Canada's business trust boom is teetering toward bust. What's an IRO to do?
Barbara Gray, an analyst with Blackmont Capital in Vancouver, calls them ‘fallen angels’: business trusts that have cut their distributions. Her feisty research reports compare trusts to the risky high-yield bond market in the US, and her recent 2006 outlook opined: ‘We believe 2006 will mark a turning point in investors’ love affair with business trusts.’
Having got the scent of a short-selling opportunity, hedge funds are sniffing around, as are business reporters. The usual job of bankers these days, said a recent CanWest News Service article, is ‘foisting crummy income trusts on an unsuspecting Canadian public.’
Dirk Lever, managing director and chief income trust strategist at RBC Dominion Securities, is more sanguine. ‘There’s been more positive than negative, more distribution increases than decreases,’ he says.
There are plenty of trusts where IR is not a bad job at all. Last month Cineplex Galaxy Income Fund had its annual meeting at the Paramount Toronto theater, celebrating rising box office receipts with popcorn, candy and a 50 ft-wide PowerPoint presentation. ‘When our charts go up, they go way up,’ says the trust’s IRO, Pat Marshall.
IR may be less glamorous at BFI Canada, a waste management company, or at Connors Bros sardines, but these companies are well respected in the investment community. ‘The trust structure is for mature, stable companies; leaders in their industry sector with stable cash flows,’ says Janis Koyanagi, TSX Group’s senior manager for income trusts, structured products and ETFs. ‘But it’s not for everybody.’
And there’s the problem. A sizeable proportion of ‘everybody’ has used this unique Canadian financing for all kinds of businesses, many lacking the stable cash flow needed to sustain their promised payouts. Gray points out that 31 out of 139 business trusts have cut or suspended distributions, and she predicts that ‘half the business trusts will end up as fallen angels.’ After riding a wave of enthusiasm for the past five years, IROs are now challenged to differentiate their trusts from among a host of falling angels.
The birth of trusts
Income trusts were born in the 1980s with energy trusts. The idea is simple: a trust doesn’t pay corporate tax on income that it distributes to investors. Investors are taxed but still get more than they would from a dividend-paying stock, so the only loser is the government. Thus the outgoing Liberal government last year zeroed in on the C$300 mn in taxes it missed out on in 2004 and tried to introduce a tax on trusts. With an election looming, legions of retail unit holders made the government back off. All signs point to the new Conservative government letting the issue lie.
In the 1990s, ‘mature’ and ‘stable’ meant ‘boring’. Investors wanted price appreciation, not income stability. Only in the last five years – with the idea of steady payouts looking pretty good after the stratospheric rise and fall of many companies, and with interest rates at rock bottom – have business trusts taken off.
In 2005, $5.2 bn of TSX’s $15.2 bn in IPOs came from income trusts, and these now make up about 10 percent of the main board’s capitalization. With that kind of clout building, it made sense to admit trusts to the S&P/TSX Composite Index. Last year the trust laws were changed to introduce limited liability for trusts. That cleared the way for trusts to join the index in December 2005 with a 50 percent weighting, moving to 100 percent in March 2006. A total of 72 trusts joined the index, mostly in energy and real estate but including 16 ‘business trusts’ from a range of other industries. Some index trackers stuck with the equity-only index at first, but according to Tony North at Standard & Poor’s in Toronto, ‘acceptance of this index has increased steadily. More and more indexers are going to the composite index rather than the equity index.’
‘For large-cap trusts, the index has given them greater visibility and greater access to institutional investors,’ says John Vincic, executive vice president at BarnesMcInerney, a Toronto consultancy that worked on Aeroplan Income Fund’s award-winning IPO last year.
Barry Hildred, president of the Equicom Group, has income trust clients like ED Smith, the jam maker that went public in 2005, and CML Healthcare, which converted to a trust in 2004. Like many in trust IR, Hildred at first insists it’s the same as IR at any corporation. ‘These companies have to strive or survive in their respective industries. The messaging really isn’t any different,’ he says. But he goes on to describe a lot that is different: ‘Of course, there are new metrics.’
Earnings shmearnings
‘The information expectations for trusts are different,’ Lever confirms. ‘For example, I couldn’t care less about earnings. My focus is on the sustainability of cash flow.’
Ebitda and distributable cash (and how it’s calculated) are at the top of the list of important trust numbers, but they’re not part of Gaap and have no standard definition in Canada. They’re discussed in the MD&A but not included on the financial statement, and they’re not likely to be. ‘The accountants don’t want to touch this,’ says Lever, who is working on trust reporting standards as part of a four-person committee created by the Canadian Association of Income Funds.
The difficulty facing this group of four is devising standards that will work across the huge range of industries represented by business trusts. Related to this is the problem of research coverage for trusts. Most banks have analysts covering trusts across different industries. ‘How can an analyst be an expert in all these different businesses?’ asks Philip Koven, VP of Bryan Mills Group, a communications firm.
These generalist analysts have naturally focused on yield rather than underlying business fundamentals, the same way trusts’ traditional retail investor base fixated on yield. As the trust space expands, however, there are more sector-focused trust analysts, and a more institutional investor base is looking beyond yield. ‘Income trusts don’t want to be trading on the basis of yield,’ Koven says. ‘It’s incumbent on them to convince investors that they should be valued on the intrinsic value of their businesses, not their distributions.’
In the meantime, if you’re an IRO at an income trust valued on your yield and on the verge of cutting your distribution – in other words, about to become a fallen angel – what’s Koven’s advice? ‘Panic.’