Dividend Watch List

A corporate conversion was the reason for last month’s sole dividend cut in the Canadian Edge coverage universe. Daylight Energy (TSX: DAY, OTC: DAYYF), formerly Daylight Resources Trust, announced a reduction in its monthly dividend to CAD0.05 per share from the CAD0.08 it’s paid as a trust since February 2009.

Daylight management had been decidedly vague about its post-conversion dividend for months after setting the process in motion earlier this year, stating only it would continue to offer “a monthly income component.” In my view, one major reason was uncertainty about the direction of natural gas prices, which remain depressed around USD4 per million British thermal units.

Gas has historically accounted for the lion’s share of Daylight’s output. Recently, management has made some major moves to boost the company’s production of liquids, including the acquisition of West Energy Ltd that closed last month. The West deal adds to Daylight’s drilling rights in the emerging Cardium light oil trend, providing immediate production growth as well as opportunities for expansion by pooling efforts. The company will now also be able to cut operating costs in the region by combining existing light oil facilities, gathering systems and other infrastructure.

Combined with the rest of Daylight’s 2010 capital program, the West deal will boost the company’s overall production to the 43,000 to 44,000 barrels of oil equivalent per day (boe/d) range this year with an exit rate of 47,000 boe/d. That’s a 23 percent increase from fourth-quarter 2009 output.

Even those aggressive moves, however, will still leave Daylight’s production mix at least 55 percent weighted toward natural gas. And they will require no small expenditure of capital, which management is loath to borrow. With natural gas prices not helping, the obvious solution was to increase the percentage of cash from operations reinvested in the business. And the result was the reduction in the distribution announced when the conversion was completed on May12.

The reduction did not come as much of a surprise to the market. Daylight’s share price is down slightly from the cut date, but so are prices of most energy producers since last month’s Flash Crash. And the share price is actually up since we published the previous issue of Canadian Edge. Clearly, it hasn’t cost investors yet.

The question is, What happens now? Is Daylight still a worthwhile holding yielding around 6 percent and relying on natural gas production for at least half of cash flow? Or are we better off looking for something either higher yielding or more reliant on oil and natural gas liquids, which currently enjoy far more favorable pricing?

Daylight is still worth holding for three reasons. First, the company is growing its production, and rapidly, both through acquisitions and organically (developing its existing properties). In fact, acquisitions like that of West are actually organic in nature, as they expand operations in a region where the company has extensive knowledge of the geology and needed technology to exploit it.

When we first recommended Daylight several years ago, we noted management’s unique strategy of investing in areas adjacent to where major players were developing. By this strategy, it was able to learn from others’ mistakes and to best target areas that made the most sense for a small company anxious to get larger quickly.

The rapid growth of Daylight’s output in recent years at a stable cost–and without taxing its capital structure–testifies that this strategy has been consistently applied and is working. And management’s projections of robust growth this year and into next demonstrate there’s very real potential for a whole lot more.

Second, Daylight’s assets are still cheap. In the aftermath of last month’s Flash Crash and corporate conversion, the shares trade for roughly a 10 percent discount to the value of the company’s assets in the ground. That low price may or may not ever lead to a takeover offer for Daylight. But it does make the company one of the cheapest oil and gas producers around, particularly given its growth trajectory for both output and reserves. And, at the least, that’s solid downside protection, particularly since reserve valuations are pre-acquisitions and are based on natural gas and oil prices lower than current levels.

Finally, it’s highly unlikely the current CAD0.05 per share monthly dividend would go any lower, even if natural gas prices were to move lower. And it’s very likely that the yield will go higher if there’s any recovery at all in natural gas prices.

Forecasting this last is, of course, a very frustrating business. Clearly, using more natural gas is a national priority given its relative cleanliness when burned, low price and the availability of abundant shale reserves. And most assuredly the incentive to use more gas has grown exponentially with the disaster in the Gulf and the certitude that offshore drilling is going to become a lot more expensive, if it’s permitted at all.

