Two How They Rate entries announced distribution cuts in the last month. One–Conservative Holding Innergex Power Income Fund’s (TSX: IEF-U, OTC: INRGF) 15 percent trimming, was part and parcel of a conversion to a corporation.

As I point out in High Yield of the Month, the company is merging with the manager of its assets–Innergex Renewable Energy (TSX: INE, OTC: INGXF)–to form a premier renewable energy company. The new dividend yield is still over 8 percent and is well-protected from both 2011 taxes and economic pressures. In fact, it’s likely to be increased as the company boosts its generating capacity by 40 percent in the next couple years.

The upshot is Innergex now rates a perfect “6” according to my Canadian Edge Safety Rating System. It’s still a buy up to USD12.

Circumstances behind the other cut, unfortunately, are considerably less favorable. As I warned last month, a covenant attached to FP Newspapers Income Fund’s (TSX: FP-U, OTC: FPNUF) recent CAD60 million debt refinancing placed stringent conditions on the trust’s ability to pay distributions.

Last month–with the ink barely dry on the new loan deal–management made its move: It cut the payout by 36.8 percent to a monthly rate of CAD0.06 from the prior rate of CAD0.095. That rate had prevailed since December 2008, following a one-month suspension in the distribution. Before that, FP had paid out 10.75 cents Canadian per month starting in December 2004, the result of the last of a series of increases dating back from the trust’s inception in late 2002.

The new annualized rate of CAD0.72 still adds up to a generous yield of 13.9 percent. And it’s relatively well-covered for the moment, at a payout ratio of roughly 70 percent based on third-quarter earnings. Fourth-quarter and full year results are due March 11.

Unfortunately, as the dividend declines of the past couple years attest, FP’s is not a growing business. All of the trust’s income comes from its 49 percent share of cash flow from the FP Canadian Newspapers LP. This is basically income from subscriptions, advertising and related businesses from the Winnipeg Free Press, the Brandon Sun and the Canstar Community News.

The largest of these is the Winnipeg paper, with 129,000 printed and electronic copies distributed seven days a week. The Brandon Sun publishes seven days as week, with an average circulation of 14,600, while the Canstar publication goes to 206,000.

All three publications are based in Winnipeg, providing some scale as well as home-field advantage in maintaining market share. Coupled with cost controls, that’s enabled FP to date to manage the recession, as well as the long-term decline in print media.

Unfortunately, as the declining distribution and tough conditions of the new credit agreement attest, companies can only do so much managing when the underlying fundamentals of their industry are fraying. FP’s push into electronic media is a formula nearly every traditional publisher is working on. But until it becomes the lion’s share of the business, overall cash flows are going to be under pressure.

The new debt agreement ensures FP will remain solvent, at least for the foreseeable future. For one thing, it continues to have financially powerful backers, mainly investors Ronald N. Stern and Robert I. Silver, who together control the other 51 percent of FP Canadian Newspapers LP. And their interests are clearly conjoined with those of FP Newspapers Income Fund unitholders.

The new payout, however, already faces a stiff challenge in pending trust taxation.

Because the income fund is basically a financial construct, one of two things is likely. First, Stern and Silver may elect to buy out the fund’s interest in FP Canadian Newspapers LP, taking the enterprise private. That could also be achieved by simply acquiring the income fund, which currently has a market value of just CAD36 million and sells for just 64 percent of book value. Stern and Silver are also on the hook for a portion of FP’s CAD10 million loan.

The other possibility is that the partnership changes form by either simply absorbing the new taxes, converting to a corporation or combining with the income fund to form a new corporation. In that case, ownership of the post-conversion company would still be divided between Stern and Silver and current unitholders holding 49 percent. This would follow the pattern of other converting trusts, including Food & Hospitality company Imvescor Restaurant Group (TSX: IRG, OTC: IRGIF).

In Imvescor’s case, the trust in question–Priszm Income Fund–was in a deeper decline than FP Newspapers is now. As a result, the conversion process involved a steep, two-step decline in the distribution from a monthly rate of CAD0.12 paid in June 2009 to the current quarterly rate of 7.5 cents.

The new rate looks solid and is still generous at more than 8.5 percent. But those who held on over the past year have seen the value of their shares fall 35 percent in US dollar terms, 44 percent in Canadian dollar terms.

In FP’s case, units are actually up 32 percent over the past year in US dollar terms. Getting there, however, has been a rocky ride, as the units bounced off a low of barely USD2 in March 2009 to hit a high of more than USD6.50 in October. That was followed by a plunge beginning in November to a December 21 low of barely CAD4, as it became clear the company’s credit agreement would include more stringent terms.

FP units, however, are less than half their level of mid-2008, before the credit crunch. As a result, they’re now much less at risk to a steep decline than Priszm/Imvescor’s were a year ago. In fact, they’re actually flat since the dividend cut announcement, indicating the news was not unexpected. The possibility of a buyout offers some upside promise. And the new distribution rate should hold at least until late 2010, as management appears in no great hurry to convert.

