Numbers Matter

Despite a vicious November selloff, two-thirds of the Canadian Edge Portfolio trusts are still up for the year. We’ve generally avoided the real business meltdowns. And some picks, such as Energy Savings Income Fund (SIF.UN, ESIUF), Keyera Facilities (KEY.UN, KEYUF) and Yellow Pages Income Fund (YLO.UN, YLWPF), have scored substantial gains.

Unfortunately, premature bets on a recovery in natural gas prices and related drilling activities continue to cost us. The trusts we hold in these sectors have proven their ability to cope in the worst-possible market conditions. (See the Feature Article.)

They’re also cheap and in great shape to capitalize when the recovery finally kicks in. The bad news is we may have to wait a while for that recovery, and in the meantime, more downside is likely.

Returns on a brokerage statement aren’t the only numbers that matter in investing. In fact, those basing decisions solely on how much a stock has risen or fallen invariably buy too close to tops and sell near bottoms. Rather, market returns must be viewed as critically as any other number.

A big near-term gain or loss can occur for any number of reasons. Some of them mean sell, some buy and some just hang on. The key is how market returns mesh with business returns—how an income trust is doing in terms of its market share, sales and costs, and ultimately its balance sheet, cash flow and the sustainability of its distributions.

My rule is always to sell if a trust’s business is unraveling and to hang on if it’s still healthy and growing. Any number of things can move prices in the near term. But long term, only one thing does: distribution growth.

That’s the clear message of any price chart for Canadian trusts going back more than a year or two. When distributions rise, share prices invariably follow. When they’re cut, share prices come down as well.

Even the November 2006 meltdown proves the point: Investors reacted to the potential for dividend cuts in 2011 because of new taxes. That’s no longer a factor at this point because trust taxation has been priced into the market for more than a year. In fact, today’s yields anticipate far more severe distribution cuts than will actually occur, given trusts’ ability to reduce their effective taxation rates well below the statutory 31.5 percent rate. And some trusts have demonstrated they won’t have to cut dividends at all.

Over the long haul, trusts with the best businesses will enjoy the strongest distribution and capital growth. Share prices will lag distribution growth in bad markets just as they outpace them in good ones. But eventually, the market will value the income stream for what it’s worth. That adds up to big gains for trusts backed by sustainable, growing and healthy businesses.

This is easy to forget in a market where even the strongest trusts routinely rise and fall several percentage points in a day. And as long as fear of a US recession runs rampant, the volatility will continue. But as long as trusts’ distributions are sustained, downside will be temporary.

As I pointed out in flash alerts sent Nov. 13 and 14, almost all Portfolio trusts demonstrated the ability to sustain distributions in their third quarter results. That includes all Conservative Portfolio holdings, with the exception of Boralex Power Income Fund (BPT.UN, BLXJF), which was hit by low water flows to its hydro plants.

By their nature, Aggressive Portfolio holdings are more cyclical and risky than those in the Conservative Portfolio because prospects are closely tied to energy prices and economic growth. But despite severe stress tests, these trusts, too, proved their mettle. You can access the prior month’s flash alerts anytime by clicking on the “Flash Alerts” item in the main menu on the Canadian Edge Web site. You can retrieve older flash alerts by clicking on “Archives.”

Year-End Moves 

Ten of the 27 trusts in the Canadian Edge portfolios—including new Conservative Portfolio holding and High Yield of the Month GMP Capital Trust (GMP.UN, GMCPF)—have increased their distributions at least once since Halloween 2006. That’s a sure sign their businesses are solid, and it means management will keep them paying big dividends well past 2011.

Another 15 have held distributions steady, instead plowing excess cash flows into growing businesses. That includes the six core oil and gas producer trusts ARC Energy Trust(AET.UN, AETUF), High Yield of the Month 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).

Only two of our holdings have reduced distributions since we’ve held them: Paramount Energy Trust (PMT.UN, PMGYF) and Precision Drilling (PD.UN, NYSE: PDS). Both, however, will quickly turn around when natural gas prices recover.

A third, Newalta Income Fund (NAL.UN, NALUF), has been underearning its payout for most of this year. But it’s rapidly wiping out the deficit by expanding environmental cleanup operations outside the energy patch.

