Transcript Research on Income Trusts

Income Trusts
Amin Mawani
Schulich School of Business
York University
[email protected]
Taxes matter– in timing of death!

Estate tax rates have varied across the
past century
– “Dying to Save Taxes: Evidence from
Estate-Tax Returns on the Death Elasticity”
by Slemrod and Kopczuk. Review of
Economics and Statistics May 2003.
Dying to Save Taxes
High tax
Low tax
Low tax
High tax
What is an Income Trust?

“An investment that pays out substantially
all of the cash-flows generated from
relatively mature, revenue producing
assets in a tax efficient manner”
Bank of Canada Working Paper: “Income
Trusts – Understanding the Issues” Sept 2003

A publicly traded entity designed
specifically to distribute substantially all of
its pre-tax income from an underlying
business to its unitholders
A Simple Income Trust
UNITHOLDERS
↓
↓
Income
Trust
Notes
(High
interest
rate)
Equity
Operating
Company
Business
Explosive Growth
1995: first income trust was Labrador
Iron Ore for $200 million driven by
Norcen’s need to monetize small stake
in Iron Ore Corp
 Feb 2006: 235 Income Trusts with
market capitalization of $186 billion
 Represents > 10% of total Canadian
equity market

Explosive Growth - Numbers
250
200
150
# of Trusts
100
50
0
1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
Explosive Growth – Market Value $
200
180
160
140
120
$b 100
80
60
40
20
0
1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
Anticipated new conversions


General Electric’s insurance assets
BCE Inc’s telephone land line holdings
– expected market cap > $4 billion
– But telecoms need to make strategic investments


AGF Management Ltd
CI Financial Inc (stock ↑ 6.5% on news)
– “we pay out all our earnings anyway, either through
share buy-backs or dividends: we’ve paid out all our
earnings for the past six or seven years”
– “it will lower our cost of capital, which makes
acquisitions easier and cheaper” –Bill Holland, CEO
Types of Income Trusts

Real Estate Investment Trusts (REITs)
– income-producing real estate

Oil & Gas Trusts
– income stream from Oil &Gas properties

Power & Pipeline Trusts
– Income from public utilities

Business Trusts
– Income from mfg, service or industrial
Ideal Income Trusts
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Predictable yield
Stable cash income (margins) arising from
– Non-cyclical, contractual revenues,
protection from competitive pressures,
inflation protected
Low sustaining Cap. Expenditure (CAPEX)
– Defensive CAPEX to maintain existing CF
High Income (and Capital) Tax-paying
100% Canadian content to reduce currency
risk & to reduce complexity of repatriating
foreign income into tax-exempt Trust
Business Trusts


Biggest # of new trusts & also highest risk
Cyclical, non-stable businesses getting into
trust business – e.g., Legacy REIT (owns
Fairmont Hotels) – even though hotels are
both cyclical (business & leisure travel
dependent on economic activity) and high
sustaining CAPEX (always renovating)
 Legacy suspended distribution in 2003, citing
SARS as main cause
 E.g., Sleep Country, Aeroplan
Statistics: Trusts vs. Corporations
TRUSTS
Debt : Assets
EBIT : Interest
EBIT : Sales
Volatility of CF
Sales
Book Value
Mean
0.26
5.6x
0.18
0.59
228m
219m
Median
0.20
6.8x
0.14
0.47
140m
110m
CORPORATIONS
Mean
0.19
5.6x
0.12
0.65
479m
414m
Median
0.15
6.9x
0.10
0.58
132m
71m
SOURCE: Klassen & McDonald; Klassen & Mescall (2005) U. of Waterloo
Risks Unique to Income Trusts

Risk of a distribution cut
– Less income going forward
– Value of investment falls
– PHN sample of business trusts: average
distribution cut was over 50% and average drop in
trust unit price was nearly 40%

Risk of under investing in core business
– since greater emphasis on distributing cash than
on reinvesting in equipment

Risk of new tax legislation
– Alberta suffering tax loss from Ontario unit-holders
Risks facing Income Trusts

Royalty trusts face risk of accelerated
depletion of assets
 REITs susceptible to downturn in real estate
market – in part due to rising interest rates
 Higher interest rates can increase cost of
doing business and reduce distributions (and
therefore reduce yields & value)
 E.g., Menu Foods breached covenants with
creditors and suspended distribution,
reducing unit value from $14 high to $3 low
Should retirees hold business trusts?
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Business trusts are like highly leveraged
equities that retain little capital for
reinvestment (or rainy day)
Trusts are not just high-yielding equities, but
also high-risk equities (i.e., no free lunch)
Offer less safety of principal compared to
corporations who retain some capital
Offer limited organic growth potential
Many don’t have the strength & stability to
maintain distributions in bad times
Blackmont Capital on Business
Trusts
Even modest increases in interest rates
may reduce trust unit values by 5-10%
 1 in 4 business trusts < $10 IPO price
 Prediction: 50% of business trusts
expected to fall below IPO price
 Only 15% of business trusts have
sufficient quality to be held by retirees

