Dividend Watch List

Distribution cuts continued for energy producer trusts last month. That was no real surprise, however, as oil prices sank all the way to the USD50s, and actually lower for a few days.

In fact, the bigger surprise is the magnitude of reductions hasn’t been more severe to date. And with many trusts yielding 15 to 20 percent and higher, that’s certainly what’s being priced in, and then some.

As I stated in the October Feature Article, all energy producing trusts are at risk to distribution cuts over the next few months, pending what happens to energy prices. But again, share prices are basically back where they were when oil was selling for less than USD30 a barrel and natural gas was under USD3 per million British thermal units. That’s a lot of bad news for energy prices already reflected in share prices, and the fuel for a major rally in trusts when oil and gas recover. And it’s again why I continue to recommend hanging onto virtually all of the oil and gas trusts.

Last month, Bonterra Energy Trust, now Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF), followed through on its promise to convert to a corporation without trimming its dividend. But though the trust also posted solid third quarter results, it nonetheless couldn’t avoid an 18.8 percent rollback of its distribution in the wake of falling oil prices (71 percent of output). The current dividend level of CAD0.26 a share is roughly back to what Bonterra paid in May 2008, before it boosted its monthly payout twice in the wake of surging oil prices.

Bonterra still expects to increase production in the fourth quarter on the strength of acquisitions and successful drilling. It will monitor capital expenditures and dividends on a monthly basis, with the goal of maintaining a roughly 70 to 80 percent payout ratio.

Ultimately, what Bonterra can pay in dividends will depend on oil prices, but this new level should be sustainable barring a renewed plunge in energy. Bonterra Oil & Gas remains a buy up to USD22 for those who don’t already own it.

Progress Energy Trust (TSX: PGX-U, OTC: PGXFF) is being acquired by affiliate ProEx Energy Ltd as part of an early conversion to a corporation. As has been the case with every early conversion involving a strong trust, the transaction is designed to shepherd more capital to fire up growth; the new combination expects a growth rate of 10 to 15 percent in output.

The chief drawback, of course, is a distribution cut back to an annual rate of CAD0.40 paid quarterly. That’s a roughly two-thirds reduction, but it will leave plenty of cash to fund growth as well as hold down debt levels, now at 1.5 times annual cash flow.

The deal will require approval of two-thirds of shareholders and so could still be defeated when it comes up for a vote. I advise owners to think long and hard about this. Progress shares have already taken a hit from the announcement, though it’s hard to discern how much is due to this move and how much to the market. I’d have preferred a higher post-conversion dividend. But this deal does have the potential to create a much larger and stronger company with a very strong production profile. And as a prominent junior, the new Progress will almost certainly be a takeover target as well, possibly for one of the larger trusts. That may, in fact, be what this deal between closely related companies was designed to fend off.

If you’ve continued to hold Progress this far, there’s no real point in cashing out now. This trust actually sells below book value, and even the lower yield is attractive for juniors. On the other hand, you might consider voting against the transaction. For those without a position, the buy target for Progress Energy Trust is USD10.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX) announced a 25 percent reduction to its fourth quarter distribution simultaneously with its third quarter results. Falling energy prices were the clear fundamental reason cited, though midstream operations also reported a dropoff in returns that may be continuing into the fourth quarter.

On the bright side, the company has slashed its bank debt by 58 percent over the last 12 months. That’s a huge plus for Provident, as it brings total debt into line with other energy producing trusts. And the midstream unit is in most environments at least a steadying influence for overall earnings.

Third quarter results did paint the picture of a steadier Provident more able to weather a difficult environment than the trust was before it sold its US operations. That makes Provident Energy Trust worth continuing to hold and a buy up to USD10 for those without positions.

Ironically, the one energy trust most expected to slash distributions–Harvest Energy Trust (TSX: HTE, NYSE: HTE)–wound up holding the line. The saving graces were aggressive hedging and dramatically better results at the refinery operation, where overall margins rose 88 percent and throughput topped expectations as well. Oil and gas production slipped 1 percent sequentially and the payout ratio fell to 66 percent.

