Performance First
Efforts to convince ruling Conservative Party officials to change policy have routinely fallen on deaf ears. Meanwhile, the opposition Liberals and Bloc Quebecois—which have listened—have made little headway toward regaining power.
With 2011 more than three years away, there’s still plenty of time for the policy to change. Meanwhile, a USD6.5 billion challenge has been brought by two septuagenarian US investors under the North American Free Trade Agreement (NAFTA). Trust investors can get more information on the case and how to get involved by visiting http://www.naftatrustclaims.com/.
Canadian income trusts, however, are already making strong progress back from their lows of last November, when investors dumped them en masse in response to the tax change. In fact, outside of a handful of real weaklings and those highly leveraged to natural gas prices, trusts have been off to the races.
Of the 29 current Canadian Edge Portfolio selections, 25 are up 20 percent or more in the past 12 months in US dollar terms, with 17 up more than 30 percent. Only Newalta Income Fund (NAL.UN, NALUF), Paramount Energy Trust (PMT.UN, PMGYF) and Precision Drilling (PD.UN, NYSE: PDS) are down on the year. And even those three are poised for big gains if natural gas makes a comeback as I expect.
Calling this a stealth rally for trusts is like saying the New England Patriots and Indianapolis Colts have just mediocre quarterbacks. The only Americans who’ve noticed the recovery are those who had the brains and guts to hang in there when many were swearing off Canada as just another socialist country. Even now, most US investors can’t get past the tax questions when talking about Canadian trusts—as though that’s the only factor that’s important for their future returns.
Ironically, the reality is trusts’ 2011 tax status has basically become a nonfactor in their returns. The market has accepted and priced in the fact that trusts will be taxed as corporations in three years. And that’s the way things are going to stay unless Ottawa changes its mind.
We have started to see—and will continue to witness—trusts gain market value as they demonstrate the ability to minimize taxes after 2011. The average Canadian corporation pays an effective tax rate of only between 6 and 7 percent, versus a statutory rate of 31.5 percent, so there are obviously plenty of potential loopholes. Several trusts, for example, are showing how they can use passive income, cash flow from foreign operations and so-called noncash expenses or “tax pools” to cut future taxes, and are starting to command premium valuations to other trusts.
Some oil and gas producer trusts are likely to get a similar kick as they show they can benefit from Alberta’s new provincial royalties scheme. The plan continues to advantage development of so-called low productivity or mature wells, which are trusts’ bread and butter. Others will likely get a lift from operating in jurisdictions with lower royalty rates such as Saskatchewan and Montana, where the governor is trying to attract producers. (See the Nov. 6 issue of Maple Leaf Memo.)
The last 12 months also saw trusts benefit from two other factors that proved to be far more important than Ottawa’s tax machinations. The biggest was the 20 percent-plus increase in the Canadian dollar exchange rate versus the US dollar. That’s the equivalent of a 20 percent distribution increase for US investors, as well as an automatic 20 percent lift for the trusts’ US dollar unit prices.
The other factor is high-premium takeovers. Before Halloween 2006, there was plenty of takeover interest for trusts, including private capital that was willing to pay richly for high cash flow businesses. After Halloween, there were also willing sellers at a number of trusts for the first time, as management contemplated its future under corporate taxation.
The result has been more than three dozen trust takeovers, some at premiums to pre-deal prices of up to 50 percent. Surprising, this activity has done little to lift the prices of similar trusts. That’s why the premiums have remained as high as they have for subsequent deals. But they’ve been quite enriching for those holding shares of the acquired trusts.
As I’ve pointed out before, you can’t count on a rising Canadian dollar or high-premium takeover to generate high returns for trusts any more than you can count on Ottawa to change course. Any of these three factors can potentially trigger a windfall gain at any time, but they’re inherently beyond our control.
The good news is you don’t have to count on them. These factors will continue to carry a lot of weight in the market for trusts in the near term. Over the longer run, however, trust returns are going to be determined primarily by how they perform as businesses.
Assessing those operating prospects is the key to success in trust investing and my primary focus at Canadian Edge. And there’s no time like earnings season to get a good read on the health of a trust’s underlying business. Below, I take a look at the first wave of earnings reports for Canadian Edge Portfolio picks, as well as key developments reported by a number of other trusts.
Two Moves
Please note two changes to the Portfolios this month. First, I’m adding High Yield of the Month TransForce Income Fund (TIF.UN, TIFUF) to the Aggressive Portfolio. This transportation trust has been hit hard since I sold it from the Portfolio a year ago.
One reason is traffic has been crimped by weaker Canadian exports to the US, from the combination of slowing growth here and the soaring loonie, which has made Canadian goods and services far more expensive here. The trust has also felt the bite of the slump in Canada’s natural gas patch.
