Dividend Watch List

Three How They Rate entries announced distribution cuts last month: Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF), EnCana Corp (TSX: ECA, NYSE: ECA) and Trilogy Energy Trust (TSX: TET-U, OTC: TETFF).

Meanwhile, a fourth, FP Newspapers Income Fund (TSX: FP-U, OTC: FPNUF), agreed to a new covenant on a CAD60 million debt refinancing that could trigger a distribution cut later this year.

For the past couple years, Boralex has been plagued by problems at its biomass power plants, which rely on wood waste from the timber industry for fuel. The timber industry has been battered continent-wide by weak conditions in the US home construction market, which has stabilized but shows no sign of making a rapid recovery.

The bankruptcy of giant AbitibiBowater earlier this year brought matters to a head by forcing intermittent closures at the biomass plants, hitting Boralex’ cash flows directly. Management had anticipated problems as early as March 2008, when it trimmed the distribution from a monthly rate of 7.5 cents Canadian to 5.833 cents. But with the Abitibi problems still festering, the company’s US cash flows hit by the rising Canadian dollar and 2011 taxation looming, it moved again on December 14, this time cutting the monthly rate to just 3.3333 cents per unit.

The good news about this cut is first that the market was already pricing it in. In fact, units have risen roughly 7 percent since the reduction. Second, the remaining yield still represents a healthy level of close to 10 percent. And last but not least, the new rate now appears sustainable, even after 2011 taxation kicks in.

Management’s statement that the “annual saving of nearly CAD18 million will allow the distributions to be maintained at a level lower than the distributable cash for several years” is particularly encouraging.

Dominion Bond Rating Service estimates that the new distribution level will be covered by the hydroelectric facilities alone, “assuming normal hydrology.” As a result, any cash from the hampered biomass facilities will add to what’s already a CAD17 million cash reserve. So will earnings from the cogeneration facility, which to date has continued to operate efficiently and profitably.

Looking ahead, Boralex faces some uncertainty when a major purchase power agreement at a hydro plant expires in 2012. This output, however, will almost certainly find a market because demand for reliable, low-carbon power continues to rise in North America. Meanwhile, the added cash will enhance the balance sheet, which is relatively unencumbered by debt (a CAD15 million credit facility is largely undrawn).

As yet, neither Boralex nor its parent and 23 percent owner Boralex Inc (TSX: BLX, OTC: BRLXF)–which operates all of its facilities–has said much about 2011, when it will presumably be subject to taxation. The trust abandoned an attempt to sell itself last year, due to a dearth of adequate bids amid the market meltdown.

Meanwhile, Boralex Inc, the parent, has been actively expanding, but mainly in Europe. Last month, the company acquired three wind farms in France, bringing its installed capacity on the Continent to 170 megawatts versus roughly 195 in North America. It has another 300 megawatts of wind under development globally. It would be purely speculative to suggest it will buy up the rest of the income fund, though its price of 2.21 times book value is nearly three times the fund’s 0.89 and suggests an immediately accretive stock-for-units deal could be done relatively cheaply.

The biggest positive for Boralex’ unitholders now is the distribution looks reliable for now and expectations for it are very low. That suggests that any further certainty regarding 2011 will be viewed as a major plus, whether it involves a takeover or not. The biggest negative is the continuing struggles of the forestry sector and their impact on cash flow. Last month’s distribution cut seems to take that well into account.

There are safer Canadian power companies, particularly Conservative Holding Brookfield Renewable Power (TSX: BRC-U, BRPFF).

But Boralex Power Income Fund looks solid enough to take off the Dividend Watch List, at least for now; it’s a buy up to CAD5 for aggressive investors who don’t already own it.

EnCana’s dividend “cut” was actually not a reduction at all, but rather the result of the spinoff of its oil production operations as Cenovus Energy (TSX: CVE-U, NYSE: CVE). Both Cenovus and EnCana now pay a quarterly distribution of CAD0.20 per share. And since the spinoff is basically one share of Cenovus per share of EnCana, investors are still getting the same overall quarterly rate of CAD0.40.

The EnCana/Cenovus split creates two attractive takeover targets, should the North American energy production industry consolidate in the wake of the proposed ExxonMobil (NYSE: XOM)/XTO Energy (NYSE: XTO) merger. Cenovus’ assets include a joint venture in the oil sands with ConocoPhillips (NYSE: COP), a half share of two Conoco refineries in the US and conventional oil and gas properties in Western Canada. Its fortunes depend heavily on what happens to oil prices. But its assets are certain to attract attention from interested purchasers, as 30 percent of cash flow comes from oil sands ventures.

EnCana, meanwhile, is now primarily a play on the accelerating growth of shale gas production in North America, including the Haynesville region in the US Southeast and the Horn River region in northern British Columbia. Management has proven extremely adept at adding new output and reserves at low cost and dumping its less competitive assets. The company is now one of the most efficient in North America as well as one of its largest gas producers.

