It was once the most popular income trust in Canada. Now, with the units paying around 16%, investors don't know whether to hold on or bail out. Gordon Pape offers some advice.

It appears that investors don't know what to make of Yellow Pages Income Fund. The market seems to be saying it's in a downward spiral that will inevitably lead to even bigger losses for anyone who holds the shares. But is it really? I don't think so.

First, a little history. Yellow Pages went public as an income trust in mid-2003 at an IPO price of $10. The issue sold out quickly (in fact, it was oversubscribed) and the units eventually hit a high of $17.20 in 2006. After the announcement by Finance Minister Jim Flaherty that trusts would be taxed beginning in 2011 the shares briefly dropped to below $12 but they bounced back to as high as $14.81 in 2007 after the initial shock wore off.

That was the high water mark. In early 2008, Yellow Pages shares began a prolonged slide which saw them trade for as little as $4.68 in February. They have staged a modest recovery since but remain stuck in the $5 range. It's clear from this pattern that investors don't expect good news any time soon. Many people who held the shares for years have given up hope and sold.

So what are the facts? Yellow Pages recently announced second-quarter results which were down from last year but were respectable given the economic conditions. The trust reported consolidated net earnings of $116.8 million compared with $135.7 million for the same period in 2008. Income from operations was $169.5 million, including restructuring and special charges of $20.6 million, compared to $185.1 million in the prior year. Cash flow from operating activities was $185.5 million, up slightly from $181.8 million in 2008. Distributable income per unit came in at $0.35, off a penny from last year. The trust paid investors $0.23 a unit during the quarter for a payout ratio of 65.7%.

With management forecasting an increase of 1% to 3% in distributable cash per unit in 2010, it would appear that the monthly payment of $0.0667 per unit ($0.80 annually) is safe. However, the market is sceptical. With the shares trading in the $5 range, the current yield is 16%. That's a sign that investors expect another distribution cut in the relatively near future. The fund announced a 32% cut in May but there appears to be a widespread feeling that it wasn't enough.

I believe there will be another cut, but not for a year or so. Based on the numbers we are seeing and the likelihood of some improvement in the economy in the months ahead, the current distribution should be sustainable until the income trust tax takes effect in 2011, at which time Yellow Pages will convert to a corporation. Management has already said that when that happens, it will aim for a payout of 60% to 70% of earnings per share.

Earnings for the first half of 2009 were $0.48 a share (this includes a provision for income taxes of $18.5 million even though the trust is not yet taxable). Using a 65% payout ratio, that would produce a quarterly dividend of $0.156 a share or $0.624 a year. Based on a $5 share price, the yield at that point would be a very attractive 12.5%. As a bonus, the payments will qualify for the dividend tax credit if the shares held in a non-registered account. The some people, that could actually increase the after-tax return.

Remember, this projection is based on the results achieved during the depths of the recession. It is reasonable to expect that Yellow Pages should do better as economic conditions improve.

I know that the confidence of Yellow Pages investors has been sorely tested but based on these assumptions I advise hanging in there. Talk to your financial advisor if you own units.

Adapted from an article that originally appeared in Gordon Pape's weekly newsletter, the Internet Wealth Builder. Try it for one month (4 issues) for only $13.95 plus tax. Details at http://www.buildingwealth.ca/bookstore/productdetail.cfm?product_id=617