Grilled Turkey

Playing in the big leagues is all about decision making. Whether lifestyle, training or game time, it’s safe to say the folks in the arena have made choices in all three areas over significant periods of time, the sum of which justifies their participation.

Playing good defense is about knowing which decisions to make, even before you have to execute them. Between the lines, instinct and athleticism take over only after preparation puts you in the right spot. And athletes and coaches always have to answer to skeptical sportswriters and the ticket-buying public.

In the halls of government, an active press, an informed electorate (nice chicken-and-egg problem there, no?) and/or a properly incentivized opposition party can hold power accountable for specific decisions the way in which keyboard jockeys in the press box and juiced fanatics in the front row attempt.     

One simple question lingering now more than a year after Finance Minister Jim Flaherty made like Slim Pickens and decided to drop a bomb on the income trust sector is: Why?

The party line is that the threat to Canada’s tax base posed by the BCE and Telus conversions to the income trust form made quick action necessary. But so-called tax leakage and tax fairness have been exposed as a chimera, a politician’s twin trick to enliven a stale debate about the relative fiscal burdens placed on corporations and individuals.

The “tax trusts” issue came up under Flaherty’s predecessor Ralph Goodale a little more than two years ago. The 2005 review addressed tax leakage in a study conducted jointly by the Dept of Finance and HLB Decision Economics.

They created a common model for determining tax leakage that used identical assumptions and identical input data. Both published their results; HLB’s took the form of a report entitled “Tax Revenue Implications of Income Trusts.” The Finance Dept’s took the form of 18 pages of blacked-out documents.

Mark Carney, Flaherty’s choice to succeed David Dodge as governor of the Bank of Canada on Feb. 1, will appear before the House of Commons Finance Committee to answer questions about the Canadian dollar, and those with an interest in understanding the decisions made on the public’s behalf will also probe his role in Flaherty’s Oct. 31, 2006, announcement that trusts would be taxed as corporations beginning in 2011.

No date for his testimony has been set, but it could happen as early as next week. Canadian lawmakers have never held an appointment hearing for a central bank chief; in this case, one would allow them an opportunity to question Carney about the loonie at a time when manufacturers are urging the Bank of Canada to cut interest rates to help them cope with a currency that’s soared to record highs.

Some may also take advantage of the opportunity to pick the brain of the man who ran the income trust file in Flaherty’s department.

Opposition members could start here: Did Carney, in fact, omit from his calculations 38 percent of taxes that are collected from income trusts that reside in Registered Retirement Savings Plans and pension plans? And did he decide to make the tax collection under the corporate model appear more robust by not factoring in reductions in corporate tax rates that had been legislated and approved by Parliament prior to Oct. 31, 2006?  

On Holidays

One element of the Tax Fairness Plan–the formal name of the scheme to subject income trusts to double taxation–that provides at least some comfort is the three-year window before flow-through entities have to start coughing up more cash to the government.

A lot can happen in 36 months. The political landscape could shift, providing an opening for the Liberals to follow through on a promise to revisit the situation. But that hope is no basis on which to make investment decisions.

Thirty-six months is also a long time in the life of a business. But strong trusts can say with certainty that they enjoy what’s essentially a tax holiday for that duration. Considering the many variables that must be negotiated in the successful operation of a business, having that knowledge is one helluva gift. 

Perhaps like no other, Yellow Pages Income Fund illustrates “strong business trust.” Yellow boosted its cash distribution a second time in 2007 and the sixth time since its 2003 initial public offering.

And although the absolute amount of cash paid to unitholders continues to rise, Yellow’s payout ratio is dropping. So far in 2007, it’s paid out 83 percent of its distributable cash, down from 87 percent in 2006.  

As 2011 approaches, trusts such as Yellow will get serious about converting back to conventional corporate structures. The strong trusts will most likely become common stocks that pay big dividends in order to preserve the element that gives them an edge in the competition for capital.

Yellow Pages is on track to pay about CAD1.20 per unit into 2010. The subtleties of the Canadian tax code mean that a trust distribution at that level would–with tax credits to investors–bump up the cash they receive to about CAD1.70.

The bottom line, as it’s been since the beginning of Canadian Edge, is to focus on strong businesses that pay sustainable, growing distributions. You’ll enjoy the next 36 months, and you’re likely to get paid a healthy rate even beyond 2011.

So enjoy the holidays: Thanksgiving, Kwanzaa, Christmas, Hanukkah and Income Trust Tax.

The Roundup

Canadian Edge Portfolio earnings for the period ended Sept. 30 are in, and the results have been largely encouraging.

Below are the final six breakdowns; we’ll include our summaries for all Portfolio trusts in next week’s Roundup.

Enjoy Thanksgiving.

Conservative Portfolio

Artis REIT (AX.UN, ARESF) reported a 147.5 percent increase in funds from operations (FFO) in the third quarter to CAD10 million (36 cents Canadian per unit). Revenue was up 71.8 percent to CAD27 million, and net operating income (NOI) rose 85.1 percent to CAD18.7 million.

Distributable income increased 85.1 percent to CAD18.7 million. Same property NOI was up 10.5 percent from a year ago.

Artis’ occupancy rate as of Sept. 30 was 97.1 percent. Mortgage debt-to-gross book value decreased to 49.9 percent from 52.1 percent at Dec. 31, 2006. Buy Artis REIT up to USD18.

