Contagions and Canada

CIBC World Markets senior economist Avery Shenfeld took a Canada-specific look at the subprime mortgage meltdown last week, concluding that recent selling on the Toronto Stock Exchange is driven by “unwarranted fears” the American malady would spread north because of its impact on global growth.

The Canadian subprime market is growing, but it has a lower default rate than in the US, according to Dominion Bond Rating Service. Canada has been slower to adopt subprime mortgages, and borrowers can’t deduct mortgage interest payments from their taxes.

Brenda Lum, who covers Canadian banks for DBRS, wrote in a report last week that there are no credit-rating implications for the five largest Canadian banks, describing the potential impact as “minimal.”

Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Toronto-Dominion Bank are exposed to the US subprime market through various businesses but not sufficiently to alter their credit-risk profile or current ratings.

Takeovers and speculation over new deals boosted US exchanges as well as the Toronto Stock Exchange, but the main Canadian market has drooped nearly 7 percent as investors have questioned the lending that’s financed acquisitions.

But Shenfeld pointed out that corporate default rates and debt burdens are low and that earnings have been generally strong; Canadian earnings are poised for a 16 percent gain in 2007 and another double-digit rise in 2008.

According to CIBC’s study, private equity has fueled 27 percent of US deals in the past two years but only 17 percent of Canadian takeovers. And that’s concentrated in high-profile telecom and media deals.

Corporate buyers have made up 95 percent of takeovers in Canada’s resource sector. Those kinds of deals aren’t likely to be impacted in a credit contraction because potential buyers have strong cash flow and balance sheets.

Canadian equities should outperform near-term expectations because of good global growth and a fundamentally sound domestic economy.

Offseason Update

Stephen Harper is looking to shake things up a bit in his cabinet in an effort to generate some momentum toward a majority.

To the chagrin of income trust investors in Canada and abroad, Finance Minister Jim Flaherty won’t be cashiered. But Defence Minister Gordon O’Connor, who’s made many Afghanistan-related gaffes in his time in charge, is out.

Recent poll numbers show a stagnant political environment; Canadians don’t want an election, and they have no clear party preference at the moment. According to an Ipsos Reid poll released last week, the Conservatives have support of 34 percent of Canadians, down from the 36 percent the party got in the February 2006 election. The Liberals are backed by 32 percent of voters.

Harper hasn’t broadened the Conservatives’ appeal beyond its Alberta-centric base. The Tories lag the Grits in Ontario, Canada’s most populous province, and have fallen back in Atlantic Canada after the controversy over the 2007 federal budget’s treatment of the Atlantic Accords on offshore oil and gas revenues.

They’re also behind the separatist Bloc Quebecois party in the French-speaking province of Quebec. And the Conservatives failed to win seats in districts in any of Toronto, Montreal or Vancouver in the 2006 election.

Pundits of the Great White North have generally agreed that Harper’s minority government has run out of ideas, that there must be a renewing of “Canada’s New Government.” Most observers believe the government will prorogue Parliament in September.  

“Prorogation” is the “abrupt end to a parliamentary session and all parliamentary business, brought about through the recommendation of the prime minister and proclaimed by the governor general.”

The principal effect of ending a session by prorogation is to terminate business. Members are released from their parliamentary duties until Parliament is next summoned.

Parliament is still constituted. (All members remain as members, and a general election isn’t necessary.) But all orders of the body (bills, motions, etc.) are expunged.

All unfinished business is dropped, and all committees lose their power to transact business, providing a fresh start for the next session. No committee can sit during a prorogation. Bills that haven’t received Royal Assent before prorogation are “entirely terminated” and, in order to be proceeded within the new session, must be reintroduced as if they’d never existed.

The government doesn’t need any support from the opposition parties and can simply prorogue the House before the parliamentary calendar expires.

Proroguing would set the stage for a throne speech by Harper, where he would presumably roll out the New, New Government’s fresh policy priorities.  

The Roundup

Conservative Portfolio

Boralex Power Income Trust (BPT.UN, BLXJF) reported a CD44.3 million (75 cents Canadian per unit) loss for the three months ended June 30, 2007, down from a CD7.2 million (12 cents Canadian per unit) gain during the second quarter of 2006. Without the change in Canadian tax law, net earnings would have been CD2.8 million (5 cents Canadian per unit).

The adjustment for future income taxes based on the passage of the Tax Fairness Plan was CD47.1 million. On the operations side, the second quarter is revenue was off CD3.3 million to CD23.9 million from CD27.2 million a year ago. Boralex’s hydroelectric facilities aren’t served by reservoirs, so it’s dependent on natural conditions for operational efficiency. Water was tight during the second quarter, even for what’s ordinarily a slower period for the company.

