Volume 5, Number 10
Issue #0710
May 30, 2007
Single Issue $15.00

In this issue:

Next issue June 27

TAKEOVER ACTION SLOWS TEMPORARILY

The pace of trust takeovers has slackened in recent weeks, but I suggest it’s just the calm before the phase two storm. The only big takeover story this month was the announcement that CanWest Global Communications is buying back the CanWest MediaWorks Income Fund, which controls 10 daily newspapers that were spun into an income trust in August 2005.

Unlike many of the other takeovers this year, there is no pot of gold for investors in this one. CanWest Global is offering $9 a share for the trust, which is a dollar less than the IPO price. With distributions taken into account, original investors will just about break even.

The good news is that the $9 price is a lot better than the $6.13 low that the shares hit on Nov. 3, three days after the announcement of the Flaherty trust tax. It’s just one more example of why panic selling is usually a very bad move.

Earlier this month, RBC Capital Markets published its updated list of the trusts it regards as the top takeover targets. Two Income Investor recommendations are included. They are:

Consumers’ Waterheater Income Fund (TSX: CWI.UN), which was originally recommended by Gavin Graham at $16.35 and closed on May 25 at $17.66. It is currently rated as a Buy.

North West Company Fund (TSX: NWF.UN), which I recommended last month at $18.83 and which is now at $19.45. I still rate it as a Buy.

In an in-depth analysis of the trust takeover situation, RBC analyst Justin Cook pooh-poohed Finance Minister’s Flaherty’s contention that the recent spate of buy-outs by private venture capital firms, foreign companies, and rival trusts has little to do with his tax proposal and is more directly related to a world-wide upsurge in M&A activity.

“We firmly believe that the high payouts, premium valuations, and tax advantaged structures in fact insulated trusts from LBO (leveraged buy-out) takeovers,” the brokerage firm said. “We believe the majority of the trust takeout announcements come as a direct result of the October 31 government announcement…We believe this trend will continue.”

I don’t think there is any doubt that is exactly what is going to happen.  Before the tax takes effect in 2011, virtually every income trust in Canada will either have converted to corporate status, been taken over, gone private, or ceased operations. So don’t be in too great a hurry to sell any of your positions. The next couple of years will be turbulent but they will also provide some unexpected profit opportunities for patient investors. – G.P.

 

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TAKEOVERS:
ARE ENERGY TRUSTS NEXT?

By Gavin Graham, Contributing Editor

“I would draw your attention to the curious incident of the dog in the night-time,” said Sherlock Holmes.

“But the dog did nothing in the night-time,” I replied.

“That was the curious incident.”

From The Adventures of Sherlock Holmes by Sir Arthur Conan Doyle.

One of the most interesting developments in the income trust area over the last few months has been the absence of any takeover activity in the energy sector. While there have been a couple of mergers, such as that between PrimeWest Energy Trust and Shiningbank Energy Income Fund, and a failed attempted re-conversion from an income trust to a corporation by True Energy, there has been nothing to compare with the torrent of deals that have been announced in the business, power, and property trust sectors, as discussed last month (The Amazing Trust Takeover Party).

It’s difficult to work out why this has been the case. Energy trusts were the worst affected by a sell-off that followed the tax changes announced in October, down by over 20% on average. With some exceptions, such as Canadian Oil Sands, they have rebounded the least.

In a few cases, the answer is obvious. Some trusts, especially those with a high exposure to gas (Focus Energy Trust) and oil services companies (Precision Drilling Corp.) have cut their distributions and market prices directly reflect the regular income that’s generated. That’s why conventional energy and resource trusts have always had the highest yields in the income trust universe. Their income stream has been the most volatile and any significant change in oil or gas prices (or coal, iron ore, timber, or sugar for some of the non-petroleum trusts) has been directly reflected in their unit price. As always, in investment as in life, you get what you pay for.

In August 2006, the price of oil reached US$78 per barrel (bbl) during the height of the Lebanese civil war and concerns over the Gulf of Mexico hurricane season. The price subsequently fell to under US$60 and that was reflected in energy trust prices. And while that happened well before the tax changes announced at the end of October, a subsequent decline to US$50 in January reinforced the bearish sentiment on the sector.