Equally clearly, however, North America still lacks the ability to export its natural gas overseas, as virtually all of the liquefied natural gas processing centers are geared for imports. That basically means what’s produced here must be used here. And right now, with the economy just starting to get back on its feet, demand is very low even as supply is high.

What will soak up the gas glut? Faster economic growth in the US is the most likely catalyst, and we may have a while to wait. But as utilities use more natural gas to produce electricity, as vehicle fleets turn to the fuel over gasoline and as industry begins to demand for energy, it will most assuredly happen. And when it does, the gas producers who survive and grow now–under the worst possible conditions–will be huge winners.

That certainly applies to Daylight Energy. And that’s a compelling reason to keep holding it, despite the lower yield they’re dishing out now. I also continue to rate the stock a buy up to USD11 for those who don’t already own it.

As I’ve said, dividend cuts made with conversions are entirely at the discretion of management. That makes them impossible to forecast for a company like Daylight, which had the wherewithal to keep paying at the same rate but chose not to.

Rather than try to play long-distance mind-reader and anticipate management moves, the best strategy is to stay focused on the health of the underlying business. In Daylight’s case, the fundamentals are strong indeed. That’s the real reason why its dividend cut did no real damage to the stock price. And it’s why the company is set to build wealth for investors for years to come.

In contrast, investors should try to minimize exposure to companies with weaker fundamentals, no matter what management professes to do with the post-conversion dividend. That’s the kind of company represented on the Dividend Watch List. Here’s the list along with a brief rundown of how they fared with first-quarter results.

Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)–The restaurant franchise posted a 4.3 percent increase in revenue and reduced its payout ratio to 67 percent for the first quarter from 115 percent in the fourth. The improvement, however, was due entirely to the opening of 17 new restaurants. Same store sales–i.e., revenue from stores owned the entire year–actually fell 5.4 percent, continuing the trend of the last several quarters. That’s not a good sign for sustainability as the 12 percent yield indicates. The post-taxation dividend policy isn’t set either. Sell.

Consumers’ Waterheater Income Fund(TSX: CWI-U, OTC: CSUWF)–The renter of water heaters and provider of sub-metering services to apartments posted flat revenue and cash flow in the first quarter. But competitive pressures remained high in both of the company’s core markets. The payout ratio was a modest 60 percent, largely thanks to halving of the distribution in late 2009. But interest expense rose 45.7 percent, and the company has a hefty credit line to refinance next year. The 16.9 percent yield is a sucker’s bet. Sell.

FP Newspapers Income Fund’s (TSX: FP-U, OTC: FPNUF)–Maybe it’s the fact that my publishing company faces many of the same issues as a paper company trying to move its business to the Internet. But I’m becoming considerably more favorable on FP, which saw cash flow surge 74.4 percent in the first quarter, as advertising and subscription sales stabilized. The payout ratio is down to 66 percent as well. Unfortunately, the near 15 percent yield is a warning that the dividend is still at risk, not only to the economy but management’s decision about what to do in 2011. It’s a hold only for aggressive investors.

InterRent Properties REIT (TSX: IIP-U, OTC: IIPZF)–Times are tough for this small residential property owner, as first-quarter revenue dipped 2.3 percent and distributable cash flow swung into the red. A cash drain is typical for apartment REITs in Canada, owing to the fact that many landlords provide heat to their tenants. But with the number of equity units up 55.4 percent over the past 12 months, this is not a situation with strength in it. Sell.

Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)–The energy services trust is on the verge of coming off the Dividend Watch List after reporting a solid first quarter on improved industry conditions. Management has also signaled in the past that it will hold the current dividend rate after converting to a corporation last this year. The payout ratio is just 52 percent and virtually no debt to worry about. My recommendation for aggressive investors remains to buy up to USD8.

Primaris Retail REIT (TSX: PMZ-U, OTC: PMZFF)–The owner of shopping centers also looks ready to come off the Watch List, after a successful debt refinancing and solid first quarter earnings release last month. The clear upshot of a drop in the payout ratio to 87 percent is the cash hoard accumulated last year has been put to work and is producing profits. I still like rival RioCan REIT (TSX: REI-U, OTC: RIOCF) much more. But Primaris is a worthy hold.

