A Double-Digit Yield With Up Side

10/20/2009 10:18 am EST

Focus: GLOBAL

Gordon Pape

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

Canadian energy trust Daylight Resources boasts strong cash flow and bright expansion prospects, writes Gordon Pape in The Income Investor.

Daylight Resources (TSX: DAY-UN, OTC: DAYYF) is a Calgary-based mid-sized energy trust that has been out of favor for some time because of its heavy weighting to natural gas (about 70% of total output). At one point in 2006, the shares traded for over $14, but they plunged all the way to $5.12 in March of this year.

However, the recent rebound in gas prices plus the announcement of the pending acquisition of Highpine Oil & Gas has sparked renewed interest in the company. The trust operates primarily in central and western Alberta in the Western Canadian Sedimentary Basin. Daylight's current daily production averages about 23,000 boe/d (barrels of oil equivalent per day), but that will increase significantly when the Highpine acquisition is complete. The deal is expected to close in mid-October.

Daylight is a well-managed trust that offers a good yield and excellent up side potential, as the recent price jump has shown. Management has been aggressively seeking expansion opportunities and in the second quarter the trust completed the acquisition of Intrepid Energy Corp., which it says will add "multiple low-risk drilling opportunities in our core West Central area." [Shares closed at C$8.89 in Toronto Monday, for a current yield of 10.8%—Editor.]

The $530-million offer to acquire Highpine is the trust's biggest move yet. The deal is expected to be highly accretive to Daylight's cash flow and production while greatly strengthening the trust's balance sheet, the [companies have said]. As a result, Daylight will be in a much better position to maintain its current distribution at eight cents (Canadian) per month. As well, the transaction will increase Daylight's tax pools to over $1.4 billion, which will enable it to ease the impact of the new income trust tax for investors.

Once the transaction is completed, Daylight's production will be more evenly balanced, with 58% coming from gas and 42% from oil. As primarily a natural gas producer, Daylight was hit hard by the deep and prolonged slump in gas prices. Petroleum and natural gas revenues for the first half of this year were down 48% from 2008.

As a result, funds from operations (FFO) dropped from $1.51 per unit to 87 cents (fully diluted). The decline led to a 38.5% cut in distributions in January, from 13 cents to eight cents per month. As a result of the cut, the payout ratio in the second quarter was only 54%. With the price of natural gas apparently having bottomed, the distribution appears safe for now.

Steve Nielsen, Daylight's vice-president and CFO, says that plans are to convert to a corporation in 2010. If there is a distribution cut, "it will be relatively minor," he says.

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