Conventional oil and gas companies suffered as well, but less so than trusts, which was ironic considering that the yields on even integrated oil companies such as Petro-Canada and Husky were only 2% to 3% while exploration and production stocks yielded less than 1% in most cases. Yet some energy trusts were yielding over 10%, even after cuts in distributions. However, the high level of foreign ownership of these conventional oil and gas trusts meant that there was a great deal of panic selling by mainly US holders, who were also hit by a temporary weakening of the Canadian dollar, which fell from US91c in May 2006 to US84c in early January 2007.

It seems highly probable that the two separate waves of takeovers, the first of temporarily depressed trusts after the tax change and the second by foreign investors eager to gain access to Canada’s long reserve life and politically secure natural resource assets, will coincide in the oil and gas trust sector. This is not a reason to buy oil and gas trusts, as was noted last month. The investment case for owning a company must be strong enough for an investor to be comfortable owning it even if a takeover never materializes. It would not be unreasonable, however, to wonder if a number of foreign oil companies aren’t running their numbers on some of the large Canadian trusts.

The Norwegian state-controlled oil company Statoil, from a country that’s actually increasing oil and gas production, saw fit to spend $2.2 billion on North American Oil Sands this month, benefiting the shareholders of this private company – Paramount Energy, ARC Energy, and the Ontario Teachers’ Pension Plan. Even the conventional producers that have been cautious on their distribution policy and been “growing by the drill-bit rather than the chequebook” (i.e. not issuing highly-rated paper to acquire assets but instead drilling their existing acreage or swapping assets to gain economies of scale in certain fields) are looking relatively attractive.

The valuation premium that existed before the tax changes has vanished. Oil and gas trusts now sell at effectively the same or only slightly higher Price to Cash-flow, Price to Net Asset Value, and Enterprise Value to barrel of Production as their corporate counterparts. Investors can choose to either buy conventional energy trusts with no growth but a high yield or energy stocks with a low yield but some potential growth.

The more cautious investor might choose the bird in the hand. Even though most Canadian energy companies are operating in mature and well-surveyed areas such as the Western Sedimentary Basin and the Rockies’ Foothills, there’s always the risk of not finding reserves of a suitable size, or the decline rate of production being higher than anticipated. Besides, the better trusts may well be able to pick up assets from distressed sellers such as weaker trusts with too high a payout ratio or which have cash flow issues as drilling and labour costs continue to increase rapidly.

The recommendation this month, therefore, is one of the largest conventional oil and gas trusts, Penn West Energy Trust. It converted from a corporate structure 18 months ago and therefore has a long track record of proven delivery. It is run by Murray Edwards, one of the most successful Calgary-based oil entrepreneurs. He also controls Canadian Natural Resources, which has remained as an exploration and production company. It is one of the largest holdings in both GGOF Monthly High Income Funds, which invest in large-cap income trusts. Penn West is currently yielding approximately 10.7% and has a market capitalization of $9 billion. See this month’s Top Picks section for complete details.

Gavin Graham is Chief Investment Officer for Guardian Group of Funds (GGOF).

 

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BCE PREFERREDS NOW
EXCELLENT VALUE, DESPITE RISK

By Tom Slee, Contributing Editor

Whichever way you look at it, leveraged buyouts are a mixed blessing. Sure, they spur a company’s stock but they also inflict some very bad side effects. Just ask BCE’s preferred shareholders and bondholders. Their once rock-solid investments have plummeted by 15% or more since the giant telecom became a takeover target. The company’s credit ratings are in jeopardy and some institutions are bailing out while others seek legal recourse. Ma Bell, once the haven of widows and orphans, could even be headed for the junk bond bin. It’s the end of an era.

Why all this grief when the common shares are soaring for the first time in years? Well, it has to do with the way leveraged buyouts work. Controversial from day one, they were originally conceived as an internal management defense against hostile takeovers. Bypassing their own shareholders, executives would go to a bank, pledge the company’s assets as collateral, and borrow enough to buy up all the common stock. Then, with a free hand and no dividends to pay, they would hopefully retire the new debt. The concept caught on and soon corporate raiders, often financed by junk bond king Michael Milken, were employing externally leveraged buyouts. They refined the process. One aspect has remained constant, however. The takeover target is always saddled with a huge debt and that is what is going to happen to BCE.

