Dividend Watch List

The rising Canadian dollar has delivered windfall gains to US investors in trusts this year. For some individual trusts’ businesses, however, the loonie’s surge is an unfolding disaster.

Canfor Pulp Income Fund (CFX.UN) trimmed its distribution again last month, from 14 cents Canadian to 12 cents Canadian per share. As I pointed out last issue—when Canfor reduced its payout from 18 cents Canadian to 14 cents Canadian—the trust has suffered from weak margins on sales of its pulp products south of the border. That’s directly traceable to a drop in the Canadian dollar value of US-based revenue.

The good news is the second distribution cut was more than priced in beforehand. After plunging in the wake of the first reduction, Canfor shares have rallied nearly 20 percent from their lows. The trust is financially solid, and its facilities are well run. Canfor Pulp Income Fund still faces some headwinds in the currency department but remains a buy for risk takers up to USD13.

Unfortunately, problems at rival pulp producer SFK Pulp Fund (SFK.UN, SKFUF) run somewhat deeper. Last month, the trust slashed its distribution yet again, this time in half to just a Canadian penny a share. Management continues to blame the strength in the Canadian dollar.

But the greater worry is the performance of SFK’s Saint-Felicien mill in Quebec. With debt still low—despite a massive increase in the past 12 months—and the new dividend rate apparently sustainable, a comeback is still likely. But it’s not going to happen overnight. SFK Pulp Fund is a good candidate for a tax-loss sale.

Other trusts increasingly at risk to a rising Canadian dollar include virtually any business that incurs production costs north of the border and sells heavily south. That includes seafood trusts Clearwater Seafoods Income Fund (CLR.UN, CWFOF), Connors Brothers Income Fund (CBF.UN, CBICF), metallurgical coal play Fording Canadian Coal (FDG.UN, NYSE: FDG), timber trusts Acadian Timber Income Fund (ADN.UN, ATBUF) and TimberWest Forest Corp (TWF.UN, TWTUF), trucking trust Mullin Group Fund (MTL.UN, MNTZF), Sun Gro Horticulture Income Fund (GRO.UN, SGHRF) and Swiss Water Decaf Coffee Fund (SWS.UN, SWSSF).

Some of these have posted big gains this year, others losses. None, however, are suitable for conservative investors, and all are good candidates for December sales.

They may enjoy some relief in the next few months as the Canadian government attempts to rein in the loonie’s rise. But payout margins are stretched, and as long as the global resource bull market is intact, the Canadian currency will have an upward bias. That means rough sledding for all.

Primary Energy Recycling (PRI.UN, PYGYF) has elected to resume distributions to holders of its Enhanced Income Securities (EIS), which represent a combination of equity dividends and debt interest. The new annual rate of 80 cents a share is well below the USD1.15 paid as recently as May.

It also depends on the company meeting certain provisions of its new agreements with lenders, including winning final approval of an amendment to its Harbor Coal contract. In my view, there are still too many ifs here to re-enter Primary. Primary Energy Recycling remains a sell.

The shakeout in Canada’s energy patch continued in November with three distribution cuts. Shares of widely held Harvest Energy Trust (HTE.UN, NYSE: HTE) took a major hit when the trust trimmed its distribution from 38 cents Canadian to 30 cents Canadian per share. The trust is down more than 25 percent from where it traded at the beginning of November, actually cutting briefly below USD20 at one point.

As expected, Harvest’s move was in response to crimped second half 2007 cash flows, mostly because of third quarter refining margins that were 70.9 percent below the average for the first nine months of 2007. Cash flow from refining was further curtailed by the trust’s decision to speed up scheduled maintenance on its facility so that it would be ready to go full out in early 2008 when margins are expected to rebound.

Harvest’s oil and gas production business remains solid, with stakes in a wide range of promising reserves. Like virtually all oil and gas trusts, it will see no negative material impact on cash flows from Alberta’s move to raise royalty rates. In fact, the changes may actually increase the trust’s value because its mature reserve base could see lower royalty rates.

The sharp reaction to a relatively small distribution cut also seems somewhat overdone. So have been recent comments from some analysts warning about high debt levels and forecasting deeper dividend cuts in 2008.

As the Feature Article points out, a drop in oil prices to around USD70 is certainly possible, particularly if the global economy drops into a recession. Like all trusts, however, Harvest has been selling its light oil output for well below that level: USD66.18 per barrel in the third quarter.

