Dividend Watch List

Vault Energy (VNG.UN, VNGFF) escapes the Canadian Edge Dividend Watch List this month, thanks to a takeover offer from core energy holding Penn West Energy Trust (PWT.UN, NYSE: PWE). The deal calls for each unit of Vault to be exchanged for 0.14 shares of Penn West.

That’s very little premium to Vault’s pre-deal price and a sharp discount to book value. Nonetheless, it’s the best unitholders are going to get because the alternative for the trust is either to slash production or pour on more debt. Either choice would have diluted the value of its assets. Because this deal involves getting shares in a powerful trust, my advice is to hold Vault Energy shares until the deal closes, which is expected to happen in December.
 
Other small, natural gas-focused trusts, however, continued their death spiral. Enterra Energy Trust’s (ENT.UN, NYSE: ENT) total suspension of its distribution was the most dramatic event last month. The shares rebounded slightly in the wake of the PrimeWest Energy Trust’s (PWI.UN, NYSE: PWI) all-cash buyout by a unit of Abu Dhabi’s National Energy Co.

But even with the cash saved from not paying a dividend, the trust is severely challenged to reduce debt to a level acceptable to creditors and is unloading productive assets for cash. Sell Enterra Energy Trust if you haven’t already.

Note that the remaining small, natural gas-focused trusts also remain on the Watch List. And they’ll almost surely stay there until either natural gas prices recover or they receive a takeover offer.

These include Daylight Resources Trust (DAY.UN, DAYFF), despite a successful offering of convertible debt that settled a potential worry concerning a bridge loan. The good news is the units are already discounting another distribution cut, which limits downside risk. But there are better bets in the trust universe. Sell Daylight Resources Trust.

Ditto Trilogy Energy (TET.UN, TETFF) and True Energy (TUI.UN, TUIJF), both of which are weak and neither of which is likely to command much of a premium in a takeover.

One other energy producer trimmed its dividend last month, Pengrowth Energy Trust (PGF.A, NYSE: PGH). The 10 percent reduction, however, was modest and largely anticipated by the very high current yield. The new rate should be sustainable, barring a steep drop in natural gas and oil from here.

The shares are hardly expensive at 1.54 times book value. But neither are they particularly attractive, given Pengrowth’s heavy debt load, still-lofty payout ratio, high cost structure and popularity in the media. Also, the trust is organized as a limited partnership in the US, which makes for unique tax complications not shared by other trusts. Hold Pengrowth Energy Trust , but put your new money in higher-quality fare such as the trusts recommended in the Feature Article.

Note that’s also my advice for Harvest Energy Trust (HTE.UN, NYSE: HTE), which is partially shutting its refinery operation for repairs in the face of reduced margins. I’m putting it back on the list, pending the effects of lower refinery cash flows in the second half of 2007.

Energy service trusts continue to take a beating as gas producers pull in their horns. Last month, Wellco Energy Services Trust (WLL.UN, WLLUF) became the latest casualty as it hacked its dividend in half. The new rate should hold, thanks in large part to a thriving oil sands operation. But I’m going to keep Wellco on the Watch List until conditions improve. Wellco Energy Services Trust is now a hold.

The same goes for little Essential Energy Services Trust (ESN.UN, EEYUF), though it’s been able to hold its distribution thus far in the downturn. On a hopeful note, management has indicated a “dramatic improvement in utilization rates in the third quarter of 2007 as compared to the second quarter.” But with the previous payout ratio at 696 percent, there’s a lot of ground to make up and a distribution cut seems almost impossible to avoid.

On the other hand, one is definitely priced in. Hold Essential Energy Services Trust.

I’m also keeping Peak Energy Services (PES.UN, PKGFF) and Precision Drilling (PD.UN, NYSE: PDS) on the Watch List this month, as well as environmental cleanup trust Newalta Income Fund (NAL.UN, NALUF). All three continue to suffer from dramatically diminished natural gas drilling activity in Canada. The difference is they have far lower debt levels, which ensures survival.

Also, Newalta is rapidly diversifying into nonenergy sector operations. As a result, I’m still recommending all three as buys for more aggressive investors as a bet on a recovery in the gas patch. Buy Newalta Income Fund (up to USD25), Peak Energy Services (USD4) and Precision Drilling (USD25).