Of course, in the case of BCE we have no details of any bid and only know that takeover talks are taking place. The betting is, however, that any transaction would consist of at least 75% new debt, and perhaps more. That’s a ratio analysts used when putting a possible $40 bid price on the stock. If that happens, the company will have to borrow about $38 billion, assume a lot more risk, and jeopardize its existing bonds and preferred shares. It’s a serious concern, so much so that the Dominion Bond Rating Service (DBRS), Moody’s, and Standard & Poor’s each placed all BCE and Bell issues on credit watch with a view to downgrading. As a result, fixed-income buyers started shying away and the company’s senior issues were in free fall for a while. At one time, some BCE bonds were down $15 and the straight preferred shares lost as much as $4 before traders stepped in and started snapping up bargains.

Is it time to bail out? Have we seen the worst? My feeling is that, regardless of what happens, BCE is no longer going to be a stable, investment-grade company. If the present deals fall through, other predators will emerge. So investors who cannot afford any risk in their bond portfolios should switch into comparable Canada or senior provincial issues. Avoid senior corporate bonds for now. The chances are that we are going to see more leveraged buyouts. Private equity firms are already circling Telus and TransAlta. I know that probably means giving up about 100 basis points in yield, the normal spread between Bells and Canadas in the long end, and incurring a capital loss but it’s worth it to be able to sleep nights.

BCE preferred shareholders and bondholders who can live with some uncertainty, however, should think about maintaining their positions. As a matter of fact, I think that some BCE preferreds are even a Buy right now.  Here’s why.

These days, assuming debt and retiring the common stock is only a first step in the leveraged buyout process. At one time, the new owners just dismembered a company, selling divisions and pocketing the proceeds. Not any longer. Private equity firms now restructure their new acquisition so that it can service additional debt and earn an on-going return. They then make their killing by eventually taking the company public again through an IPO. That’s what Kohlberg Kravis Roberts (KKR), one of the players at BCE, did with Shoppers Drug and Bell Canada Directories.

As a matter of fact, reverse leveraged buyouts, as they are called, have become big business and the public has been gobbling them up. A new Harvard Business School study of 496 private equity-led IPOs between 1980 and 2002 showed that reverse leveraged buyouts consistently outperformed conventional new financings and the market generally. Far from sucking out the profits, private equity firms improved their acquisitions and then successfully marketed them. I think that is what we are going to see at BCE.

For a start, the company is immensely strong, retains a loyal customer base, and throws off pots full of cash. BCE is expected to generate as much as $900 million of free cash flow in 2007, enough to service a mountain of new and existing debt as well as its preferred dividends. So the new owners should have no liquidity problems. At the same time, they are likely to bend over backwards to appease an already irate financial community.

Remember, they want a good reception for the reverse leveraged buyout in a few years. They are not going to sour the IPO by defaulting on their bonds or preferred dividend payments. That suggests the senior securities currently outstanding will remain excellent investments, even if for technical reasons they are downgraded.

So I think that some BCE preferred shares look very attractive at current prices, as long as you can handle the risk. One issue that I like in particular is the BCE Series AC (TSX: BCE.PR.C) priced at $23.40 and paying a $1.385 dividend to yield 5.92%, equal to about 8.4% from a bond for investors paying higher marginal tax rates who hold the shares in a non-registered portfolio. The shares offer above-average income, as well as the possibility of a capital gain, and are my May Pick of the Month.  Incidentally, to put their return in perspective, the S&P/TSX Preferred Share Index was yielding 4.66% at the time of writing.

Tom Slee was a professional money manager for many years and holds CFA and CGA designations.

 

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TOP PICKS

Here are our selections for May. All prices, including updates, are as of the close of trading on Friday, May 25 unless otherwise indicated.

MAY’S INCOME TRUST PICK: PENN WEST ENERGY TRUST

(TSX: PWT.UN, NYSE: PWE)

  • Security: Penn West Energy Trust
  • Type: Income Trust
  • Trading symbols: PWT.UN, PWE
  • Exchanges: TSX, NYSE
  • Current Price: C$38.06, US$35.28
  • Entry level: Current price
  • Stability Rating: Not rated by S&P or DBRS
  • Risk Rating: Higher risk
  • Recommended by: Gavin Graham
  • Website: www.pennwest.com

The business: Penn West is one of the largest oil and gas trusts listed on the Toronto and New York stock exchanges with gas, light crude, heavy crude, and oil sands operations in north-eastern British Columbia, Alberta, and south-western Saskatchewan.