Earnings before interest, taxes, depreciation and amortization (EBITDA) amounted to CD11.2 million, down from CD16.1 million in 2006. Revenue from the hydroelectric segment was CD11.6 million, down CD3 million from the same period in 2006.

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 in the second quarter of 2006. The wood-residue segment reported revenue of CD7.3 million compared with CD7.5 million for the second quarter of 2006. EBITDA was CD1.8 million, compared with CD2.3 million for the same quarter a year earlier, because of nonrecurring items related to municipal taxes and downtime because of scheduled maintenance.

The natural gas segment recorded revenue of CD5.0 million, down CD0.2 million compared to the second quarter of 2006. Boralex continues to accept merger proposals and offers to buy the business. The trust has received offers it’s currently reviewing but says it can’t put a timeline or make a prediction on the outcome. Boralex Power Income Trust is a buy up to USD10.

Pembina Pipeline Income Fund (PIF.UN, PMBIF) generated net earnings of CD30.9 million for the second quarter, up 83 percent from a year ago. Year-to-date earnings are up 63 percent over 2006 levels.

The conventional pipelines contributed CD60 million in revenue and CD37 million in net operating income during the second quarter of 2007, up by 10 percent and 16 percent, respectively, from the same quarter of 2006. Pembina’s oil sands business segment contributed CD15 million in revenue and CD10 million in net operating income during the second quarter of 2007, a 12 percent and 4 percent increase, respectively, from the same quarter of 2006.

Construction activities on the Horizon Pipeline proceeded on schedule to meet Pembina’s targeted mid-2008 completion; it will add 250,000 barrels a day in capacity. The midstream business unit contributed CD18 million in revenue and CD15 million in net operating income during the second quarter of 2007, resulting in increases of 41 percent and 33 percent, respectively, over the same quarter of 2006.

Operating expenses totaled CD30.7 million during the second quarter of 2007 and CD61.9 million for the first half of the year, up from operating expenses incurred during the same periods of 2006 of CD27.7 million and CD57.3 million, respectively. Operating costs on the conventional pipeline systems totaled CD47 million during the first half of 2007, up from CD45.3 million incurred during the first half of 2006.

On a per-barrel-of-throughput basis, operating expenses on the conventional systems averaged 53 cents Canadian for the quarter, compared with 52 cents Canadian during the same quarter of 2006. General and administrative expenses of CD14.6 million were recorded during the first half of 2007, CD0.6 million higher than the previous year on salary pressures.

Long-term debt to total enterprise value stood at 25 percent, up from 24 percent as of Dec. 31, 2006. Pembina also announced a 9 percent increase in its distribution to 12 cents Canadian per unit effective for the distribution to be paid in September 2007 to unitholders of record on Aug. 31, 2007.

The fund distributed 33 cents Canadian per unit during the second quarter of 2007 for total cash distributions of CD42.9 million. Buy Pembina Pipeline Income Fund up to USD16.

RioCan REIT (REI.UN, RIOCF) reported a net loss for the quarter ended June 30, 2007, of CD106.1 million (51 cents Canadian per unit) compared with net earnings of CD39.6 million (20 cents Canadian per unit) a year ago because of a noncash charge of CD150 million brought on by the passage of the Tax Fairness Plan.

The charge is based on temporary differences between the accounting and tax basis of the REITs assets and liabilities. It has no impact on cash flow or distributions.

Rental revenue was up 12 percent to CD158.3 million from CD141.6 million. Funds from operations (FFO) was CD79.8 million (38 cents Canadian per unit), up from CD68.2 million (35 cents Canadian per unit) a year ago. Occupancy increased to 97.7 percent.

RioCan continues to run a stable portfolio of assets: 64.6 percent of rental revenue came from high-growth markets; 82.6 percent of annualized revenue comes from and 83.1 percent of space is rented to national, anchor tenants; 49.7 percent of second quarter revenue derived from its 25 largest tenants; and no individual tenant accounted for more than 5.7 percent of annualized rental revenue. RioCan REIT is a buy up to USD25.
 
TimberWest Forest Corp (TWF.UN, TWTUF) reported a net loss of CD7.3 million (9 cents Canadian per unit) after earning CD12.2 million (16 cents Canadian per unit) during the second quarter of 2006. Sales revenue declined from CD145 million to CD104 million on slackening volume and lower average sales realizations.

The US log and lumber market continued to be weak, the Japanese market was oversupplied, contractor costs in the timberlands business rose, and the company also realized lower real estate sales during the period. TimberWest generated distributable cash of CD13.6 million (17 cents Canadian per unit), down from CD35.5 million (46 cents Canadian per unit) a year ago.

Log sales realizations averaged CD90 per cubic meter, CD10 per cubic meter lower than the same quarter last year. Domestic sales represented 58 percent of total volume, up from 49 percent a year ago; pricing is lower in Canada compared to the export market.

