Dividend Watch List

Three How They Rate entries announced distribution cuts last month: Acadian Timber Income Fund (TSX: ADN-U, ATBUF), Essential Energy Services Trust (TSX: ESN-U, OTC: EEYUF) and Priszm Income Fund (TSX: QSR-U, OTC: PSZMF).

The moves at Acadian and Essential were made simultaneously with announcements of conversions to corporations. At the root of all three, however, was the economic weakness in North America that continues to hammer their sales, cash flow and distributions.

For Essential, eliminating the distribution is the latest step on a well-worn path followed by every other Canadian energy services trust and company, starting when natural gas prices hit their late 2005 peak in the wake of hurricanes Katrina and Rita.

From that point, a combination of shale gas discoveries elsewhere in North America and slumping demand began to push down traditional drilling activity in the Western Canada Sedimentary Basin.

After gas prices peaked again in mid-2008, their resulting plunge dried up drilling in the rest of North America as well, including for shale gas. Third-quarter drilling activity is now at barely a third of capacity. And despite a recovery in gas prices back to around USD5 per million British thermal units (MMBtu) this fall, producers are loath to ramp up output again.

Worries include the looming threat of liquefied natural gas (LNG) imports, already high inventories, still sluggish demand for gas from heavy industrial users and for generating electricity, and worries winter–like the summer before it–will prove historically mild.

Essential was spun off from Avenir Diversified Income Trust (TSX: AVF-U, OTC: AVNDF) in mid-2006. Since then, it has responded to worsening conditions by trimming its distribution three times, before eliminating it entirely with the November payment.

Third-quarter results weren’t completely discouraging. Drilling activity in the Western Canada Sedimentary Basin was just 21 percent versus what was already a poor figure of 48 percent a year ago. But even that was an improvement over the second quarter. Moreover, there were signs that activity is stabilizing thanks to higher oil and firming gas prices.

Essential has been successful with its cost-cutting efforts, trimming 30 percent of its workforce since December 2008. And it’s successfully refocused operations on specialty services where it has a competitive advantage, such as downhole tubing and coil tubing rigs, as well as faster-growing drilling regions such as Bakken. Long-term debt was slashed by 35 percent.

On the other hand, revenue was barely half year-earlier levels. Cash flow from continuing operations was down more than 90 percent, and cash flow margin has plunged from 20 percent to just 3 percent of revenue. Third-quarter funds flow from operations was barely positive. And operating expenses rose to 88 percent of revenue, up from 74 percent.

Eliminating the distribution entirely and converting to a corporation will save roughly USD2.4 million in cash annually. Management expects to complete the switch by April 30, 2010, pending shareholder and regulatory approval. It’s expected to take place on a tax-free basis. That’s a potential plus for those who’ve held since the spinoff from Avenir, depending on how they accounted for that transaction.

The company’s product and service mix appears to be well-positioned. Rolling over a CAD50 million revolving loan coming due May 30, 2010, is a potential concern, particularly should business conditions deteriorate further. As of September 30, however, Essential had drawn only CAD14.3 million on the facility and all financial covenants were met.

The real question isn’t whether Essential will survive. Rather, it’s whether this is still a worthwhile holding as a small company in an intensely competitive and quite challenged industry. I rated Essential Energy Services Trust a sell when it paid a distribution; now paying none, it’s less attractive than ever.

In contrast, Acadian Timber Income does remain attractive as a converting corporation. The cut in the monthly distribution from a rate of 6.875 cents Canadian per unit to 1.667 cents is only slightly less severe than Essential’s. But the company’s prospects are also considerably brighter. In fact, dividends could be fully restored as growth returns to the battered North American timber industry.

Unlike most rivals, Acadian actually increased volume sales in the third quarter of 2009 by 3.5 percent over last year’s levels. Pricing pressures (down 13 percent for overall output from 2008) from weak demand for most products, however, crimped sales 16 percent and hit cash flow 70 percent, driving distributable cash flow into the red.

As a result, management has elected to cut its projected harvest levels in 2010 to reduce costs, and by extension to slash distributions roughly 75.7 percent.

Ultimately, a recovery in the North American timber industry is likely to require a real rebound in the US home building market, which has been its primary source of demand. That may not occur for some months yet, and in any case is unlikely to approach the manic levels of earlier this decade. And Acadian is particularly focused on this continent, given that its properties are in eastern Canada, mainly New Brunswick, and also Maine.

On the other hand, Acadian’s assets are rich and long-term, and it’s certainly capable of surviving whatever’s left of this downturn. The company maintains a powerful backer in Brookfield Asset Management (TSX: BAM-A, NYSE: BAM). Debt isn’t a major factor after the recent renegotiation of its credit agreement. The company will incur roughly CAD500,000 in additional interest expense next year, but that amount and then some will be absorbed by the savings from the distribution cut.