However, now paying a yield of nearly 16 percent that’s still well covered by distributable cash flow as of the third quarter, TransForce units are undeniably cheap. There’s dividend risk, but it’s priced in under any reasonable circumstance.
That makes the trust safe enough for conservative investors, provided it’s held as part of a high-quality, diversified portfolio. Buy TransForce Income Fund up to USD14.
My other move this month is to move TimberWest Forest Corp (TWF.UN, TWTUF) from the Conservative to the Aggressive Portfolio. The trust’s earnings have been soft in recent quarters, as costs have risen and its key markets in the US and Asia have weakened, as well as domestically. Third quarter profits, however, were nothing short of abysmal.
The trust posted a loss of 7 cents Canadian per share in distributable cash flow, down from a year-earlier gain. Sixty percent of the decline was related to a labor strike that’s now mostly settled after dramatically disrupting production for several months. In addition, real estate sales were lower than anticipated, and weak log markets in Japan and the US kept selling prices low.
Though most of its contractors’ employees have returned to work, the strike by the United Steelworkers union continues. That remains a threat to production, as the key fourth quarter of 2007 and first quarter of 2008 loom. This is the time of year when TimberWest realizes the bulk of its output, as its British Columbia base remains relatively temperate while other forestry regions are snowed under. It’s important that the harvest support cash flows for the rest of the year.
As for the weak markets, the US is likely to remain a trouble spot for timber exports for three reasons. First, housing starts in this country remain weak. Second, the soaring Canadian dollar has pushed up TimberWest’s costs versus those of US rivals.
Third, faced with weak markets at home, US timber exporters are working overtime to sell more of their output overseas, particularly in Japan. The result is markets there are also depressed.
TimberWest’s saving grace thus far has been the prime location of its timberlands, which has allowed it to sell real estate at hefty prices. The company expects some CAD65 million in proceeds from one major sale alone by the end of the year. That’s money that can be used to dramatically slash the trust’s CAD228 million in debt, as well as shore up distributions.
Because it’s so rich in assets—its Douglas Firs are a premium variety of timber—TimberWest remains a worthy holding despite its near-term challenges. But with operating cash flow lagging the distribution consistently in the past nine months, it’s no longer worthy to be considered a Conservative Portfolio holding. I’m moving TimberWest Forest Corp to the Aggressive Portfolio as a hold.
Conservative Portfolio
Conservative Portfolio holdings are chosen for two reasons. First, they’re backed by steady businesses that should be able to churn out reliable, growing cash flows, regardless of what’s going on in the economy or with energy prices. Second, management must be both committed to and have the weapons to pay big distributions, no matter how they’re taxed in 2011 and beyond.
If you’re searching for yield, this is the group on which you should be focusing your portfolio. None of my current picks trade on New York Stock Exchange (NYSE), and your broker may not have heard of them. But all major houses can buy them, either directly on the Toronto Stock Exchange (TSX) or in the US using their five-letter over-the-counter (OTC) symbols.
Dividends paid by all are withheld 15 percent at the Canadian border. The tax can be reclaimed by filing a Form 1116 with your US taxes. All except Atlantic Power Income Fund (ATP.UN, ATPWF)—which is a stapled share consisting of part debt and part equity—pay 100 percent qualified distributions in the US.
Note the equity portion of Atlantic’s distribution is a qualified dividend (roughly 40 percent), with the rest as debt interest. Atlantic is also 100 percent exempt from Canada’s 2011 trust taxation.
The best way to buy into the Conservative Portfolio is to gradually take positions in all of the holdings, taking care to buy only when they trade below designated buy prices. There’s usually at least one best buy reviewed in High Yield of the Month from the portfolio, though both entries this issue hail from the Aggressive Portfolio.
As of press time of this issue, several Conservative Portfolio trusts posted third quarter earnings results. The rest will be reviewed weekly in the Maple Leaf Memo and in full with the December issue.
Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) posted a modest 1.6 percent boost in operating revenue in the third quarter. That result was driven by 9 percent growth in data and Internet revenues and a 19 percent jump in high-speed Internet subscribers. The trust also reported solid growth at its Information Technology division and held line losses to a much lower level than in prior quarters.
This last item was likely helped by three major factors. First, the company kept a very tight leash on costs, improving competitiveness. Second, regulators granted it forbearance from restrictive rules in several areas, which enabled it to compete far more forcefully with rivals. The trust continues to face little competition from anyone its own size, by virtue of operating in rural areas that are cost-prohibitive for the cable industry.
Finally, Bell Aliant continues to roll out its fiber-to-the-node (FTTN) technology, creating an almost insurmountable technical lead over rivals in its markets. The FTTN effort led to a boost in total capital expenditures of 6.1 percent.
But the investment should prove well worth it in coming years as it enables the company to offer more services faster and cheaper. Buy Bell Aliant Regional Communications Income Fund up to USD33.
