Why Canada Is Set to Hand You Big Gains

We’re on the ground at the Las Vegas Money Show, enjoying unusually mild, La Jolla-like weather in America’s Playground.

Several Canadian trusts–including Penn West Energy Trust, Paramount Energy Trust and Enerplus Resources–are exhibiting in the convention hall, and we’ll be tracking down representatives during our stay; we’ll pass along any insights we’re able to glean.

What’s remarkable thus far is the sheer number of self-directed investors making the rounds. Registration was up more than 30 percent for the show, which seems counterintuitive given the prevailing noise about the market and the economy.

At its most basic level, though, investing is an optimist’s endeavor: It’s inherently forward-looking. You must have some faith that things will improve if you’re going to lay out hard-earned cash for companies.

Short-term market gyrations and temporary economic setbacks aside, we do this to make money over time. The dips and depressions can be tough, but you’ve got to stay in the game.

Looking Forward

Canadian Edge began life in a still-expanding world of income trusts. Much has changed since July 2004–our understanding of Canada’s politics, what it means for the business climate and the economic fundamentals that underlie it all.

The Oct. 31, 2006, announcement that Canada would begin taxing specified investment flow-throughs (SIFT) at the entity level–effectively eliminating the advantage that allowed trusts to pass cash flow on to unitholders to be taxed in their hands–obviously had significant implications for CE and our readers.

CE is essentially an income-focused investment advisory, but as Warren Buffett famously said and as has always been the fundamental underpinning of what we do here, when you invest in a company, you’re buying a business. A steady dividend stream is a reliable route to building wealth–but first and foremost is what’s happening at the operational level.

Canada’s political dialogue in superficial ways mirrors the one down here: You have “liberals” and “conservatives,” seemingly intractable policy differences at the headline level, apparently irreconcilable regional priorities. What you don’t have, however, and crucially, is a vocal, powerful segment of the ruling class seriously advocating for a government you could drown in a bathtub. There’s a broad recognition that government can and should reconcile the inevitable inefficiencies a robust but imperfect market economy creates.

The bottom line is the Canadian economy is fundamentally sound, anchored by a solid balance sheet and ample natural resources. The federal government was running a CAD12.9 billion surplus for the 11 months ended Feb. 29, 2008. (That number will come down after CAD2.5 billion in year-end adjustments based on allocation of funds for public transit and a project to demonstrate how companies may be able to capture and store carbon emissions.)

Canada’s minority Conservative government also pushed through a five-year, CAD60 billion tax-cut package last year to help shield the world’s eighth-largest economy from a slowdown in the US. The plan included immediate reductions in personal income taxes and a 1 percentage point cut in the federal sales tax as of Jan. 1. In the end, the 2007-08 surplus will come in about 16 percent below the CAD15.29 billion posted for 2006-07.

Employment in Canada is not only growing, but the proportion of the adult population with jobs has reached a record high of 63.9 percent. In the US, this ratio has been dropping sharply, down 0.6 to 62.7 percent so far.

Retail sales are up 6.8 percent in Canada over this time last year. In the US, sales are up just 2.9 percent and growth is still slowing. Housing construction, a major creator of employment in recent years, has collapsed in the US to roughly half its peak level, down 29 percent just in the past year. It’s still rising in Canada, up 3.9 percent over the past year.

Home prices, a crucial indicator of household wealth because a home is the most valuable asset for most families, have plunged nearly 13 percent on average in the US over the past year, and the rate of decline has accelerated in recent months. By contrast, Canadian home prices are up by more than 5 percent over the past year. Auto sales, a useful index of consumers’ willingness and ability to make a big purchase, are down 7.7 percent in the US this year, to a 10-year low. They’re up 6.1 percent in Canada to a new record.

And Canada, unusual among developed countries in the importance of natural resources and raw materials, now ranks with the world’s top five producers of 14 mineral commodities. Overall, commodities account for about half of Canada’s exports.    

With all that in mind, we’ve broadened our coverage of investment opportunities in the Great White North.

The original approach to Canada-based companies outside the income and royalty trust space centered on dividend payers. But we ignored that loose construct in our first discussion in the April 2007 issue of CE, recommending alternative power generator Canadian Hydro Developers, a long-term growth play on increasing awareness of and demand for cleaner sources of electricity.