The bottom line: All of these trusts are on solid ground as businesses. As long as that remains the case, they’ll recover from whatever losses they suffer now. In fact, they’ve passed a stress test few sectors have ever faced.

A year ago in the December 2006 issue, I made a series of moves with the portfolios to reflect the changed environment for trusts and the stress tests they were likely to face in 2007. The good news is the quality-first strategy and most individual selections have held up during what the Feature Article shows has been an extraordinarily tough environment. With our selections solid as ever and extremely cheap, there’s no reason not to hang in there. And although I don’t advise overloading on a single stock or sector no matter how attractive, every trust in the portfolios now rates a strong buy.

There are two holdings, however, that merit a sell, based on the numbers: Precision Drilling and TimberWest Forest Corp (TWF.UN, TWFUF).

As the biggest of the Canadian drillers (27 percent market share) and with virtually no debt, Precision is in no danger of Chapter 11, no matter how horrible its numbers look now. It’s also hard to imagine those numbers not being at least very close to bottoming, after a 35 percent drop in revenue and a decline in its rig utilization rate to just 38 percent of capacity. There’s even a bright spot in third quarter results: the sixfold increase in US drilling days, with eight rigs operating at near 100 percent capacity.

On the other hand, the numbers say recovery may take time. Producers’ capital spending plans forecast another drop in drilling activity into 2008. That could put Precision’s distribution under pressure again. Shares could also go lower if oil prices should drop precipitously amid recession fears.

Precision shares are down substantially this year, after steadily falling from about mid-May on. I’m still a believer in its ultimate recovery. But the trust is an ideal candidate for tax-loss selling. I’ll look to buy it back—hopefully even cheaper—in early 2008.

In stark contrast, TimberWest has enjoyed powerful gains since originally recommended in August 2004. Its strength this year was mainly because of its exemption from 2011 taxation, by virtue of being a stapled share combining debt with equity. But avoiding taxes alone is never a good reason to hold, and unfortunately, that’s increasingly TimberWest’s sole attraction.

The labor strike that interrupted production this year appears settled, and real estate sales are going swimmingly. The core timber business, however, is being ravaged by economic weakness in the US, which, in turn, has weakened the market for its logs in Asia as well as Canada.

I love the assets, and management seems determined to hold the dividend. It just looks to me that, at 5.6 times book value, the market is pricing in the good news on taxes and ignoring the very real business risk. That’s never a good formula. Take the profit on TimberWest Forest Corp. We can always get back in next year once the macro issues have clarified a bit.

I’m making two additional moves to the portfolios this month. As mentioned above, I’m adding GMP Capital to the Conservative Portfolio. And I’m moving Boralex Power Income Fund to the Aggressive Portfolio, while keeping it a buy up to USD8.

As I’ve written several times since its disappointing third quarter earnings, Boralex is still a solid franchise with well-run hydro, biomass and cogeneration plants. This year’s results are sub-par for reasons beyond its control, i.e., low water flows, and the market’s reaction to them was clearly extreme. In fact, we’ve been here before: In 2006, Boralex sold off sharply in the wake of poor cash flows because of weak hydro output, only to bounce back to even higher highs as the waters rose.

The trust appears to have the cash reserves to sustain its distribution for several more quarters. And its manager and parent Boralex may elect to once again wait out the current period of weak water flows, rather than cut, as capital needs are few. The shares also sell for barely book value, and the 13 percent-plus yield clearly prices in a dividend cut.

Boralex is an attractive buy for those who don’t already own it. But with its distribution in danger, it can’t be called a Conservative Portfolio holding.

On a general note, investors focused on garnering sustainable yields should concentrate on the Conservative Portfolio recommendations first. I suggest an allocation of 70 percent Conservative, 30 percent Aggressive, though the ideal will vary from individual to individual depending on risk tolerance. More aggressive investors can weight more to the Aggressive Portfolio, provided they understand sweet yields can sometimes bring sour consequences.

Earnings Highlights

Here are highlights from the third quarter earnings season for Canadian Edge Portfolio picks. For more information, click on the “Archives” item in the menu on the Canadian Edge Web site and click on the Nov. 27 Maple Leaf Memo in the box titled “Archived Maple Leaf Memo Issues.”

