Income Trusts
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Transcript of Income Trusts
Income Trusts
Amin MawaniSchulich School of BusinessYork [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 ↓ ↓
Operating Company
Income Trust
Business
Notes (High interest rate)
Equity
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
0
50
100
150
200
250
1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
# of Trusts
Explosive Growth – Market Value $
020406080
100120140160180200
$b
1997 1998 1999 2000 2001 2002 2003 2004 2005Year
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 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 CORPORATIONS Mean Median Mean Median
Debt : Assets 0.26 0.20 0.19 0.15EBIT : Interest 5.6x 6.8x 5.6x 6.9xEBIT : Sales 0.18 0.14 0.12 0.10Volatility of CF 0.59 0.47 0.65 0.58Sales 228m 140m 479m 132mBook Value 219m 110m 414m 71mSOURCE: 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?
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
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)
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
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
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
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
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 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
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 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Assumed P/E 10XEquity Value 550Enterprise Value 650Multiple of EBITDA 6.5X
*Assume $100 Debt at 4%
Income Trust $ EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Assumed Yield 10%Equity Value 850Enterprise Value 950Multiple of EBITDA 9.5X
Valuation Premium = 55%
SOURCE: PWC (PriceWaterhouseCoopers)
Growth Assumption
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 assumptions2) Distributable Cash vs. Cash Distributed3) 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 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Dividend paid 0Assumed P/E 12XEquity Value 660Enterprise Value 760Multiple of EBITDA 7.6X
*Assume $100 Debt at 4%
Income Trust $___EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Cash Distributed 75**Assumed Yield 10%Equity Value 750Enterprise Value 850Multiple of EBITDA 8.5X
**Average distribution = 88%Valuation Premium = 12%
Comparative Valuation – based on correcting assumptions (3) and (4) Corporation $ EBITDA 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Dividend paid 55After-tax Div Received 43Assumed Yield 10%Equity Value 430Enterprise Value 530Multiple of EBITDA 5.3X
*Assume $100 Debt at 4%
Income Trust $EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Cash Distributed 85Cash Received 48Assumed Yield 10%Equity Value 480Enterprise Value 580Multiple of EBITDA 5.8X
Valuation Premium = 9%
Accounting Issues 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 Cash Rent Rec’d Distributed1 0 92 9 93 12 94 12 95 12 9
Total 45 45
Where to hold Income Trusts 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
R
NR
P
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
Bond CorpBond
GovBond
High yield
IT
T-bills 1.00
Equities -0.3 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 0.37 0.15 0.19 0.11 -0.05 1.0
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* 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)
Return on / of Capital
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?