On the negative side, Harvest’s debt continued to rise, hitting 9 percent over year-earlier levels by quarter’s end. Debt-to-cash flow is at the very high end of the group at 2.7 times and is expected to soar to 3.0 by the end of the year. The trust has barely a quarter left of its CAD1.6 billion borrowing facility.

Refining does provide a natural hedge for energy production, as improved margins were mostly due to the steep plunge in oil prices. But this is one trust that would be increasingly strained by a further drop in energy prices, and no one should own it without the expectation of at least a 50 percent distribution cut, management protestations to the contrary. Hold Harvest Energy Trust.

Other natural resources haven’t captured the attention of oil’s demise of recent months. But the damage has been arguably even worse on trusts operating in this sector.

TimberWest Forest Corp (TSX: TWF-U, OTC: TWTUF), as I had feared, has suspended its distribution indefinitely. The third quarter marked yet another period of negative distributable cash flow generation, as very low global prices shut in timber production. The company also announced it doesn’t expect to remain in compliance with its debt covenants in the fourth quarter, an ominous sign for future solvency prospects.

At the root of TimberWest’s problems is the collapsed US home building market, which is mirrored by similar weakness globally. On the plus side, almost all “Bill 13” harvesting rights have expired, which triggered a third quarter charge but should ultimately allow the company more flexibility negotiating terms for future harvests. Moreover, global supplies are expected to tighten over the next year, due to a new Russian tax and mountain pine beetle troubles in other parts of Canada.

The bottom line is TimberWest’s underlying assets are valuable, both for timber and for real estate on Vancouver Island. The key challenge is navigating the company through the current tight credit conditions and weak global economy. That means first coming to some sort of deal with banks. Debt-to-capitalization is still relatively low at 22.1 percent, but it’s certain to face higher borrowing costs.

As for unitholders, distributions aren’t likely for a while and, when they do return, will likely be at a reduced level. The share price, however, is at its lowest level ever, and the underlying assets are solid. This one’s certainly not for everyone, and there’s a possibility it may go belly-up. But up to USD3, TimberWest Forest Corp is a worthy speculation.

Another victim of the weak US housing market, Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF), has cut its distribution in half, beginning with this month’s payment. The trust has been able to tread water in an increasingly weak environment by taking a greater portion of its wire production and sales outside of Canada, particularly to Asia, as well as by aggressively cutting costs. The trust’s US workforce has been reduced by 46 percent since the second quarter, while its Canadian operation has just 14 percent of jobs.

Tree’s aggressive actions have probably ensured its survival, and third quarter results did mark a strong improvement over year-earlier levels. But no one should expect a swift recovery in the share price or distribution until conditions improve, and that may be some months off. Hold Tree Island Wire Income Fund.

Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF) looks like an increasingly likely candidate for a distribution cut by early next year. The reason is sliding iron ore prices, which will offset the continued improvements to production at the Iron Ore of Canada facility that contributes all of Labrador’s cash flow.

The facility is operated by powerful global giant Rio Tinto (NYSE: RTP) and so is in no danger of being shut down, and iron ore remains in strong demand globally despite the slowdown. But falling prices for a commodity-based trust do mean lower cash flow and almost certainly distribution cuts.

By the same token, today’s washed out price holds open the promise for an equally explosive gain as the global economy finds a bottom and investor panic subsides. Labrador will be a very valuable franchise when that occurs. The proof is explosive third quarter results, which came in on the last big upsurge of iron ore prices. Labrador Iron Ore Royalty Income Fund is a buy for those who don’t already own it up to USD25.

Turning to business and real estate, debt remains the primary concern. FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF) has mostly restored its distribution after suspending it in the wake of a labor strike last month. The new rate of CAD0.095 may be bumped up again to the old rate of CAD0.1075, but much will depend on tight conditions. FP is a good tax loss candidate. But trading at just 67 percent of book value and otherwise a solid operation, FP Newspapers Income Fund is otherwise a hold.