Atlantic Power Corp (ATP.UN, ATPWF) reported a 15 percent increase in cash flow, as measured by earnings before interest, taxes, depreciation and amortization (EBITDA) on the strong performance of recently added assets, including the Path 15 power link in California. The Chambers plant also ran well and reaped the benefit of rising wholesale power prices.

Atlantic Power’s payout ratio ticked up to 104 percent for the third quarter, reflecting a 13.9 percent increase in outstanding shares to finance growth and a commensurate boost in debt. The company’s securities are stapled shares combining a high-yielding debt security with equity, so new issues boost both dilution and interest owed.

The trust’s nine-month payout ratio–which factors out seasonality–came in at a conservative 84 percent. Atlantic also increased its portfolio of fee-generating assets, adding another 50 percent stake in the Pasco project that will add to income the rest of the year.

As a result, Atlantic still looks on target for solid growth in its now 10 percent-plus distribution in the next few years. Atlantic Power Corp remains a buy up to USD12.

Energy Savings Income Fund (SIF.UN, ESIUF) reported net income for its fiscal second quarter of CAD4.8 million (4 cents Canadian per unit), up from a net loss of CAD1.3 million (1 cent Canadian per unit) a year ago. Sales for the period increased 16 percent to CAD381.9 million from CAD330.1 million.

Distributable cash was up 42 percent to CAD37.6 percent (35 cents Canadian per unit) from CAD26.5 million (25 cents Canadian per unit); the fund actually distributed CAD32.3 million (30 cents Canadian per unit) during the period, up from CAD26.9 million (25 cents Canadian per unit).

Margin-per-customer improved in all markets in which Energy Savings operates. Sales in US markets were up 168 percent. Overall sales and margins were hurt by the rising Canadian dollar, but distributable cash was unscathed because Energy Savings’ investment in US growth still exceeds US cash flow. The fund signed more than 90,000 new customers again in the second quarter, concentrated in the US.

Energy Savings’ board has also approved a special distribution of approximately 33 cents Canadian to 37 cents Canadian per unit, which will be declared Dec. 31, 2007, and will be paid during 2008 in a combination of cash and units. The fund’s payout ratio for the period was 86 percent, down from 102 percent a year ago. Energy Savings Income Fund is a buy up to USD18.

Keyera Facilities Income Fund’s (KEY.UN, KEYUF) net earnings rose 30 percent in the third quarter from CAD11.8 million (16 cents Canadian per unit) to CAD15.3 million (25 cents Canadian per unit). Gathering and processing revenue for the quarter was CAD50.7 million, up 15 percent from CAD44.2 million a year ago.

Higher throughput and higher fees accounted for most of the increase. Expenses for the gathering and processing segment rose by 13 percent.

NGL infrastructure revenue dipped 8 percent to CAD10 million on a fee adjustment and lower sales for Rimbey Pipeline and lower throughput at the Fort Saskatewan fractionation plant. Expenses in the NGL infrastructure operation came down by 16 percent on lower natural gas costs.

Keyera’s marketing segment delivered operating margin of CAD11.2 million, down slightly from a year ago on unrealized financial instrument gains and losses. Keyera’s cash outflow from operating activities was CAD8 million because of a CAD43 million seasonal increase in noncash working capital; the fund paid CAD22.9 million in distributions to unitholders. Keyerya Facilities Income Fund is a buy up to USD19.

Aggressive Portfolio

Advantage Energy Income Fund (AVN.UN, NYSE: AAV) reported a slight decrease in FFO to CAD62.3 million (51 cents Canadian per unit) from CAD63.1 million (63 cents Canadian per unit) a year ago; the fund recorded a net loss of CAD26.2 million (22 cents Canadian per unit) for the third quarter of 2007.

Revenue was up to CAD130.8 million from CAD124.5 million a year ago. Advantage declared distributions of CAD55 million (45 cents Canadian per unit), down from CAD60.5 million (60 cents Canadian per unit) in the third quarter of 2006.

Realized gas prices averaged CAD6.35 per million cubic feet, while oil came in at USD67.77. Production volumes were on track with expectations for the third quarter of 2007, and volumes increased 8 percent to 29,346 barrels of oil equivalent per day compared to the second quarter of 2007, mainly because of the inclusion of 26 days of Sound Energy Trust volumes in the third quarter.

Advantage had a 100 percent success rate in its third quarter drilling program, but third-party facility maintenance outages and inclement weather delayed the tie-in and drilling of new oil and gas wells. The payout ratio ticked up to 88 percent in the third quarter from 83 percent in the second quarter. Buy Advantage Energy Income Fund up to USD14.

Trinidad Energy Services Income Trust (TDG.UN, TDGNF) reported net earnings of CAD15 million (18 cents Canadian per unit), down from CAD31.6 million (37 cents Canadian per unit) in the third quarter of 2006.

Revenue for the recently concluded quarter was CAD162.2 million, up from CAD150.6 a year ago. EBITDA were CAD54.3 million (64 cents Canadian per unit), basically flat with third quarter 2006.

Trinidad paid CAD28.8 million (34 cents Canadian per unit), consistent with third quarter 2006 distributions. The payout ratio for 2007 year-to-date as of Sept. 30 was 61 percent, up from 54 percent at a comparable point a year ago because of an increase in units outstanding.

Trinidad has expanded its geographic footprint and service lines, sustaining unitholder value and distributions in the face of terrible industry fundamentals for Canadian drilling. Third quarter revenue for its US operations exceeded that of its Canadian operations by 23.8 percent, and utilization rates were consistently at or above 85 percent. Trinidad Energy Services Income Trust is a buy up to USD18.