With natural gas prices slumping, the most robust numbers came from the Conservative Portfolio holdings. Last month, I highlighted the exploits of standout Pembina Pipeline Income Fund (PIF.UN, PMBIF), which has increased its distribution by nearly 30 percent since Halloween 2006. Buy Pembina Pipeline Income Fund up to USD18.

AltaGas Income Trust (ALA.UN, ATGFF) was another big winner, posting a 9 percent boost in net income and 10 percent higher funds from operations (FFO). More important, the trust continued to add solid, fee-generating assets to its portfolio, while cutting its debt-to-assets ratio to 20 percent since the beginning of the year and issuing just 3.4 percent more outstanding shares.

Last month, AltaGas announced it would buy the 90.4 percent of Taylor Natural Gas Liquids LP it didn’t already own for CAD448 million, dramatically increasing processing capacity. It also started up a coalbed methane gas processing facility in Alberta, reached a new pipeline agreement to bring more of its output to profitable markets and made a deal to build out its British Columbia wind farm.

All that should add to cash flows in coming years, even as management seeks out more opportunities. Buy AltaGas Income Trust, which is down slightly on the Taylor purchase, up to USD28.

Energy Savings Income Fund (SIF.UN, ESIUF) and Keyera Facilities Income Fund (KEY.UN, KEYUF) also reported torrid growth. Energy Savings’ sales rose 16 percent, spurring a 40 percent explosion in distributable cash per share to 35 cents Canadian. Margin-per-customer improved in all markets, while US sales skyrocketed 168 percent.

Even the plunging US dollar didn’t hurt, as the company “outgrew” its impact by signing on more than 90,000 new customers. On track for torrid growth—and increasing its distribution by more than 20 percent since Halloween 2006—Energy Savings Income Fund is a powerful buy up to USD18.

Keyera’s third quarter earnings soared 30 percent, on a 15 percent jump in gathering and processing revenue. The unique nature of its assets has kept the trust in the pink, even while much of Canada’s energy patch has sunk deeply in the red. The natural gas liquids (NGL) infrastructure and marketing segments also posted solid results.

The bottom line is a 59 percent boost in distributable cash flow for the trust, which has increased its payout by 5 percent since Halloween 2006. Buy Keyera Facilities Income Fund up to USD19.

Yellow Pages Income Fund (YLO.UN, YLWPF) increased its distribution by 3.7 percent, pushing its payout growth to 9.7 percent since Halloween 2006. Distributable cash flow per share surged nearly 10 percent during the third quarter as the trust continued to successfully transition its business from cash cow print directories to the high-growth Internet.

Revenue surged 12.9 percent, with acquisitions accounting for roughly half of growth. On track for more into 2008 and beyond and selling for less than 1.3 times book value, Yellow Pages Income Fund is a buy up to USD16.

Our Canadian REITs continued their rapid growth. The speediest was Artis REIT (AX.UN, ARESF), which reported a 147.5 percent increase in third quarter FFO on a 71.8 percent jump in revenue and 85.1 percent surge in net operating income (NOI). Distributable income increased 85.1 percent to CAD18.7 million. Occupancy was strong at 97.1 percent, and mortgage debt-to-gross book value decreased to 49.9 percent from 52.1 percent at the beginning of year.

The REIT also closed CAD68.3 million of acquisitions, pointing to fatter profits ahead. Buy Artis REIT up to USD18.

Northern Property REIT (NPR.UN, NPRUF) hiked its distribution 7.25 percent, riding a surge in third quarter distributable income per share to a record of 50 cents Canadian. Revenue soared 26.9 percent as the trust benefited from rising rents, strong occupancy of 95.4 percent—despite a series of renovations—portfolio expansion and cost controls. NOI rose 27.9 percent.

Meanwhile, the payout ratio slid to just 74.3 percent, opening the door for more dividend growth ahead. Buy and lock away Northern Property REIT up to USD25.

RioCan REIT (REI.UN, RIOCF) had another steady quarter, as reported in the November issue. Its low-risk strategy points the way toward more ultra-reliable cash flow and dividend growth for years to come, such as the recent modest 2.3 percent boost. Buy RioCan REIT up to USD25.

