When a trust’s yield hits the teens, you can bet there’s substantial dividend risk. But if management can navigate its challenges, there’s also the real possibility of big capital gains, in addition to outsized income.

Buying into this type of story means accepting risk. The market is pricing in some dividend risk already. But a cut almost always brings on additional selling in the near term. And no matter how well you do your homework, it’s always possible to overlook something or to underestimate the impact of forces beyond the trust’s control.

No one should hold a high-yield comeback play on the basis of seeking safe income. But even the most conservative investor can own them as part of a diversified portfolio focused on quality, as we do in Canadian Edge.

Both of this issue’s High Yields of the Month are Aggressive Portfolio holdings. Penn West Energy Trust (PWT.UN, NYSE: PWE) is facing the challenge of completing multiple mergers in the next couple months, even as market conditions for natural gas remain daunting. New addition TransForce Income Fund (TIF.UN, TIFUF) is dealing with weak conditions in Canada’s transportation sector, mostly precipitated by the plunging US dollar.

Both trusts, however, have continued to find enough positives in the past year to keep paying big distributions. More important, both have used the weakness in their industries to build more valuable franchises. That’s the key to big shareholder returns well past 2011, no matter how they’re taxed.

Both trusts are cheap. Penn West sells for 1.5 times the book value of increasingly valuable oil and gas reserves. It will be lower priced still once it completes its merger early next year with Canetic Resources (CNE.UN, NYSE: CNE), trading for just 1.16 times book. TransForce, meanwhile, sells for just 1.57 times book and an astounding 45 percent of annual sales.

When a merger is announced, the market typically buys the target and sells the acquirer. Both trusts have been prolific asset acquirers in the past year, another reason why PennWest has an annual dividend yield of nearly 14 percent and TransForce of almost 16 percent.

Of the pair, Penn West’s New York Stock Exchange (NYSE) listing has earned it the greatest attention. Shortly after converting from a corporation on May 31, 2005, the trust emerged as the largest outside the oil sands sector by merging with Petrofund in mid-2006. It followed that mega-deal with a series of smaller ones in the subsequent months, taking advantage of sinking natural gas prices to pick up distressed properties.

In late September, Penn West inked a deal to buy Vault Energy (VNG.UN, VNGFF) for barely half the trust’s book value. The timing of the purchase was exemplary because it gave Vault management a way out—attaching to a large and powerful trust—before it had to load up on debt to survive. Penn West, meanwhile, acquired a solid reserve base at an extremely low price.

Barely a month later, Penn West offered 0.515 of its own units per Canetic unit plus an additional special dividend of 9 cents Canadian a share. The timing and price are again well timed for both parties.

Canetic becomes part of a larger, more powerful entity; Penn West absorbs high-quality assets at a good price, as well as much-needed personnel to carry out its expansion plans. This could ultimately prove the most valuable feature of the deal, given the growing shortage of skilled industry personnel.

The announcement of the Canetic deal has delayed the closing of the Vault deal. That merger was originally scheduled for a shareholder vote later this month, but Vault’s board delayed it to fulfill its fiduciary responsibility to examine the combined financial statements of Penn West and Canetic.

The good news is rejection is out of the question because pulling out would resume Vault’s death spiral. In any case, the board is still on record of being in favor of the deal, and the vote should occur by the end of the year, with consummation following shortly afterward.

Canetic also has a merger of junior producer Titan Exploration in the works. That deal involves the exchange of roughly 6.5 million Canetic units for additional daily oil production of 1,800 barrels of oil equivalent (63 percent oil) with a proved plus probable reserve life of 11 years. The new properties are in Saskatchewan. It’s expected to close later this year, with an information circular mailed to Titan owners by Nov. 15.

Assuming these deals are completed, a Canetic/Penn West vote will be held in mid-January 2008, with a close shortly thereafter. The new Penn West will be the dominant independent light oil producer in western Canada, producing 200,000 to 210,000 barrels of oil equivalent per day in 2008. Already several times the output of the typical large trust, that figure could be ramped up considerably in coming years.

For starters, there are proven plus probable reserves in excess of 800 million barrels of oil equivalent in conventional oil and gas. There are also major opportunities to develop unconventional sources, including a multi-billion barrel oil sands reserve in the Peace River region.

This project is already in production and will be ramped up substantially in coming years. Penn West also has substantial undeveloped land reserves, both from recent mergers and as a legacy of the Petrofund deal, which shareholders refused to spin off.

The combined trust will operate approximately 80 percent of its output. Significant, Canetic and Penn West operate adjacent to each other in several areas. That should mean numerous opportunities to pool knowledge and synergize development efforts.

One key area will be Saskatchewan, where royalty rates remain very low to better steal away business from Alberta. There are also significant opportunities in carbon dioxide sequestration, coal bed methane development and shale gas. And the new trust will be in a strong position to expand in the US, which along with CAD5.5 billion in tax pools (projected for end 2007) will help reduce prospective 2011 taxes and keep distributions high.