The security: Formerly a conventional oil and gas exploration and production company, Penn West converted to an income trust in June 2005 and acquired Petrofund, another conventional oil and gas trust, in mid-2006.

Why we like it: We believe Penn West offers a good combination of current income and growth potential. The share price has declined 10.4% since Oct. 31 although the trust has maintained its 34c per unit monthly distribution over that period. Over the five years ending April 30, Penn West has given shareholders a total return of 199%, of which 136% has been capital appreciation and the remainder income. That’s more than double the 94% total return of the S&P/TSX Composite Index and in excess of the 186% total return of the S&P/TSX Energy Index.

Financial highlights: Penn West has forecast production of 131,000 to 135,000 barrels of oil equivalent per day (boe/d) for 2007. In the first quarter, this was weighted 44% towards natural gas and 56% oil and natural gas liquids (NGLs). Capital spending is expected to be $600-700 million in 2007 of which approximately 12% will be funded by the dividend reinvestment program.

Of the $1.31 per unit cash flow generated in the first quarter, equivalent to $311.3 million, the $1.02 per unit distribution represented a 78% payout ratio. That is somewhat above the 64% average for the universe of large-cap trusts. This, however, includes a couple of trusts (Peyto Energy Trust and Bonavista Energy Trust) which pay out less than 60% of their cash flow, as they are essentially exploration and production (E&P) companies in a trust structure, funding their reserve replacement and growth totally from retained cash flow.

Meanwhile, Penn West’s valuation of 5.6 times Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA), when compared to 6.6 times for large trusts and 7.7 times for intermediate E&P companies, make it one of the more reasonably valued opportunities.

Risks: Penn West has maintained a good handle on costs, with a year-over-year increase of only 8% and a flat first quarter compared to the fourth quarter of fiscal 2006. However, escalating costs in the western oil patch are a serious concern for all operators, though they work in favour of some other recommendations such as The Keg and Liquor Stores Income Fund which benefit from higher wages paid to oil workers.

A fire at Penn West’s Wildboy gas facility in north-eastern BC caused its production of 50,000 mcf/day to be shut in recently, although production should be restored shortly.

An increased focus on carbon emissions may lead to additional costs being borne by oil and gas producers, especially those with oil sands projects such as Peace River, which is coming on stream. However, those projects where work has already started are exempted from the recent government tax change and Penn West is aiming to become a leader in carbon dioxide re-injection.

Finally on our review of risks, the price of oil could fall below US$50 per barrel, as happened briefly in January. This could cause Penn West to cut its 34c per unit monthly distribution back to the 31c level it paid until January 2006. Like other major trusts, however, Penn West has hedged some of its production with 16% of its 2008 output hedged at a floor price of US$65 per barrel and a ceiling price of US$75.

Recent developments and outlook: During the first quarter, Penn West drilled 106 gross wells (61 net) with a 95% success rate. Of these, 53 were oil wells and 49 were natural gas. In addition, 95 wells were drilled on Penn West’s lands through farm-out arrangements.

In February, the trust announced it had bought conventional oil and gas assets for $329 million with 82% of the production within or near its Peace River or Red Earth area in Alberta. Production from these purchases totals 4,900 boe/d, and Penn West also secured interests in a 10,000 bbl/d oil processing facility and a natural gas plant with a capacity of 33,000 mcf/day. The price was the equivalent of $61,000 per boe/d, lower than the valuation the market attributes to Penn West’s production. It was funded in part from proceeds of a US$475 million private placement of medium term notes which closed this month, with an average cost of 5.85% and terms ranging from 2015 to 2022.

Penn West also announced a plan in April to construct a 303 km 100,000 bbl/d pipeline to deliver Athabasca oil sands output via Nipisi to Edmonton. Its own Peace River Oil Sands Project saw 16 horizontal and 15 stratigraphic test wells drilled in the first quarter, which confirmed the existence of 6.8 billion boe of heavy oil. It is estimated that conventional recovery techniques will permit 3% to be released, producing 223 million barrels, without using water-flood or thermal recovery procedures.

