk for such an asset-rich entity. As a result, TimberWest remains a buy up to USD16.
Yellow Pages Income Fund (YLO.UN, YLWPF) continues to generate steady growth at its print pages business, supplemented by rapid growth at its Internet-based operations. The overall result: 21 percent revenue growth and 10 percent growth in distributable cash per unit. Yellow also added to its dominance of the Canadian directories business with the purchase of Aliant Directory Services in Atlantic Canada.
With a formula for robust and steady growth for the long haul–and committed to paying a big dividend well past 2011–Yellow Pages Income Fund is a solid buy up to USD15.
Getting Aggressive
The Aggressive Portfolio’s focus is finding the best plays on the continued growth of Canada’s energy patch. The bulk of the holdings are all-weather plays that have proven their ability to hold up in all manner of markets. I’ve also mixed in some more aggressive bets on oil and natural gas prices.
This is the trust sector that’s by far the most popular with US investors. A number of the holdings are listed on the New York Stock Exchange, and several are allegedly considering organizational moves that will either boost their involvement here or even relocate here. Management is aggressive and–as producers’ cash flows move in tandem with energy prices–distributions and share prices both stand to gain a lot from further jumps in energy prices.
And as long as we see only half-hearted conservation in the US, little use of real alternatives, few or no discoveries of conventional oil and gas reserves and no world recession, energy prices are headed a lot higher.
Ironically, during the past year or so, the energy producer trusts have been by far the weakest component of the CE Portfolios. Especially battered have been the energy services and natural gas-focused producers. The reason is simply extremely weak natural gas prices.
Gas producers can forestall cash flow declines due to falling prices by using hedging. Sooner or later, however, they mean falling income. Energy service trusts like Precision Drilling (PD.UN, NYSE: PDS), meanwhile, depend heavily on activity in the natural gas patch, which has virtually ground to a halt in recent months. Even the strongest energy producer and service trusts have taken hits, as damage from natural gas’ slump has more than offset strength from oil prices.
Natural gas supplies are becoming increasingly tight as production wanes and demand waxes in the US and around the world. Natural gas prices, however, follow weekly inventory figures and those, in turn, follow weather patterns. Basically, as long as weather is mild and hurricanes don’t interrupt production, prices are going to remain weak.
The situation can’t and won’t last forever. But as long as it does, we’re going to have to hang in there with the trusts we own. The good news is not even the weakest are in any danger of a real crack-up, stock price weakness notwithstanding. Here are the numbers.
Advantage Energy Income Fund (AVN.UN, NYSE: AAV) is slated to complete its merger with Sound Energy any day. Meanwhile, the trust reduced its payout ratio to 83 percent in the second quarter, despite weak gas prices, as it controlled costs and expanded output 48 percent. Advantage currently has approximately 54 percent of its net natural gas production hedged for summer and another 28 percent to the spring of 2008.
That won’t wholly protect it from continued gas price weakness. But it does leave Advantage Energy a buy up to USD14 for those who want to bet on gas.
ARC Energy Trust (AET.UN, AETUF) posted steady second quarter results, as strength in oil prices and cost controls mostly offset weakness in gas prices. Overall revenue and production levels were flat and distributable income per share dipped 16.7 percent. But the trust still covered distributions handily with a 74 percent payout ratio.
Cash flow plus the dividend reinvestment plan proceeds covered capital spending as well, as the trust continued to avoid issuing shares and debt in a weak market. Output is expected to rise the rest of the year, which should provide a boost to cash flow despite weak gas prices. Buy ARC Energy Trust up to USD23.
Enerplus Resources (ERF.UN, NYSE: ERF) was also hurt by lower natural gas prices, as well as a 4 percent drop in production because of weather and seasonal factors. Management also pulled in its horns during a weak pricing environment for natural gas as cash flow covered both capital spending and the distribution. Long term, the trust continued to put pieces in place for a massive ramping up of output, investing in the Sleeping Giant property in Montana and its oil sands holdings.
US capital spending will help shelter additional income from taxation in 2011. Impressively, debt to cash flow is among the lowest in the industry at 0.7-to-1 and share issues are sparse, making dilution negligible despite the trust’s rapid growth. That’s the ideal formula to weather low gas prices and profit as they inevitably recover. Buy Enerplus Resources up to USD50.
Newalta Income Fund’s (NAL.UN, NALUF) core oilfield cleanup business has taken a huge whack from the country’s historic drop in gas drilling. To date, that’s been only partly offset by the robust growth at its eastern Canada industrial cleanup business. As a result, the second quarter payout ratio surged to 266.7 percent of distributable cash after maintenance capital spending, and 111 percent for the first half of 2007.