On the other hand, the core business faces obvious headwinds, both for circulation and ad revenue. There will be new taxes in 2011. And the income fund investors’ fate is pretty much in the hands of Stern and Silver.

A huge yield notwithstanding, there are more sure-footed yield plays than FP Newspapers Income Fund; it’s cheap enough to hold if you have it, otherwise look elsewhere.

My favorite super-high-yield play remains Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF). The company has maintained its current monthly payout of 6.67 cents Canadian since May 2009, when it suffered the first cut in its history from a prior rate of 9.75 cents. Until that point, it had consistently increased its payout roughly every nine months, as it expanded revenue sources and above all its Internet presence.

The current distribution rate is roughly equal to Yellow’s initial rate of 6.88 cents in late 2003 when it was launched as an income trust. When it made the cut in May, management stated it was needed to adopt a “more conservative financial policy that will result in lower financial leverage.” It also asserted the new rate would allow “a payout of 60 to 70 percent of cash earnings per share” that “should provide sufficient financial flexibility to YPG as we convert while we aim to grow returns to shareholders.”

Since then, management has been true to its word, applying cash to strengthen its balance sheet by replacing near-term maturities with longer-term ones. Only CAD87 million in maturities are left over the next two years, leaving the company free to tackle the CAD700 million coming due in 2012. Overall debt has been taken down to CAD2.96 billion. Meanwhile, it continues to hold investment-grade ratings from Standard & Poor’s and Dominion Bond Ratings Service, which management has identified as a top priority.

Fourth-quarter and full-year earnings won’t be out until February 11. But to date overall cash flow has been steady, as strength at the core print and Internet directory business has offset weakness at the Trader publications, mainly those focused on real estate and automobiles. And the company continues to launch new web directory/advertising offerings that dominate the Canadian market in a way US directory companies failed to. Dividend coverage by distributable cash flow has been nearly 2-to-1 the past two quarters.

The mere size of Yellow’s dividend yield is a clear sign of extreme investor skepticism. That’s in part due to circumstances beyond the company’s control, such as investors’ tendency to lump them in with the bankrupt US directory companies. But management credibility was also undermined by last year’s distribution cut, which followed several years of insisting that Yellow could out earn its potential 2011 tax liability.

The bad news is erasing that skepticism is going to take two things: Yellow’s conversion to a corporation, clarifying its 2011 dividend policy, and a solid rebound in advertising. It may be that neither happens before late 2010, which will keep Yellow a laggard.

Ultimately, however, Yellow’s fate will depend on its numbers, and here the situation is considerably more promising. Not only are its long-term business initiatives of moving onto the Internet intact. But the Canadian economy has shown signs of strength since mid-2009, while management’s plans were formed on the assumption there would be no recovery going into 2010.

On the other hand, the company also stated in May 2009 that “strong free cash flow generation” would enable it to “self-finance its business plan and meet liability maturities through 2012 without having to access capital markets.” That statement seemed to be contradicted by a series of bond issues since, though they were used to pay down debt.

In short, management is going to have to put up results that match its words. And we’re only going to find out how well it’s succeeded by waiting on the numbers. The good news is it’s hard to argue another distribution cut isn’t already priced in with the current yield at 15 percent-plus, or at the shares’ price of just 53 percent of book value.

Low expectations mean low risks. They also mean strong upside if the company exceeds them. Yellow has definitely been through the wars. But even in the worst possible conditions, it’s remained very profitable and able to access capital markets. And that’s a pretty good reason to stick with them, particularly at its current price. Yellow Pages Income Fund remains a buy up to USD8 for those who don’t already own it.

Here’s the rest of the Dividend Watch List. Note that starting later this month we’ll see a new batch of quarterly results. Some of these trusts and high-yielding corporations will earn exits, and others are likely to be added.

Energy producer trusts should always be considered at risk to dividend cuts, as cash flows follow often volatile energy prices.

The list below is made of up companies facing business weakness with a real possibility of triggering a distribution cut. Excluded are trusts with strong businesses that may elect to trim distribution as part of converting to corporations later this year.

One reason is such cuts are basically elective, and forecasting them would require mind-reading skills I don’t possess. The other is that trusts with strong businesses have repeatedly posted powerful share price gains after announcing conversions. Those that haven’t cut dividends have scored windfall gains almost immediately. But even the cutters have ultimately surged.

The point is strong businesses always build wealth, no matter how they’re organized or taxed. Weak ones lose value, no matter how high their current yields look or what tax advantages they enjoy.

Buying the strong and selling the weak will not only save you a lot of market pain, it’s the surest road to long-term gain.

• 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)
• Jazz Air Income Fund (TSX: JAZ-U, OTC: JAARF)
• 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)
• Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF)

Bay Street Beat

Two companies make their debut in How They Rate this month, Energy Infrastructure outfit Fort Chicago Energy Partners LP (TSX: FCE-U, OTC: FCGYF) and Oil and Gas producer Cenovus Energy (TSX: CVE, NYSE: CVE), the spun-off oil segment of EnCana Corp (TSX: ECA, NYSE: ECA), which is now a pure natural gas play.

