So far, so good: That’s the overwhelming impression left by the Canadian Edge Portfolio trusts that have reported third quarter earnings thus far.

Over the past two-plus years, trusts have faced a series of stress tests, commencing in mid-2006 with sliding natural gas prices, accelerating with the Halloween announcement of 2011 trust taxation and hitting a crescendo with the credit crunch and US economic slowdown. Through it all, however, strong businesses have continued to report steady revenue and cash flows, covering distributions and funding growth.

The common element of all of these stress tests is they progressively forced businesses to rely ever-more on their own resources to survive and thrive. Before mid-2006, even the weakest, most ill-conceived new trusts were able to access the capital market almost at will. Scores of them regularly doubled and tripled their shares outstanding, taking advantage of the public’s seemingly insatiable demand for higher yields.

In one fell swoop, the announcement of the Tax Fairness Act forced trusts to become dramatically more conservative in their financial policies. Not only did share prices plunge deeply in the following two weeks, making equity capital considerably more expensive, but the Act also actually limited the number of shares trusts could issue.

Specifically, the safe harbor limits were an increase of no more than 40 percent in outstanding shares for 2007 and boosts of no more than 20 percent in each of the next three years, for a total increase of no more than 100 percent. Increases in shares due to mergers between trusts were excluded from the limits, presumably because they didn’t affect the total number of trust shares in circulation. 

Strict limits on share issues alone were enough to crater the prospects of dozens of trusts. Some three dozen were lucky enough to find buyers. But others entered a death spiral as their businesses died from a lack of funding that became progressively more difficult to access.

A few trusts, such as food services firm Colabor Income Fund (TSX: CLB, OTC: COLAF), did exceed the safe harbor limits to further their growth objectives. The result is they’re now paying the trust tax. Notably, Colabor continues to pay its regular distribution as its business has grown sufficiently to absorb the tax. Most trusts, however, have elected to either stay within the safe harbor or convert to a corporate structure that’s taxed at a lower rate.

The good news, of course, is many trusts did learn to live with the new restrictions, particularly those that had always been judicious with issuing new capital to avoid dilution. This had always been the group favored in Canadian Edge, and they proved resilient once again.

The credit crunch that began in mid-2007 ratcheted up the importance of prudent financial management to a new level. The first casualty was the wave of trust takeovers that accelerated in early 2007, before coming to an abrupt end later that year as private capital market funding evaporated.

Today, there are a handful of ongoing takeovers of trusts. Fording’s buyout by Teck Cominco, for example, has been completed for a combination of stock and cash. But other buyouts have collapsed due to lack of accessible funding, including that of Clearwater Seafoods Income Fund (TSX: CLR-U, OTC: CWFOF).

Unlike many US corporations, Canadian companies and trusts have traditionally eschewed debt as much as possible. Virtually all trusts employ it to some extent, particularly through bank credit lines. Prior to Halloween 2006, however, equity financing by issuing new trust units was by far a cheaper, easier option. And since then, tightening credit conditions have discouraged replacing equity with debt.

The result: Debt levels today are very low, particularly relative to US companies. In fact, over the past two years, trusts in many industries have worked toward–and actually achieved–a goal of generating enough cash flow internally to fund both capital spending and distributions, thereby limiting–if not eliminating–any exposure to the volatile credit markets.

History shows that’s an ideal position to be in entering into an economic downturn, particularly one that may continue for a while. Unfortunately, not every company or trust has the underlying strength to practically do that, particularly if they operate in industries in which revenues tend to be more volatile, such as oil and gas production.

Completely avoiding capital markets and relying on internal resources also severely restricts firms’ ability to grow. In the case of some trusts, management has chosen to reduce distributions—often by converting early to corporations—in order to shepherd more cash for growth.

That’s a step some wouldn’t have taken had capital markets been healthier, as they’ve paid a price in the stock market. Only time will tell if the likes of CE Portfolio converts TransForce (TSX: TFI, OTC: TFIFF) and Trinidad Drilling (TSX: TDG, OTC: TDGCF) will be better served in their growth goals as corporations.

As noted in the Portfolio article, TransForce did post very strong third quarter earnings in what its management called the most challenging environment in 80 years. Meanwhile, Trinidad came in with record sales and cash flows, as it continued to use the saved cash from its conversion to expand its rig fleet in both the US and Canada.

Revenue growth actually accelerated in the quarter to 18.2 percent, as the US rig utilization rate soared to 85 percent and the Canadian rate rose to 63 percent. The company continued to build out its fleet, virtually all of which is locked into long-term contracts with creditworthy customers who pay come what may. And it simultaneously cut debt by 33 percent over the past year, even as it made another CAD81 million in capital expenditures during the quarter.

