Natural gas lags while oil soars. Some trusts win high-premium takeover bids, while others collapse following sharp dividend cuts. The rising Canadian dollar lifts share prices and dividends, yet pulls the rug out from under some trusts’ businesses.

It’s clearly a time to be very choosy in the income trust universe. My primary goal at Canadian Edge is to point out the difference makers: what ultimately separates the strong from the weak.

The good news in early October is there’s powerful momentum behind strong trusts. Investors have figured out the best were never really threatened by the US subprime mortgage crisis, and takeover activity is lifting off again.

Every one of the three dozen takeovers of trusts announced since last November has either closed or is rapidly moving in that direction. That includes Penn West Energy Trust’s (PWT.UN, NYSE: PWE) takeover of Vault Energy (VNG.UN, VNGFF) and the private-capital buyout of shipping trust Oceanex Income Fund (OAX.UN, OCNXF).

The Abu Dhabi National Energy Co’s acquisition of PrimeWest Energy Trust (PWI.UN, NYSE: PWI) opens a new chapter for trust takeovers. It’s by far the biggest deal to date and the first high-premium buyout of an energy producer trust. Unless the Canadian government takes a hard line, unlikely given Prime Minister Harper’s recent comments, it’s likely to be the first of many in this sharply undervalued sector.

Even decisions by Boralex Power Income Fund (BPT.UN, BLXJF) and others to put off selling themselves are bullish. Nearly a year after Mr. Flaherty laid his egg on the trust market, managements are in no hurry to do anything rash. Not one significant trust has yet converted back to a corporation and virtually all have affirmed their desire to find a way to pay big dividends well after 2011.

In fact, the trusts themselves are back on the market buying assets, and they’re having no problems raising capital to do so. With the Canadian dollar reaching and passing parity with the US dollar, trusts’ buying power in this country is greater than ever, and income from US assets won’t be taxed in 2011. Last month, Provident Energy Trust (PVE.UN, NYSE: PVX) made its biggest buy here ever when its BreitBurn LP unit bought production and midstream assets from Quicksilver Resources in a USD1.45 billion deal.

Looking ahead, it’s likely the loonie will move higher still against the greenback. For one thing, the US Federal Reserve is cutting interest rates to stave off recession. And the resource bull market—the most important catalyst for Canada’s strength—is still in full swing.

A strong loonie will continue to provide a powerful lift to all the Canadian Edge Portfolio picks. The situation is a bit more complicated, however, when it comes to trusts’ businesses.

Many of my Portfolio picks have US operations but also natural hedges against currency swings. For example, the rising loonie clips the value of their US dollar-based revenue but also expenses and debt. That’s unfortunately not the case with some trusts.

Last month’s sharp dividend cut at SFK Pulp (SFK.UN, SFKUF) shows damage can be quite severe. Odds are we’ll see more fallout when third quarter earnings season kicks in during the next few weeks.

Nowhere is the divergence between strong and weak trusts as great as the oil and gas production sector. As the PrimeWest offer illustrates, there are extreme values here. But as the Enterra Energy Trust (ENT.UN, NYSE: ENT) meltdown shows, there are extreme risks as well. And during the next several months, differentiating strong and weak will literally be the difference between multiplying your wealth and getting wiped out. 

Strategy is a major part of the equation. In the Feature Article, I look at how the oil and gas trusts stack up, while I review my top recommendations in the Portfolio section. The two High Yield of the Month picks—ARC Energy Trust (AET.UN, AETUF) and Yellow Pages Income Fund (YLO.UN, YLWPF)—are among the most adept and an ideal place for new investors to get started in trusts.

Perhaps the most bullish development for trusts during the past few months is investors are starting to focus on business fundamentals, rather than every twitch by the politicians in Ottawa. Changing trust taxation remains a possibility, and I continue to follow the developments closely, particularly in the complementary weekly e-zine Maple Leaf Memo (www.mapleleafmemo.com).

Royalty taxes are another issue that could swing trusts’ way. And Canada seems to be charting a course to control carbon emissions that will be relatively benign for trusts.

My focus remains clear, however: I won’t recommend buying anything based on a political bet or even a possible takeover. Rather, I want growing businesses with solid balance sheets and strong cash flows through thick and thin. And that’s what you’ll find in this October 2007 issue.

Portfolio Action

There are no additions or subtractions to either the Conservative Portfolio or the Aggressive Portfolio this month. I’m downgrading long-time Canadian Edge recommendation TimberWest Forest Corp (TWF.UN, TWTUF) to a hold because of what appears to be a sharp escalation of a dispute with its primary union. The article reviews prospects for all of the recommendations based on management strategy. I also discuss a simple strategy for those just getting started in trusts.

High Yields of the Month

Old friends are best. This month’s Conservative Portfolio and Aggressive Portfolio entries for High Yield of the Month are both charter Canadian Edge Portfolio members. On the Conservative side is Yellow Pages Income Fund (YLO.UN, YLWPF). From the Aggressive camp is ARC Energy Trust (AET.UN, AETUF). Both are ultra-high quality and cheap.

How They Rate

I’m adding one trust to coverage this month: Eveready Income Fund (EIS.UN, EISFF). Countryside Power and Versacold are now off the list after takeovers of them were completed last month. Sound Energy Trust (SND.UN, SNDFF) is now part of Advantage Energy Income Fund (AVN.UN, NYSE: AAV) and will come off the list next month. So will recently acquired Legacy Hotels REIT (LGY.UN, LEGYF).