Dividend cuts outside the energy sector have been thankfully rare this year. Last month, however, three of the more volatile trusts made a move. Fording Coal (FDG.UN, NYSE: FDG) cut its quarterly payout from 65 cents Canadian to 60 cents Canadian a share. Primary Energy Recycling (PRI.UN, PYGYF) suspended its monthly distribution entirely. And SFK Pulp (SFK.UN, SFKUF) cut its monthly payout by 60 percent to 2 cents Canadian a share.

In Fording’s case, the reduction is due entirely to coal prices. Encouraging, these now appear to have bottomed.

Moreover, the trust has signed its entire unionized labor force to long-term contracts, and operating partner Teck Cominco has boosted its ownership stake to 19.95 percent. As a result, the share price has continued to rise. I now rate Fording Coal a buy up to USD38.

Shares of Primary Energy have also scarcely missed a beat since management made its move. Investors appear to be banking on the trust’s ability to change the terms of its contract at the Harbor Coal facility enough to satisfy lenders to allow distributions to resume. Management is also pursuing waivers of certain credit conditions that would permit cash payments even before the contract is changed.

The optimists may prove justified. But for my money, this is classic hold-and-hope and not a place I want to be. Sell Primary Energy.

SFK’s move surprised me, mainly because of its strong second quarter results that reduced the payout ratio to less than 60 percent. Management blamed lower cash flows from its US operations (39 percent of overall revenue)—because of the rapidly appreciating Canadian dollar—as well as the costs to repair a generator at its largest pulp mill. Since the cut, management has announced an acceleration of the mill’s “semiannual shutdown,” because of equipment breakdown, adding CD1.7 million to the cost of sales in the fourth quarter.

A growing number of trusts now derive an increasing amount of revenue from US-based operations. A falling US dollar reduces the Canadian dollar value of this cash flow. It also makes Canadian-produced goods less competitive versus those of US rivals. I’m putting one of the more exposed, high-payout-ratio trusts back on the Watch List this month: Swiss Water Decaf Coffee Fund (SWS.UN, SWSSF).

I’ll be watching for more vulnerable trusts in coming weeks. As for SFK Pulp, it rates a hold until it works out its production problems, the likely real catalyst for the distribution cut.

Here’s the rest of the Watch List. Note Chartwell Seniors Housing (CSH.UN, CWSRF) is back on the list, following the apparent collapse of confidential takeover talks. Sell Chartwell Seniors Housing.

Also Connors Brothers Income Fund (CBF.UN, CBICF) has amended its credit agreement to cover the cost of the recent product recall and has also reopened the Georgia facility responsible. That raises the possibility of a restoration of the distribution by March of next year. Connors Brothers Income Fund is now a hold.

Chartwell Seniors Housing (CSH.UN, CWSRF)
Clearwater Seafoods (CLR.UN, CWFOF)
Connors Brothers Income Fund (CBF.UN, CBICF)
Daylight Resources Trust (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)
Paramount Energy Trust (PMT.UN, PMGYF)
Peak Energy Services (PES.UN, PKGFF)
Precision Drilling (PD.UN, NYSE: PDS)
Primary Energy (PRI.UN, PYGYF)
Priszm Income Fund (QSR.UN, PSZMF)
Swiss Water Decaf Coffee Fund (SWS.UN, SWSSF)
Trilogy Energy (TET.UN, TETFF)
True Energy Trust (TUI.UN, TUIJF)
Wellco Energy Services Trust (WLL.UN, WLLUF)
Westshore Terminals (WTE.UN, WTSHF)

Bay Street Beat

Energy patch trusts made a run at the top slots in the latest iteration of Bloomberg’s regular analysis of Bay Street analysts’ ratings for listings in the S&P/Toronto Stock Exchange Composite Index.

Bloomberg assigns a number to each analyst rating, ranging from 1 (lowest) to 5 (highest). The rating numbers for each listing are added together then divided by how many recommendations were made during the past 12 months. A listing must draw the attention of at least four analysts to be included in the analysis.

