Menu’s not alone in the trust universe’s death sprial list. Like Wall Street, Canada’s Bay Street always produces to demand. And last year—when investors were clamoring for yields—was a prime time for businesses of every type to turn trust, whether they were suitable for paying out big regular distributions or not.

The result: There’s a lot of junk out there that’s rapidly melting away in today’s challenged environment. And no matter how much private capital is looking for places to invest—or how friendly Canadian politicians may become to the trust structure—complete failure is only a matter of time.

Since I started Canadian Edge in mid-2004, I’ve strived to avoid the junk and focus solely on the real businesses. As a result, we’ve avoided the real traps, both inside and outside of the hypervolatile oil and gas production business. Even the handful of trusts I dumped in November and December last year—largely on worries about falling energy prices and their response to the Halloween taxation—have survived and moved into recovery mode.

Unfortunately, the most-careful strategy will still land you in the tall grass occasionally. And that’s the case with my recommendation of Primary Energy Recycling (PRI.UN, PYGYF).

I first featured Primary in a mid-November Flash Alert as an antidote to the trust taxation plan. Like Atlantic Power Income Fund (ATP.UN, ATPWF) and TimberWest Forest Corp (TWF.UN, TWTUF), Primary is a stapled share called an Enhanced Income Security, essentially combining a bond with a stock into a high-yielding security with dividend growth potential. As a result, its distributions are exempt from the 2011 plan.

Primary’s assets are four recycled energy projects and a 50 percent interest in a pulverized coal facility. The projects have a total generating capacity of 283 megawatts and equivalent steam generating capability, with first dibs on a number of other projects for expansion.

All five current projects are tied to steel industry facilities under contracts expiring from 2011-18. Ironically, the company’s current problems have nothing to do with the perpetually challenged North American steel industry. Rather, it’s the disappointing performance of its assets.

Last issue, I reported problems at Primary’s Harbor Coal facility had crimped 2006 results but that management had taken aggressive steps to boost performance and had ample reserves to cover the shortfall until there was improvement. Since then, however, the opposite has happened.

First came the announcement from Mittal Steel—the host company for four of Primary’s projects—of a massive negative inventory adjustment for coke and coal at the Harbor Coal facility. That forced the company to set aside a USD2 million-plus reserve for project losses.

More alarming was management’s simultaneous warning of an unexpected outage of a steam turbine generator at the North Lake project, which also has Mittal Steel as its host. That will impact revenue at least USD1 million to USD2 million even if repairs are made immediately, and the cost is only partially recoverable by insurance.

Finally, the company announced first quarter earnings that can only be described as abysmal, with earned revenue falling 35 percent and the payout ratio ballooning to 216.5 percent.

Primary’s management stated in the earnings release that it may have to seek a waiver from lenders in order to pay either the equity or interest portion of its distribution during the next few months. Based on the quality of its projects and customers, as well as lenders’ cooperative response in similar situations with power trusts, I expect a waiver to be granted if needed.

What worries me, however, is that performance problems have now spread beyond Harbor Coal. Management’s protestations to the contrary, it’s going to have to prove to me it can turn this around. And I’m not the only one concerned;  Dominion Bond Rating Service (DBRS) has put the trust’s STA-3(low) rating on watch for downgrade.

Primary shows no sign of a complete blowup. The shares have come well off and now sell for just 1.24 times book value. That’s a price guaranteed to put it on at least someone’s radar screen as a possible takeover.

The real question, however, isn’t whether or not Primary ultimately goes to zero or shoots out to new highs. It’s whether or not there’s a better place for our money now.

In my view, that’s High Yield Of The Month Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF). Risk to the company’s current distribution is low, and as the takeover of Clean Power Income Fund (CLE.UN, CEANF) demonstrates, the trust has capital to expand and the will and skill to use it.

The yield is somewhat lower than Primary’s now but still generous at nearly 10 percent. And making the swap will require swallowing a loss on Primary, depending on when you bought it. But with operating risks much lower, growth prospects greater and the shares just as cheap on a price-to-book value basis, Macquarie Power & Infrastructure Income Fund is by far the place I’d rather be and a buy up to USD12.

Winning By Losing

Macquarie Power & Infrastructure’s purchase of Clean Power came at the expense of Algonquin Power Income Fund’s (APF.UN, AGQNF) competing bid. But the owner of 47 hydroelectric plants, five cogen facilities, 17 alternative fuels stations and 17 water supply and waste water facilities walks away with the CD1.75 million breakup fee plus CD850,000 recovery for costs incurred.

That leaves management free to pursue other deals and in better financial shape than ever. It also keeps the trust a potential takeover target, selling for just 1.5 times the book value of its portfolio of carbon neutral plants. The shares rebounded sharply following the failure of the Clean purchase. Algonquin Power Income Fund is still a solid buy up to USD9.

Bell Aliant (BA.UN, BLIAF) also lost out in a bidding war to private capital last month. The trust’s target, Amtelecom, attracted a white knight willing to pony up more than Bell’s hostile offer. There’s no breakup fee, but the trust will be able to sell shares it already purchased for a profit.