As has been the case with every other trust that’s converted to a corporation and cut its distribution, Trinidad and TransForce shares took a hit immediately following their moves. Then they rebounded as a new group of buyers—who valued growth and income more equally—began to step in.

Both stocks have sold off sharply along with everything else in this financial crisis. But their underlying businesses remain very solid and, based on these results, the conversion/dividend cut appears to have done the trick for management: allowing both to grow robustly without having to hit up the capital markets for funding.

The good news about the past few weeks is it looks like the credit markets are at least partly unfreezing. Thanks to an unprecedented global infusion of liquidity by monetary authorities everywhere, banks appear to be rapidly recapitalizing. The key London Interbank Offered Rate (LIBOR) is still above the Federal Reserve’s target of 1 percent. In the 2.5 percent range, it’s barely half of where it was at the peak of the panic, indicating banks are increasingly willing to lend to each other in the overnight market at less than usury rates.

Meanwhile, commercial paper trading and issue volumes are at last starting to pick up. And yields paid on bonds issued by investment grade companies are starting to moderate as well. Even the giant banks—which seemed so vulnerable just a few weeks ago—appear to be moving decisively back to financial health–and maybe even more fiscal prudence.

Those are all great signs, particularly if things continue to move in that direction. Moreover, as we’ve pointed out repeatedly, Canada’s banking system remains fundamentally healthier than our own. There was never a subprime crisis in Canada because the banks never abandoned the discipline of requiring tough credit standards. In fact, the only banks that did get into some hot water in the financial crisis were those that got mixed up in US assets, particularly mortgage-backed securities.

On the other hand, the days of easy credit are over. Not only are loans likely to remain tougher to come by, but they’re coming off at higher rates as well. Companies and trusts forced to roll over debt in the coming months run the risk of paying higher rates on the refinancing. That means higher interest costs and a corresponding bite out of earnings. Those seeking to finance expansion will face tough questions about whether or not their projects are worth the effort.

That’s why tighter credit always slows economic growth, amounting to double jeopardy for some more economically sensitive businesses. Their sales will diminish at the same time margins are squeezed by rising interest costs. And if things get bad enough, the certain result will be dividend cuts and possibly much worse.

The Canadian market certainly hasn’t been immune from the massive global selloff, and our positions have given up a lot of ground. But history shows those that continue to operate well as businesses will recover fully when business conditions do improve. Not faltering, however, depends on two factors: holding revenue steady and not succumbing to credit pressures.

In the past few months, we’ve spent a lot of time focusing on the revenue side of the equation. This month, we’ve taken an exhaustive look at the credit side of the picture, putting all of the Canadian Edge Portfolio holdings under the microscope.

The tables accompanying this article list trusts by industry sector and rates them on several metrics. Debt to cash flow is simply total debt as a percentage of annual cash flow. The lower the number, the lower debt is to the size of the enterprise and its ability to pay it off. Given the cash-intensive nature of trusts, this is my favorite measurement for most of the CE universe.

Debt to capital is a more globally recognized measure of financial strength and compares total debt to the sum of debt plus shareholders’ equity. Again, lower percentages are preferable because they indicate companies that hold less debt relative to the size of the enterprise.

Debt to capital is mainly useful because data for it is universally available. Unlike the cash flow statement, however, a company or trust’s balance sheet is more of a snapshot in time, rather than a dynamic figure. But taken with the debt-to-cash flow measurement, it provides a valuable piece of the puzzle.

The third column of the table varies from industry to industry, reflecting the very real differences between these businesses. In the Canadian Edge Portfolio, I’ve divided trusts essentially into two groups: those that are highly leveraged to commodity prices (Aggressive) and those that aren’t (Conservative). As a result, I’ve grouped a lot of trusts and high dividend-paying corporations together that have broad differences.

The table breaks down the most important differences as far as credit markets are concerned. We’ve broken the portfolio trusts into several groups by industry on the basis of debt characteristics.

Importantly, different industries can handle differing levels and qualities of debt. A power producer or pipeline operator, for example, operates in a very stable business with predictable revenue, as third quarter earnings results have shown once again. That’s a stark contrast with energy producer trusts, which must hold debt at much lower levels in order to ride out the ups and downs in energy prices.

Our tables break trusts into several industries. Oil and gas producers are the most volatile and therefore require the most strict debt metrics. REITs are also tied to the economy but have considerably more predictable revenue, as it’s basically tied to long-term rentals. The other two tables separate out different varieties of business trusts.

Interest expense per barrel of oil equivalent (BOE) produced is a great measure for gauging how oil and gas producer trusts are matching debt with output. In fact, it’s more important for a trust to keep a low interest expense per BOE than a low overall debt level.

The recent turmoil engulfing the global financial system and economy has had a significant impact on all businesses. There’s a great deal of uncertainty about where we’re headed, which makes it all the more important to understand how tightening credit conditions will affect day-to-day operations for companies.