Crescent Point Energy Trust (CPG.UN, CPGCF), which earned a perfect 5.0 average, is one of a handful of energy companies to enter the ring with Alberta Premier Ed Stelmach’s Royalty Review Panel. Crescent, along with EnCana Corp, Petro-Canada and Talisman Energy, has made headlines with threats to pull significant cash out of Alberta in the wake of the Panel’s recommendation that the provincial government boost its take from oil and gas resources. (See Canadian Currents.)

ARC Energy Trust (AET.UN, AETUF) is a long-time CE favorite and a charter Portfolio member. It earned a 4.467 average rating and now seems to be back in the fancy of Bay Street’s pros. It’s been recommended here long enough to generate a hefty total return.

Trinidad Energy Services Income Fund (TDG.UN, TDGNF), added to the Aggressive Portfolio in December 2006, earned a perfect 5.0 average.

Relative Portfolio newcomer Energy Savings Income Fund (SIF.UN, ESIUF) scored well at 4.778, as did longtime CE favorite Yellow Pages Income Fund (YLO.UN, YLWPF) at 4.615.

Advantage Energy Income Fund’s (AVN.UN, NYSE: AAV) acquisition of Sound Energy didn’t turn many heads on Bay Street, but the company has managed to maintain an 83 percent payout ratio despite the downturn in the natural gas market. Production gains, debt reduction and solid hedging make Advantage a solid play on an eventual gas turnaround.

Algonquin Power Income Fund (APF.UN, AGQNF) reported a loss for the second quarter, but a one-time accounting charge required by the passage of the Tax Fairness Plan masked solid operating performance. Algonquin continues to make good acquisition decisions.

Non-Trust Stars

The Bank of Nova Scotia (NYSE: BNS) has continued its post-credit crunch climb and established a 52-week intraday high of USD53.52 Oct. 1.

Scotiabank agreed Sept. 18 to pay CD348 million (CD12.76 per share) in cash for a stake in mutual fund dealer DundeeWealth and CD260 in cash for Dundee Bank of Canada. The deal for the bank closed Sept. 28.

Six days after Scotiabank made its two-part offer, CI Financial Income Fund (CIX.UN, CIXUF) unveiled an unsolicited offer for all of DundeeWealth.

CI Financial subsequently removed a clause of its bid that required parent Dundee Corp to back out of the deal to sell a stake in DundeeWealth to Scotiabank. Dundee’s board rejected CI Financial’s original offer and, because it’s focusing on a Scotiabank deal, hasn’t responded to the revised terms.  

DundeeWealth’s Dynamic Mutual Funds unit is the eighth-largest non-bank mutual fund seller in Canada. Scotiabank currently owns the smallest mutual fund business of Canada’s five largest banks; expanding its money management business is a priority.

The bank hired three fund managers from Royal Bank of Canada and boosted sales through its branches, contributing to a 19 percent gain in asset-management revenue last quarter. Scotiabank’s Scotia Securities unit had CD17.9 billion in mutual fund assets at the end of August, compared with CD19.8 billion at Dundee’s Dynamic, according to the Investment Funds Institute of Canada.

Buying Dundee Bank of Canada allows Scotiabank to offer high-interest deposit accounts without eating away at its own deposit base. The bank may also be able to buy the rest of DundeeWealth.

The Bank of Nova Scotia is a buy up to USD56.

Manitoba Telecom Services (TSX: MBT, OTC: MOBAF) is still angling for the early 2008 wireless spectrum auction, but Reuters reported Sept. 25 that Canada’s largest telecom companies–BCE, Telus Corp and Rogers Communications–are meeting on the sly with Industry Minister Jim Prentice to discuss rules for the auction.

The rumored meeting would be an opportunity for the big players to argue against setting aside spectrum for new market entrants such as Manitoba Telecom and its ally Quebecor. The big three deride set-asides as subsidies; upstarts say BCE, Telus and Rogers have an unfair hold that stifles competition.

At stake is the market leaders’ dominance of Canada’s wireless landscape. The wireless business is seen as the engine of growth for the companies, some of which face declining revenue from older services such as land lines and long-distance calling.

Sources told Reuters that Prentice hasn’t yet decided the question of set-asides. We’ll keep you up to date.

Manitoba Telecom Services is a buy up to USD53.

Russel Metals (TSX: RUS, OTC: RUSMF) completed its acquisition of JMS Metals Services, a full-line distributor of steel and aluminum products with eight processing and distribution facilities in Alabama, Arkansas, Georgia, Kentucky and Tennessee.