Canadian Apartment Properties REIT (CAR.UN, CDPYF) distributable income per share ticked up 5.9 percent in the third quarter, driving its payout ratio down to just 77.8 percent. The trust enjoyed rising rents and occupancy (97.7 percent) at its residential rental portfolio, a market that continues to strengthen. 

NOI for properties owned rose 4.3 percent, a good sign for continued profit growth even as the REIT continues to expand its portfolio Canada-wide. Management’s focus on controlling debt may limit dividend growth near term. But solid, sustainable Canadian Apartment Properties REIT is a strong buy for growth and income up to USD20.

Large and growing US-based operations posed a particular risk to third quarter cash flows at three Conservative Portfolio trusts. Happily, Algonquin Power Income Fund (APF.UN, AGQNF), Arctic Glacier Income Fund (AG.UN, AGUNF) and Atlantic Power Corp (ATP.UN, ATPWF) offset the impact with strong internal results and well-timed expansion.

Algonquin’s payout ratio actually declined in the quarter to 95.8 percent, as cost controls and debt reduction offset a drop in revenue to the stronger Canadian dollar. The trust continues to pay out at an aggressive rate and enjoys some 2011 protection thanks to nearly two-thirds of income coming from power plants and water facilities in the US. Algonquin Power Income Fund is a buy for income and some growth up to USD9.50.

Arctic Glacier’s revenue rose just 2.3 percent because of the $5.5 million impact of the rising Canadian dollar on its US revenue. Distributable cash flow, however, surged 22.5 percent on acquisitions and the trust’s focus on cutting debt.

Purchases in California, Michigan and New York this year have pushed US income to 79.8 percent of Arctic’s total, insulating the distribution from 2011 taxation. Buy and lock away Arctic Glacier Income Fund up to USD14.

A changed asset mix that shifted cash flow to other quarters pushed up Atlantic’s third quarter payout ratio to 104 percent. The nine-month ratio, however, came in at just 84 percent.

Meanwhile, the addition of another 50 percent stake in the Pasco project will boost cash flow going forward. Buy Atlantic Power Corp, a staple share immune from 2011 taxation, up to USD12.

Rounding out the Conservative Portfolio holdings, Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) turned in another steady performance, as reported in the November issue. Bell Aliant Regional Communications Income Fund is a buy up to USD33.

Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF), meanwhile, boosted revenue 33 percent, thanks to this year’s acquisition of carbon neutral power producer Clean Power Income Fund’s wind, hydro and biomass power assets. The payout ratio ticked up to 143 percent, largely because of a shift in seasonal income. But management still expects a 95 percent rate for the full year, providing the basis for dividend boosts down the road. Buy Macquarie Power & Infrastructure Income Fund—which, even in a worst case, is well insulated from the supposed troubles of its parent—up to USD12.

Sustainably Aggressive

The Aggressive Portfolio’s earnings performance was largely driven by energy prices. With natural gas sinking and oil’s rise offset by the rising Canadian dollar and higher costs, the comparisons with year-earlier tallies were tough.

The majority, however, earned their distributions comfortably. Moreover, those third quarter payout ratios were based on selling oil at prices roughly $20 below current levels, so they’re clearly sustainable.

The top performer was Vermilion Energy Trust, whose solid earnings gain was reviewed in the November issue. The trust rode favorable production and pricing trends in Australia and the Netherlands, offsetting declines in Canada and France. The yield is low, but this is one oil and gas trust that won’t be cutting dividends in 2011, thanks in large part to heavy foreign income. Buy Vermilion Energy Trust, which has a payout ratio of just 34 percent, up to USD40.

My other five “core” oil and gas producer trusts generally reported lower distributable income, again due to gas prices. All of them, however, were able to maintain production and reserves with solid capital spending programs, even while controlling debt and sustaining distributions. That includes Enerplus Resources, profiled in High Yield of the Month.

ARC Energy Trust’s payout ratio was a steady 70 percent, as the company maintained production and held realized prices relatively flat overall. The trust also announced a CAD355 million capital spending plan for 2008, mostly for lands it already owns. With a relentless focus on sustainability, ARC Energy Trust is a buy up to USD23.

Penn West Energy Trust boosted cash flow 6 percent from its second quarter, though the level was down year over year. Production was reduced by a fire at a facility but was generally steady with last year’s levels as were costs.