We’ve added our non-trust recommendations to How They Rate coverage, grouped at the bottom of the table. The plan is expand the Canadian Edge universe, slowly, over time, building on the same principles that frame our trust coverage: Buy good businesses at value-based levels, and stick around for the long term.

Speaking Engagements

Be sure to wear a flower in your hair when you venture west to San Francisco. I’ll be heading to “The City” with Neil George and Elliott Gue Aug. 7-10, 2008, for the San Francisco Money Show.

Neil, Elliott and I will discuss infrastructure, partnerships, utilities, resources and energy, and to tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011362 to attend as our guest.

The Roundup

Income Portfolio

Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF) reported cash available for distribution of CAD15.9 million (21 cents Canadian per unit), up from CAD15.1 million (20 cents Canadian per unit) during the first quarter of 2007. Cash from operating activities was CAD14.7 million (20 cents Canadian per unit), up from CAD10 million (14 cents Canadian per unit) a year ago.

Cash distributions in the first quarter of 2008 were 23 cents Canadian per trust unit, unchanged from the first quarter of 2007. Revenue was CAD48 million, a slight uptick from CAD47.6 million in the first quarter of 2007. The fund reported a net loss of CAD1.6 million (2 cents Canadian per unit), compared to net income from continuing operations a year ago of CAD6.9 million (9 cents Canadian per unit).

The revenue increase was primarily due to increased energy production and higher rates. The strong Canadian dollar held down US-source revenue. Net income was lower because of higher interest costs, losses on financial instruments, lower earnings on portfolio investments, foreign exchange losses and an increased income tax expense booked in the quarter. Algonquin Power Income Fund is a buy up to USD9.50.

AltaGas Income Trust (TSX: ALA.UN, OTC: ATGFF) reported a 53 percent rise in net income for the first quarter of 2007 to CAD37.6 million (58 cents Canadian per unit) from CAD24.6 million (43 cents Canadian per unit) for the same period of 2007. The Taylor LNG LP acquisition, which AltaGas completed Jan. 10, 2008, for CAD600 million, accounted for most of the increase. Hedging gains, strong power prices and favorable fractionation spreads also drove results.

Earnings before interest, taxes, depreciation and amortization (EBITDA) were CAD63.6 million (98 cents Canadian per unit) during the first quarter, up from CAD41.2 million (73 cents Canadian per unit) a year ago. Cash from operations was CAD37 million (57 cents Canadian per unit), compared to CAD46.1 million (81 cents Canadian per unit) for the first quarter of 2007. Funds from operations (FFO) were CAD56.3 million (87 cents Canadian per unit) for first quarter 2008 compared to CAD38.2 million (67 cents Canadian per unit) for the same period in 2007.

Total debt at March 31, 2008, was CAD639.8 million, compared to CAD220.7 million at Dec. 31, 2007, because of the Taylor acquisition. The trust’s debt-to-total capitalization ratio was 45.1 percent versus 27.4 percent at the end of 2007. AltaGas Income Trust is a buy up to USD28.

Bell Aliant Regional Communications Income Fund (TSX: BA.UN, OTC: BLIAF) reported a 1.6 percent increase (CAD14 million) in operating revenue in the first quarter of 2008 on growth in its information technology (IT) and Internet segments. Internet revenue grew by CAD8.3 million, driven by 14.6 percent growth in its high-speed Internet subscriber base.

Local service and long-distance revenue declined by CAD8.4 million (2.4 percent) and CAD2.5 million (2.2 percent), respectively. Higher revenues, cost controls and lower provincial capital taxes resulted in an EBITDA increase of CAD5.6 million (1.6 percent) in the first quarter. Distributable cash increased by CAD14.7 million (7.7 percent). Buy Bell Aliant Regional Communications Income Fund up to USD33.

GMP Capital Trust’s (TSX: GMP.UN, OTC: GMCPF) first quarter numbers reflect what CEO Kevin Sullivan described as “some of the worst” market conditions he’s seen in his 23 years in the financial services industry. Distributable cash of CAD26.2 million (41 cents Canadian per unit) was down 47 percent from CAD49.9 million (80 cents Canadian per unit) a year ago.