Management, however, remains convinced the western waste and recovered crude operations business will rebound in the second half, and so had elected to maintain the distribution. If it’s correct, shares will rebound sharply. If not, a dividend cut is already priced in to the slumping shares. Meanwhile, what the trust does control–internal margins and division growth targets–still looks pretty good for its long-term fortunes. It’s aggressive. But low-debt Newalta Income Fund is a buy up to USD25.
Paramount Energy Trust (PMT.UN, PMGYF) should be able to maintain its 10 cents Canadian per month distribution in the second half of 2007, barring a further drop in gas prices. The trust’s recent acquisition from a unit of Dominion Resources should dramatically increase production in the second half at a reasonable cost. Much of its output is hedged and price assumptions are conservative. Nothing should be taken for granted with a trust so heavily leveraged to natural gas prices. But for those in search of a very aggressive gas play, Paramount Energy Trust is a buy up to USD10.
Penn West Energy Trust (PWT.UN, NYSE: PWE) was hurt by lower natural gas prices and one-time production problems, which held output gains to just 36.8 percent more than year earlier levels. As a result, dilution from the Petrofund merger drove down cash flow per unit to CD1.37 from CD1.59 a year earlier. Also, the trust’s capital spending plus distributions exceeded cash flow by 30 percent.
The good news is debt is still relatively low, and the trust has the wherewithal to back up the Board’s commitment to maintain the distribution and capital spending while gain prices remain weak. That’s something only a handful of very powerful trusts can boast. Penn West Energy Trust is a buy up to USD38.
Peyto Energy Trust’s (PEY.UN, PEYUF) saving grace during the crash in gas prices (83 percent of output) is simply very low costs (CD2.70 per barrel of oil equivalent) and long-life reserves (14 years proven). Those strengths give management the ability to control production–down 10 percent in the second quarter–while still maintaining a robust capital program and generous distribution, and paying off debt. The payout ratio currently stands at a modest 64 percent of funds from operations. Easily the lowest risk play on natural gas’ recovery in the trust universe, Peyto Energy Trust is a buy up to USD20.
Precision Drilling’s (PD.UN, NYSE: PDS) business has plainly collapsed in the wake of the historic drop in Canadian gas drilling. The company’s rig fleet was just 14 percent utilized in the second quarter, despite strong growth in the US. Sales fell 45 percent and earnings sank 70 percent. The only good thing from the report was that management had already positioned for it with the recent distribution cut.
Meanwhile, its great balance sheet–debt is now just 4 percent of equity–strong reputation and unmatched asset base portend a mighty recovery when natural gas inevitably bounces back. Also a takeover target, Precision Drilling remains a buy up to USD25.
Provident Energy Trust’s (PVE.UN, NYSE: PVX) robust midstream natural gas liquids business is the main reason its payout ratio slid to just 73.5 percent in the second quarter. Natural gas liquids sales volumes increased 9 percent, offsetting the impact of lower natural gas prices and reduced realized crude oil prices, as well as higher operating costs.
Earnings at US-based spinoff BreitBurn Energy Partners were robust, as it added more properties, though the drop in the US dollar reduced the value of the parent’s take. Overall crude oil and natural gas production increased 13 percent. With its growing US income sheltered from the 2011 tax, Provident Energy Trust is a buy up to USD14.
Trinidad Energy Services Income Trust’s (TDG.UN, TDGNF) funds from operations per share actually rose to 31 cents Canadian a share in the second quarter. That’s remarkable considering the meltdown elsewhere in Canada’s drilling services sector, pointing to Trinidad’s unique position in the far stronger US market and the state-of-the-art nature of its rig fleet. The US focus meant currency losses for Trinidad, as the US dollar sank against the Canadian.
Nonetheless, the trust’s payout ratio for the first six months of 2007 was just 60 percent, and 125.9 percent in the seasonally challenged second quarter. The key was much better rig utilization than the averages, exceeding industry averages by 17.6 percentage points for the quarter. Not even Trinidad–with 87.4 percent of its income coming from the US–is entirely proof against the energy patch slump. But there’s no higher-percentage bet on the Canadian sector. But Trinidad Energy Services Income Trust up to USD18.
Vermilion Energy Trust (VET.UN, VETMF) remains the one real star of the Aggressive Portfolio, thanks to a growing multinational production portfolio, debt and operating cost controls and a very low payout ratio of 44 percent. Vermilion has about 40 percent of its production in Canada. Income on the rest, however, is exempt from 2011 trust taxation. Attesting to the unique nature of the trust, funds from operations per unit rose 11 percent in the second quarter, as the trust sold to stronger markets in Europe and Australia. Vermilion Energy Trust is a long-term buy up to USD38.