What can be said generally about CE Portfolio trusts is that they entered this tumultuous period in positions of relative strength. Oil and gas trusts, in particular, used significant second quarter windfalls to pay down existing debt and fund capital expenditures.

Some, such as ARC Energy Trust (TSX: AET-U, OTC: AETUF) and Enerplus Resources (TSX: ERF-U, NYSE: ERF), have already taken prudent steps to ensure long-term sustainability of their distributions.

Declines in commodity prices during and after the third quarter will directly impact cash flows, payout ratios and use of debt to fund development projects going forward. Banks are faced with reduced capacity to lend, which limits trusts’ access to capital and will push borrowing costs higher. The current environment will challenge all businesses, investors and regular people, but relatively conservative balance sheets and capital structures put oil and gas trusts in position to weather the storm better than most.

All companies are affected by the financial crisis and corresponding economic slowdown. Some face more difficult roads than others. You can see that variation in the microcosm that is the CE Portfolio, but our recommendations have used cash flows made possible by strong operating conditions to position themselves to withstand the further stress the global financial crisis and corresponding economic downturn better than most companies. Companies saddled with disproportionate amounts of debt before the global financial system buckled face rocky rides.

The quickest way to understand a trust’s ability to cope is to look at its payout ratio; lower rates correspond to greater financial flexibility because excess funds from operations can either be invested in capital expenditures for the long term or utilized to repay debt and reduce leverage.

Second quarter cash flows set up oil and gas trusts to deal with what happened to global credit markets following Lehman Brothers’ Sept. 15 implosion. The test will be whether they can live within their means during times of fiscal constraint while still replacing production.

The lending capacity of all financial institutions has been diminished, and risk premiums have increased. These issues may impact oil and gas trusts and how they approach financing alternatives for capital programs and manage cash flow in the future. ARC Energy Trust’s decision to roll back its top-up distributions, which have taken its monthly payout to CAD0.20 per unit once again, indicates this type of decision-making: ARC has an enormous present opportunity to exploit its Montney natural gas assets, and given all the factors at play, a judicious “cut” in favor of devoting cash to long-term growth means the trust will be able to sustain a strong distribution well into the future.

Under ordinary circumstances, a cut is cause for concern; these, however, aren’t ordinary times. ARC has decided to fund its Montney development activity internally rather than increasing costs by accessing debt or diluting unitholders with a new equity issue.

In April 2008, ARC renewed its syndicated credit facility, extending the maturity date to April 15, 2011. ARC has approximately CAD270 million of unused credit available under the facility.

ARC will refinance a total of CAD28.8 million in senior secured notes during the next 12 months through its credit facility. As at Sept. 30, ARC’s net debt to annualized cash flow from operating activities ratio is 0.8, and its net debt to total capitalization ratio is 13.3 percent, conservative by any standard. ARC’s business remains strong, its assets are top quality and its financial position allows it to fund internal development prospects with an eye on paying a sustainable distribution well into the future.

Enerplus Resources’ long-term debt increased from Dec. 31, 2007, to the end of the second quarter of 2008 by CAD301.6 million mainly because of the CAD330.9 million of debt assumed on the Focus Energy Trust acquisition. Enerplus did, however, reduce long term debt by CAD68.7 million during the second quarter with the excess cash flow resulting from high commodity prices.

Enerplus recently announced a 19 percent cut in its distribution, but that move must be considered, as is the case with ARC, in light of current unprecedented stresses on the global economy. The reduction, from CAD0.47 per unit per month to CAD0.38, is all about preserving financial flexibility.

Advantage Energy Income Fund’s (TSX: AVN.UN, NYSE: AAV) Sept. 5, 2007, acquisition of Sound Energy Trust pushed interest expenses higher early in 2008, but during the second quarter, the fund repaid CAD15.6 million of bank indebtedness on strong operating results.

The fund has a CAD710 million credit facility, which is collateralized by a CAD1 billion floating charge demand debenture, a general security agreement and a subordination agreement covering all assets and cash flows. In June 2008, the fund renewed its credit facilities for a further year, with the next annual review scheduled to occur in June 2009. For the six months ended June 30, 2008, the effective interest rate on the outstanding amounts under the facility was approximately 5.4 percent.

Daylight Resources Trust’s (TSX: DAY-U, OTC: DAYYF) banking syndicate completed its semiannual borrowing base review on Oct. 31, and the bank credit facility remains at CAD350 million. The trust expects to finance its 2008 cash capital expenditures program and distributions from internally generated funds from operations.

At June 30, 2008, Daylight had CAD274 million outstanding on its credit facilities which, during May 2008, increased from CAD300 million to CAD350 million. The next regularly scheduled review date is Nov. 30. Daylight’s effective bank debt interest rate was 4.5 percent for the second quarter.

Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) applied excess funds flows for the second quarter to outstanding bank debt, resulting in a CAD35.5 million reduction in net bank debt from CAD346.3 million at March 31 to CAD310.8 million at June 30, 2008.

For the infinitely more stable real estate investment trust sector, one of the keys to effective financing is managing the mortgage portfolio, balancing the cost versus property rents. The column “Average Maturity” lists the average time until each REIT’s mortgage portfolio matures or will have to be refinanced.

Finally, we’ve offered a comment on the unique credit situation with each of the Portfolio trusts. Some related to pending financing challenges, others to the nature of that financing.

When we started this exercise, we were looking for one thing: evidence that we weren’t overlooking anything regarding our holdings’ credit situation. The tables show the details of our study.

The good news is the vast majority of our trusts have very manageable debt loads, as well as relatively few immediate needs to roll over facilities in this still-tight market. That’s one reason why third quarter earnings are generally coming in well. Even GMP Capital Trust (TSX: GMP-U, OTC: GMCPF), an investment house trust that’s increasingly challenged in its revenue, looks fairly well placed on the debt front. As today’s tough third quarter earnings comparisons attest, it won’t bounce back until market conditions recover. But it’s holding market share, and solvency doesn’t appear to be an issue.

All of our energy producing trusts once held much higher debt burdens. But most used the surge in natural gas and oil prices over the past year to their distinct advantage by paying down debt. Even my most leveraged play, Advantage Energy Trust, has basically cut its debt-to-cash flow ratio in half over the past two years. As a result, their debt ratios are now quite manageable and even trusts in an expansion mode—such as Enerplus Resources—are keeping a tight hold on the reins.

Revenue depends heavily on energy prices, as I’ve said before. But lower debt does dramatically enhance their ability to weather a prolonged period of weakness in energy prices. And as third quarter results attest, most are still going full on with their capital spending projects as well.

In the “All About the Business” chart below, converted corporation Trinidad Drilling and Newalta Income Fund (TSX: NAL-U, OTC: NALUF)—which plans to convert to a trust at the end of the year—have dramatically enhanced their ability to fund expansion without having to borrow. AG Growth’s (TSX: AFN-U, OTC: AGGRF) needs are modest. Boralex Power Income Fund’s (TSX: BPT-U, OTC: BLXJF) operates in a business where revenues are basically recession proof and is backed by larger parent Boralex Inc (TSX: BLX).

Finally, the “Squeezed but Sustaining” chart below is mostly comprised of large, asset-backed companies that continue to demonstrate no problems accessing the capital market to fund acquisitions and internal growth. That’s the clear message from the robust results of Altagas Income Fund (TSX: ALA-U, OTC: ATGFF) and the others whose earnings are discussed in the Portfolio section.

Atlantic Power Corp’s (TSX: ATP-U, OTC: ATPWF) debt is based entirely on project-level financing. That financing is entirely structured as non-recourse loans that don’t implicate the entire corporate entity; each project is funded through its own facilities–difficult conditions at any one project have no influence on the ability to finance operations at other projects. And in virtually all cases the principal fully amortizes before the primary power purchase agreement expires.

Atlantic has the option to redeem the subordinated note portion of its income participating securities as of Nov. 18, 2009, at an initial redemption price equal to 105 percent of the principal amount being redeemed. 

Management has said it will exercise the call at its earliest convenience, subject, of course, to credit market conditions. If it can obtain favorable financing terms, such as reducing interest expenses by refinancing in US dollar terms or at a lower interest rate, the company will call. But it isn’t required to repay before November 2016. It’s all about alternatives. Given that cash on hand and projected future cash flows should support current levels cash distributions through 2014–and that doesn’t account for the potential impact of acquisitions or organic growth opportunities–Atlantic is in solid position to exploit alternatives on its terms.

The upshot: None of our recommendations are currently having anything resembling credit troubles, both because their debt levels are well within the conservative range for their industries and because revenue is also solid—even in more volatile industries such as oil and gas production. There’s no substitute for continuing to review the numbers, and we’ll be doing so again in the fourth quarter, as well as in flash alerts for those yet to report.

Also, revenue for even the steadiest industries is always at risk to either internal business failures or a worsening of macro conditions beyond management’s control. The oil and gas producers are definitely pricing in a drop to $30 oil and $5 natural gas already. But a drop to that level would definitely affect revenue and make credit situations a bit tighter.

Again, there’s no substitute for a thorough review of all holdings every quarter, no matter how low share prices have dipped. But in an environment where there’s a lot to worry about, it’s nice to know conservative is still spelled with a capital “C” in Canada. And as long as that’s the case, these high dividend-paying corporations and trusts will stay in the game for the ultimate recovery when credit conditions inevitably calm and the global economy at last begins to revive.