The Canadian government may balk at a foreign company attempting a takeover of what it’s considered to be a real national treasure. EnCana, for example, is rumored to have forced the Conservative Party government’s hand in October 2006, by threatening to convert to an income trust. The rumor is that was a primary factor in Prime Minister Harper’s and Finance Minister Flaherty’s decision to prohibit new trusts and impose the infamous 2011 tax.

In any case, however, EnCana has strong value on its own, whether a merger offer comes or not. And that’s particularly true if natural gas prices stage a rebound this year. Buy EnCana up to USD40.

Given the deep crash in natural gas prices since mid-2008, Trilogy’s decision to cut its distribution and convert to a corporation was hardly a surprise. In fact, I fully expected management to completely eliminate the payout, given the trust’s small size (19,000 barrels of oil equivalent per day output), high debt load (3.3 times annualized cash flow) and heavy reliance on natural gas production (80 percent of output).

Instead, however, Trilogy cut by just 30 percent. That left its post-conversion payout at basically the same after-tax level for taxable Canadian unitholders as the pre-conversion trust’s distribution. That move has already been applauded by investors, who have sent its units higher by about 6 percent since.

Under the terms of the proposed conversion, Trilogy will become a corporation on February 5, assuming an affirmative vote by unitholders at a meeting slated for the day before. It must also garner the approvals for the Court of Queen’s Bench of Alberta, the Toronto Stock Exchange, the federal Competition Bureau and Trilogy’s lenders, though none of these should be more than a formality. The last distribution as a trust will be made in February to shareholders of record January 31.

I’ve never been a huge fan of Trilogy, owning mainly to its small size, heavy debt and reliance on extremely volatile natural gas prices. In my opinion, this cut is really the result of weak natural gas prices, rather than prospective taxation or any desire for “growth.” But the prospect of reviving natural gas prices, gas industry takeover interest and the trust’s resolution of its prospective 2011 structure have turned my opinion in a decidedly more positive direction.

Paramount Resources (TSX: POU, OTC: PRMRF) and its controlling shareholder Clayton H. Riddell are the most likely acquirers. After a purchase of more than 2 million units last month, Paramount and Riddell now control a combined 56.7 percent of Trilogy’s outstanding trust units. A deal to take it all would require a fairness opinion under Canadian law, and almost surely a sales price closer to Trilogy’s 2008 high in the low teens.

The post-conversion dividend rate isn’t particularly attractive at around 5 percent. That payout, however, is based on what are still very low prices for natural gas and could easily go a lot higher if the fuel starts to move up or if efforts to lift production pay off. Trilogy Energy Trust is a buy for aggressive investors up to USD10.

On the surface, FP Newspapers’ payout is still the same this month as it was last month. The trust, however, has signed a credit agreement with HSBC Bank Canada that, barring a sharp improvement in results in coming quarters, likely locks in a sizeable distribution cut sometime in 2010.

The HSBC money will pay off a CAD60 million loan facility with The Prudential Insurance Company of America. The HSBC loan is in two facilities, one for CAD50 million and the other for CAD10 million, both for a three-year term. The facilities are secured by all the assets of FP and include an initial deposit of CAD10 million, which is partly guaranteed by investors Ronald N. Stern and Robert I. Silver. This pair, in turn, controls 51 percent of the operating partnership from which FP Newspapers Income Fund derives all of its income.

Now for the negatives: The CAD50 million facility will be amortized at a rate of CAD5 million a year, an estimated negative impact of CAD0.03 a share to annual distributable cash flow. In addition, HSBC has imposed a covenant that FP’s distributions won’t exceed distributable cash flow by CAD1 million in any year. Any greater shortfall will come right off the distribution.

Of course, no trust or corporation can indefinitely pay out more than it takes in, which is exactly what FP has been doing in recent quarters. Newspaper advertising remains a troubled business, not only because of the economy. The secular decline of newspapers in general hasn’t helped. Then there’s the approach of 2011 taxation, which the board plans to address at the next general unitholders meeting this spring, and which will almost certainly bring a distribution cut. Finally, it’s hard to argue that a steep distribution cut isn’t already priced in for FP, given its yield of nearly 23 percent.

Those are all reasons why I haven’t changed by recommendation on FP from hold to sell. In fact, this credit deal does reduce leverage and refinancing risk, and comes with a lower initial interest rate on the larger facility.

Neither am I upgrading FP to a buy however, given its tough operating environment, remaining 2011 uncertainty and, most important, the fact there are better comeback plays available–such as Portfolio holding Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF). Hold FP Newspapers Income Fund.

Here’s the rest of the Dividend Watch List. Starting later this month, we’ll see a new batch of quarterly results. Some of these trusts and high-yielding corporations will earn exits, while others are likely to be added. Energy producer trusts should always be considered at risk to dividend cuts because cash flows follow often volatile energy prices.