Here are advice changes. See the How They Rate or Portfolio tables for changes in buy targets. Price and yield information is updated every 15 minutes on both tables.

• Baytex Energy Trust (BTE.UN, NYSE: BTE)—Buy @20 to hold. This trust has been too heavily touted in national media and has some potential operating issues as well.
• Bonterra Energy Fund (BNE.UN, BNEUF)—Buy @28 to hold. This trust’s small size and high costs make it a proxy for oil prices, and it could be vulnerable in the near term.
• Chartwell Senior Housing (CSH.UN, CWSRF)—Hold to sell. This REIT won’t be selling itself, and the payout ratio is very high.
• Connors Brothers Income Fund (CBF.UN, CBICF)—Sell to hold. You can’t hold something you’ve sold. But for those who didn’t take my advice, the shares have now fallen enough to limit downside risk.
• Daylight Resources Trust (DAY.UN, DAYFF)—Hold to sell. The trust may have saved itself and its remaining dividend with a new credit deal. But it’s still at risk, and a takeover almost surely won’t produce much of a premium, given the offer by Penn West for Vault Energy.
• NAL Oil & Gas Trust (NAE.UN, NOIGF)—Hold to buy @12. This trust appears to have cut its distribution enough to sustain it, despite low gas prices.
• Peak Energy Services Trust (PES.UN, PKGFF)—Hold to buy @4. The energy services trust has dropped again to a level that reflects all reasonable risk and then some.
• Primary Energy Recycling (PRI.UN, PYGYF)—Hold to sell. The trust’s suspension of its distribution pending a new credit agreement constitutes a worsening of its situation, and the shares are still hanging up.
• SFK Pulp Fund (SFK.UN, SFKUF)—Buy @6 to hold. The suddenness of the recent dividend cut has me worried there may be deeper problems.
• Trilogy Energy (TET.UN, TETFF)—Hold to sell. There’s too much risk if natural gas prices fall. And premiums paid for weak trusts just aren’t worth hanging around for the possibility of a takeover.
• True Energy Trust (TUI.UN, TUIJF)—Buy @5 to sell. The shares have already risen above my buy target since I recommended the trust as a comeback bet. But given the pitiful premiums paid for weak trusts and the risks, it’s just not worth sticking around for.
• Vault Energy (VNG.UN, VNGFF)—Sell to hold. You can’t hold if you’ve already sold. But for those still holding Vault, the Penn West takeover limits downside risk. And because payment is in stock, there’s even some upside, though the premium paid is very low.
• Wellco Energy Services Trust (WLL.UN, WLLUF)—Buy @6 to hold. Admittedly, the horse is out of the barn with this one. But Peak Energy looks like a more attractive services play to me.

Feature Article

The best oil and gas trusts are acting increasingly well, but the death spiral of the small and weaker fare continues. I analyze the prospects of every oil and gas producer trust in the Canadian Edge universe and highlight my favorites once again.

Canadian Currents

Some time ago, the Alberta provincial government commissioned a report on the current structure for assessing royalties on energy reserves. The report is now in and recommends a steep increase in assessments on oil sands projects, though a possible reduction for royalties on mature production such as those most trusts focus on. A final decision from Alberta on what it will adopt is due in the next couple weeks. Maple Leaf Memo co-editor David Dittman looks at the prospects.

Tips On Trusts

This section features short bits on a wide range of topics. For more evergreen and tutorial items, see the Subscribers Guide “Subscriber Tips” section.

Dividend Watch List—No fewer than six trusts cut their distributions last month. Four were usual suspects and repeat offenders. Enterra Energy Trust, Pengrowth Energy Trust (PGF.A, NYSE: PGH) and Wellco Energy Services Trust are all victims of the drop in natural gas prices in recent months. Primary Energy suspended its distribution because of operating problems at its Harbor Coal facility.

The fifth cut was a surprise. SFK Pulp trimmed its payout a whopping 60 percent because of the combined impact of the falling US dollar and the shutdown of a major facility, accounting for about half overall output. See the table in this section for the comprehensive list of endangered dividends.
Bay Street Beat—Here, I look at how the Canadian analyst community views trusts and how to use that information.
Non-Trust Stars—As I’ve pointed out in prior issues, trusts aren’t the only high-profit action in Canada. Here’s an update on my non-trust recommendations.
Ottawa Watch—Here’s what’s going on in Canadian politics and how it affects the trusts we own.

More Information

The following is a regular repeat from prior issues.

Use our live quote feed on the How They Rate Table for US dollar prices of trusts intraday. For other information, go directly to a trust’s Web site by clicking on its name in the table. Clicking on the Toronto symbol (suffix “.UN”) will take you to the Web site of our Canadian partner Toronto-based MPL Communications (133 Richmond St. West, Toronto M5H 3M8) www.adviceforinvestors.com, which has price charts and access to press trust releases. For questions and comments, drop us a line at canadianedge@kci-com.com. Check out the Toronto Stock Exchange Web site for a range of information on income and royalty trusts. The Web site www.sedar.com is an online library of documents filed by trusts with the Canadian equivalent of our Securities and Exchange Commission. The Toronto Globe & Mail features the “Globe Investor” section with all the latest news on trusts. Dominion Bond Rating Service is the pre-eminent credit rater for trusts. The Bank of Canada Web site features a handy currency converter for Canadian dollars and US dollars into 50 other currencies around the world, and it’s a great source of free information on the Canadian economy.

Roger Conrad
Editor, Canadian Edge