Meanwhile, Bell’s business position continues to improve. The trust completed the sale of its yellow pages operation to Yellow Pages Income Fund (YLO.UN, YLWPF), netting CD330 million to fund future growth and shore up finances. In addition, management is taking advantage of positive regulatory change to remove rules restricting how it can compete with rivals.

First quarter revenue rose 3.6 percent, as torrid 21.7 percent growth in Internet subscribers offset less-than-expected declines in the legacy local and long-distance telephone businesses. Distributable cash rose 4.3 percent.

This is the same formula US rural telephone companies are using to generate steady growth and big distributions for shareholders. And armed with money, expertise and now-favorable regulation, Bell Aliant’s well positioned to make it work. Despite a mighty comeback from its late 2006 lows, Bell Aliant shares are still a strong buy up to USD30.
 
AltaGas Income Trust (ALA.UN, ATGFF) is always a candidate for acquisitions. Last month, the trust acquired another 14.4 megawatts of power-generating capacity to boost its portfolio in southern Alberta. It also announced plans to construct a new natural gas pipeline linking British Columbia fields with a northwest Alberta processing facility.

One hallmark of AltaGas’ projects is they almost always have customers before the first shovel of earth is turned. The plans highlighted above are no exception and consequently will boost cash flow and probably distributions as they come on stream in the coming months. AltaGas is a strong buy up to USD26 and a safe bet to pay big dividends to 2011 and beyond, unless it’s taken over first.

That, incidentally, is also true of another Conservative Portfolio energy infrastructure trust, Pembina Pipeline Income Fund (PIF.UN, PMBIF). The trust’s shares are nearly 30 percent up from their lows following the Halloween tax announcement and look set to make new all-time highs sometime this year, no matter what happens in Ottawa.

The reasons can be viewed at length in Pembina’s first quarter earnings report: solid results at all three businesses—conventional pipelines, oil sands infrastructure and midstream infrastructure—a conservative financial strategy highlighted by superior bond ratings and continued aggressive spending on future growth. The payout ratio of 88 percent allows more room for dividend increases along the lines of last year’s total of 16 percent.

Pembina’s primary investment in the oil sands region remains infrastructure servicing the Syncrude partnership. That’s the largest oil sands producer and a joint venture between several big oils and operated by ExxonMobil unit Imperial Oil. Earnings for Syncrude’s proxy stock, Canadian Oil Sands Trust (COS.UN, COSWF), surged 175 percent in the first quarter as bitumen production rose 44 percent and operating costs per barrel fell 41 percent.

With Canada’s conventional oil and gas fields in decline, the country is counting on growing oil sands output to pick up the slack. That’s money in the bank for Pembina, whose arrangement locks in revenue the more Syncrude and other ventures expand. And because it’s not a producer, the trust is protected against potential cost increases because of environmental concerns. Pembina Pipeline Income Fund remains a strong buy up to USD16.

Yellow Pages is up 25 percent from its late 2006 low on much the same formula: strong results, aggressive spending on future growth and investors’ growing realization it will be paying a big dividend long after Finance Minister Jim Flaherty is sent packing from Ottawa.

Last month, the trust completed its purchase of Bell Aliant’s yellow pages unit, which it had operated for the past decade, further tightening its hold on Canada’s print directory business. At the same time, its Trader Corp unit further revved up its Internet presence to reach 43 percent of all online Canadians. Those activities make good on the trust’s pledge to maintain at least its current dividend rate if it does wind up being taxed as a corporation in 2011. Buy Yellow Pages Income Fund up to USD14.

In the tax-exempt trust department, Arctic Glacier Income Fund (AG.UN, AGUNF) got a further confirmation from DBRS that its investors have little to worry about in 2011. Arctic Glacier Income Fund is a buy up to USD12.

Unlike fellow staple share Primary (see above), TimberWest Forest Corp posted solid first quarter earnings well in line with prior years and covering the distribution comfortably with a 76.9 percent payout ratio. Once again, management’s commitment to market diversification and cost controls paid off, as robust Canadian sales and log prices offset an 18 percent drop in Asian sales, a 5 percent slip in US sales and higher production costs because of contractor rate increases.

Impressive, results included virtually no real estate sales, which are being evaluated by a new vice president hired for that purpose. That promises to unlock more shareholder value even as the basic timber business remains strong. My only problem with TimberWest is the big run-up in its share price; I’d be a buyer on a dip to USD14. Until then, however, Brookfield Asset Management unit Acadian Timber Income (ADN.UN, ATBUF) is probably a better buy in timber.

One other Conservative Holding deserves comment this month. Keyera Facilities Income Fund (KEY.UN, KEYUF) has surged almost 18 percent this year because of the growing perception that its portfolio of high-quality midstream energy assets is dirt cheap, selling at less than two times book value. Potential takeover interest was in effect confirmed April 30, as its board of directors adopted a “rights plan” to prevent stealth takeovers not at a premium price. That’s another reason to buy Keyera Facilities Income Fund, a high-quality holding, up to USD18.