• Boston Pizza Royalties Income Fund (TSX: BPF-U, OTC: BPZZF)
• Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF)
• 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)
• Royal Host REIT (TSX: RYL-U, OTC: ROYHF)
• Swiss Water Decaf Coffee Fund (TSX: SWS-U, OTC: SWSSF)

Bay Street Beat

It seemed a drastic step at the time, and it certainly alienated what had been a significant segment of its investor base. But the economy was busted, commodity prices were sagging and a new tax loomed. And there were significant resources waiting to be exploited. It was a time of great trial, but these decision-makers seem to have passed.

And now the boys on Bay Street are taking notice.

Advantage Energy Income Fund announced its intention to convert to a corporation in March 2009. It immediately suspended its distribution, part of an effort to shepherd and drive cash toward its promising portfolio of non-conventional assets, particularly its piece of the estimated 50-trillion-cubic-feet Montney Shale natural gas formation.

The income fund held 94 net sections in what’s called the Glacier play. In 2008, it drilled 12 wells and spent about CAD92 million evaluating Glacier’s resource potential. A Sproule Associates estimate of proven and probable reserves at the end of 2008 showed an increase of 313 percent to 38.6 million barrels of oil equivalent from 9.3 million barrels of oil equivalent in 2007. Clearly, this was a unique opportunity for the company.

According to management, the second phase of Advantage’s Glacier program should hit 50 million cubic feet per day (MMcf/d) of production by the second quarter of 2010. This is possible because–in addition to drastically reducing debt over the last couple years–the income fund became Advantage Oil & Gas (TSX: AAV, NYSE: AAV) and cut its distribution to zero. The new corporation essentially poured everything it had into the Montney.

As of early December, eight of the 22 horizontal wells Advantage drilled since July 2009–the same month it became a corporation–had been completed and tested. Combined production tests for these eight wells amounted to over 44 MMcf/d. And a Glacier well recently brought on stream exceed its test run by more than 25 percent, suggesting the aggressive effort will pay off beyond expectations.

Advantage is also building a 50 MMcf/d gas plant and related infrastructure at Glacier; once complete–regulatory approvals have been received and construction is underway–the facility is forecast to reduce operating costs by 67 percent.

Advantage has also hedged 58 percent of its natural gas production for 2010 at an average price of CAD7.46 AECO per thousand cubic feet (Mcf). In management’s words, “This significantly enhances our ability to leverage capital spending during this low supply cost environment and to capitalize on the Alberta Royalty Incentive Programs.” (The provincial government has incentivized producers during the economic downturn, reducing its take on gas drawn from its land to stimulate activity.)

AECO natural gas closed at CAD5.85 on January 7.

Cutting the distribution to zero was the best move for Advantage Energy Income Fund given the set of circumstances before it. Its case illustrates a point made here within weeks of Halloween 2006: There are as many solutions to 2011 taxation as there are income and royalty trusts.

Bay Street is happy with what it sees from the new Advantage: six of the seven analysts who cover the stock rate it a buy, while the other one has it a hold. The six buy-raters have each reiterated their call within the past month.

Make no mistake: Advantage Oil & Gas is a growth play now, focused on maximizing its Montney assets. The timing of its reorientation, however, could not have been better: It announced amid the market lows in March 2009; its move was completed just as the global economy began to show signs of life; it’s announced significant successes in a non-conventional shale gas play right when non-conventional shale gas is the object of the biggest Super Oil in the world’s desire; ExxonMobil’s (NYSE: XOM) startling offer for XTO Energy (NYSE: XTO) means natural gas is a serious fuel for the future.

Advantage Oil & Gas is well positioned, and it’s still cheap, even after rallying nearly 20 percent following the Exxon/XTO announcement.

Thank You, Vanguard

In an Oct. 22, 2009, Flash Alert we detailed an unfortunate set of circumstances surrounding Vanguard Brokerage Services. The once-investor friendly outfit had taken to charging an extra fee to buy Canadian and other foreign-based stocks, and its clearing corporation insisted on withholding 25 percent from Canadian-source dividends rather than the 15 percent mandated by the US-Canada Income Tax Convention.

Well, the CE community spoke, and Vanguard listened: Although this brokerage, like all of them, will continue to charge any fees it can, Vanguard has cajoled its clearing agent into withholding at the proper, 15 percent rate.

Collecting Convertibles

We’ve seen a spate of offerings of convertible debentures, a debt security that could become equity, in recent weeks. Portfolio mainstay Atlantic Power Corp (TSX: ATP, OTC: ATLIF) as well as several members of the How They Rate coverage universe are taking advantage of a narrowing of credit spreads to lock in cheap funding.

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.

If you’re sick of extra fees and surcharges on your Canadian trading activity, check out PennTrade.

How They Rate for 2011

The table below updates the conversion status of CE’s How They Rate coverage universe. We’ll be updating the table as information becomes available.