Dividend Watch List

Three Canadian income trusts cut their distributions this month. Not surprisingly, two were in the energy patch.

Daylight Resources Trust (DAY.UN, DAYFF) followed Paramount Energy Trust’s (PMT.UN, PMGYF) lead from last month, slashing its distribution sharply in the face of weak natural gas prices. The new monthly rate of 10 cents Canadian is a third less than the prior rate, and management was upbeat in the release that it can be maintained.

The trust expects to be able to produce between 20,500 and 21,000 barrels of oil equivalent a day for 2007. That’s despite a reduced capital budget and second quarter output that trailed first quarter tallies by 5 percent. There’s a major potential problem, however: The oil and gas producer trust will have to be able to continue extending some CD380 million in combined credit facilities on reasonably favorable terms, despite its own growing weakness.

Last month, management was able to extend its current facilities to Nov. 30, 2007. That in its own words should give it time to “assess our many options for increasing our financial flexibility.”

The best option for Daylight is still to combine with another gas-focused trust to bulk up reserves and increase financial power. The trust’s 76.2 percent increase in outstanding shares during the past 12 months was in large part because of the Sequoia merger. But issues of that magnitude are clearly not sustainable, as they would theoretically open the trust up to corporate taxation. And as long as the price of natural gas (61 percent of output) is depressed, the only way to finance operations is to boost debt past the already high level of 2.54 times annual cash flow.

Daylight is attractively priced for a deal at just 95 percent of book value. And assuming the credit facilities are extended in November, the lowered distribution rate should hold. Nonetheless, as long as natural gas prices remain weak, a death spiral of bleeding cash and falling production remains a distinct risk. I’m a believer in gas’ ultimate recovery. But until a recovery is evident, Daylight Resources Trust is a hold only for rank speculators.

Peak Energy Services Trust (PES.UN, PKGFF) also cut its distribution by one-third last month, to a monthly rate of 4 cents Canadian a share. The energy services trust has been hit hard by the same meltdown in natural gas production that’s impacted larger and more financially secure rivals like Precision Drilling (PD.UN, NYSE: PDS). As a result, a reduction had been in the cards for some time.

As was the case industry wide, Peak’s second quarter results were horrific. Sales fell 24 percent on a 47 percent drop in rig use. The trust swung to negative operating cash flow, and pushed its payout ratio up to 110 percent of its six-month cash flow as well.

The key, of course, is whether last month’s distribution cut will be enough to forestall even more drastic action, or even a death spiral for the trust, as it’s unable to raise capital to survive. The good news here is management appears to be making some pretty negative assumptions about its industry in setting the new dividend rate. Debt is low and maintenance costs–what’s needed to keep the operation running with no expansion–is less than 10 percent of overall capital expenditures.

That’s a good sign the trust would be able to survive at least several more quarters of gas patch weakness. Unfortunately, no one should expect a fast turnaround, either for the gas patch or for Peak. Peak Energy Services Trust is a hold for speculators only.

The third trust distribution cut this month is at Connors Brothers Income Fund (CBF.UN, CBICF). The trust has elected to suspend its distribution, effective immediately. The reason: Projected costs net of insurance of USD35 million to recall all of the canned products manufactured on one of its production lines at its Augusta, Ga., facility, owned by subsidiary Castleberry.

Castleberry is currently working with the U.S. Food and Drug Administration, the U.S. Department of Agriculture and the Centers for Disease Control and Prevention to investigate possible contamination of these products with Clostridium botulinum. This bacterium can cause life-threatening botulism.

As of yet, there have been two incidents of botulism involving four individuals that may be linked to Castleberry products. All appear to be recovering, and the recalled products are only 4 percent of Connors’ total revenue. Nonetheless, as the still-unfolding Menu Foods (MEW.UN, MNUFF) saga demonstrates, the unknowns when it comes to food poisoning are all on the downside. In short, this is not the kind of situation conservative investors want to be involved with. Despite the recent dip in the shares, Connors Brothers Income Fund remains a sell.

Note Countryside Power Income (COU.UN, COUUF) has now been taken over by Fort Chicago Energy Partners and is therefore no longer on the list. Shareholders by now should have received the takeover price of CD9.60 per share in cash. Sound Energy (SND.UN, SNDFF) is also off the list, now that its merger with Advantage Energy (AVN.UN, NYSE: AAV) is on track to be completed this month. Sound investors should elect to take the maximum value in Advantage shares possible.

Sun Gro Horticulture (GRO.UN, SGHRF) and Tree Island Wire (TIL.UN, TWIRF) are off the list due to solid second quarter earnings. So are Canetic Energy (CNE.UN, NYSE: CNE) and Harvest Energy (HTE.UN, NYSE: HTE), both of which reported modest second quarter payout ratios despite weak natural gas prices.