Given the strong focus by investors and governments on carbon emissions, Penn West reiterated its desire to be amongst the leaders in carbon dioxide injection, to capture the CO2 in depleted oil fields as well as enhancing the production of those fields by injection of the gas into the heavy oil deposits. In the first quarter, a water alternative CO2 scheme was begun near the existing horizontal well technology pilot project at Penn West’s Pembina field and two injection patterns were begun at its Joffre field, while Penn West is investigating purchasing CO2 from existing greenhouse gas emitters near Edmonton.

Distribution policy: As noted, the units currently pay 34c a month ($4.08 a year) for a yield of 10.7% on the price of $38.06.

Tax implications: For the 2006 tax year, the entire distribution was 100% taxable to Canadian investors so there is no tax break here. For US residents, the distributions were treated as “qualified dividends” which means they were eligible for the low rate. So, ironically, Americans get better tax treatment on Penn West’s payments than Canadians do.

Who it’s for: Penn West is suitable for investors who are prepared to accept the risks involved in the energy sector in return for an attractive distribution and growth potential. Because there are no tax advantages for Canadians, the units may be held in an RRSP or RRIF.

How to buy: Penn West Energy Trust is a publicly traded investment trust listed on the Toronto Stock Exchange under the symbol PWT.UN and in New York as PWE. The shares are very liquid and any broker can acquire them for you.

Summing up: This is a blue-ribbon energy trust. As with all energy companies there are risks involved but the potential rewards more than compensate in this case. – G.G.

 

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PREFERRED SHARE PICK

BCE FIRST PREFERRED SHARES SERIES AC

  • Security: BCE First Preferred Shares Series AC
  • Type: Straight preferred shares
  • Trading Symbol: BCE.PR.C
  • Exchange: TSX
  • Current Price: $23.40
  • Yield: 5.9%
  • Entry Level: Current price
  • Credit Rating: S&P, DBRS: P2 Low (On watch)
  • Risk Rating: Moderate risk
  • Recommended by: Tom Slee
  • Website: www.bce.com

The business: BCE is Canada’s largest telecom with more than 12 million access lines, six million wireless subscribers, and 1.8 million video customers. The company also provides broadcast and media services through 15% owned Bell Globemedia. 

The security: The First Preferred Shares rank in priority to all other shares of BCE with respect to payments of dividends and distribution of assets in the event of liquidation or winding-up of the company. BCE has a strong balance sheet and impeccable track record of measured growth.

Why we like it: Good quality preferred shares currently yield about 4.66% but the Series AC, because of takeover discussions, yield 5.9%, a spread of 124 basis points. The company has the right to redeem the shares at $25 on March 1, 2008 and, in the unlikely event that call is exercised, yield to maturity is about 12%. After March 1, 2008, BCE will replace the current fixed dividend of $1.385 per annum with a floating rate not less than 80% of the five-year Government of Canada yield.

Financial highlights: BCE’s total revenues exceeded $18 billion last year, producing an operating profit of almost $7 billion. Market capitalization was in the $25 billion range before current speculation about a possible takeover and now exceeds $30 billion.

Risks: A private equity group may acquire BCE and, by restructuring the company, cause the credit agencies to lower their ratings. In turn, the preferred shares would drop in value, creating an unrealized loss. This would not affect the dividend stream or redemption price. Moreover, if the shares are not redeemed the dividend floats with a floor equal to 80% of the return on five-year Canada bonds. Based on our interest rate forecast, this could be as low as 94c per annum. The likelihood, though, is that BCE, or its new owners, will maintain a rate of approximately $1.385 in order not to antagonize the institutions that salted away most of the $210 million issue in 2003.

Distribution policy: Fixed cumulative dividends of 34.625c a share are paid quarterly.

Tax implications: Dividends, subject to the dividend tax credit, are taxable in the year that they are received but of course are taxed at a much lower rate than interest income. Any profit or loss on sale or redemption is treated as a capital gain or loss at the time.

Who it’s for: These good quality preferred shares are suitable for investors seeking above average income who are able to assume some risk. There is an active market if you wish to dispose of the shares at any time. The shares are not recommended for RRSPs/RRIFs because of the loss of the dividend tax credit.

How to buy: These securities are TSX-listed and are available through any broker or dealer.

Summing up: This high quality investment offers an above average return and a possible capital gain or an increasing yield after March 1, 2008, if interest rates rise significantly.