Log sales volumes for the quarter were off slightly from 2006 at 892,300 cubic meters. TimberWest’s debt-to-total capitalization ratio as of June 30, 2007, was 19-to-81, compared with 17-to-83 at the end of 2006. TimberWest Forest Corp remains a buy up to USD16.

Aggressive Portfolio

ARC Energy Trust (AET.UN, AETUF) reported net income in the second quarter of 2007 was CD184.9 million (90 cents Canadian per unit), basically flat compared with the CD182.5 million (91 cents Canadian per unit) net income in the second quarter of 2006. Higher operating costs, interest costs and depletion expense were almost entirely offset by an increased gain on foreign exchange.

ARC recorded an increased gain on risk management contracts that was offset by a lower future income tax recovery and the recording of a gain on sale of investment. Cash flow for the period was CD167.6 million, down 14 percent from CD194.7 a year ago on a CD11 million decrease in realized cash hedging gains, a CD8.5 million increase in cash operating costs and a CD5.7 million increase in cash general and administrative costs.

Revenue was flat at CD305.6 million, compared with CD306.7 million for the second quarter of 2006. Production volume averaged 61,637 barrels of oil equivalent per day (boe/d), relatively unchanged from 61,803 boe/d during the second quarter of 2006.

The trust experienced significant production loss during the second quarter as a result of planned turnarounds and workovers. ARC has maintained its full-year production guidance of 63,000 boe/d. Capital expenditures for the quarter were CD48.5 million, 86 percent of which was funded from cash flow. Year-to-date capital expenditures are CD126 million, most which have been funded from cash flow.

Prior to hedging activities, ARC’s total realized commodity price was USD54.48 per barrel of oil equivalent (boe) in the second quarter of 2007, relatively unchanged from the USD54.54 per boe received prior to hedging in the second quarter of 2006. ARC’s balanced production mix helped keep realized prices stable.

As of June 30, 2007, ARC had CD644.8 million of debt outstanding, of which CD238.3 million was fixed at a weighted average rate of 5.06 percent and CD406.5 million was floating at current market rates plus a credit spread of 60 basis points. Sixty-three percent of the trust’s debt is denominated in US dollars. Buy ARC Energy Trust up to USD23.

Enerplus Resources (ERF.UN, NYSE: ERF) reported a decline in net income to CD40.1 million (31 cents Canadian per unit) from CD146 million (CD1.19 per unit) in the second quarter of 2006. Revenue was CD333.9 million, up from CD318.5 million a year ago.

Crude oil and natural gas revenues were CD382.5 million, compared with CD403.5 million for the same period in 2006. Production volumes averaged 82,478 boe/d, a decrease of 4 percent from 86,028 boe/d during the first quarter of 2007. Average production was weighted 54 percent natural gas and 46 percent crude oil and natural gas liquids on a boe basis.

Distributions to unitholders were 42 cents Canadian per unit per month for a total of CD1.26 per unit during the second quarter. That works out to a 68 percent payout ratio after working capital.

Enerplus spent CD80.4 million on development activity in the period, with CD33 million of that devoted to its Sleeping Giant property in Montana. Enerplus is reallocating an additional CD10 million from its 2007 capital budget to this US property; US capital spending will account for more than a quarter of the full-year total.

Operating costs averaged CD9.69 per boe in the period; the full-year average is projected to be CD9 per boe, up from previous guidance of CD8.45 per boe. Enerplus’ debt-to-cash flow ratio was 0.7 times as of June 30, 2007.

On July 18, Enerplus was added to the S&P/TSX 60 Index, a market-weighted index of 60 of the largest Canadian public companies. Inclusion should provide increased liquidity, visibility and institutional ownership. Buy Enerplus Resources up to USD50.

Penn West Energy Trust (PWT.UN, NYSE: PWE) reported cash flow of CD326 million (CD1.37 per unit) in the second quarter compared to CD265 million (CD1.59 per unit) a year ago. The trust recorded a net loss of CD185 million (77 cents Canadian per unit) compared to net income of CD221 million (CD1.34 per unit, basic) in the second quarter of 2006 because of a CD326 million future income tax charge taken to reflect the enactment of the Tax Fairness Plan.

Absent the charge, net income would have been CD140 million (59 cents Canadian per unit). Production averaged 126,599 boe/d in the second quarter of 2007, compared with 93,242 boe/d in the same period of 2006. Crude oil and natural gas liquids production averaged 70,923 barrels per day and natural gas production averaged 334 million cubic feet per day in the second quarter of 2007.

Penn West invested CD484 million on capital development, including CD351 million of net property acquisitions, and drilled 13 net wells in the second quarter with a success rate of 92 percent. Penn West’s board has committed to keeping the trust’s distribution at 34 cents Canadian per unit per month for the next three months. Penn West Energy Trust is a buy up to USD38.