Management’s decision to reduce hardwood volumes will preserve the long-term value of the timberland assets at a time when prices are low. Meanwhile, biomass remains a major potential market, with many new facilities planned in the Northeast. Notably, Acadian continues to be able to sell all of its biomass despite tough market conditions.

Management will put the proposed conversion to a unitholder vote at a special meeting slated for December 22, with closing anticipated for Jan. 1, 2010. As has been the case with many other early conversions, the deal involves a “merger.” Acadian’s transaction partner is a company called CellFor, the world’s leading independent provider of high-technology seedlings to the global forestry industry.

This is purely to avoid tax implications and involves no real economic change. Rather, at the end of the transaction current Acadian owners will essentially be swapped one share of Acadian Timber Corp for every trust unit they previously owned. Effective ownership will be the same. The only difference is the former distribution will be treated as an equity dividend for tax purposes. Acadian will also gain CAD95 million in tax writeoffs with which to shelter cash flow.

At the reduced rate, Acadian’s distribution is considerably less attractive than before. In an industry as depressed as timber, however, the 3 percent is not only reasonable but it demonstrates management’s commitment to pay dividends long term, ramping up the payout when business conditions merit. The trust still warrants the riskiest CE safety rating of “6.” But selling for just 91 percent of very depressed book value, Acadian Timber Income Fund remains a suitable buy for speculators up to USD9.

Priszm Income Fund has yet to clarify what dividend it will pay in 2011. Instead, management states “the trustees will continue to assess the status of distributions in the coming years as long term capital commitments are quantified, re-financing options become available and the optimal corporate structure is developed to reflect the income trust legislation taking effect in 2011.

What is certain now, however, is the trust won’t pay a distribution until its restructuring efforts bear fruit and business conditions improve. As has been the case in prior periods, third-quarter results again showed rising costs and slumping sales, as the restaurant franchiser’s core brands continue to lose ground in a tough environment.

The bottom line was a 15.3 percent drop in cash from operating activities at a time when financing costs continue to rise, with year-over-year interest expense ticking up 14.4 percent.

Rising debt costs and falling sales form a deadly combination in any environment, all the more so when conditions are less than ideal. Fortunately, management’s actions should go a long way toward bolstering Priszm’s staying power.

For starters, eliminating the distribution will preserve approximately CAD6.5 million in cash annually, aiding efforts to buy back its own debt and get interest costs under control. The company is also taking a hard look at its underperforming assets. Last month, management announced a series of agreements with Yum! Restaurants International (Canada) to operate KFC, Taco Bell and Pizza Hut restaurants, with the goal of extending its franchise contracts and upgrading its system.

Priszm has now reached agreements on one group of 69 restaurants as well as another of 75 restaurants to extend franchises for an additional 10 years. By the end of 2010, it expects to have more than 150 restaurants under similar long-term contracts and 195 facilities that meet Yum! franchiser standards. It will also close 16 underperforming facilities by the end of 2010, and incur an additional capital investment of CAD15 million to 16.5 million to bring other restaurants up to snuff.

That shouldn’t be too much of a problem for the company, given the support of Yum! and what should be adequate cash flows. That should keep Priszm’s head above water, even as it benefits from what should be gradually improving overall business conditions. The units trade for just 57 percent of book value, 3 percent of sales and barely twice free cash flow per share.

That’s hardly expensive and enough to rate Priszm Income Fund units a hold. On the other hand, given the heavy lifting the restaurant trust must do, it’s not much reason to buy, either.

Here’s the rest of the Dividend Watch List. See How They Rate for buy/hold/sell advice.

I don’t include energy producer trusts, which should always be considered at risk since dividends depend on energy prices. However, with oil and gas prices improving and these trusts dug in, they’re clearly not where dividend risk lies now.

I also don’t include closed-end mutual funds, whose distributions depend on the payouts of their holdings.

• Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF)
• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)
• Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)
• FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF)
• InnVest REIT (TSX: INN-U, OTC: IVRVF)
• Labrador Iron Ore Royalty Income Fund (TSX: LIF-U, OTC: LBRYF)
• Phoenix Technology Income Fund (TSX: PHX-U, OTC: PHXHF)
• Primaris REIT (TSX: PMZ-U, OTC: PMZFF)
• Primary Energy Recycling (TSX: PRI-U, OTC: PYGYF)
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)

Bay Street Beat

Bay Street is growing more bullish on Canadian energy producers, anticipating a resumption of the long-term upward trend for per barrel prices as global demand recovers into 2010.