Action now: Buy BCE First Preferred Shares AC at $23.40.

 

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UPDATES

NATIONAL BANK OF CANADA (TSX: NA, OTC: NTIOF)

  • Type: Common stock
  • Trading symbol: NA, NTIOF
  • Exchange: TSX, Pink Sheets
  • Current price: C$65.50, US$59.76 (May 24)
  • Originally recommended: March 22/06 at C$63.60, US$55.44
  • Credit Rating: DBRS: A (high)
  • Risk Rating: Conservative
  • Recommended by: Tom Slee
  • Website: www.bnc.ca

Comments: National Bank made a strong start to the year, reporting first quarter earnings of $235 million, or $1.43 a share, up 13% from $1.26 in 2006 and well ahead of the $1.31 analysts had been looking for. Tight controls and good loan loss experience paid off and the Wealth Management and Financial Markets divisions turned in some exceptional numbers. Return on Equity (ROE) was an impressive 20%. As a result, National now seems set to earn about $5.50 a share this year and as much as $5.80 a share in 2008.

The numbers are impressive and should have driven the stock higher. In fact, it did touch $66.80 at one stage. Unfortunately, Mr. Flaherty’s heavy-handed decision to eliminate deductibility of interest incurred to fund business operations abroad cast a pall over the entire banking sector. Analysts estimate that 4% of all bank earnings are at risk if this law is enacted. Talk about a slash-and-burn policy! Fine tuning? Never heard of it! Hopefully the government will ease its proposed regulations and CEOs are already rearranging their affairs in order to limit the damage. 

National dipped to $62.25 at one stage but has since recovered and closed on May 25 at $65.50. It yields 3.3% on a $2.16 dividend. It continues to be a buy, especially as we could see an increase in the dividend later this year.

Action now: Buy National Bank for increasing income and some growth. I am maintaining a $70 target and will revisit the stock if it drops to $58. – T.S.

ENBRIDGE (TSX, NYSE: ENB)

  • Type: Common stock
  • Trading symbol: ENB
  • Exchange: TSX, NYSE
  • Current price: C$37.36, US$34.63
  • Originally recommended: Nov. 22/06 at C$39.16, US$34.17
  • Credit Rating: DBRS, S&P: A
  • Risk Rating: Conservative
  • Recommended by: Tom Slee
  • Website: www.enbridge.com

Comments: Enbridge had a good first quarter. Adjusted operating profit rose 9.5% year-over-year to 65c a share, beating the consensus forecast of 62c. However, the results were dampened a little by a warning from CEO Patrick Daniel that near-term growth is likely to slow. The company has 10 new major projects in the works but their pay-off won’t start until 2009, not that shareholders are going to suffer in the meantime. We should see earnings of about $1.80 a share this year, up almost 10% from $1.64 in 2006, and $1.95 or more in 2008.

Nevertheless, the stock is languishing for several reasons. First, ENB always tends to be weak during the first quarter as almost inevitable winter disruptions are written off. For example, recently the company’s Edmonton to Wisconsin pipeline ruptured and is still functioning at reduced pressure. 

Second, Moody’s has temporarily downgraded Enbridge debt because of the expensive projects underway. Third, there is a possibility that the company may have to issue more common shares.

I see all of these as passing concerns. With its new wind farm in Ontario and proposed pipelines to Texas and the Gulf Coast in the works, ENB remains a top-quality blue chip with exciting prospects.

Action now: Buy Enbridge for increasing income and growth with a target of $42. The shares, paying a dividend of $1.23, yield 3.3%, equal to about 4.7% from a bond in after-tax terms for investors paying higher marginal tax rates. – T.S.

PRECISION DRILLING (TSX: PD.UN, NYSE: PDS)

  • Type: Income trust
  • Trading symbol: PD.UN, PDS
  • Exchange: TSX, NYSE
  • Current price: C$ 28.66, US$26.75
  • Originally recommended: Feb. 22/06 at C$35.40, US$30.69
  • Stability Rating: Not rated by S&P or DBRS
  • Risk Rating: Higher risk
  • Recommended by: Gordon Pape
  • Website: www.precisiondrilling.com

Comments: Investors were hit with a second distribution cut in six months when the trust announced on May 18 that it is chopping another 32% off its monthly payment, slicing it to 13c. That reduces the annual payment to $1.56 a share, less than half last year’s level of $3.24.

