When a company slashes its dividend, should you always cut and run?

At least to this point the answer has been a definite “no” for both March Best Buys, Colabor Group Inc (TSX: GCL, OTC: COLFF) and Enerplus Corp (TSX: ERF, NYSE: ERF).

Last year I unloaded Enerplus from the Canadian Edge Portfolio Aggressive Holdings. My concern was that the company was rolling up debt at an alarming rate to fund its development and seemed almost certainly headed for a dividend cut.

As it turned out Enerplus did wind up cutting its payout in half. But management kept its eye on the prize of expanding production of oil from its Bakken Shale properties as well as growing output of liquids-rich natural gas from the Marcellus Shale.

The savings from the dividend cut went a long way toward arresting the rapid accumulation of debt. Enerplus caught a real break from a surprise mid-year recovery in the price of natural gas, which lifted cash flows. And management was able to successfully complete the sale of several non-core assets at good prices, including unused acreage in the Marcellus for a sizeable gain.

Fourth-quarter 2012 results show just how far the company has come from last year’s nadir. Overall production rose 11 percent to 85,490 barrels of oil equivalent (BOE) per day, spurred by a 22 percent boost in oil output.

The company also saw wet natural gas volumes from its Marcellus properties surge 40 percent over third-quarter levels, as previously delayed wells were brought on stream.

Higher output translated to vastly improved scale and cost structure. Operating costs per barrel of oil equivalent dropped 25 percent from third-quarter levels, even as the company held other expenses in line.

Finding and development costs for proved plus probable reserves fell to USD24.41 per BOE from last year’s USD26.26. Excluding future development capital, that number was just USD14.88 per BOE.

That’s further evidence this company can replenish reserves at a reasonable cost, also a major goal of management with its move to boost liquids output. The company increased its oil and liquids reserves by 12 percent in 2012, bringing them to 60 percent of total energy reserves. And new additions of crude oil reserves were 283 percent of 2012 production.

The area of fastest development remains Enerplus’ Bakken properties, particularly Fort Berthold, which saw a 52 percent boost in reserves en route to replacing nearly 800 percent of production. This region promises to produce more robust gains in 2013, even as the company realizes gains on its older fields by employing waterflood drilling techniques.

As is the case for all but a tiny handful of Canadian energy producers, natural gas was a drag on Enerplus’ operations last year. Growth in liquids-rich Marcellus reserves to 29 percent of total gas reserves is a big step toward limiting the future impact of weak dry-gas prices.

But despite a collapse in selling prices for gas, Enerplus still managed a 12 percent increase in full-year funds from operations (FFO). Fourth-quarter FFO was 27.5 percent higher than year-ago levels and covered the total of cash and stock dividends by a very healthy 3.73-to-1 margin. The payout ratio was 27 percent.

Fourth-quarter FFO also came very close to covering the sum of stock and cash dividends plus capital spending with a 0.94-to-1 ratio. That was a massive improvement on last year’s 0.35-to-1 ratio, and it reflected higher FFO as much as the reduced dividend and CAPEX.

Most impressive, the company produced that FFO despite lower selling prices for all three major products. Crude oil, for example, managed an average selling price of just USD76.75, down 12.3 percent from year-ago levels. Average natural gas liquids’ selling prices took a huge 30.8 percent hit. Fourth-quarter natural gas, meanwhile, sold for USD3.01 per thousand cubic feet. That was 25.9 percent above the company’s average selling price for all of 2012 but still 11.7 percent below last year’s levels.

With its transition now complete to a liquids focus, Enerplus is on track to grow production in its key areas while actually scaling back CAPEX by about 20 percent overall.

The company will also develop its stakes in key Canadian gas plays Wilrich and Duvernay, which are on track to become major profit centers as export capacity in British Columbia becomes a reality in coming years.

Even with the expectation of slower production growth and subdued pricing, management’s guidance is for an 8 percent increase in FFO for 2013.

And the company has safeguarded a fair chunk of that cash flow already by hedging 60 percent of its oil at prices of over USD100 a barrel. It’s hedged 28 percent of gas output as well.

The upshot is I’m adding Enerplus back to the Aggressive Holdings this month as a buy up to USD15. The stock yields a generous 7.4 percent, with dividends paid on a monthly basis.

Colabor Group has an even more attractive yield at 9.7 percent, mainly because of investor fears there may be another cut. I’ve kept the stock on “probation” in the Aggressive Holdings since last year’s cut, on the condition that it continue to meet three benchmarks: that it post a cash flow per share payout ratio of no more than 80 percent for any rolling 12 month period; that it report positive “comparable sales” (revenue excluding the impact of acquisitions and dispositions); and that it show progress on debt reduction.

Colabor met these criteria in each of the first three quarters of 2012. Now, thanks to the strategic acquisition of meat operations of T. Lauzon, Colabor may have put itself on firm enough footing to earn a move back to the Conservative Holdings.

We’ll know more when Colabor releases its fourth-quarter and full-year results on March 25, and we’ll highlight what we learn in a Flash Alert shortly thereafter.

For now, however, what we do know is the food services and related products distributor financed this deal with 100 percent equity from a private placement.