Fort Chicago owns interests in two pipeline systems, a natural gas liquids (NGL) extraction facility and renewable power generating facilities in Ontario, Colorado and California. The company will close the USD80 million acquisition of a 33 megawatt run-of-river hydro facility in Upstate New York in the first quarter of 2010.

The Northbrook facility is operated by an experienced third-party contractor. In the past, power produced by the facility has been sold under two-year contracts; Fort Chicago intends to explore opportunities for a longer-term sales arrangement.

Bay Street is rather lukewarm on Fort Chicago: Nine analysts rate the company a hold, while only one says “buy.” One rates it a sell. We’re initiating coverage of Fort Chicago Energy Partners LP with a hold rating.

Management recently announced that Fort Chicago would convert to a corporation without cutting distributions. The Canadian LP currently pays CAD0.0833 per unit per month, good for an annualized yield of 9.8 percent. The company’s payout ratio is 80 percent, conservative by Energy Infrastructure standards, and its debt-to-assets ratio of 59 percent is also very manageable.

The problem with Fort Chicago is that there are restrictions on ownership by US residents included within the partnership agreement; that means only the most aggressive American investors, who are also fortunate enough to deal with an accommodating broker, can get a buy order executed. When it does convert, however, particularly in light of the commitment to continue with the generous payout, Fort Chicago Energy shares will be easy to come by.

Cenovus Energy split from EnCana in December 2009. Twelve Bay Street houses initiated coverage with buy ratings, while nine say to hold. The costs of the structural change have exceeded management expectations, but at the end of the day Cenovus is endowed with an attractive set of assets.

Management of the old EnCana first articulated its ambition to split into an oil-focused company and a gas-focused company, but the combination of tightening credit markets and plummeting commodity prices forced a mothballing of these ambitions. Credit conditions began to ease in the second half of 2009; the decision to make the split at the end of 2009 was a clear bet by management that natural gas prices were poised to recover. The new EnCana is set up to take advantage.

Cenovus is interesting to watch because of its involvement in new, more efficient methods of exploiting heavy oil reserves. Cenovus employs the enhanced recovery method called steam assisted gravity drainage (SAGD) at both its Foster Creek and Christina Lake projects.

The company also operates the world’s largest geological carbon dioxide (CO₂) sequestration project in Weyburn, Saskatchewan. Since the start of CO₂ injection in 2000, more than 15 million ton of have been sequestered. The project is the site of an aggressive research initiative operated sponsored by the International Energy Agency. Cenovus Energy is a buy up to USD25.

Alberta’s Royalty Muck

A Republican will sit in Ted Kennedy’s Seat. President Obama is floating a “spending freeze” that has left-leaning pundits either a. comparing him to Herbert Hoover, or b. invoking “1937!” but still comparing him to the Republican who preceded FDR.

Meanwhile, in Alberta, provincial liberals have proposed an industry-friendly reduction in oil and gas royalty rates at a time when Premier Ed Stelmach–leader of Alberta’s Tories–is plunging in the polls because of his mishandling of the province’s most important economic issue. Stelmach’s political difficulties–he’s getting squeezed from left and right on a position that was flawed from the start–are likely to result in a royalty-rate reduction that could be announced by the end of January.

OK, Stelmach’s Tories are losing ground not to the liberals but to a newer, younger, dazzlingly named conservative rival, the Wildrose Alliance, so it’s not quite as topsy-turvy as what’s going on stateside. But the potential consequences for potential natural gas producers in Alberta are much clearer.

A provincial energy ministry “competitiveness review” instigated by the premier is said to be on the way to his desk; Stelmach ordered the study last summer when the reality of the economic downturn and the potential for unconventional natural gas production essentially forced a reevaluation of Alberta’s energy industry. The report’s release has been delayed several times; it was originally promised by last fall, then by the end of 2009, then by the end of January. Now, the Alberta government says it will come with next week’s provincial budget announcement, or perhaps afterward. 

Nevertheless, the politics as well as the policy suggest producers may have cause to come back to Alberta once the review finally sees the light of day and elected officials implement its recommendations. A January 12 report by Energy Navigator found that an energy company drilling an unconventional shale gas well in Alberta must pay the province CAD165 in royalties before it shows CAD100 in profit. On the other hand, in British Columbia, which revised its royalty structure to attract producers and encourage natural gas production, a company drilling the same unconventional well must pay the government only CAD36 in royalties before it shows a profit of CAD100.

That Alberta oil and gas producers could be looking at more favorable royalty structures is, obviously, a positive; every little bit that helps the bottom line counts. However, at this point the folks who have to manage these companies would settle for predictability. The current Alberta regime’s handling of the royalty structure has sowed mistrust among industry players and among investors.

As one industry executive put it to the National Post, “The industry and the investment community feel there’s a substantial lack of credibility with regards to past measures that have been put in place that are short-term in nature and don’t really address a solution for Alberta to remain competitive.”

Under Stelmach’s watch Alberta raised royalty rates just as signs of recession were popping up in 2007. This initial mistake was followed by five adjustments. The market’s been confused by his government’s inconsistency and would welcome a definitive resolution.