GMP’s payout ratio rose to 102.7 percent from 47.1 percent. Net income was CAD21 million, down from CAD44.5 million in the first quarter of 2007. Revenue of CAD94.1 million was off 18 percent from the first quarter of 2007.

Excluding the prior year’s gains from the sale of the shares of Montreal Exchange of CAD12.8 million, revenue and net income decreased 8 percent and 36 percent, respectively. GMP’s strong balance sheet puts it in decent position to capitalize once some semblance of normalcy returns to the market.

Sullivan warned that “should the current business environment continue for much longer, it may impact our growth prospects and we would need to re-examine the sustainability of our current monthly distribution level of 14 cents.” GMP Capital Trust is a buy up to USD25.

Macquarie Power & Infrastructure Income Fund (TSX: MPT.UN, OTC: MCQPF) reported distributable cash of CAD16.5 million (33 cents Canadian per unit), up from CAD12.1 million (41 cents Canadian per unit) a year ago. Revenue was CAD43.7 million, up from CAD29 million because of the contribution of wind, hydro and biomass assets acquired as part of the June 2007 takeover of Clean Power Income Fund, higher rates and increased production.

The payout ratio ticked up to 80 percent from 64 percent in the first quarter of 2007 on the issuance of units in connection with the Clean Power deal and a distribution increase. The Leisureworld unit posted a 27.1 percent revenue increase and an 8.1 percent increase in operating income. Seven newly acquired homes, higher occupancy rates, increased use of private, higher-cost accommodations and more government funding boosted results.

Going forward, Macquarie will focus on boosting occupancy and private occupancy at its Leisureworld care facilities; routine major maintenance at the fund’s power plants is covered by “major maintenance reserve account,” which means no impact on distributable cash. Macquarie Power & Infrastructure Income Fund is a buy up to USD12.

Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF) continues to distinguish itself from the companies it’s often compared to by the investing establishment. Its successful transition from a print-based to a Web-based operation is revealed by 47.7 percent first quarter organic growth in online revenue.

Distributable cash increased by 11.6 percent to CAD183 million; on a per-unit basis, the increase was 12.9 percent to 35 cents Canadian from 31 cents Canadian in the first quarter of 2007. Net earnings amounted to CAD127 million compared to CAD121 million for the same period in 2007.

Income from operations increased 7.5 percent to CAD171.4 million versus CAD159.4 million a year ago. Yellow’s directories segment posted revenue of CAD338 million and an adjusted EBITDA margin of 60.2 percent, an increase of 100 basis points over comparable margin performance in the first quarter of 2007 and a record high for the company.

On March 28, 2008, Yellow announced plans to repurchase up to 25 million units, approximately 5 percent of its outstanding units, through a normal course issuer bid. The unit repurchase will be financed through cash flow in excess of cash distributions throughout 2008 and 2009 and will be immediately accretive to distributable cash per unit.

The repurchase will accelerate the reduction in the payout ratio, which declined to 82 percent from 88 percent a year ago. In April, Yellow repurchased 2.8 million units for cancelation for approximately CAD31 million. Yellow Pages Income Fund is a buy up to USD16.

Aggressive Portfolio

ARC Energy Trust (TSX: AET.UN, OTC: AETUF) units have been surging this year in anticipation of rising cash flows from surging natural gas prices. First quarter earnings not only backed up the market’s rising expectations, they actually exceeded them.

Also spurred by a modest 4 percent rise in overall output and cost controls, cash flow per unit rose 18.1 percent from first quarter 2007 levels. And with realized selling prices during the quarter of less than USD90 per barrel for oil and less than USD8 per million British thermal units for gas, cash flow is on track to grow further in coming quarters, particularly as recent British Columbia finds come on stream.

Reflecting its rising fortunes, ARC boosted its distribution 20 percent, effective with the next monthly payment. Shares aren’t as cheap as they were earlier this year. But ARC Energy Trust is still a solid buy up to USD30 for those who don’t already own it.

Enerplus Resources (NYSE: ERF, TSX: ERF.UN) reported first quarter cash flow of CAD256.2 million (CAD1.74 per unit), up from CAD193.2 million (CAD1.57 per unit) a year ago, on increased production and higher realized prices on its crude oil and natural gas. Net income was CAD121.4 million (82 cents Canadian per unit), compared to CAD107.9 million (88 cents Canadian per unit) in the first quarter of 2007.

