By Roger Conrad & David Dittman
  December 5, 2006
  Maple Leaf Memo

May you live in interesting times–they sure have been. But even after a turbulent and dangerous November, income trusts haven’t gone away.

Many were poor investments before Canadian Finance Minister Jim Flaherty’s October 31 announcement to tax trusts, and they look even worse now. But many are backed by strong businesses and have begun to trade on fundamentals rather than the one-off (yes, a big one) tax announcement event. After recent market losses, many players have been sifting through the wreckage for bargains.

This isn’t a “spend money to save money” situation; buyers are putting their money behind good businesses that are well situated for the next four years and beyond. Trusts can still be a viable structure and can satisfy yield-seeking investors.

Pembina Pipeline announced a 10 percent distribution hike heading into 2007, and Yellow Pages Income Fund, in a statement announcing a boost in its payout, also made a straightforward commitment to the trust structure beyond 2011. It’s obviously helpful and encouraging that trusts are beginning to make their intentions known, but basic conclusions supporting their investment viability can certainly be drawn in advance of such clarity.

Existing trusts will enjoy a four-year tax holiday. And it’s possible–though not likely–that a Liberal victory in a parliamentary election that may happen as soon as spring 2007 could result in a longer reprieve or at least a favorable modification of the Conservatives’ decision.

The base-case scenario, though, is that trusts other than those devoted to real estate will be taxed under the Conservative regime. But some characterize a portion of their distributions as return of capital; those portions would remain untaxed until the trust units were sold.

Return of capital is more tax efficient, since taxes can be deferred until the trust is sold.
Although return of capital puts cash in your hands, it shouldn’t be regarded as income. It’s really a tax deduction that compensates you for depreciating assets like buildings or equipment, or depleting reserves of oil and gas or other natural resources.

And then there’s this: Cash distributions exceed the dividend yields of stocks or the interest yields of bonds. There’s still money to be made in trusts whose underlying businesses are healthy (but it remains foolish to buy solely on the basis of a high yield).

Rates & Oil

Recent reports from investment houses and government agencies point to some sort of 2007 slowdown and predict interest rate cuts by the US Federal Reserve and other central banks, including Canada’s.

Other analysts point to inflation pressure growing out of a revived energy commodity market that may soon beg for tighter money. After languishing near USD60 per barrel during the fall shoulder season, oil has rallied to the mid-60s and seems poised to make new highs in 2007.

As a general matter, stable businesses with decent distributions will shine in a low interest-rate environment, but energy trusts would obviously benefit from a rebound in crude prices.

Signs of economic weakness have already led to increased speculation that the Bank of Canada (BoC) will cut interest rates. Economic growth slowed from a 2 percent annual rate in the second quarter to 1.7 percent in the third, and the September contraction of the world’s eighth-largest economy was the biggest since March 2002 (excluding August 2003, when a power blackout in Ontario interrupted production in Canada and the US).

The BoC predicts that the country’s economic growth will narrow to 2.5 percent in 2007 from 2.8 percent this year on reduced US demand for Canadian exports.

Commodities account for about 54 percent of Canada’s exports and 12 percent of its CD1.09 trillion economy. More than 80 percent of Canada’s exports, including natural gas, crude oil and lumber, are shipped to the US.

CIBC World Markets forecasts as many as four interest rate cuts by the BoC during the next year because of mounting job losses in the manufacturing sector and economic weakness in central Canada. Manufacturing output fell 0.5 percent in the quarter, the third straight decline. Exports rose 0.9 percent after two prior declines and still trailed import growth of 1 percent as US demand slipped. CIBC also predicted a sub-4 percent yield on the Canadian 10-year bond.

The BoC raised interest rates seven times to 4.25 percent before pausing in July. It will probably keep the benchmark rate unchanged at its meeting today. Interest-rate futures in the US show that traders see about an 85 percent chance of a quarter-point rate cut by the US Federal Reserve, to 5 percent, by March.

The New Guy

Canadian business will watch Stephane Dion, the newly elected head of the opposition, closely, waiting for the surprise leadership-election winner to detail his economic and environmental policies.

Dion, a former academic from Quebec with cabinet experience in two Liberal governments, focused his leadership campaign on his record as environment minister. He backs the Kyoto Accord on reducing greenhouse gases that’s been downplayed by the Conservatives and wants to spend more on research and development.

As leader of the largest opposition party in Canada’s Parliament, he’s an automatic front-runner to become prime minister in an election expected within a year.