Here’s the rest of the Watch List:

• Clearwater Seafoods (CLR.UN, CWFOF)
• Connors Brothers Income Fund (CBF.UN, CBICF)
• Daylight Energy (DAY.UN, DAYFF)
• Enterra Energy Trust (ENT.UN, NYSE: ENT)
• Essential Energy Services (ESN.UN, EEYUF)
• Fording Coal (FDG.UN, NYSE: FDG)
• Freehold Royalty (FRU.UN, FRHLF)
• Newalta Income Fund (NAL.UN, NALUF)
• Newport Partners Income Fund (NPF.UN, NWPIF)
• Noranda Income Fund (NIF.UN, NNDIF)
• Priszm Income Fund (QSR.UN, PSZMF)
• Paramount Energy (PMT.UN, PMGYF)
• Peak Energy Services (PES.UN, PKGFF)
• Precision Drilling (PD.UN, NYSE: PDS)
• Primary Energy (PRI.UN, PYGYF)
• Trilogy Energy (TET.UN, TETFF)
• Vault Energy (VNG.UN, VNGFF)
• Wellco Energy Services (WLL.UN, WLLUF)
• Westshore Terminals (WTE.UN, WTSHF)

Bay Street Beat

Cineplex Galaxy Income Fund (CGX.UN, CPXGF) is a star.

The watchers on Bay Street conferred another perfect 5.0 average rating on the trust, which has interests in 1,305 movie screens in 130 theaters across Canada.

High-profile sequels Spiderman 3, Shrek the Third and Pirates of the Caribbean: At World’s End made it a good summer blockbuster season as the fund reported a 185 percent jump in second quarter profits. Revenue for Cineplex Entertainment LP, of which the fund owns 76 percent, was up 8.9 percent to CD199.9 million. Box-office sales were up 5.3 percent, concession revenue increased by 11 percent and revenue from on-screen advertising swelled 27.3 percent.

Industry box office revenue is up 19 percent over year-ago levels in the third quarter to date. That figure will come down as movie-going slows into September after the summer rush. A strong fourth quarter film lineup and corresponding strong box office season may not translate into a distribution hike, but Galaxy could pay a special distribution in the range of CD0.20 to CD0.25 per unit. That would bring the fund’s payout ratio into its target range of 80 to 85 percent. 

Aggressive Portfolio recommendation Trinidad Energy Services Trust (TDG.UN, TDGNF) soared above pre-Halloween 2006 levels in the spring before giving it all back. Natural gas prices remained weak, drilling activity continued at depressed levels and the broader market succumbed to subprime-inspired fear in August. But the oil and natural gas services provider is still fundamentally strong, as its 5.0 average Bay Street rating confirms.

Trinidad’s rig utilization rates have exceeded industry norms throughout the drilling downturn, and the trust is set to run once the natural gas market turns around. 

July 2007 Conservative Portfolio addition Energy Savings Income Fund (SIF.UN, ESIUF) continues to earn the praise of Canada’s pros and drew a 4.778 average rating.

The Canadian real estate investment trust (REIT) market–as the Feature Article details–is full of solid investment opportunities. A solid domestic economy continues to fuel a boom for all types of property–residential, retail, office–north of the border. Calloway REIT (CWT.UN, CWYUF) and H&R REIT (HR.UN, HRREF) both scored nicely in Bloomberg’s regular survey.

Conservative Portfolio holding Yellow Pages Income Fund (YLO.UN, YLWPF) and Aggressive Portfolio recommendation ARC Energy Trust (AET.UN, AETUF) were also among the highest-rated stocks in the S&P/TSX Composite Index.

And the other side of the story: Conservative Portfolio denizen Bell Aliant Regional Communications Income Fund (BA.UN, BLIAF) finds itself among the lowly in the eyes of Bay Street.

A 2.833 average rating probably more a reflection of Bell Aliant’s rapid recovery and continuation of its long-term ascent than any fundamental issue; the unit price is near CD32, and Bay Streeters may be having trouble seeing more upside. 

But second quarter results illustrate a steady shift in focus from traditional telephony to broadband services: Bell Aliant’s high-speed Internet users were up 21 percent year-over-year to 642,434 while landline users declined by 94,000 to 3,264,763. Local and long-distance revenue declined 1 percent and 3.9 percent. Overall operating revenue was up 1.3 percent and earnings rose 1.4 percent.

Non-Trust Stars

In the April 2007 Canadian Currents article, “A Piece of the Action,” we recommended five dividend paying, non-income trust Canadian companies.