Royal Host REIT (TSX: RYL-U, OTC: ROYHF)–The hospitality industry is still a weak point for the Canadian economy, evidenced by this REIT’s continued weak results. Part of that is due to the reduced purchasing power of the US dollar, which has apparently affected tourism negatively to a greater extent than increased travel by Asians has helped. In the end, the latter is probably the great hope for this business, and Royal has a great position. But with distributable cash flow negative in the first quarter and margins lower, there’s good reason why the dividend is approaching 12 percent. Management says cash flows won’t be affected by 2011 taxes, which is positive. But weak business is enough reason to stay away for now.

Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)–I raised both the CE Safety Rating and my advice for this company to hold, as noted in How They Rate. And the 116.3 percent increase in cash flow is certainly encouraging. So is the 46.3 percent jump in distributable cash and the drop in the payout ratio to 38 percent. I’d like to see a couple more quarters of the same before taking this one off the Watch List, however, given the competitive pressures of its business and the often extremely negative impact on profits of a strong Canadian dollar. Hold.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–Same-store sales for the restaurant chain fell sharply in the first quarter, particularly in the US. The payout ratio is back at 95 percent. Hold.

Bay Street Beat

The Bay Street reaction to first-quarter earnings season for CE Aggressive Portfolio recommendations can be summed up in a word: steady.

Of the more than 100 new reports issued in response to Aggressive Holdings’ numbers, there were but two changes, an upgrade to “buy” from TD Newcrest for Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) and a downgrade to “market perform” by FirstEnergy Capital on Trinidad Drilling (TSX: TDG, OTC: TDGCF).

Mackie Research initiated coverage of recently converted Daylight Energy (TSX: DAY, OTC: DAYYF) with a “buy” rating.

On the Conservative ledger, Bay Street dished out more than 160 calls in response to the recent round of quarterly numbers. The word here is “upward,” as 10 analysts boosted their views of our picks.

AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) earned two upgrades, to “buy” at TD Newcrest and “sector outperform” from Scotia Capital. Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) also earned two upgrades, to “hold” from GMP Securities and to “sector perform” from Scotia Capital.

Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPFF) earned two upgrades–to “outperform” and “sector perform”–and is under new coverage as a “buy” at Jacob Securities. Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) also earned two upgrades, to “outperform” and “buy,” from National Bank Financial and TD Newcrest, respectively.

Broker-Dealers’ Dodge

Each individual state has its own securities laws and rules, commonly known as “Blue Sky” laws, designed to regulate offers and sales of securities.

Blue sky laws are state or jurisdictional laws in the US that regulate the offering and sale of securities in order to protect the public investors from fraud. These laws vary among states. States may require securities to be registered at the state level or to have an available exemption from registration. Without compliance with, or exemption from, Blue Sky laws, statutes can prevent brokers from soliciting interest in a company from their clients.

Companies listed on a US exchange such as the New York Stock Exchange or Nasdaq are granted automatic Blue Sky exemption in all 50 states. But issuers don’t apply for over-the-counter (OTC) listing; OTC listings–either on the Pink Sheets or the Bulletin Board–are the result of broker-dealers who are market makers applying to publish quotations through the particular OTC tier. For Pink Sheets listings there are no Securities and Exchange Commission (SEC) filing requirements, while the Bulletin Board requires some compliance with SEC requirements. Once a company commences trading in the OTC market its Blue Sky status must be determined on a state-by-state basis before offers be made in a given state.

The majority of the US states/jurisdictions have written into their statutes a provision for a “manual exemption” that may exempt a company from state registration if it’s covered in a “Recognized Securities Manual” such as Standard & Poor’s Corporation Records.

More often than not assertions by your broker that it’s illegal to own a particular OTC-listed company are driven more by a desire to get you to invest in equities for which his or her broker-dealer house is making a market.