Dion’s environmental policies will likely face opposition from Alberta, the country’s fastest-growing region. The oil sector is worried that cuts to carbon-dioxide emissions called for in the Kyoto treaty will come at its expense, but a spokesperson for the oil industry’s largest lobby group said Dion’s track record on energy issues is positive.

“He’s open, constructive and technology-focused,” said Pierre Alvarez, president of the Canadian Association of Petroleum Producers. “If his focus is on technology improvement and not discriminating against the oil and gas industry so we end up with a bigger burden then other sectors, which he has tried to signal over the last while…there is ground for us to work on.”

The third quarter earnings report season is behind us, as is Jim Flaherty’s announcement that the Canadian government would tax income trusts beginning in 2011. This provides a nice opportunity to summarize the health of operations at Canadian Edge Portfolio trusts and evaluate the potential impact of the tax change.

I look at three points for each trust, based on their most-recent results: Good Business Points, Bad Business Points and 2011 Tax Position.

For more numbers and current trading advice, see the How They Rate Table.

Conservative Portfolio

Algonquin Energy (APF.UN, AGQNF)

1. Good Business Points: Acquisitions of wind power assets and strong hydroelectric assets lift third quarter sales 19.4 percent. Algonquin continues to find ways to increase cash flows.
2. Bad Business Points: Its payout ratio remains on the high side as the trust focuses on growth.
3. 2011 Tax Position: Return of capital was 60 percent of 2005 distributions, and non-cash expenses were 63.4 percent. These should be sustainable figures.

Altagas Income (ALA.UN, ATGUF)

1. Good Business Points: The third quarter showed more evidence that asset expansion and acquisitions are paying off. Cash flow per share was up 35.1 percent.
2. Bad Business Points: Lots of moving parts mean management must keep a tight grip.
3. 2011 Tax Position: Return of capital was 35.7 percent of 2005 distributions, which should be sustainable.

Atlantic Power (ATP.UN, ATPWF)

1. Good Business Points: Third quarter cash flows per share were up 23.3 percent as new investments pay off. The Path 15 power line should be a very valuable asset.
2. Bad Business Points: Management doesn’t control assets but depends on partners to run them well.
3. 2011 Tax Position: Technically an income deposit security, Atlantic should be exempt from the Canadian tax proposal. The interest portion of its dividend isn’t withheld by Canadian authorities.

Bell Aliant (BA.UN, BLIAF)

1. Good Business Points: The rural phone business faces little competition and steady growth. The trust has multiple opportunities to up-sell customers to advanced services.
2. Bad Business Points: Like all local phone businesses, there will be some loss of customers for local phone service.
3. 2011 Tax Position: Return of capital is estimated at 12 percent of 2006 distributions, based on Bell Nordiq’s 2005 return of capital.

Boralex Power (TSX: BPT.UN, OTC: BLXJF)

1. Good Business Points: Its hydro plants run well. Biomass and cogeneration output are steady and diversify against unpredictable water conditions.
2. Bad Business Points: The payout ratio is on the high side, which limits growth, though it’s sustainable.
3. 2011 Tax Position: Return of capital was 75 percent of 2005 distributions. That number may decline to 2011 unless the trust adds assets.

Keyera Facilities (KEY.UN, KEYUF)

1. Good Business Points: Keyera controls solid midstream assets that generate exceptionally steady cash flows. It’s also pursuing several opportunities for low-risk growth.
2. Bad Business Points: Third quarter earnings demonstrate that cash flow isn’t immune from slowdown in activity in gathering and processing, but the dividend should be solid.
3. 2011 Tax Position: Return of capital was 75 percent of 2005 distributions, which should fall slightly in 2011.

Newalta Income Fund (NAL.UN, NALUF)

1. Good Business Points: Sales rose 83 percent in the third quarter of 2006, fueling an 11 percent increase in cash flow per share. Return on investments rose to 27 percent, up from 24 percent a year ago. Expenses were cut, and both industrial and energy services enjoyed growth.\
2. Bad Business Points: Exposure to the energy services business means sales could slow if that industry does, though they’re shielded by the environmental focus.
3. 2011 Tax Position: Return of capital was just 1.7 percent of 2005 distributions.