As I pointed out last issue, Penn West’s biggest challenge is completing takeovers of Canetic Energy Trust (CNE.UN, NYSE: CNE) and Vault Energy Trust (VNG.UN, VNGFF) by early next year. Odds are heavy on the ultimate success of these deals, though Vault has delayed the shareholder vote until January.

Both purchases add considerable reserves and potential production at less than their book value. Penn West Energy Trust shares have fallen sharply for no good reason and are a buy all the way up to USD38.

Peyto Energy Trust continued to pull in its horns in the third quarter, hardly surprising given the drop in gas prices and the fact that gas is 82 percent of its output. FFO fell 13 percent, and the trust’s payout ratio rose to 71 percent from 61 percent a year ago. Production decreased 16 percent and net debt rose 2 percent. On the other hand, this is one trust that’s poised to benefit from a recovery in gas prices, and it’s better equipped than any gas producer to weather the storm until then.

Peyto Energy Trust is a buy up to USD20. Note unitholders should vote “yes” to the proposed reorganization, which should be a plus for future cash flows.

Provident Energy Trust’s third quarter FFO sank 29.5 percent but still covered the distribution with a payout ratio of 89 percent. The results were mainly due to weak natural gas prices, which offset a 26 percent jump in oil and gas production at its growing US and Canadian asset base.

The increased payout ratio looks like a short-term event, particularly with the trust completing successful acquisitions of new production assets in Canada and a range of assets in the US under its BreitBurn Energy Partners LP unit. Provident Energy Trust remains a buy up to USD14.

Trinidad Energy Services Income Trust (TDG.UN, TDGNF), alone in the energy service sector, reported flat distributable income per share relative to year-earlier comparisons. Revenue actually rose 7.7 percent as the trust’s rigs continued to realize utilization rates at or above 85 percent, thanks to its focus in the US and on signing long-term contracts for primarily deep drilling.

The US focus will also protect dividends from 2011 trust taxation, though management has yet to comment on its plans. The shares have been pummeled.

But with a nine-month and third quarter payout ratio of only about 60 percent, the distribution looks solid unless this sector depression lasts several years. Trinidad Energy Services Income Trust is a buy up to USD18 for aggressive investors.

Advantage Energy Income Fund (AVN.UN, NYSE: AAV) saw its FFO per share slide to 51 cents Canadian a share from 63 cents Canadian a year earlier. That was entirely due to falling natural gas prices, which offset an 8 percent boost in production.

Output will rise sharply in coming quarters, now that the Sound Energy Trust merger is completed. The payout ratio of 88 percent is dangerous but should drop in the next few quarters. Advantage Energy Income Fund is a buy up to USD14 for more aggressive investors who want to bet on gas.

I have the same advice for another leveraged gas play we’ve taken larger losses on: Paramount Energy Trust (PMT.UN, PMGYF). The thing I like about Paramount is that management always lays out what it can afford to pay out at what level for natural gas. That makes it an excellent way to play a natural gas comeback aggressively. The bet hasn’t worked out yet, but Paramount’s flexibility should ensure its survival, as well as a big profit when gas does revive. Paramount is a buy up to USD10 for speculators.

Newalta Income Fund shares have been very weak this month. Ironically, it had one of the more encouraging third quarter earnings reports, boosting revenue 11 percent overall as it continues to shift resources to nonenergy sectors. Specially, eastern Canada revenue surged 61 percent, and margin rose 34 percent, while western margins firmed despite very weak industry conditions.

That’s a formula management expects to lift cash flow to more than cover distributions by early 2008. If it does succeed, it will be a huge positive surprise for the shares. Newalta Income Fund remains a buy up to USD25.

Finally, TransForce Income Fund (TIF.UN, TIFUF) shares have weakened since I added them to the portfolio last month as an aggressive income play. But the trust continues to give encouraging signs, such as the announced purchase of a huge less-than-truckload carrier, the Thibodeau Group of companies, which had some CD80 million of revenue last year.

Management’s goal is to continue to consolidate its industry with accretive acquisitions. And its persistence is a good sign the market’s wrong on its assessment of the trust’s prospects. TransForce Income Fund is a buy up to USD14.