Those of you who invested in the companies we profiled in the spring have benefited, however, from a sharply appreciating Canadian dollar. The Loonie has surged toward parity with the US dollar, and your positions in Canada-based dividend payers have served the dual purpose of equity investments and de facto long positions in the Canadian dollar.

The Bank of Nova Scotia (NYSE: BNS) tumbled along with the rest of the market last month, reaching a nadir of USD44.08 on Aug. 15. But the shares recovered quickly. 

Scotiabank has announced plans to acquire 79 percent of Chile-based Banco del Desarrollo for USD810 million, pushing its market share in the South American country to 6.4 percent in loans and 5.2 percent in deposits.

Still boosting its international presence and yielding 3.5 percent, The Bank of Nova Scotia is a buy up to USD52.

Manitoba Telecom Services (TSX: MBT, OTC: MOBAF) increased its 2007 earnings forecast after reporting strong growth in its wireless, high-speed Internet and digital-TV revenue. These services contributed about 39 percent of total revenue during the quarter, up from 35 percent a year ago.

MTS also raised its 2007 earnings outlook, boosting the target range to CD2.55 to CD2.75 per unit from CD2.30 to CD2.50. Its takeover candidacy has weakened alongside the credit markets, but two Bay Street analysts boosted long-term price targets in August.

The company has partnered with Quebecor in an effort to crack a Canadian cellphone provider market now dominated by Rogers Communications, Telus Corp and BCE. The pleasant trip up to Parliament Hill in Ottawa will be an incongruent prelude for the steep climb the upstarts face to persuade federal legislators that an early 2008 auction of wireless spectrum should result in a fourth wireless carrier.

MTS has its own wireless network in Manitoba but would like to expand; Quebecor resells Rogers’ service in Quebec.

Quebecor and MTS will lobby for rules that allocate spectrum for new entrants and limit how much of the total incumbents can own. The Big Three will push back, favoring a structure that allows them to buy as much remaining spectrum as possible. They don’t want the competition.

Negative vibes on the auction’s outcome could hold it back a bit, but MTS’ consistent results during its transition from landline provider to broadband upseller recommend it well, as does its greater than 5 percent dividend yield.

Manitoba Telecom Services is a buy up to USD50 or CD53.

Russel Metals (TSX: RUS, OTC: RUSMF) reported Aug. 24 that CD11 million of its CD207 million in cash is frozen in asset-backed commercial paper issued by Coventree, the main issuer of non-bank sponsored ABCP in Canada. It also has CD196 million invested in asset-backed paper sponsored by Royal Bank of Canada and in bank term deposits.

Asset-backed commercial paper is short-term debt in the form of mortgages, auto loans and credit card balances. It’s packaged and sold by banks or financial companies to corporate investors seeking to park surplus cash for short periods.

But in a sign those positions haven’t limited its flexibility, Russel announced Tuesday it’s buying US-based JMS Metals Services for CD125 million. JMS makes steel and aluminum products at plants located in Alabama, Arkansas, Georgia, Kentucky and Tennessee. JMS revenues are expected to approach CD200 million for 2007.

Yielding 6.0 percent, Russel Metals is a buy up to USD31 or CD33.   

Norbord (TSX: NBD, OTC: NBDFF) has retraced a decent price gain and slipped into the red; this may have been an over-eager stab at an eventual US housing market recovery. The good news is it’s tough to imagine it getting any worse from here, so we have a decent idea of Norbord’s bottom.

Another nice thing is the dividend. Keep taking your quarterly cut and look for Norbord to resume its slow, steady climb. The housing market in Canada is still strong, not quite burly enough to totally offset US weakness but sufficient to sustain the payout.

Still a decent way to play an eventual real estate recovery, Norbord is a buy up to USD8.50 or CD9.

Canadian Hydro Developers (TSX: KHD) won two 20-year standard offer contracts from the Ontario Power Authority for the supply of 18 megawatts of electricity from two wind projects in Ontario. Canadian Hydro will receive CD110 per megawatt hour (MWh) for power generated. And the company expects to be eligible for the Canadian federal government’s ecoEnergy Renewable Initiative of CD10 per MWh for 10 years.

The electricity will come from two phases of the Royal Road Wind Project, acquired by Canadian Hydro through the acquisition of Vector Wind Energy in December 2006. Royal Road will generate an aggregate estimated 47,300 MWh of power per year.

And an analyst for CIBC World Markets has included Canadian Hydro in his forecast of companies to be added to the S&P/TSX Composite Index when Standard & Poor’s makes its quarterly adjustments after the markets close Sept. 21. Look for an announcement around Sept. 19.

Buy Canadian Hydro Developers up to CD6.75 or USD5.95.