Northern Property REIT (NPR.UN, NPRUF)

1. Good Business Points: A 5.1 percent boost in the real estate investment trust’s (REIT) dividend was spurred by a 7 percent increase in funds from operations per share. Properties are located mostly in remote areas and are rented to creditworthy parties.
2. Bad Business Points: The challenge is finding new place to invest, but management has a conservative focus.
3. 2011 Tax Position: REITs focused on Canada are exempt from the tax changes.

Pembina Pipeline (PIF.UN, PMBIF)

1. Good Business Points: The trust enjoyed a 12.4 percent boost in distributable cash per share in the third quarter, fueling a 10 percent increase in its dividend. The midstream business thrived, as did the trust’s conventional gas and oil sands pipelines operations. The best news is that there’s a lot more on tap as the trust adds assets in coming years.
2. Bad Business Points: A crash in the oil sands business would rob Pembina of a key growth measure. Profitability will also depend on executing new asset construction and the operation of old ones.
3. 2011 Tax Position: Return of capital was 25 percent of 2005 distributions, which should be sustainable.

Primary Energy Recycling (PRI.UN, PYGYF)

1. Good Business Points: Primary Energy continues to find new plants and investments to boost output and cash flow.
2. Bad Business Points: The increase in cash flow in the third quarter was directly offset by shares issued to finance growth, but payoff should come later.
3. 2011 Tax Position: A staple share combining debt and equity, Primary Energy’s taxation shouldn’t be affected by the Canadian tax proposal.

RioCan REIT (REI.UN, RIOCF)

1. Good Business Points: Canada’s largest REIT continues to enjoy steady sales and cash flow growth, with strong occupancy. RioCan is now cashing in on the first of a series of investments with a major Canadian pension plan. The REIT is also a logical takeover target for US investors.
2. Bad Business Points: The trust’s strong position means growth is moderate.
3. 2011 Tax Position: REITs focused on Canada are exempt from the tax changes.

TimberWest Trust (TWF.UN, TWTUF)

1. Good Business Points: The third quarter was very rough because of extremely dry conditions that prevented harvesting, as well as rising production costs. It’s well reserved for cash shortfalls, and nine-month cash flows cover the dividend.
2. Bad Business Points: The timber market is vulnerable to continued weakness in the US housing market, as well as a slump in Asian sales.
3. 2011 Tax Position: Shares are technically stapled securities of debt and equity. They’re not affected by the proposed change in Canadian tax law.

TransForce Income (TIF.UN, TIFUF)

1. Good Business Points: Sales rose 18.2 percent in the second quarter, fueling 26.3 percent growth in operating income. Management continues to find solid opportunities to add business with expansion and acquisitions.
2. Bad Business Points: Expansion hasn’t done much lately for the bottom line, as cash flow per share dipped 2.2 percent. Much of the growth lately has come in the energy patch, which may be slowing down.
3. 2011 Tax Position: Return of capital was 3 percent of 2005 distributions.

Yellow Pages Income (YLO.UN, YLWPF)

1. Good Business Points: The trust’s basic print pages business is very steady, while its Internet business is growing rapidly, and it continues to add new advertising media to its mix. Cash flow per share rose 11 percent in the third quarter, continuing a string of solid growth.
2. Bad Business Points: The print pages business has been stagnant for a while, as business migrates to the Internet. Yellow Pages appears well prepared for that. It’s also one of the first to declare that it will remain a trust for 2011 and beyond.
3. 2011 Tax Position: Return of capital was 4 percent of 2005 distributions.

Aggressive Portfolio

ARC Energy Trust (AET.UN, AETUF)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps the trust at the top of the heap for oil and gas producers. It had 12 percent production growth with only 7.2 percent share growth during the past 12 months.
2. Bad Business Points: Production costs have risen during the past year. Like all oil and gas producers, cash flow is vulnerable to energy price volatility.
3. 2011 Tax Position: Return of capital was just 2 percent of 2005 dividends, but non-cash, non-taxable expenses were 43.8 percent.

Avenir Diversified Income (AVF.UN, AVNNF)

1. Good Business Points: Oil and gas production continues to increase. The EnerVest management contract and other financial investments are solid and offset energy price volatility. Avenir is within a targeted payout ratio.
2. Bad Business Points: EnerVest profit depends on the size of the fund’s assets and took a major hit when the trust market declined. Funds from operations per share fell nearly in half in the third quarter of 2007 and will take a further hit from a decline in EnerVest in the fourth quarter. Oil and gas operations remain small.
3. 2011 Tax Position: Return of capital was zero in 2005, though non-cash expenses were 14 percent. Management could move to alternative structure after 2011.