Assuming it can complete these mergers as expected, the primary risks at Penn West will be relatively high leverage and volatile energy prices. Adding Canetic’s lofty debt load will increase the debt-to-cash flow ratio to the 1.9 to 2.0 range.

Capital spending on developing conventional and unconventional reserves will put further pressure on cash flow. So would low natural gas prices in the coming months. Noncore asset sales, however, should afford ample opportunity to reduce debt.

Meanwhile, the trust can issue shares off a much larger base. Penn West Energy Trust is a buy up to USD38.

Transportation trust TransForce has also been a prodigious acquirer since it became an income trust in October 2002. Today, after a total of 69 separate deals, it’s the leader in the Canadian transport and logistics industry, posting nearly half a billion Canadian dollars in third quarter revenue.

The latest of these is the Nov. 1, 2007, absorption of Toronto-based Century II Holdings and its wholly owned Information Communications Services (ICS) unit. ICS is a structured route carrier that services some 35,000 accounts in the insurance, optical, financial, dental and hearing appliance business across Canada. The unit had revenue of approximately CAD90 million in 2006 and is now combined with existing TransForce units.

Making its many acquisitions fit together has been the central challenge for the Quebec-based trust over the years. Happily, it’s proven more than up to the task of translating business growth into increased revenue, cash flow and distributions. As of the third quarter, return on equity sat at a superior 23.5 percent, while return on assets was at 10 percent, following an 8 percent jump in revenue.

As for distributions, the monthly rate has been hiked nine times since the income fund’s inception, for a total of 39.5 percent. And cash flow coverage remains solid, with the third quarter payout ratio coming in at 81.9 percent and the nine-month ratio at 86.1 percent. Net debt to equity is roughly 1-to-1, moderate for a business based largely on tangible assets (trucks and facilities).

Impressive, share growth has been held to almost zero in the past year. Management has been able to utilize additional debt and operating cash flow to expand operations. Eschewing issuing shares is partly out of necessity because a distribution of nearly 16 percent equates to a very high cost of capital. But it’s also in keeping with the conservative nature of this trust, which increased its share count by only 11.4 percent in the 12 months before Halloween 2006 placed limits on all trusts’ growth.

That conservative focus has served the trust well in the tough times for the transport sector that have emerged over the past year. For example, unlike several of its rivals—notably Mullen Group Income Fund (MTL.UN, MNTZF)—TransForce has only expanded in the energy patch in measure with its operations elsewhere in Canada. As a result, rapid growth in operations such as parcel delivery has been able to offset weakness in the oilfield division as well as the timber shipping segment, which has suffered from the 20 percent-plus decline in the US dollar this year versus the Canadian as well as weak housing market conditions here.

Longer-term readers may recall TransForce was a Canadian Edge Portfolio member up until late 2006. At that point, I judged the combination of prospective transport sector weakness and 2011 taxation’s crimping of access to capital as too severe and unloaded it.

Since then, the shares have slipped slightly in US dollar terms but have fallen sharply in Canadian dollar terms. As a result, they again represent solid value.

Consensus expectations are conditions in the Canadian transport sector won’t significantly improve before the end of 2008. That leaves a lot of room for upside surprises. It also leaves a lot of opportunities for TransForce to keep making purchases of smaller rivals, and management has tripled credit facilities for that purpose.

Also, unlike the sector’s fry, the trust is large enough to shift its capacity around the country to take advantage of pockets of strength and reduce supply to keep rates stable. And management plans some CAD200 million to CAD300 million in sales and leasebacks of facilities, which can be used to keep debt under control, leaven out further sector turmoil, buy back its depressed shares or even make new strategic purposes.

No trust or any business can fully insulate itself from mega-forces affecting its market. The steep rise in the Canadian dollar—coupled with a weakening US economy—have presented challenges this year and likely will for several more quarters.

Based on third quarter results, however, TransForce is hanging in there. And although there will be some dividend risk until conditions turn for the better, it appears to be well priced into the units.

The upshot: It’s time to take a chance on this trust again. I’m adding TransForce Income Fund to the Aggressive Portfolio as a buy recommendation up to USD14. Those who buy now should be able to get it well below that for a ride up to substantial gains in coming years, in addition to getting paid one of the biggest dividends in the world.

For more information on both trusts, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner, MPL Communications, for press releases, charts and other data. Note these are huge companies, so any broker should be able to buy them, either with their Toronto or NYSE/over-the-counter symbols. Ask which way is cheapest.

 

Penn West Energy Trust & TransForce Income Fund
Toronto Symbol	PWT.UN	TIF.UN
US Symbol	NYSE: PWE	TIFUF
Recent USD Price*	30.65	10.73
Yield	14.0%	15.6%
Price/Book Value	1.45	1.57
Market Capitalization (bil)	CAD6.862	CAD0.857
DBRS Stability Rating	STA-5 (high)	none
Canadian Edge Rating	5	5

_{*Recent USD Price as of 11/07/07.}