Dividend Watch List

Only one Canadian income trust cut its payout last month: Big Rock Brewery (TSX: BR.UN, OTC: BRBMF). The specialty brewer suffered a 32 percent drop in fourth quarter distributable cash flow, and sluggish performance has continued into 2008. The new monthly rate of 9 cents a share should bring the full-year payout ratio back under 100 percent, as well as provide some funds to invest in growth.

Since last November, Big Rock units have plunged from the high teens to a current level of around USD11. But the current distribution should be sustainable, and the trust still yields nearly 10 percent.

Unlike hard liquor, it’s questionable how recession resistant beer sales are, evidenced by the slump at major US brewers. But downside for Big Rock at this point is limited, and Canada is still running strong. (See Feature Article.) Hold Big Rock Brewery.

Keystone North America (TSX: KNA.UN, OTC: KYSNF) is attempting to convert its income participating securities (IPS) into all common stock. Each IPS currently consists of a bond portion worth CAD4.29 per share and a stock portion worth roughly CAD2.29, based on Keystone’s recent price. The current distribution is 3.15 cents Canadian common stock dividend and 5.18 cents Canadian debt interest.

Keystone, an owner of funeral homes and cemeteries across the US and in Ontario, won’t pay cash for the bond portion. Instead, it’s offering to exchange it for a right to buy five additional common shares. The cost of exercising the right—i.e., buying the shares—is essentially giving up the bond portion of the IPS.

For Keystone, the advantages of the conversion are obvious. First, it will rid itself of extremely expensive subordinated notes that pay out 14.5 percent annually. Management is also buying back CAD16 million in other very high cost debt, though with cash.

In a statement to IPS holders last month, Keystone’s board of directors cited the appreciation of the Canadian dollar over the past year as having an “adverse impact on the financial covenants” in its senior credit facility and note indenture. It also slammed “limited prospects for growth of the market for IPSes,” “investor confusion” and “time consuming requirements for maintaining the IPS structure.”

Finally, it asserted Keystone’s IPS structure left “a payout ratio that does not provide the company with sufficient cash flow to fund acquisitions, growth capital expenditures or other internal financing needs without increasing debt or selling equity.” That last point is borne out by Keystone’s recent financial results. The payout ratio is a lofty 94 percent, and the company increased IPSes outstanding by 47.1 percent over last year’s level.

Management has stated its intention to maintain an overall dividend of 84 cents Canadian after the conversion. That’s roughly a 16 percent reduction from the current annual level of about CAD1 per share. It’s also set an initial target payout ratio of 80 to 90 percent, with a goal to bring that down to 70 to 80 percent as earnings grow. Its success should be aided by the historical steadiness of the funeral home/cemetery business, as well as ample opportunities for consolidation.

For the conversion to succeed, 66.7 percent of IPS holders must opt for the rights by 5 pm May 15. If that benchmark isn’t met, the rights will be pulled. And IPS holders will retain their securities as they are now, at least until management comes up with another offer.

On the other hand, if the offer is successful, management has telegraphed it will delist the IPS units from the Toronto Stock Exchange. It can do that either by “deeming the market for IPS units to not have sufficient liquidity” or by not taking action to ensure they meet Toronto Stock Exchange listing requirements. If they’re delisted, the IPS units will continue to pay dividends, both from the bond and stock portions. But it may be very difficult to buy or sell them.

I have covered Keystone for several months in How They Rate. I haven’t to date recommended buying the IPSes, however, mainly because I wanted to see the high payout ratio come down to a more sustainable level. That will certainly be the case if the conversion is successful. Also, at current prices, the reduced dividend will still be quite high at nearly 13 percent.

Until its future structure is set, I don’t see any reason to jump into Keystone. If it gets enough IPS owners to make the swap, management plans to complete this deal by the end of the month. If it fails, we’ll know that as well when it’s time for the June issue of Canadian Edge. Stand aside Keystone North America for now.

If you already own Keystone, management has made plain that its eyes are on growth—and the fastest way to raise cash is to chop down the dividend one way or the other. If it fails with the conversion, it may try another offer, or it may simply cut the equity portion of the IPS distribution.

