An Income Trust with a Twist

11/26/2008 10:06 am EST


Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

This income trust has unique advantages, says Gordon Pape, editor of The Canada Report.

Although a Canadian income trust, Vermilion Energy Trust (TSX: VET.UN, OTC: VETMF) is unlike most other trusts in that it has extensive foreign operations with producing facilities in France, the Netherlands, and Australia.

Vermilion offers advantages that more than offset concerns related to falling oil prices and a new tax scheduled to kick in on January 1st, 2011. First, about 60% of Vermilion's third-quarter production came from its overseas operations which the trust is planning to expand in the years ahead. What makes this especially important is that Vermilion is already paying tax on the profits earned from this production in the home countries, so a large percentage of its earnings will not be exposed to the new Canadian tax when it takes effect.

Next, Vermilion’s monthly distribution is 19c per unit ($2.28 a year, figures in Canadian dollars), for a payout ratio of 30% in the third quarter, the lowest in its peer group. This makes a distribution cut unlikely—in fact, one of management's stated goals is to maintain stable distributions for the next five years.

Additionally, Vermilion has been using some of its excess cash flow to reduce debt.
As of September 30, Vermilion had $132 million in cash and existing line of credit of $675 million, which management says it hopes to use for strategic acquisitions.

Third quarter fund flows from operations (FFO) were $132 million ($1.73 per unit), up 33% from the same period a year ago. Cash distributions were $39.8 million (57c per unit). For the first nine months of this fiscal year, FFO was almost $442 million ($5.78 per unit) compared to $260 million ($3.58 per unit) in 2007.

The sharp decline in the price of oil in recent months will obviously have a major impact on Vermilion's revenue in the coming quarters. Another risk factor to consider is replacement costs—as of the end of the 2007 fiscal year, Vermilion reported a Reserve Life Index (proved plus probable) of 10.6 years. The trust is planning a capital expenditure program of $175-$250 million in 2009.

Vermilion is well positioned to not only weather a prolonged global economic downturn but to benefit from it through bargain basement acquisitions. I like the trust's conservative business model and the low payout ratio should enable it to fulfill its promise not to cut distributions, although that could lead to reduced capital expenditures next year.

I recommend that if possible you buy units on the Toronto Stock Exchange where they are more liquid. If you do not have access to the TSX, the shares can be bought over-the-counter through the Pink Sheets. In that case, use a limit order.

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