A Market of Trusts

Any number of things can move trust unit prices in the near term. But long term, only one thing does: distribution growth.

That’s the clear message of any price chart for trusts going back more than a year or two. When distributions rise, share prices invariably follow. When they’re cut, share prices come down.

The Tax Fairness Plan-induced meltdown in November 2006 proves the point: Investors reacted to the potential for dividend cuts in 2011 because of new taxes. That’s no longer a factor at this point because trust taxation has been priced into the market for more than a year.

In fact, today’s yields anticipate far more severe distribution cuts than will actually occur, given trusts’ ability to reduce their effective taxation rates well below the statutory 31.5 percent rate. And some trusts have demonstrated they won’t have to cut dividends at all.

Over the long haul, trusts with the best businesses will enjoy the strongest distribution and capital growth. Share prices will lag distribution growth in bad markets just as they outpace them in good ones. But eventually, the market will value the income stream for what it’s worth. That adds up to big gains for trusts backed by sustainable, growing and healthy businesses.

This is easy to forget in a market where even the strongest trusts routinely rise and fall several percentage points in a day. And as long as fear of a US recession runs rampant, the volatility will continue. But as long as trusts’ distributions are sustained, downside will be temporary.

What that means as far as investment decision-making is concerned is this: focus on solid businesses. Ten of the 27 trusts in the Canadian Edge portfolios have increased their distributions at least once since Halloween 2006. That’s a sure sign their businesses are solid, and it means management will keep them paying big dividends well past 2011. Another 15 have held distributions steady, instead plowing excess cash flows into growing businesses.

Here’s a sector-by-sector look at the Canadian Edge coverage universe.

Oil and Gas

On Dec. 15, CE Aggressive Portfolio holding Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) became the first conventional oil and gas producer trust to boost its dividend since Halloween 2006. The 12-percent increase is the first in the trust’s history and reflects steady production gains on four continents and conservative financial policies that have consistently kept debt low and the payout ratio at less than 50 percent.

The move also signals something else about Vermilion: Management plans to keep it as a dividend-paying entity well after 2011, and its well-run operations and trust tax-exempt overseas income ensure its ability to do that. Moreover, the trust has clearly been able to protect itself against falling natural gas prices in North America and to insulate itself against the possibility of falling oil prices in early 2008.

Fellow Aggressive Portfolio member Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) illustrates the difficulty natural-gas levered trusts face. Advantage cut its distribution from 18 cents Canadian per unit to 15 cents Canadian, though it’s less vulnerable than Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF). Advantage’s recent cut is part of a plan that appears to ensure the trust will continue to operate profitably while gas prices remain low.

Gas prices have languished longer than we anticipated but should recover in 2008, either on a return to normal weather or as US utilities start to fire up massive natural gas-fired power plants. The rush to use gas for power plants should really accelerate as future carbon-dioxide regulation comes into focus. (Gas emits less than half the carbon of chief rival coal.)

Investors seem to have forgotten that just a couple months ago Abu Dhabi’s national energy company TAQA offered 40 percent over market value in cash to take over PrimeWest Energy Trust (NYSE: PWI, TSX: PWI-U). And TAQA didn’t walk away from its offer, despite the recent market slide and some initial political opposition in Canada.

Electric Power

Power generation trusts and other essential service businesses undergo very few real ups and downs with demand or pricing for their products and services. As Boralex Power Income Fund’s (TSX: BPT.UN, OTC: BLXJF) second and third quarter earnings shortfalls show, there are things outside its control that can affect performance, such as water flows to its hydroelectric power plants.

Boralex is still a solid franchise with well-run hydro, biomass and cogeneration plants. This year’s results are subpar for reasons beyond its control, i.e., low water flows, and the market’s reaction to them was clearly extreme. In fact, we’ve been here before: In 2006, Boralex sold off sharply in the wake of poor cash flows because of weak hydro output, only to bounce back to even higher highs as the waters rose.

The trust appears to have the cash reserves to sustain its distribution for several more quarters.

Macquarie Power & Infrastructure (TSX: MPT-U, OTC: MCQPF) boosted its payout a modest 2 percent to an annual rate of CAD1.05 per share. The increase was a pleasant surprise because it came in the aftermath of a rather high third quarter payout ratio for the trust. The boost is a clear sign the trust’s portfolio continues to run well. Moreover, it comes at the same time the trust prepaid a USD22 million loan, cutting debt and eliminating its remaining foreign exchange exposure.

Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) recently started up its St. Leon wind power facility, instantly becoming a major player in the fuel in North America. Output is sold to Manitoba Hydro under a lucrative contract.

At the same time, the trust announced the sale of certain noncore landfill gas power-generating stations for USD11.69 million in proceeds. That will provide needed cash for expansion, and it eliminates exposure to an asset class that’s been trouble for many trusts.