Good vs. Bad Business Trusts

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Monetized spin-offs from larger corps led by
management were up by 8% in 2005
Trusts sold by private equity funds were down
by 8%; trusts sold by private corp. down 4%
Subordination by seller retaining 20% chunk
of corporation and agreeing to not receive
cash distributions signals higher than normal
risk; subgroup down by 14%
Debt capacity and flexibility in debt covenants
Retained earnings: compare with corporation
REITs

(-) Low interest rates means more home-buyers and
few renters
 (-) Hotel REITs susceptible to strong Canadian dollar
with its corresponding fewer tourists
 (+) Higher interest rates means economy expanding
& firms renting more space
 (-) Higher rates means higher discount rate applied to
REIT valuation (higher capitalization costs)
 (-) REITs (like bonds) have an inverse relationship
with interest rates
 Real estate considered sound hedge against inflation
Income Trusts curtail Agency Costs

Agency costs: loss to shareholders or
unitholders due to abuse of discretion by
management hired to run the firm
–
–
–
–

Insufficient effort
Self dealing (perks and theft)
Entrenchment strategies (e.g., poison pills)
Extravagant investments (NPV < 0)
Some agency costs reduced by Trusts
 If distributions ↓, agency costs may reappear
Two Options
(+) Shareholders get the option of keeping
management’s feet to the fire by forcing
higher distributions

Options forced by tax legislation
(-) Shareholders give up the option of
allowing mgmt to retain cash flows
Income Trusts vs. Stocks & Bonds
Income Trusts, Stocks and Bonds all
span a wide spectrum of risk and return
 Like Bonds & Equities, Income Trusts
should be judged on risk versus return
 None in high-tech fields, and generally
do not make risky capital expenditures
 Tax motivation for conversion from corp
to income trust largely diminished

Income Trusts are like
BONDS
 Periodic payments (but
not contractually fixed)
 Yield increases with risk
 Market value sensitive
to changes in interest
rates (due to higher
yields)

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
STOCKS
Distributions not
contractually
guaranteed and can
fluctuate
Returns and Price
depend on underlying
business profits
Unitholders have
residual claim on
earnings
Income Trust IPOs
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IPOs consist of small companies that would
not see light of day because they are boring
Now market likes them because they are
boring
Trusts are crowding out corporate IPOs
High Tech IPOs not getting much attention
Trusts ≈equity for commissions, IPO liability…
New Issues in Progress
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Total Issues in Progress in Aug/05: $860mm
5% Underwriter Fees in Progress ≈ $40+ mm
Plus large fees for accountants & lawyers
Plus no competition from US underwriters
Provinces (especially Alberta) still thinking
about taxing Income Trusts
Trusts domiciled in Alberta pay large
distributions to unitholders in Ontario
Yield major determinant of pricing
Trust valuation depends on business
risk, financial risk (leverage), quality of
management, governance,…& YIELD
 ↑ demand from GIC & equity refugees
 Dedicated new $$$ from retail investors
 $1.5 billion of new money in July 2005
 ↑ Growth after tech bubble burst in 2000

Valuation: Priced to Yield
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Distribution yield = key performance metric
Risk premium for REITs in 1998: 350 bps
Unit Price ≈Dist / (10-yr GOC yield + 350bps)
H&R REIT issued @ $11.75 in May 1998
Annualized distribution: $1.044
10-Yr GOC yield =5.4%; +350 bps = 8.9%
Therefore, Price = $1.044 / 0.089 = $11.73
Shrinking Risk Premium & Yields
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H&R REIT on Feb 25/05 = $19.10
Annual Distribution =$1.244; Yield =6.51%
10-Yr GOC=4.24%, Risk premium=2.27%
Risk premium and yields have been largely
declining with maturity of sector
Increased liquidity also reduces risk premium
IPOs promise 100% payout ratio (of
distributable cash flow) to maximize proceeds
Adjusted Funds From Operations
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Return of Capital priced increasingly lower
by investors than Return on Capital
E.g., Retirement Residences REIT (RR)
Analyst notes that RR distributing more than
DIPU (distributable income per unit)
Analysts prefer AFFO per unit since more
closely related to GAAP
DIPU = $0.88; AFFO = $0.66;
Therefore Return of Capital = $0.22
Price/Earnings vs. Price/Free EBITDA