Essential Energy Services (ESN.UN, EEYUF)

1. Good Business Points: Acquisitions continue to drive rapid growth at the energy services trust. Third quarter earnings lagged, but fourth quarter activity is off to a rapid start.
2. Bad Business Points: Energy services trusts are extremely vulnerable to a drop-off in energy patch activity, as appears to be happening in Canada’s shallow natural gas.
3. 2011 Tax Position: Return of capital for the new trust isn’t available for 2005, but non-cash, non-taxable expenses were equal to distribution. The trust’s management says it may have to make a strategic move due to small size.

Fording Canadian Coal (FDG.UN, FDG)

1. Good Business Points: Fording’s metallurgical coal reserves are first rate, as is its partner Teck-Cominco.
2. Bad Business Points: Demand for metallurgical coal has fallen, particularly in Asia, which is pushing down both demand and prices from last year’s robust levels.
3. 2011 Tax Position: Return of capital was 25.7 percent of 2005 distributions, which should be sustainable.

Harvest Energy (HTE.UN, HTE)

1. Good Business Points: It’s increased output and diversification of tax flows over the past year with a series of mergers and acquisitions, including of a refinery in the summer. Third quarter earnings were generally solid, as strength in oil sales offset natural gas price weakness.
2. Bad Business Points: The jury is still out on last summer’s generally expensive acquisitions. The financing of the refinery deal was completed on worse terms than expected because of the government’s tax proposal timing. It’s payout ratio, debt and operating costs are high.
3. 2011 Tax Position: None of the distribution was return of capital in 2005, but non-cash, non-taxable expenses were 80 percent-plus of third quarter cash flows.

Paramount Energy (PMT.UN, PMGYF)

1. Good Business Points: Paramount has a large reserve of undeveloped land that’s enabled it to maintain production year after year. It also derives a steady stream of cash flow from the Alberta government as part of a settlement for shutting in a portion of its capacity.
2. Bad Business Points: Falling natural gas prices have taken a bite out of cash flows this year. The third quarter payout ratio is still 83.2 percent because of extensive hedging, and rising gas prices are helping. But this remains an extremely aggressive play on gas and a small trust.
3. 2011 Tax Position: Only 4.6 percent of the 2005 dividend was return of capital, though 80 percent of third quarter cash flow was non-cash, non-taxable expense.

Peak Energy (PES.UN, PKGFF)

1. Good Business Points: Peak’s payout ratio is low and preserves the dividend in the third quarter, despite a drop in energy patch activity. The trust has a solid fleet of energy services assets and rigs.
2. Bad Business Points: All energy services trusts are very vulnerable to a drop-off in energy patch activity. Third quarter funds from operations per share were off 30 percent.
3. 2011 Tax Position: Return of capital was just 6.7 percent of 2005 distributions, which should be sustainable.

Penn West Energy (PWT.UN, PWE)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps Penn West at the top of the heap for oil and gas producers. The trust also has investment in oil sands and prolific oil developments.
2. Bad Business Points: Penn West is still absorbing the Petrofund merger. Its third quarter payout ratio came down, but there’s potential dilution from share issues.
3. 2011 Tax Position: None of the 2005 dividend was return of capital, but nearly 60 percent was non-cash, non-taxable expense.

Precision Drilling (PD.UN, PDS)

1. Good Business Points: The rust’s assets and business growth continue to fuel superior performance.
2. Bad Business Points: Like all energy services trusts, Precision is affected by a slowdown in energy patch activity. Seventy percent of its business is in the natural gas sector, and its payout ratio in the third quarter rose to 83.8 percent.
3. 2011 Tax Position: Return of capital was just 0.2 percent of 2005 distributions.

Vermilion Energy (VET.UN, VETMF)

1. Good Business Points: A solid balance of production from long-life, low-cost reserves, low payout ratio, low debt and strong management keeps Vermilion at the top of the heap for oil and gas producers. The trust’s global diversification is a major plus, as is its ability to fund dividend and capital costs internally.
2. Bad Business Points: Like all trusts, this one is vulnerable to a drop in energy prices. International exposure means management must keep on top of more.
3. 2011 Tax Position: The 2005 dividend was 13.7 percent return of capital, and non-cash, non-taxable expenses were 48.7 percent. Foreign income may also be exempt from new Canadian tax proposal.