Energized Again

My recommended closed-end trust mutual funds took a huge hit last year in the wake of the Halloween trust tax announcement and the relentless drop in energy prices. So far this year, it’s been payback time. Onmec battered EnerVest Diversified Income Fund (EIT.UN, EVDVF) is now up more than 16 percent year to date, while Select 50 S-1 Income Trust (SON.UN, SFYIF) is up a bit less than 10 percent.

Takeover fever is one reason for the rebound, and I expect to see more on that score. But I’m more excited about the potential impact of a narrowing in these funds’ discounts to net asset value—EnerVest still trades for less than 87 cents per dollar of assets, while Select 50 goes for barely 95 cents—and recovering energy prices. EnerVest Diversified Income Fund is a buy again up to USD6.50; Select 50 S-1 Income Trust is a bargain to USD11.50.

It also looks like recovery time for the seven oil and gas producer trusts and three energy service trusts that make up the Aggressive Portfolio. Some readers have asked me why these haven’t rallied more strongly in lockstep with rising oil and gas prices over the past few months. Here’s why.

Basically, oil and gas trusts’ cash flows can’t help but follow energy prices up and down. However, they also sell a good chunk of their output forward at locked-in prices. As a result, there’s always a lag.

For example, oil and particularly natural gas prices declined sharply from late 2005 through early 2007. But because of forward selling, it wasn’t until the third quarter of 2006 that falling energy prices really started catching up to trusts’ cash flows, forcing weaker trusts to cut distributions and shoving the weakest into a death spiral.

Now oil and gas have apparently bottomed and started heading higher. But because of forward selling to lock in prices, we’re not likely to see the full positive impact show up in trusts’ cash flows until at least midsummer.

If you look at a long-term chart of oil and gas producer trust prices compared with energy prices, you’ll see the same pattern over and over again. Trusts’ cash flows, distributions and share prices have always tracked energy prices over time, and they always will. But unlike other types of energy stocks, it’s with a lag.

There is another obvious reason why oil and gas trusts are currently underperforming the commodities they produce: lingering investor fear and skepticism following the Halloween trust tax announcement.

My firm belief remains that energy producer trusts are ultimately valued on what they have in the ground. At this point, even the strongest of the breed are trading at big book value discounts to what producing corporations trade for. That fact isn’t lost on the prospective private capital buyers now circling the industry.

As long as energy remains in a bull market, strong energy trusts won’t be able to help going up. The key is to make certain what you own remains healthy as a business. That means sticking to the same discipline we’ve been advocating all along: looking for trusts with long-life reserves, low operating costs, low payout ratios, low dilution from new share issues, low debt and proven disciplined management. (See the Oil And Gas Reserve Life table.)

Yes, a takeover or change in trust tax law may hand us a windfall in 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), Vermilion Energy Trust (VET.UN, VETMF) or even riskier Paramount Energy Trust (PMT.UN, PMGYF). But the point is, as long as energy prices stay in a bull market, these trusts are going a lot higher from here and all rate strong buys, no matter what happens in Ottawa.

Once rising energy prices start to elevate these trusts’ cash flows, their share prices should start to move out of the doldrums they now occupy. Until then, their high distributions will pay you for your patience, provided you’re willing to stomach the pessimism that’s typical of battered though bottoming markets.

One case in point is the skepticism of some surrounding Enerplus’ purchase of oil sands properties for CD182.5 million. The properties’ ultimate projected output of 30,000 to 40,000 barrels of oil equivalent a day is potentially significant, as it represents nearly half the trust’s current output.

The 4.05 million unit issue to finance the deal, however, is decidedly not a big deal, representing just a 3.3 percent boost in outstanding shares; neither is the projected CD320 million initial capital requirement to get the project up and running at 10,000 barrels per day at the expected date of early 2011. That would represent only a 5 percent increase in shares at current prices.

As for debt, it’s projected to remain at just 0.8 times annual cash flow, among the lowest in the oil and gas producer trust sector.

Much is unknown about the oil sands at this time. There’s apparently massive potential for reserve and production growth at these properties, and it’s hard to bet against Enerplus management’s 20-year-plus record of successful development. But there are also pollution concerns—particularly with carbon regulation likely in North America—and the oil sands region still has been unable to utilize growing scale to bring down costs.

The point is the trust is taking relatively little financial risk to get a piece of what could be a hugely profitable pie. That incidentally is precisely the same course management has followed buying into the Baaken find in the US.

No one should ever mistake a high-yielding bet on energy prices for a safe income investment. But anyone looking for a well-run producer that pays a lot of cash and is leveraged to the next bull move in energy will find a lot to like in Enerplus. I continue to rate Enerplus Resources a buy up to USD50.

For buy prices of the other oil and gas producer trusts—as well as energy service picks Precision Drilling (PD.UN, NYSE: PDS), Trinidad Energy Services Income Trust (TDG.UN, TDGNF) and the clean-up services trust Newalta Income Fund (NAL.UN, NALUF)—see the Aggressive Portfolio table below. Note Precision is this issue’s High Yield Of The Month.