In contrast, Boralex Power Income Fund’s (BPT.UN, BLXJF) third quarter earnings were something of a disappointment. The primary culprit was a 33.8 percent drop in the output from its hydroelectric power plants. The trust has little reservoir capacity at its facilities, which makes production more sensitive to rainfall and river flows than most hydroelectric generators.
The shortfall overshadowed relatively strong results at the gas cogeneration and wood waste facilities, as well as management’s efforts at cost and debt reduction. It also took a bite out of cash reserves, which the trust had to draw heavily on to maintain its distribution.
Even with another dry quarter, Boralex can hold distributions. Its assets are solid, and it’s kept growth in outstanding shares to basically nil in recent years. Moreover, after taking a beating following the earnings announcement, the trust sells for just 1.2 times book value and yields well more than 12 percent, a level that prices in substantial distribution risk.
True, a number of Bay Street analysts have turned negative. But all it takes is a quarter of good water flows to set it all right quickly.
Boralex Power Income Fund remains a buy up to USD10. Note that US facilities typically generate about two-thirds of the trust’s power, which should help reduce post-2011 tax burdens substantially, should it remain independent.
Pembina Pipeline Income Fund (PIF.UN, PMBIF) turned in another explosive quarter, with net earnings surging 36 percent on a 15.7 percent jump in revenue. Growth was universal across all the trust’s business segments.
Conventional pipelines boosted revenue 13 percent and operating income 19 percent from year-earlier tallies. Oil sands infrastructure revenue grew just 6 percent, and operating income grew 3 percent. But capacity rose by roughly a third, portending much more explosive growth ahead. Meanwhile, the midstream business unit saw revenue jump 35 percent and net operating income increase 32 percent year-over-year. Moreover, operating expenses ticked up just 8.9 percent, expanding margins and profitability.
The trust has already increased distributions three times since Halloween 2006 by at least 9 percent. That’s a pretty clear indication it intends to keep rewarding shareholders with hefty cash flow, no matter how it’s ultimately taxed.
The payout ratio is an aggressive 92 percent for the past nine months, in line with the prior policy of devoting the majority of its discretionary cash flow to dividends. Buy Pembina Pipeline Income Fund up to USD18.
RioCan REIT (REI.UN, RIOCF) turned in another solid quarter, with funds from operations rising 5 percent on a 10 percent boost in rental revenue. That, in turn, supported the REIT’s modest 2.3 percent distribution increase.
As has been the case for the past several years, RioCan continues to put the lion’s share of its cash flow to work in developing new fee-generating properties. The REIT is currently involved in some CAD1 billion of new projects that are slated to start producing income in the next few years. That should further fire up growth in sales, cash flow and distributions.
Portfolio quality remains unmatched. Occupancy as of the end of September was a stellar 97.6 percent. Some 65.1 percent of rental revenue was derived from properties located in high-growth markets (Calgary, Edmonton, Montreal, Ottawa, Toronto and Vancouver), and no one client accounted for more than a sliver of overall revenue. On track for more strong returns for years to come, RioCan REIT is a buy up to USD25.
Three other Conservative Portfolio picks announced major strategic deals last month that will fuel growth for the rest of the year and beyond. Arctic Glacier Income Fund (AG.UN, AGUNF) purchased the assets and operations of another California ice company, boosting its revenue base by USD2 million. The trust’s US dollar cash flows have likely been hurt by the currency shift.
The impact, however, is offset by hedging, as well as the fact that production costs for US operations are in US dollars. Buy Arctic Glacier Income Fund up to USD14.
Algonquin Power Income Fund (APF.UN, AGQNF) has started up its St. Leon wind power facility, instantly becoming a major player in the fuel in North America. Output is sold to Manitoba Hydro under a lucrative contract.
At the same time, the trust announced the sale of certain noncore landfill gas power generating stations for USD11.69 million in proceeds. That will provide needed cash for expansion, and it eliminates exposure to an asset class that’s been trouble for many trusts. Also heavily focused on the US and yielding well more than 10 percent, Algonquin Power Income Fund is a buy up to USD9.50.
Yellow Pages Income Fund (YLO.UN, YLWPF) has expanded its strategic relationship with Web giant Google, becoming the first Canada-based reseller of Google AdWords TM ads. The deal further enhances the trust’s leveraged migration of its traditional print directory business to the Internet and provides massive opportunities for upselling clients. Buy Yellow Pages Income Fund, which grew third quarter distributable cash flow per share a robust 9.7 percent, up to USD16.
Lastly, Northern Property REIT (NPR.UN, NPRUF) has recently slipped back to the low 20s for no good reason. The REIT now yields twice as much as its high-quality US counterparts and sells for less than twice book value.