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Price / Earnings Ratio for Stocks
Price / Free EBITDA for Trust Units
Free EBITDA ≈ measure of cash flow
= Earnings Before Interest, Taxes,
Depreciation & Amortization less anticipated
Annual Capital Expenditures
 Compare your Income Fund with other similar
Income Funds
 Higher valuation than shares reduces the
cost of capital, & thereby ↑ competitiveness
Dividend Valuation Models
 Perceived as flattening of growth
 Myron Gordon’s Growth Valuation
Model:
Price = DIV / (r - g)
e.g., $1.24 / (0.11 – 0.03) = $15.50
 Low growth rate (g)  lower prices
 “Stable cash flows” or “mature” may not be
compliments in any valuation model
 “lazy capitalism” or “opposite of capitalism”
 Microsoft’s initial dividend ≠ good news
How Conversions were justified
Corporation
EBITDA
Interest Expense*
Depreciation
Corporate Tax
Net Income
Assumed P/E
Equity Value
Enterprise Value
Multiple of EBITDA
$
100
4
10
31
55
10X
550
650
6.5X
*Assume $100 Debt at 4%
Income Trust
$
EBITDA
100
Interest Expense*
4
Sustaining Capex
10
Capital & Other Taxes 1
Distributable Cash
85
Assumed Yield
10%
Equity Value
850
Enterprise Value
950
Multiple of EBITDA
9.5X
Valuation Premium = 55%
SOURCE: PWC
(PriceWaterhouseCoopers)
Growth Assumption
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Corporation assumed to have P/E= 10X
Corporate growth rate must be zero for
corporation to be comparable to trust
Zero growth rare since earnings normally
retained for reinvestment
P/E = 10 implies P = 10Estatic
If Corporate E growing, then P > 10Estatic
Therefore P/Estatic > 10
Say P/E = 12 if Earnings are growing
Assumptions questioned
1) Differences in growth assumptions
2) Distributable Cash vs. Cash Distributed
3) Zero corporate dividend distribution
4) Differences in Personal level taxes:
– tax on capital gains realized on corporate
shares is 22% (≈ tax on dividends paid)
– tax on interest income on Trust units =44%

All of these 4 factors impact valuation
Comparative Valuation – based on
correcting assumptions (1) and (2)
Corporation
EBITDA
Interest Expense*
Depreciation
Corporate Tax
Net Income
Dividend paid
Assumed P/E
Equity Value
Enterprise Value
Multiple of EBITDA
$___
100
4
10
31
55
0
12X
660
760
7.6X
*Assume $100 Debt at 4%
Income Trust
$___
EBITDA
100
Interest Expense*
4
Sustaining Capex
10
Capital & Other Taxes 1
Distributable Cash
85
Cash Distributed
75**
Assumed Yield
10%
Equity Value
750
Enterprise Value
850
Multiple of EBITDA
8.5X
**Average distribution = 88%
Valuation Premium = 12%
Comparative Valuation – based on
correcting assumptions (3) and (4)
Corporation
EBITDA
Interest Expense*
Depreciation
Corporate Tax
Net Income
Dividend paid
After-tax Div Received
Assumed Yield
Equity Value
Enterprise Value
Multiple of EBITDA
*Assume $100 Debt at 4%
$
100
4
10
31
55
55
43
10%
430
530
5.3X
Income Trust
EBITDA
Interest Expense*
Sustaining Capex
Capital & Other Taxes
Distributable Cash
Cash Distributed
Cash Received
Assumed Yield
Equity Value
Enterprise Value
Multiple of EBITDA
Valuation Premium = 9%
$
100
4
10
1
85
85
48
10%
480
580
5.8X
Accounting Issues
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Yield, like Income, can be manipulated
70% of ITs distribute some Return of Capital
Distributable Income (DI) =GAAP Net Income
+ Non-Cash Expense – Normalized CAPEX
DI and CAPEX not GAAP measures,
therefore Trusts have significant discretion
Can always borrow to payout DIV or DIST
E.g., free rent tenant inducement considered
income and distributed (with borrowed $)
Not quite Cash box accounting
Free Rent Tenant Inducement
YR
1
2
3
4
5
Total
Cash Rent Rec’d
0
9
12
12
12
45
Distributed
9
9
9
9
9
45
Where to hold Income Trusts
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Interest income (t ≈ 44%) tax-disfavoured
compared to dividends or cap gains (t ≈ 22%)
Better to hold tax-disfavoured income (e.g.,
Income Trusts) inside RRSPs and equities
outside RRSPs
Equities are tax-favoured anyway
Losses inside RRSP cannot be offset against
gains outside RRSPs, and may be wasted
Diversification applies to entire Portfolio, and
not just Registered Portfolio
Trusts may constitute a separate asset class
Portfolio Diversification
P = Portfolio; R = Registered Portfolio
 NR = Non-registered Portfolio