After the CAD1.7 billion acquisition of Focus Energy Trust, Enerplus now has a production weighting of just more than 60 percent natural gas and 40 percent crude oil and natural gas liquids. Daily production volumes averaged 89,150 barrels of oil equivalent per day (boe/d), reflecting the additional volumes from Focus since Feb. 13, 2008.

Production volumes in March, the first full month of Focus contribution, were approximately 100,000 boe/d. The fund forecast full-year production volumes to average 98,000 boe/d.

Cash distributions were maintained at 42 cents Canadian per unit per month, with a payout ratio of 75 percent versus 82 percent for the first quarter of 2007. Enerplus Resources is a buy up to USD50.

Newalta Income Fund (TSX: NAL.UN, OTC: NALUF) benefitted from higher natural gas prices and a resulting increase in drilling activity during the first quarter, posting a 21 percent increase in FFO to CAD27.2 million. Revenue increased 27 percent to CAD150.2 million, mostly because of acquisitions in eastern Canada completed in 2007.

Newalta reported net earnings of CAD19.3 million, a 49 percent increase over the first quarter of 2007. The payout ratio fell to 70 percent from 83 percent. Buy Newalta Income Fund up to USD25.

Paramount Energy Trust (TSX: PMT.UN, OTC: PMGYF) reported FFO of CAD56.2 million (51 cents Canadian per unit) for the first quarter, compared to CAD65.6 million (76 cents Canadian per unit) for the first quarter of 2007. Lower realized gas prices in 2008 accounted for 93 percent of the reduction. The trust paid 30 cents Canadian per unit per month during the period for a payout ratio of 59 percent of funds flow.

Production increased 30 percent to 183.8 million cubic feet equivalent per day (MMcfe/d) from 141.7 MMcfe/d in the first quarter of 2007. Realized natural gas prices decreased to USD7.29 per thousand cubic feet equivalent (Mcfe) for the three months ended March 31, 2008, from USD8.94 per Mcfe in the first quarter of 2007.

In 2007, realized gains on financial instruments of CAD14.3 million as a result of the trust’s commodity price hedging activity significantly improved its realized gas price relative to the average AECO Monthly Index price. Paramount Energy Trust is a buy up to USD10.

Penn West Energy Trust (NYSE: PWE, TSX: PWT.UN) reported first quarter funds flow of CAD632 million (CAD1.76 per unit), up 81 percent from CAD349 million (CAD1.44 per unit) in the fourth quarter of 2007. Net income in the first quarter was CAD78 million (22 cents Canadian per unit), compared to net income of CAD127 million (53 cents Canadian per unit) in the fourth quarter of 2007, which included CAD106 million of onetime future income tax recoveries related to tax rate reductions.

Netbacks of USD40.57 per barrel of oil equivalent were 37 percent higher than the first quarter of 2007. Production averaged 192,291 boe/d, up from 128,024 boe/d in the fourth quarter of 2007. Oil and gas liquids production averaged 109,016 boe/d; natural gas output hit 500 MMcf/d. Penn West Energy Trust is a buy up to USD38.
    
Provident Energy Trust (NYSE: PVX, TSX: PVE.UN) reported FFO of CAD180 million (71 cents Canadian per unit), a 107 percent increase from CAD87 million (41 cents Canadian per unit) in the first quarter of 2007. The payout ratio was 59 percent, down from 91 percent in the first quarter of 2007.

Production for the quarter was approximately 52,300 boe/d, up 61 percent from 32,400 boe/d in the first quarter of 2007. Canadian oil and gas production averaged approximately 27,600 boe/d, up 13 percent from 24,300 boe/d in the first quarter of 2007. Production remained balanced at approximately 51 percent natural gas and 49 percent crude oil and natural gas liquids.

FFO in the Canadian oil and gas business was approximately CAD71 million in the first quarter of 2008, up 53 percent from CAD46 million in the same quarter in 2007. Provident’s midstream business delivered first quarter EBITDA of CAD76 million in 2008, up 44 percent from CAD53 million in the first quarter of 2007. In February, Provident announced it plans to sell its US oil and gas production business. Provident Energy Trust is a buy up to USD14.