Gas/Propane

As the biggest of the Canadian drillers (27 percent market share) and with virtually no debt, Precision Drilling (NYSE: PDS, TSX: PD-U) is in no danger of Chapter 11, no matter how horrible its numbers look now. It’s also hard to imagine those numbers not being at least very close to bottoming, after a 35 percent drop in revenue and a decline in its rig utilization rate to just 38 percent of capacity. There’s even a bright spot in third quarter results: the sixfold increase in US drilling days, with eight rigs operating at near 100 percent capacity.

But the numbers say recovery may take time. Producers’ capital spending plans forecast another drop in drilling activity into 2008. That could put Precision’s distribution under pressure again. Shares could also go lower if oil prices should drop precipitously amid recession fears.

Precision shares are down substantially, and it’s an ideal candidate for tax-loss selling. But the business is sound and should recover throughout 2008.

Business Trusts

Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) posted a modest 1.6 percent boost in operating revenue in the third quarter. That result was driven by 9 percent growth in data and Internet revenues and a 19 percent jump in high-speed Internet subscribers. The trust also reported solid growth at its Information Technology division and held line losses to a much lower level than in prior quarters.

This last item was likely helped by three major factors. First, the company kept a very tight leash on costs, improving competitiveness. Second, regulators granted it forbearance from restrictive rules in several areas, which enabled it to compete far more forcefully with rivals. The trust continues to face little competition from anyone its own size by virtue of operating in rural areas that are cost-prohibitive for the cable industry.

Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) has expanded its strategic relationship with Web giant Google, becoming the first Canada-based reseller of Google AdWords TM ads. The deal further enhances the trust’s leveraged migration of its traditional print directory business to the Internet and provides massive opportunities for upselling clients.

Pipeline Trusts

Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) had an outstanding third quarter, with net earnings surging 36 percent on a 15.7 percent jump in revenue. Growth was universal across all the trust’s business segments.

Conventional pipelines boosted revenue 13 percent and operating income 19 percent from year-earlier tallies. Oil sands infrastructure revenue grew just 6 percent, and operating income grew 3 percent. But capacity rose by roughly a third, portending much more explosive growth ahead.

Meanwhile, the midstream business unit saw revenue jump 35 percent and net operating income increase 32 percent year-over-year. Moreover, operating expenses ticked up just 8.9 percent, expanding margins and profitability.

Pembina has already increased distributions three times since Halloween 2006 by at least 9 percent. That’s a pretty clear indication it intends to keep rewarding shareholders with hefty cash flow, no matter how it’s ultimately taxed.

Real Estate Trusts

CE mainstay RioCan REIT’s (TSX: REI-U, OTC: RIOCF) third quarter results are just more proof of its long-term promise, with funds from operations rising 5 percent on a 10 percent boost in rental revenue. That supported the REIT’s modest 2.3 percent distribution increase.

As has been the case for the past several years, RioCan continues to put the lion’s share of its cash flow to work in developing new fee-generating properties. The REIT is currently involved in some CAD1 billion of new projects that are slated to start producing income in the next few years. That should further fire up growth in sales, cash flow and distributions.

Portfolio quality remains unmatched. Occupancy as of the end of September was a stellar 97.6 percent. Some 65.1 percent of rental revenue was derived from properties located in high-growth markets (Calgary, Edmonton, Montreal, Ottawa, Toronto and Vancouver), and no one client accounted for more than a sliver of overall revenue.

Northern Property REIT (TSX: NPR-U, OTC: NPRUF) slipped back to the low 20s for no good reason. The REIT now yields twice as much as its high-quality US counterparts and sells for less than twice book value.

That’s despite exemplary occupancy rates and development in the pipeline that promises to boost distributable income per unit by 7 to 10 percent annually in the next two years.

Natural Resources Trusts

TimberWest Forest Corp’s (TSX: TWF-U, OTC: TWTUF) 2007 strength was mainly traceable to its exemption from 2011 taxation by virtue of being a stapled share combining debt with equity. But avoiding taxes alone is never a good reason to hold, and unfortunately, that’s increasingly TimberWest’s sole attraction. Its core timber business is being ravaged by economic weakness in the US, which, in turn, has weakened the market for its logs in Asia as well as Canada.

The assets are great, and management seems determined to hold the dividend. It just looks as though the market is pricing in the good news on taxes and ignoring the very real business risk. That’s never a good formula.

Speaking Engagements

Join me and my colleagues Personal Finance Editor Neil George and Associate Editor Elliott Gue in the Sunshine Shine state for the World Money Show in Orlando Feb. 6-9, 2008, at the Gaylord Palms Resort. Reserve your spot today by calling 800-970-4355 and mentioning priority code 009859, or click here to register online. Be sure to tell them I sent you.

The Roundup

The news flow during the holiday season has slowed to a trickle. We’ll be back with a fuller look at Portfolio companies and How They Rate trusts of special note after New Year’s.