P
R
NR
Trusts more correlated to equities
than bonds
S&P / TSX
Composite Index
3- to 5-year
Canada Bonds
10-year Canada
Bonds
S&P / TSX
Composite Index
1.00
0.13
0.17
3- to 5-year
Canada Bonds
0.13
1.00
0.82
10-year Canada
Bonds
0.17
0.82
1.00
S&P / TSX
Income Trust
Index
0.50
0.42
0.31
IT = Separate Asset Class (5-yr correlations)
T-bill Equity All
Corp Gov High
Bond Bond Bond yield
T-bills
1.00
Equities
-0.3
IT
1.00
All bonds 0.25
-0.09
1.00
Corp Bond 0.24
0.04
0.97
1.00
Gov Bond 0.28
-0.11
0.98
0.92
1.00
High Yield -0.09 0.22
0.10
0.22
0.05
1.00
Inc Trusts 0.10
0.15
0.19
0.11
-0.05 1.0
0.37
Distributions vs. Dividends

Cyclical or non-stable Income Trusts may be
forced to reduce distributions, while
corporations will likely continue paying
dividends out of retained earnings (e.g.,CIBC)
 Distributions more likely to fluctuate than DIV
 Retention of distribution is penalized with
taxes - therefore does not necessarily serve
as signal of quality or ‘excuse’ for expansion
 Reduced dividends may be justified as
serving expansion or growth objectives
Few high dividend-paying stocks

Only 7 Cdn stocks have dividend yield > 4%
(= 1-year T-bill yield on March 25, 2006)
– Manitoba Telecom, Rothmans, Russel Metals,
Emera, BCE, TransAlta and Quebecor World

Only 16 of the 500 S&P companies had
dividend yield > 4.68% in February 2006
(= 1-year US Treasuries)
– Only 10 of 16 stocks were judged to be
sustainable in their dividends by Merrill Lynch
Dividend Policy
Dividend yields fall when stock price ↑
 High dividend yield not necessary good

– May reflect higher risk or sluggish growth
– higher dividend often at expense of growth
 Microsoft’s
initial dividend was not
considered good news by the market

Cdn banks known for raising dividends
Red Flags for Distribution Cuts*
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Pre-tax yield ≥ 12%
– High yield indicative of high risk
Payout ratio ≥ 90%
– May not be sustainable with volatility
Debt : EBITDA > 2
– Insufficient slack if cost of debt goes up
“Since 1999, one in five business trusts have cut their
distributions. In 2005 alone, ten business trusts cut
their distributions, and the average return six months
later was -46%.”
*McLean
& Partners Wealth Management Ltd
Trusts overstate payout ability

Sustaining CAPEX (≈ average of 22% of cash
generated from operations) was not subtracted in
reporting the amount of distributable cash by 57% of
trusts examined by S&P in January 2006
 “slack & ambiguous way in which trusts report
distributable cash”
– S&P Jan /06
 “lack of accounting rigour in trust sector” –
Independent analyst Harry Levant
 “free use of cash” can include debt
– Al Rosen
 “Pyramid schemes” via return of capital – Al Rosen
Sustainability of Distributions
Dominion Bond Rating Service (DBRS)
website at www.dbrs.com offers
stability ratings for most income funds
on a scale of STA-1 to STA-5
 Standards & Poors website at
www2.standardsandpoors.com (click
on Canada) also offers stability ratings
from SR-1 (most stable) to SR-7 (least)
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Return on / of Capital
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Aggregate yield confusing
6% of trusts had return of capital < $0.01
Not rocket science but need to get hands dirty
Distributable Income not a GAAP measure
Corporations also distribute return of capital
Despite CIBC’s $2.4 b ENRON write-off in
2005, it continued paying a dividend from its
capital (retained earnings)
Yield major determinant of Price

Unlike pension funds, retail investors (often
seniors) not averse to higher cash flows,
even if it is return of capital
 Trusts aimed at retail investors, while
shares aimed at cynical / sophisticated inv.
 Trusts similar to Housing: cash flows
(house consumption) likely remain the
same even if yield repriced
 Everyone likes relative performance
evaluation – hence inclusion of Trusts in
S&P/TSX Composite Index
Questions / Comments?