Home Equity Income Trust (TSX: HEQ-U, OTC: HEITF) has at last succumbed to a tightening mortgage and financial market by cutting its dividend 33 percent. The challenge isn’t originations, which were actually up 10 percent year-over-year in the third quarter. Nor is it a loan/loss challenge, as less than 1 percent of the portfolio has a loan-to-value of over 70 percent, with the average just 36 percent loan and 64 percent equity. Nor is it administrative expenses, which have dropped from 0.79 percent of the average mortgage balance a year ago to just 0.63 percent now.

Rather, the challenge is a combination of rising borrowing costs and an expected dropoff in activity due to the weak economy. The good news is the distribution cut and other moves should ensure the trust weathers the crisis. But until the picture for financials really does improve, Home Equity is a hold.

Turning to real estate, InnVest REIT (TSX: INN-U, OTC: IVRVF) became the latest Canadian real estate investment trust to trim its distribution. The owner of resorts and other hotels trimmed its payout by a third last month shortly after announcing what were very solid third quarter results in a weakening environment.

As was the case with other REITs, InnVest is challenged by its need to access credit and ensure it has adequate cash to fund operations at a time when its core business is weakening. In this case, it’s tourism.

On the plus side, the drop in the Canadian dollar versus the US dollar this fall could spur more cross-border visitation, should it endure and the US economy start to recover by summer. And with markets weak, hunkering down looks like a wise choice. A rival REIT is buying up shares, making it a takeover target. This one, too, has come well off its highs. But the dividend is still generous, the price is barely 40 percent of the book value of its hotels and it’s a nice recovery play. InnVest REIT, therefore, remains a buy up to USD6.

Two additional REITs may need to trim distributions in the coming months. Calloway REIT (TSX: CWT-U, CWYUF) has a very solid portfolio, backed by Wal-Mart (NYSE: WMT) anchored power centers. But despite a modest payout ratio of less than 86 percent, a challenging credit environment and the need to complete projects is presenting a strain that may force more equity issuances and dilution.

On the other hand, that’s well priced in, with a yield of nearly 18 percent and a price of 58 percent of the book value of its Wal-Mart-anchored portfolio. Calloway REIT is a buy up to USD10.

HR REIT (TSX: HR-U, OTC: HRREF) has been put under review for a reduction in its credit rating and stability rating by Dominion Bond Rating Service, as it attempts to complete a major Calgary-based office building and another project in Ontario. Both are solid projects based around strong tenants, with giant Encana (NYSE: ECA) the major client for The Bow. But the additional costs to complete them will be very difficult to come up with in this credit environment.

The result is HR now yields upward of 25 percent and sells for barely half of its book value. True, times are tough. But that kind of valuation borders on the ridiculous. As a result, I’m raising HR REIT to a buy up to USD5 for speculators, with the caveat that there will almost certainly be some sort of dividend cut in the coming months.

Here’s the rest of the Dividend Watch List. Second quarter payout ratios are now shown in How They Rate for all listed trusts and corporations. Note that Connors Brothers Income Fund is off the Watch List for good as its sale to a private equity firm for CD8.50 per share in cash is complete.

Again, note that all energy producer trusts should be considered on the Watch List until energy price reach a definitive bottom (see above).