A drop to USD70, consequently, wouldn’t negatively impact cash flows. And because the trust derives nearly three-quarters of output from fuels whose prices key off light oil—i.e., heavy oil and natural gas liquids—it’s better insulated than most from continued weakness in natural gas prices as well.

There’s still some risk from the refining operation not turning around next year, and debt is on the high side. Coupled with a still-high payout ratio, that adds up to risk for another dividend cut.

On the other hand, one is definitely priced in, with the trust yielding nearly 17 percent and selling for barely book value and a significant discount to sales. Accordingly, Harvest Energy Trusst is again a buy for risk takers up to USD22.

The prognosis is a bit grimmer for the other two dividend cutters. Trilogy Energy Trust (TET.UN, TETUF) slashed its payout 30 percent in mid-November as part of its 2008 guidance for capital spending, production volumes and operating costs. The new level of 7 cents Canadian per share is deemed sustainable at projected operating costs of CAD10.50 per barrel of oil equivalent, a roughly 16.5 percent rise from the mid-2007 figure. It also gives management more flexibility to maintain production levels, which tumbled 18 percent in the third quarter.

Like all small gas-focused producer trusts, however, Trilogy has a fundamental problem: how to deal with an environment of sluggish natural gas prices at a time when access to capital for small trusts is basically nonexistent. Several have solved this problem by merging with larger, stronger players. That’s a potential avenue for Trilogy as well; it owns substantial properties for development and isn’t too loaded down with debt.

Selling for 1.61 times book value, however, it’s unlikely to capture much of a premium. Down substantially on the year, Trilogy Energy Trust remains a good candidate for tax season selling.

Not even small gas trusts have crashed as decisively as energy service trusts have this year. Unfortunately, with activity in Canada’s natural gas patch still weak, recovery appears elusive. Last month, Essential Energy Services Trust (ESN.UN, EEYUF) finally did what the market had long expected: It cut its distribution from 8.3 cents Canadian to 5 cents Canadian per share.

Essential’s third quarter results reflected its sector’s abysmal business conditions. Revenue rose 10 percent on acquisitions. Cash flow margins, however, fell from 29 percent to 25 percent. That combined with dilution from a 30 percent increase in outstanding shares to send funds from operations (FFO) per unit falling 30 percent and the payout ratio soaring to a clearly unsustainable 146 percent year-to-date.

On the plus side, debt levels have remained flat despite the trust’s growth, resulting in an improved debt-to-capital ratio of just 29 percent. And the trust’s strategy of operating in niche areas and controlling costs has kept it above water in an exceedingly difficult market. The yield of more than 20 percent—coupled with a selling price of just 79 percent of book value and 74 percent of sales—clearly indicates investors are already pricing in a lot more bad news and a more-substantial dividend cut.

Nonetheless, with recovery likely some months off, Essential Energy Services Trust is best viewed as a tax-loss sale candidate this month. That also applies to weakened energy service trusts Peak Energy Services Trust (PES.UN, PKGFF) and Wellco Energy Services Trust (WLL.UN, WLLUF).

I’ve rated these as speculative buys at various times this year, in expectation of a recovery. I still believe we’ll see one in coming months. But both are sitting on substantial year-to-date losses that should be used to reduce your tax bill for 2007.

Note I’m also taking a tax loss on an Aggressive Portfolio energy services trust this month—Precision Drilling (PD.UN, NYSE: PDS)—with the idea to potentially add it back early next year. The Portfolio section has the details.

I’m still recommending a buy on another of the year’s losers, Boralex Power Income Fund (BPT.UN, BLXJF), in the expectation that water flows to its hydroelectric plants will improve and it will be able to hold its distribution as management expects. I’m adding it to the Dividend Watch List and moving it to the Aggressive Portfolio, however, to better reflect the risks.

Here’s the complete Dividend Watch List:

Acadian Timber Income Fund (ADN.UN, ATBUF)
Advantage Energy (AVN.UN, NYSE: AAV)
Boralex Power Income Fund (BPT.UN, BLXJF)
Canfor Pulp Income Fund (CFX.UN)
Chartwell Seniors Housing (CSH.UN, CWSRF)
Clearwater Seafoods Income Fund (CLR.UN, CWFOF)
Connors Brothers Income Fund (CBF.UN, CBICF)
Daylight Resources Trust (DAY.UN, DAYFF)
Essential Energy Services (ESN.UN, EEYUF)
Fording Canadian Coal (FDG.UN, NYSE: FDG)
Freehold Royalty (FRU.UN, FRHLF)
Harvest Energy Trust (HTE.UN, NYSE: HTE)
Mullin Group Fund (MTL.UN, MNTZF)
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 Recycling (PRI.UN, PYGYF)
Priszm Income Fund (QSR.UN, PSZMF)
SFK Pulp Fund (SFK.UN, SKFUF)
Sun Gro Horticulture Income Fund (GRO.UN, SGHRF)
Swiss Water Decaf Coffee Fund (SWS.UN, SWSSF)
TimberWest Forest Corp (TWF.UN, TWTUF)
Tree Island Wire (TIL.UN, TWIRF)
Trilogy Energy Trust (TET.UN, TETFF)
True Energy Trust (TUI.UN, TUIJF)
Wellco Energy Services (WLL.UN, WLLUF)
Westshore Terminals (WTE.UN, WTSHF)

DRIP…DRIP…DRIP

US securities laws restrict participation in dividend reinvestment plans (DRIP) of foreign-based companies that don’t register their offering with the Securities and Exchange Commission (SEC).

Most plans of Canadian income and royalty trusts that do sponsor DRIPs aren’t registered under the US Securities Act of 1933, as amended. US investors, therefore, aren’t eligible to participate.

Of the CE Portfolio recommendations, Paramount Energy Trust (PMT.UN, NTYSE: PMT), Penn West Energy Trust (PWT.UN, NYSE: PWT) and Provident Energy Trust (PVE.UN, NYSE: PVX) do allow US investors to participate in their respective DRIP offerings, with certain limitations.

Note that those three trusts and Harvest Energy Trust, which also offers US investors a DRIP option, are listed on the New York Stock Exchange and have, therefore, opted into US filing and registration requirements. It’s basically a matter of how much overhead expense trusts are willing to absorb.

Even More Northern Exposure

Norbord (TSX: NBD, OTC: NBDFF) is suspending operations at an oriented strand board mill in Huguley, Ala., for about four weeks because of poor market conditions defined by the meltdown in the US housing market.

The market reacted positively to the announcement, pushing Norbord shares above the CAD8 mark Dec. 6. Norbord is up more than 8 percent in the last month and paid a 10-cent-Canadian-per-share dividend Nov. 28.

Norbord anticipates weakness through 2008, but sales in Europe have helped offset to some degree the impact of the US housing slump. That the company is making hard choices to cuts costs is a further sign–as if we needed another–that things aren’t so great in the US, but the market has also recognized management’s willingness to make hard decisions.

The Alabama plant is located within one of the areas hardest hit by falling real estate, and the market there is currently oversupplied. Norbord, yielding around 5 percent, remains a buy up to USD8.50.    

CIBC World Markets analyst Yin Luo published his final forecast of likely additions and deletions to the S&P/Toronto Stock Exchange Composite Index when it gets rebalanced in late December. Eight companies are likely to be added to the index, including Canadian Hydro Developers (TSX: KHD, OTC: CHDVF).

Inclusion in the broad index would mean fund managers tracking its performance would have to buy shares to adjust portfolios to reflect the index, and it’s validation of Canadian Hydro’s long-term viability. Canadian Hydro Developers is a buy up to USD7.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS) reported a 6.4 percent rise in net income for its fourth quarter, the 17th consecutive three-month profit rise for Canada’s second-largest bank. Earnings from consumer banking in Canada and abroad offset a stronger loonie. Scotiabank also raised its dividend 4.4 percent to 47 cents Canadian per share, the fourth increase in two years.
 
Fourth quarter net income was CAD954 million (95 cents Canadian per share), up from CAD897 million (89 cents Canadian per share) a year ago. Scotiabank was expected to earn CAD1.03 a share, according to the average estimate of four analysts surveyed by Bloomberg.

Scotiabank kept on with its strategy to focus on the Caribbean, Mexico and other emerging markets and, in so doing, avoided the US and its subprime-related financial sector crack-up. International profit climbed 33 percent to CAD359 million because of increases from Central America and the Caribbean.

The bank has announced about CAD2.1 billion in foreign acquisitions in the past two years in countries including Peru, Chile and El Salvador. In November, it bought Chile’s Banco del Desarrollo, the seventh-largest bank in that country, for CAD1.02 billion.

The bank also bought an 18 percent stake in DundeeWealth in September and may buy the rest now that the money manager is considering a sale.
 