This alone assures a reduction in debt leverage for Colabor in 2013. And assuming the new assets perform up to snuff, as the vast majority of the company’s other additions have in the past, other leverage ratios should improve as well.

T. Lauzon is a major meat, poultry, fish, delicatessen and grocery distributor supplying Quebec’s hotel and restaurant industry.

These markets are complementary to Colabor’s previous expansion in its home province and further cement the company’s position as the largest independent food distributor in Quebec.

The company now has more than 25,000 clients for over 50,000 products in Quebec, Ontario and the Atlantic provinces.

The company also gained a major deep-pocketed investor last month, with the CAD15 million investment of major Quebec pension firm The Caisse de depot et placement du Quebec. The equity raise is in addition to the private placement financing for the T. Lauzon acquisition and puts a giant with CAD159 billion in net assets in Colabor’s corner.

Regarding upcoming earnings, management has pre-stated its expectation that results will “be in line” with the corresponding quarter of 2011. And it affirmed guidance that full-year results will be “slightly above” 2011 levels, despite continued difficult year-long economic and competitive conditions.

That’s the best available sign the quarterly dividend of CAD0.18 per share will be maintained. Colabor Group is a buy up to USD8, with the promise of an upgrade after earnings are announced.

What could go wrong at these companies? We’ve seen it already with the dividend cuts of the past year.

Colabor’s 33 percent dividend cut was declared almost a year ago, on March 21, 2012. Management moved in the wake of very weak fourth-quarter 2011 numbers to significantly cut operating and procurement costs to deal with weak market conditions and very tough competition, particularly in areas of recent expansion. It reduced the dividend mainly to lay the groundwork to cut debt, which was looming larger in view of reduced profitability.

Enerplus halved its payout in June 2012, largely in response to continued weakness in natural gas prices. The company had been moving quickly to develop new opportunities in Bakken Shale oil and liquids-rich Marcellus Shale natural gas. But with revenue from natural gas sales plummeting, funding that effort was causing debt to pile up at a staggering pace. And rather than max out credit lines the company elected to save cash.

Roughly a year later for Colabor and nine months on for Enerplus, these companies still have vulnerabilities.

Colabor appears to have greatly stabilized its results with its recent strategic initiatives. And management has taken full advantage of its Quebec focus. But it’s still trying to build a business in a very competitive industry.

Enerplus too appears to be on much firmer ground than it was just a few weeks ago. But like all energy producers, profitability depends to a large extent on what it can sell oil and gas for. Although management has proven adept at exploration and development, production is still subject to the vagaries of weather and other factors.

These aren’t utility stocks. But at today’s lower dividend levels, both of these companies are much better prepared to handle whatever market conditions throw at them. And their balance sheets are also healthier than when they made their cuts.

Enerplus’ fourth-quarter debt-to-cash flow ratio, for example, has come down to just 1.7-to-1, after surging well over 2-to-1 last year.

Colabor, meanwhile, has improved all of its leverage ratios and stands to substantially cut interest costs with the T. Lauzon purchase.

In short, dividend cuts are possible for both companies down the road, but only if conditions in their respective markets dramatically worsen.

That means considerably more potential upside and less downside than their stocks carried just a few months ago.

For more information on Colabor Group, go to How They Rate under Food and Hospitality.

Enerplus Corp is tracked under Oil and Gas. Click on their US symbols to see all previous writeups in Canadian Edge and Maple Leaf Memo.

Click on the Toronto Stock Exchange (TSX) symbol to go to their Google Finance pages for a wealth of information, ranging from news releases to price charts. Click on their names to go directly to company websites.

Enerplus is a mid-sized company with market capitalization of USD2.9 billion. Colabor is decidedly small fry at about USD190 million. But both stocks have been recommended by Canadian Edge for some time and should have plenty of liquidity. Enerplus is listed on the New York Stock Exchange (NYSE), while Colabor trades in the US over-the-counter (OTC) market under the symbol COLFF, in addition to its home listing under the symbol GCL on the TSX.

Both companies have decent coverage on Bay Street and Wall Street. Colabor has five analysts tracking it, with two rating it a “buy” and three rating it a “hold.” Enerplus is covered by 17 analysts, with nine “buys” versus six “holds” and two “sells.” Both stocks have seen net insider buying over the past six months.

As is the case with all stocks in the Canadian Edge coverage universe, you get the same ownership whether you buy in the US or Canada. These stocks are priced in and pay dividends in Canadian dollars. Appreciation in the loonie will raise dividends as well as the value of your shares.

Dividends paid by both companies are 100 percent qualified for US income tax purposes. Both stocks’ dividends are taxed at the now permanent Bush-era rates of 5 percent to 15 percent for investors’ first USD450,000 a year of income for couples (USD400,000 for singles). Above that the maximum tax rate is 20 percent.

Canadian investors enjoy favorable tax status for both companies. For US investors, dividends paid into IRAs aren’t subject to 15 percent Canadian withholding tax, though they are withheld at a 15 percent rate if held outside of an IRA.

Dividend taxes withheld from US non-IRA accounts can be recovered as a credit by filing a Form 1116 with your US income taxes. The amount of recovery allowed per year depends on your own tax situation.