• Acadian Timber Income Fund (TSX: ADN-U, OTC: ATBUF)
• Big Rock Brewery Income Trust (TSX: BR-U, OTC:
• Calloway REIT (TSX: CWT-U, CWYUF)
• Canfor Pulp Income Fund (TSX: CFX-U, OTC: CFPUF))
• EnerVest Diversified Income Trust (TSX: EIT-U, OTC: EVDVF)
• Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF)
• Extendicare REIT (TSX: EXE-U, OTC: EXMUF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• GMP Capital Trust (TSX: GMP-U, OTC: GMCPF)
• HR REIT (TSX: HR-U, OTC: HRREF)
• Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Precision Drilling Trust (TSX: PD-U, NYSE: PDS)
• Swiss Water Decaf Coffee Income Fund (TSX: SWS-U, OTC: SWSSF)
• Tree Island Wire Income Fund (TSX: TIL-U, OTC: TWIRF)
• Westshore Terminals Income Fund (TSX: WTE-U, OTC: WTSHF)

Bay Street, Canada’s version of Wall Street, has long admired CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF), and this week the analysts up north have once again bestowed a perfect 5.000 average rating on the medical imaging and diagnostic services provider in Bloomberg’s regular survey.

CML is featured in the High Yield of the Month and is also a new addition to the CE Portfolio. CML Healthcare Income Fund is a buy up to USD13.

Joining CML among those earning perfect 5.000 scores is Cineplex Galaxy Income Fund (TSX: CGX-U, OTC: CPXGF), Canada’s largest theater operator. Cineplex Galaxy Income Fund is a buy up to USD18.

Canadian Hydro Developers (TSX: KHD, OTC: CHDVF), the developer, owner and operator of 20 power generation facilities in Canada, earned a 4.833 average rating. The company has 496 megawatts (MW) of capacity in operation, 385 MW in and nearing construction, and 1,632 MW in development. Canadian Hydro’s renewable generation portfolio is diversified across three technologies (water, wind, and biomass) in the provinces of British Columbia, Alberta, Ontario and Quebec.

Canadian Hydro’s CAD285 million, 132 MW Melancthon II wind project, the second phase of the Melancthon EcoPower Center, achieved commercial operations Nov. 24. The first 67.5 MW phase achieved commercial operations on March 4, 2006. Output from the Center is sold to the Ontario Power Authority under two 20-year renewable energy supply contracts.

Canadian Hydro, quickly nearing the point where it can self-finance projects beyond its current CAD1.3 billion construction program, reported that third quarter revenue rose to CAD17.4 million, up 21 percent from CAD14.3 million a year earlier. Cash flow increased to CAD5.4 million (CAD0.04 per share), up 31 percent from CAD4.1 million (CAD0.03 per share). Non-cash foreign exchange losses pushed the company to a net loss of nearly CAD5 million (CAD0.03), compared with net income of CAD162,000 in the third quarter of 2007. The foreign exchange loss was mainly from euro-denominated cash balances set aside to pay for wind turbines.

The completion of Melancthon II and the imminent completion of its Wolfe Island project double Canadian Hydro’s power generation. The company has no need to access debt markets until September 2010. Beaten down along with the entire market, Canadian Hydro Developers makes for an intriguing speculation up to USD3.

There are fundamental economic reasons why markets have declined rapidly during the last couple months, but the volatility and the severity of the selloff are largely explained by the capitulation of mutual fund and hedge fund investors.

And we may see more of that as the year closes because of tax-loss selling.

Tax-loss selling is essentially selling an investment at a loss with the intention of taking that loss and applying it to realized capital gains. Investors must have realized capital gains in their portfolios, otherwise they can’t write off that loss.

That’s obviously not much of an issue for US-based, US-tax filing investors; few have gains to offset for 2008. But US investors in Canadian trusts and high-dividend-corporations should expect a huge amount of tax-loss selling this year by Canadians; such selling is sure to buffet prices for your holdings.

These losses follow a few good years for the market, which means many Canadian investors have claimed capital gains over the past three years. And Canadian tax law allows investors to recover taxes paid during those prior three years.

If a Canadian investor has losses this year that exceed his 2008 capital gains, he’s entitled, according to Canadian tax law, to carry those losses back and apply them against capital gains he may have realized or reported in the last three years–2007, 2006 and 2005.

Expect tax-loss selling to play havoc with your nerves in the days leading up to Christmas because trades must clear before year’s end.