The good news is the recent plunge in the shares should limit downside going forward no matter what happens. Note, however, if Keystone’s offer succeeds and you don’t take it, no one can guarantee there will be a liquid market for your IPSes.

The risk of a distribution cut at TimberWest Forest Corp (TSX; TWF.UN, OTC: TWTUF) continues to grow. Also organized as a staple share—combining debt with an equity portion into a single security—the company posted horrific first quarter 2008 earnings. Distributable cash plunged from CAD26.9 million last year to a deficit of CAD3.9 million.

Timber harvests cratered 71 percent, as management deferred production in the face of rising costs and abysmal market prices. Costs per log shot up 18 percent over year-earlier levels. Meanwhile, the company braced itself for a big loss from permanently closing its Elk Falls sawmill, though it may still be sold to a third party. Real estate sales—the saviors of prior quarters—were strong once again but not nearly enough to offset the meltdown of operating results.

Most ominous, management states: “TimberWest may not be able to remain in compliance with its debt to [earnings before interest, taxes, depreciation and amortization (EBITDA)] covenant later in 2008.” That would give it no choice but to reduce or even eliminate the distribution, which at this point is 100 percent debt interest.

I’ve rated TimberWest—formerly a Portfolio member—a sell this year, primarily because of its exposure to weak timber market conditions, which in turn are depressed because of the depression in US home building. Based on this report, it’s looking more like improvement in those conditions may not come fast enough to save TimberWest’s dividend. Despite this year’s tumble, TimberWest Forest Corp is still a sell.

In contrast, Fording Canadian Coal (NYSE: FDG, TSX: FDG.UN) and Westshore Terminals (TSX: WTE.UN, OTC: WTSHF) are now off the Watch List. As Fording’s first quarter results attest, the Elk Valley Coal Partnership is still having trouble getting its metallurgical coal output to market cost-effectively. But the surging price of met coal globally will hide many ills, at least this year.

Both Fording and Westshore—which earns its keep managing terminals from which Elk Valley Coal is shipped overseas—should enjoy sizeable distribution increases this year on higher met coal prices alone. Fording’s distribution moves in almost perfect harmony with the mineral’s price. Westshore, meanwhile, lives off fee-based income, about 45 percent of which is tied to coal prices.

I remain convinced that Westshore is the better play, as there’s less operating risk as well as limited exposure to changing coal prices. Buy Westshore Terminals up to USD18. After its move this year, Fording Canadian Coal is a sell for all but very alert momentum players.

I’m also taking Advantage Energy Trust (NYSE: AAV, TSX: AVN.UN), Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF), Paramount Energy Trust (TSX: PMT.UN, OTC: PMGYF) and True Energy Trust (TSX: TUI.UN, OTC: TUIJF) off the list, at least for now. All four are benefiting richly from rising natural gas prices and have been well stress tested over the past year. All are buys except little True Energy Trust, which now rates a hold.

Finally, Primary Energy Recycling (TSX: PRI.UN, OTC: PYGYF) comes off the list this month, after posting a sharp improvement in first quarter earnings. The company also amicably settled a long-running dispute over the Harbor Coal facility that sharply reduces its risk at the facility. Hold Primary Energy Recycling.

Here’s the rest of the Dividend Watch List. Note that first quarter payout ratios are reviewed in How They Rate as trusts report them.

Acadian Timber (TSX: ADN.UN, OTC: ATBUF)
Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF)
Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF)
Canfor Pulp (TSX: CFX.UN)
Connors Brothers Income Fund (TSX: CBF.UN, OTC: CBICF)
Essential Energy Services (TSX: ESN.UN, OTC: EEYUF)
Harvest Energy Trust (NYSE: HTE, TSX: HTE.UN)
Mullen Group Income Fund (TSX: MTL.UN, OTC: MNTZF)
Newalta Income Fund (TSX: NAL.UN, OTC: NALUF)
Newport Partners Income Fund (TSX: NPF.UN, OTC: NWPIF)
Noranda Income Fund (TSX: NIF.UN, OTC: NNDIF)
Precision Drilling (NYSE: PDS, TSX: PD.UN)
Priszm Income Fund (TSX: QSR.UN, OTC: PSZMF)
Sun Gro Horticulture (TSX: GRO.UN, OTC: SGHRF)
Swiss Water Decaf Coffee Fund (TSX: SWS.UN, OTC: SWSSF)
TimberWest Forest Corp (TSX: TWF.UN, OTC: TWTUF)
Tree Island Wire Income Fund (TSX: TIL.UN, OTC: TWIRF)