Russel will report third quarter results Wednesday, Oct. 31. CEO Ed Siegel, Jr. and CFO Brian Hedges will host a conference call Thursday, Nov. 1, at 9 am ET to review the numbers. The dial-in telephone number for US-based investors is 866-540-8136. A replay of the call will be available at 800-408-3053 until midnight Thursday, Nov. 8. Use pass code 3237741 to access the call.

Russel Metals is a buy up to USD33.   

Brookfield Asset Management bought 3.25 million common shares of Norbord (TSX: NBD, OTC: NBDFF) through its subsidiary Brascade Corp. Brookfield now owns 40 percent of Norbord’s outstanding common shares. We were underwater with this play on an eventual rebound in the US housing market until Brookfield stepped up its stake.

Norbord is a buy up to USD9.

Canadian Hydro Developers (TSX: KHD) is one of the few publicly listed alternative energy generation pure plays. Its growth potential is attracting the attention of more and more investors, and it’s seen as a potential takeover target as well.

Canadian Hydro also has a lot of exposure to efforts by Canadian provincial governments to boost wind-generation capacity. Buy Canadian Hydro Developers up to CD6.75 or USD5.95. 

Ottawa Watch

Having boxed Canada’s opposition parties into a choice between supporting his coming throne speech and forcing an election that will almost surely end with another minority Conservative government, Prime Minister Stephen Harper seems to have turned his skills as a political operator to the world stage and the debate over climate change.

Harper jumped into the coal mine for his US counterpart last month, singing of a new consensus on “flexible” targets as the best means to address global warming.

He did so at a meeting called by United Nations Secretary General Ban Ki-moon for the purpose of building momentum toward an agreement to extend the Kyoto Protocol. The next major forum to discuss international climate action is in Bali in December, at the annual meeting of the UN Framework Convention on Climate Change (UNFCCC) and Kyoto Protocol members.

The Canadian prime minister said the global community needs to balance environmental protection with economic growth. Harper said there’s an “emerging consensus” on the need for a rethink on how to respond. He referred to recent meetings of the leading industrialized and Asia-Pacific countries, where talk on climate control steered clear of setting binding targets.

“We are building on the dynamic created by the G-8 and APEC summits to promote international cooperation in the fight against global warming,” he told the UN summit.

Harper will attend the next meeting of the Asia-Pacific Partnership, an agreement among Australia, China, India, Japan, South Korea and US that allows each country to set its own goals and has no enforcement mechanism.

Harper followed his inside-the-Kyoto-tent act during a question-and-answer session after a speech to the Council on Foreign Relations: “If you go for hard caps as the only kinds of target (to limit global emissions), by definition the only countries that will sign on are countries that have no population growth and fairly limited economic growth. That’s what happened with Kyoto.”

President Bush acknowledged last week that climate change is real and that human activity is a factor. He said the US supports the UN process for an international climate agreement but argued that a long-term, nonbinding global goal should be set by the end of 2008 and finalized at a summit he would host.

Bush has rejected Kyoto because he said it would harm the US economy and didn’t require emissions cuts by China and India. The bottom line of the Bush approach is that each nation establishes for itself what methods it will use to rein in the pollution problem without stunting economic growth. That precludes mandatory obligations. New technologies and voluntary measures are the essential elements.

The US hasn’t enacted legislation to enforce Kyoto because the agreement establishes emissions reduction requirements for developed nations only; and developing emitters–led by China and India–don’t want climate sensitive restrictions to impede their economic growth. Canada’s House of Commons and Senate passed the Kyoto Protocol Implementation Act in June. It gave the government 60 days to come up with a plan for Canada to meets its target, a 6 percent cut in emissions below 1990 levels by 2012.

But the minority government’s plan, rolled out Aug. 21, wouldn’t hit the Kyoto target until 2025. Trying to achieve the cuts by 2012 would be disastrous for Canada’s economy, Environment Minister John Baird said. Because of Canada’s resource-based economy, growing population and “vast northern geography,” attempting to follow the Kyoto timetable would cut Canada’s gross domestic product by more than 6.5 percent, reduce personal incomes, lead to higher unemployment and energy prices, and kick the economy into a deep recession, the August plan states.