There’s no doubt this oilfields service provider is going through a tough period and management hasn’t tried to sugar-coat the situation. In a statement announcing the cut, the trust said: “Customer demand for Precision's oilfield services in Canada declined from prior year levels. The activity decrease has become more entrenched during the second quarter due to weather conditions and a further weakening in customer demand. This weakening in demand is consistent with the large decline in the number of government licenses issued for new natural gas wells in the Western Canada Sedimentary Basin over the past two months.”

Despite this gloomy outlook, RBC Capital Markets said in a research report that this cut probably represents the last one for the year. The trust’s payout ratio should now be marginally below that of other oil service providers and it is generally expected that drilling activity will pick up later this year.

Precision Drilling has a long history of experiencing boom and bust cycles. Selling during a down phase such as this is not a good idea so I suggest you retain your positions and wait it out. Even with the distribution cuts, you are still earning a cash flow return of 4.4% based on the original recommended price – not sensational but not terrible either. American shareholders receive a tax break on the payments as they are “qualified dividends” under US law.

Moreover, takeover speculation has started to swirl around the trust. This is not unexpected given the current low valuation of the shares and the price moved back over $30 for a brief time earlier this month as rumours spread that representatives of Kohlberg Kravis Roberts had been sniffing around. (KKK, one of New York’s most aggressive private equity firms, has been paying a lot of attention to the Canadian scene recently and is also reported to be involved in one of the BCE bids.) It’s just one more reason for biding our time and waiting while events unfold.

Action now: Hold. – G.P.

 

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YOUR QUESTIONS ANSWERED

More on return of capital (ROC)

Q – Further to the taxation of ROC (Box 42 on the T3 slip), if the ROC reduces the ACB (adjusted cost base) to zero and leaves a residual of negative ROC, how does one report the residual amount as capital gain since the slip shows the total amount of ROC?  For example, ACB is $100 prior to applying $200 ROC (Box 42), resulting in an ACB of zero and a negative ROC/capital gain of $100, which in turn produces conflicting information in capital gain and Box 42 on the T3 information slip. – Mel L.-B.

A – Our resident tax expert, Tom Slee, replies as follows:

The amount shown in Box 42 on a T3 Slip is for information purposes only and does not generate into the T1 Return. It is incumbent on the taxpayer to keep track of these amounts and reduce the investment's adjusted cost base accordingly. Then when the total cost is eliminated and there is a "negative" amount, the taxpayer reports this as a capital gain on Schedule 3 (Details) like any other capital gain not shown on a reporting slip. For instance, if you sold a cottage, the profit has to be entered manually on Schedule 3. By the way, there is no conflict between the amount in Box 42 and the capital gain. The system does not attempt to match them. – T.S.

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YOUR COMMENTS

Member comment: When you reference a mutual fund, not just in The Income Investor but in all your publications, I sometimes find it confusing when just the mutual fund name is used as opposed to using the specific fund number to identify it when it is purchased. Now, you may have a very reasonable explanation for this approach but would it be possible to include the fund number in the future? I submit this request because there are many similar funds, not just between companies but within companies. – Dave R.

Response: The problem is that in some cases a single fund may have more than 25 different codes (that is not a typo!), each identifying a separate type of unit. For example, there will be a different code for DSC Canadian dollar units, DSC US dollar units, front-end Canadian dollar units, etc. I have no way of knowing which type of unit an individual investor will want to purchase – DSC, front-end, fee-based, class version, fund version, currency, etc. and it is obviously impractical to list all the codes.

In our companion Mutual Funds Update letter, we have tried showing just the code for the units we recommend (usually front-end load at zero commission) but we have received some negative feedback on that, for example from someone who wanted a low-load version and was asking us to supply the appropriate code for it.

The mutual fund industry should be addressing this problem by setting up a site where investors could easily look up codes, but there has been no move in that direction as far as I know. If any readers have suggestions as to how we can effectively deal with this issue in a way that will be more helpful to everyone, please let me know. – G.P.

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That’s all for this month. The next regular issue of Income Investor will be published on June 27. Look for your next Update Edition during the week of June 11.

 

Best regards,
Gordon Pape, editor-in-chief
Gordon.Pape@buildingwealth.ca
Circulation matters: circulation@buildingwealth.ca

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