Indicative of the mood is RBC Dominion Securities’ view on Canadian Oil Sands Trust’s (TSX: COS-U, OTC: COSWF) lead in the race to win ConocoPhillips’ (NYSE: COP) 9 percent stake in the Syncrude venture. Canadian Oil Sands is the trading vehicle for Syncrude, of which it now owns 37 percent. ConocoPhillips’ interest is expected to fetch CAD4 billion.

“As much as bigger is not always better,” write RBC analyst Greg Pardy, “the transaction could make logical sense on two fronts. First, it would enable Canadian Oil Sands to buy oil sands assets headed into what we believe will be a continuation of a bull market for crude oil as demand recovers. Second, Canadian Oil Sands could be picking up additional interest in Syncrude before the operational improvements have fully surfaced.”

Positive views on the high-production-cost oil sands are further indication that the end of easy oil is over. The per-barrel price of oil must remain at an elevated level for high-cost, non-traditional reserves to be economic. Bullishness about energy extends to the eight oil and gas producers in the CE Aggressive Portfolio.

Of the 16 analysts covering ARC Energy Trust (TSX: AET-U, OTC: AETUF), for example, 12 rate the stock a buy, while four rank it a hold. Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF), with seven buy recommendations and three holds, is similarly regarded.

CE favorite Enerplus Resources Fund (TSX: ERF-U, NYSE: ERF) and longtime Portfolio holding Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) have one sell recommendation apiece, but, again, most analysts’ views correspond with our positive perspective.

Natural-gas-focused Paramount Energy Trust’s (TSX: PMT-U, OTC: PMGYF) ratings pale in comparison to the oil-focused names; nobody on Bay Street would have you buy the stock, although eight think it’s worth holding onto as a play on a rebound in the commodity price.

Penn West Energy Trust (TSX: PWT-U, NYSE: PWE), never a favorite on Canada’s version of Wall Street, carries two buys, 10 holds and two sells. Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF), also weighted toward natural gas but with impressive reserve-life numbers, is a buy for three houses, a hold for four more.

The views on Provident Energy Trust (TSX: PVE-U, NYSE: PVX), which has made several moves recently to reorient toward midstream operations from heavy oil, reflect some cautiousness toward a company in transition. All five Bay Streeters who cover it rate it a hold. See High Yield of the Month for the CE perspective.

Convertibles and How to Buy Them

By “converts” here we refer to convertible debentures, a debt security that could become equity.

We’ve seen a spate of such offerings in recent weeks, from Portfolio mainstay Atlantic Power Corp (TSX: ATP, OTC: ATLIF) as well as several members of the How They Rate coverage universe.

Atlantic issued CAD75 million of convertible unsecured subordinated debentures due March 15, 2017, bearing an interest rate of 6.25 percent on a bought-deal basis. A “bought-deal” financing simply means the underwriting syndicate has purchased all the debentures and will re-sell them to the public, including Canadians as well as–within certain limitations described below–Americans.

Interest will be paid semi-annually. The debentures will be convertible at the option of the holder into Atlantic common shares at a conversion rate of 76.9231 common shares per CAD1,000 principal amount of debentures, equal to a conversion price of CAD13 per share.

This type of offering is attractive to management because the cost of capital is relatively cheap; right now demand is high because investors appreciate the solid yield and the growth potential that comes with conversion to common stock.

Most management teams will retire the debt–often at a premium–before the conversion provisions kick in. This obviously limits dilution of existing equity holders; even convertibles that do become equity have a relatively limited impact on existing owners compared to straight offerings of new stock.

Difficulty arises for US investors is when a particular convertible offering, such as Atlantic Power Corp’s recent 6.75 percent note, isn’t registered in the US according to the 1933 Securities and Exchange Act (the 1933 Act).

The 1933 Act, as amended, includes several exemptions–none of which accommodate the recent Atlantic Power debenture issue–and a couple avenues for “accredited investors” as well as “non-accredited investors” who nevertheless display a level of financial sophistication and previous experience buying similar investment to work around limitations on purchases of non-registered securities by individuals.

Here’s where our old friends at Pennaluna & Company come in. Idaho-based Pennaluna specializes in trading directly on the Toronto Stock Exchange for US-based investors. You go directly to the TSX via Pennaluna’s online trading platform, PennTrade.com. All trades are USD29.95, “no exceptions, no fine print.”

If you call Pennaluna to discuss the Atlantic Power convertible debenture, for example, you won’t be met with an overburdened, underinformed back-office flunky from some huge brokerage house who is unmotivated to get your execution. You may not be able to purchase the debentures through Pennaluna, not because they can’t execute the trade but because management is not yet comfortable providing service for a product with which its brokerage staff is unfamiliar.

If you’re sick of extra fees and surcharges on your Canadian trading activity, check out PennTrade. If you qualify as an accredited investor or a non-accredited but sophisticated investor, this is the best possible outfit to handle all of your Canadian trading, and your US investing as well.