Bay Street Beat

Income trusts dominated the upper echelon of Bloomberg’s most recent compilation of average Bay Street analysts’ rankings. That’s more evidence of strength in the space; the most obvious other piece is the fact that the S&P/Toronto Stock Exchange Composite Income Trust Index hit a 52-week high May 6.

Bonavista Energy Trust (TSX: BNP.UN, OTC: BNPUF), also among those with the biggest week-to-week increases, climbed the final 0.250 points to a perfect 5.000 score.

Bonavista’s reserve life, production mix, efficiency and flexibility put it on the top shelf of Canadian oil and gas trusts. Solid properties and a strong balance sheet equip it well to use the CAD200 million it raised via a late-April unit issue to fund new acquisitions.

Joining Bonavista with 5.000s were Aggressive Portfolio recommendation Vermilion Energy Trust (TSX: VET.UN, OTC: VETMF), Baytex Energy Trust (NYSE: BTE, TSX: BTE.UN) and Cineplex Galaxy Income Fund (TSX: CPG.UN, OTC: CPXGF).

Crescent Point Energy Trust (TSX: CPG.UN, OTC: CPGCF), Daylight Resources Trust (TSX: DAY.UN, OTC: DAYYF), NAL Oil & Gas Trust (TSX: NAE.UN, OTC: NOIGF), Jazz Air Income Fund (TSX: JAZ.UN, OTC: JAARF), H&R REIT (TSX: HR.UN, OTC: HRREF) and RioCan REIT (TSX: REI.UN, OTC: RIOCF) also scored well on Bay Street.

Among those shunned by Canada’s equivalent of Wall Street were Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF), Harvest Energy Trust (NYSE: HTE, TSX: HTE.UN), Pengrowth Energy Trust (NYSE: PGH, TSX: PGF.UN), Advantage Energy Income Fund (NYSE: AAV, TSX: AVN.UN), Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF), Freehold Royalty Trust (TSX: FRU.UN, OTC: FRHLF) and Peyto Energy Trust (TSX: PEY.UN, OTC: PEYUF).

A Simple Hedge

Minimize risk, retain upside potential: That’s the prime objective for self-directed investors. One way to diversify and hedge is through currencies. Different currencies benefit from some of the same things that may hurt stock indexes, bonds or commodities and can be a great way to diversify a portfolio.

Trading or investing in currencies can be overwhelming, but currency exchange traded funds (ETF) make it easier to understand the foreign exchange (forex) market–the largest, most liquid market on the planet–and use it to manage risk.

ETF management firms buy and hold currencies in a fund. They then sell shares of that fund to the public. You can buy and sell ETF shares just like you buy and sell stock shares.

The shares of a currency ETF are valued at 100 times the current exchange rate for the currency being held. For example, CurrencyShares Canadian Dollar Trust (NYSE: FXC) is currently priced at USD98.34 per share because the underlying exchange rate for the loonie versus the US dollar (CAD/USD) is 0.9834.

Rydex Investments, the ETF’s sponsor, charges an expense ratio of 0.4 percent of assets not including broker commissions. Because ETFs trade like stocks, you’ll have to pay your broker to execute your orders.

If you’re invested in Canadian income and royalty trusts, you’re long the loonie, and Canada’s currency is also highly correlated to movements in the per barrel price of crude.

A currency basically represents an individual economy. Because Canada is a commodity producer and exporter, commodity prices drive the value of the loonie. There’s a strong correlation between it and oil and other raw materials.

One way for Canadian income and royalty trust investors to hedge downside risk is to short the ETF to take advantage of falling oil prices.

Because the Canadian dollar is on the base side of the Canadian dollar/US dollar currency pair, it will pull the ETF up when oil prices are rising and it will fall when oil prices are declining. There are other factors at play in the loonie’s value, but energy prices are a major influence.