Consumer banking earnings were boosted by a gain of CAD163 million from the restructuring of Visa, which offset a writedown of about CAD133 million on asset-backed commercial paper and structured credit products. Profit was reduced by CAD53 million because of gains in the Canadian dollar, which has increased about 15 percent this year against the US dollar. Bank of Nova Scotia is a buy up to USD58.

Demand for metals is softening in the US and Canada. Shipments of steel products from US facilities declined 8.1 percent year-over-year in September, the 13th straight month of shipment declines. And Canadian steel shipments were 8.9 percent below year-earlier levels, their 14th consecutive month of declines.

But business is still relatively good for Russel Metals (TSX: RUS, OTC: RUSMF). Russel has been insulated somewhat because it’s not too deep into the automotive sector. Russel has actually avoided selling to the carmakers because of the difficulty in turning a profit on such transactions.

But when the auto sector slows, companies have to go find something else to do with their equipment. And they fall into areas where Russel’s traditionally dominated.

The strengthening loonie also had an indirect effect on Russel’s business. Russel doesn’t sell much directly into the US, but its customers do.

The stock has backed off considerably after approaching its 52-week high early this fall, but recent signs that the US could avoid a full-blown recession have buoyed the shares. Russel paid a 45-cent-Canadian-per-share dividend Nov. 13, and there’s no indication the payout is in jeopardy. Continue to buy Russel Metals up to USD33.

Canada Industry Minister Jim Prentice announced late last month that next year’s spectrum auction will set aside room in the national wireless airwaves for new entrants to compete against the three established mobile players.

In an auction in May 2008, almost 40 percent of the 105-megahertz spectrum to be made available within the 2-gigahertz range will be set aside solely for new entrants to bid on. And the incumbent carriers must allow any new entrants that purchase enough spectrum to qualify as a national player to use their networks of cellular towers for roaming.

This is a positive development for Manitoba Telecom Services (TSX: MBT), which, along with Quebecor, had argued in favor of a spectrum set aside. Manitoba Telecom Services is a buy up to USD50.

The spectrum auction will make available a total of 236 licenses in regional service areas and a total of 28 licenses in provincial and large regional service areas. Of the total number of available licenses, 59 regional service area licenses and all of the provincial and large regional service area licenses will be reserved for new entrant bids in accordance with the spectrum set-aside.

As a result, incumbents earning more than 10 percent of Canadian wireless revenue nationally will be excluded from bidding on any new provincial and large regional service area licenses.

The set-aside virtually guarantees that the wireless market will have more players following completion of the auction. Large communications companies such as Shaw Communications (NYSE: SJR) are likely to bid for spectrum in order to add wireless to their existing suite of communications services. Shaw Communications is a buy up to USD32.
 
First Quantum Minerals (TSX: FM) boosted its stake in copper miner Equinox Minerals to 17.27 percent, suggesting it may attempt to buy the company outright.

First Quantum now owns 97.5 million shares in Equinox; the size of the new trade and the 15 percent premium paid over the closing price of Equinox on Tuesday caused a lot of excitement in the market.

Australia-based Equinox is developing the Lumwana copper mine in Zambia, about 65 40 miles west of First Quantum’s Kansanshi copper and gold mine. First Quantum Minerals is a buy up to USD103.
 
New Talisman Energy (NYSE: TLM) CEO John Manzoni made a small move toward unlocking the value his company’s assets, selling Talisman’s take in the North Sea’s Beatrice field for USD21 million to Ithaca Energy.

Talisman’s cash-flow-per-share estimate for 2008 is CAD4.31, which marks a decent rise from the full-year 2007 estimate of CAD3.97. The stock has languished since it was recommended last month, but Manzoni has already made good on his aggressive reputation. Continue to buy Talisman Energy up to USD24. 

The Movie Star

Cineplex Galaxy Income Fund (CGX.UN, CPXGF) worked its way into How They Rate last month, and this week earned another 5.000 average in Bloomberg’s regular survey of Bay Street analysts’ ratings.

The theater operator’s blockbuster third quarter results inspired a sequence of analyst upgrades and buy-target hikes. But the great reviews only draw attention to the fact that the business is solid: The fund’s high operating leverage and modest financial leverage resulted in the bottom line growing faster than revenue in the latest quarter.

Cineplex has found new ways to grow its business, with an extra focus on advertising and is well positioned to grow distributions from CAD1.18 per unit annually to CAD1.40 in 2008.