That’s despite exemplary occupancy rates and development in the pipeline that promises to boost distributable income per unit by 7 to 10 percent annually in the next two years. Take advantage of its lower price in buying Northern Property REIT up to USD25.
Note that EnerVest Diversified Income Fund (EIT.UN, EVDVF) has completed its swap for CAD280 million in units of some 57 different trusts. The move expands the closed-end fund’s asset base and flexibility, at the price of having to issue new shares at a discount to net asset value (NAV). On the plus side, the fund has made solid returns this year despite its big discount to NAV and continues to pay a massive yield.
I still prefer individual trusts. But for those who need a fund, EnerVest Diversified Income Fund is a buy up to USD7.
My other fund alternative pick, Select 50 S-1 Income Trust (SON.UN, SFYIF), is now a buy up to USD13.50. It trades at a very small discount to NAV, though its yield is lower than EnerVest’s as well.
Aggressive Portfolio
The Aggressive Portfolio’s primary objective is to provide higher risk/reward plays on the more leveraged segments of Canada’s economy. That’s primarily energy production, but it also includes energy services, timber resources and anything high yielding that’s dependent on the country’s growth.
Only those with a real appetite for risk should focus exclusively on Aggressive Portfolio holdings, which tend to be volatile, though even the most cautious can hold them as part of a diversified portfolio. The safest of the current list are what I consider to be the “core” group of producers: ARC Energy Trust (AET.UN, AETUF), Enerplus Resources (ERF.UN, NYSE: ERF), Penn West Energy Trust (PWT.UN, NYSE: PWE), Peyto Energy Trust (PEY.UN, PEYUF), Provident Energy Trust (PVE.UN, NYSE: PVX) and Vermilion Energy Trust (VET.UN, VETMF).
In a third quarter, when many trusts were hurt by soft natural gas prices, Vermilion posted stellar results. Production rose 4.1 percent, triggering a 12.3 percent jump in revenue. Distributable cash flow per share hit CAD1.36, up 15.2 percent, and drove down the payout ratio to just 34 percent. Distributions plus capital spending and all other cash needs equaled just 78 percent of quarterly cash flow, making the trust one of very few to generate free cash flow this summer.
Vermilion’s key strength is its international base of operations, which limits exposure to a particular market, weather pattern or regulatory body. For example, the trust will absorb basically no hit from Alberta’s decision to raise royalties on production. And it was able to post strong numbers despite a dry hole encountered by its offshore French unit.
Production in the fourth quarter will likely come in slightly below the third quarter average because of maintenance downtime on facilities in Canada and the Netherlands. But with so many projects on track, the trust has few worries for its long-run output. Buy Vermilion Energy Trust up to my new target of USD40.
Provident Energy completed one major acquisition last month and announced another, both of which promise big profit gains in coming years. In the US, the trust’s BreitBurn Energy Partners unit completed the purchase of production and midstream assets from Quicksilver Resources in Kentucky, Indiana and Michigan, dramatically expanding its revenue stream in this country.
Earlier, it announced a CAD92 million purchase of producing and growing light oil properties in Saskatchewan. Buy Provident Energy Trust up to USD14.
Over the past year, these six trusts have demonstrated their sustainability under very difficult conditions, notably low natural gas prices and being mostly shut out of the capital market. The fact that all are thriving now is a great reason for confidence in them going forward. All six are buys.
With the exception of TransForce, the remaining Aggressive Portfolio recommendations are much more aggressively linked to natural gas prices. No one should own them without this understanding.
On the other hand, all have proven their ability to survive tough market conditions. And when gas does recover, the losses they’ve suffered in recent months will quickly melt away.
Precision Drilling units have rung up sizeable losses over the past year. The good news: As bad as third quarter earnings look—a 48 percent drop in net earnings on a 35 percent fall in revenue—downside from here is limited, with the trust trading at just 1.6 times book value.
The trust’s key problem is the massive drop off in Canadian drilling activity in the past year. Service rig activity, for example, declined 32 percent, while average drilling rig operating day rates tumbled 12 percent. Completion and production segment revenue was slammed 33 percent, as fleet operating hours fell from 123,783 last year to just 84,490 this year.
Want more bad stats? Rig utilization fell to 38 percent in the quarter compared to 57 percent a year ago. Meanwhile, operating expenses increased from 48 percent of revenue in the third quarter of 2006 to 54 percent in 2007 because of lower sales, lower pricing, higher labor costs and fixed overhead costs.
On the bright side, the trust continued to take its business to the US, quintupling its US drilling days from the second quarter. Debt is just 9 percent of capital, giving management plenty of flexibility.
Neither earnings nor the stock price are going to recover as long as Canada’s natural gas market remains this weak. But Precision definitely has what it needs to survive and break out when gas does recover. Aggressive investors should buy Precision Drilling up to USD25.