Maple Leaf Memo
The quick and dirty way to value trusts now is to discount their cash flow by 25 percent and then ask whether the resulting yield is still attractive relative to what else is out there. It’s about the ability of any given trust to maintain an attractive post-tax distribution.
Because trusts face cash taxes in the 30 to 35 percent range in 2011, distribution cuts could be in order unless they increase their free cash flow the same amount by that time. For many, it’s going to be difficult. That makes trusts with the ability to make accretive acquisitions, grow free cash flow and buy back units with excess cash attractive buys right now.
Companies that are now sporting high double-digit yields are those the market doesn’t think will be able to maintain distributions in 2011, when Ottawa takes a bite out of the trusts’ free cash. In the meantime, many analysts and investors are comparing income trusts to their corporate counterparts and assigning similar multiples to similar trusts and corporations. Trusts, however, still enjoy a small premium.
Energy trusts and real estate investment trusts (REITs) will find that their valuations will adjust on a trust-by-trust basis. Oil and gas royalty trusts are very similar to their corporate counterparts, but there are valuation blips between the two. And these inconsistencies are factors investors should take into account when buying oil and gas companies.
Penn West Energy Trust (TSX: PWT.UN, NYSE: PWE) and Talisman Energy (TSX: TLM, NYSE: TLM) have about the same growth and the same net backs, or operating margin. Based on current production levels, Mark Bridges, an analyst at CIBC World Markets, calculates that Penn West trades at about $73,000 per flowing barrel of oil equivalent per day (boe/d) while Talisman trades at about $56,000 per flowing boe/d. So Penn West trades at a 30 percent premium to Talisman.
Historically, oil and gas royalty trusts trade at a 20 percent
premium over regular oil and gas entities in the corporate structure.
In 2011, the premium should evaporate, meaning trusts and their
corporate comparables should trade at the same flowing barrels per unit.
But because Penn West will enjoy a tax holiday for another four years,
it still deserves a premium. Bridges says that premium should be about
10 percent and dwindle down as 2011 nears.
REITs were spared the tax on income trusts, as long as they meet certain criteria. The key points are that 95 percent of a REIT’s income must come from property and that no more than 75 percent of their holdings can be outside of Canada.
So which REITs will be taxed? It’s still not clear. But RioCan REIT (TSX: REI.UN, OTC: RIOCF), H&R REIT (TSX: HR.UN, OTC: HRREF) and Calloway REIT (TSX: CWT.UN, OTC: CWYUF), among others, are likely to be exempt.
Go West?
TimberWest Forest Corp (TSX: TWF.UN, OTC: TWTUF) has actually gained ground, by a mere 1 percent, since Finance Minister Jim Flaherty issued his surprise Halloween announcement. One reason: It’s managed to buck the trend of falling unit prices because it isn’t technically a trust. It acts like one and is motivated by similar concerns. It pays unitholders a regular cash distribution and minimizes its corporate tax payments. Yet it does this through a hybrid structure, one that trusts could look to adopt or modify. A hybrid structure could get around the new rules but has the potential to spark another battle between Bay Street and Ottawa.
The trick is in the structure. Trusts pay out most of their cash flow to unitholders in the form of monthly or quarterly distributions, like a dividend, so there’s little to be taxed at the corporate level. TimberWest units, by contrast, include a piece of equity and a piece of debt stapled together. They trade as one security, but the company pays an interest payment on the debt to its unitholders each quarter. The interest payment is tax-deductible, minimizing the company’s tax hit.
For trusts that are loath to return to a conventional corporate structure, this could be an alternative. Ottawa will probably grandfather TimberWest but attempt to block other companies from following suit by denying preferential tax treatment on these stapled units.
There’s still another option, something called Income Depository Securities (IDSes), which have been used to help US companies convert into quasi-income trusts and list their units in Canada. Lawyers for Centerplate (AMEX: CVP), a catering company, are convinced that it isn’t affected by changes to Canadian tax law.
There are about a dozen companies like Centerplate, similar to TimberWest, but with one key difference: Theoretically, investors can separate the equity and debt portions of their unit and trade them individually, although practically this never happens. In this way, an IDS is comparable to a regular company whose equity and debt trade in the public markets. This makes it more difficult for Ottawa to scrap the structure without creating a ripple effect.
IDS structures could be attractive to many firms, though Bay Street will be cautious about pitching the idea until it gets more clarity from Ottawa. It might make sense for income trusts to collapse their trust structure and then distribute debt and equity directly to unitholders, much as TimberWest and these IPS structures have done.
The Roundup
These are the consequences we’re looking at as a result of the Canadian government’s decision to tax trusts: After 2011, trusts’ cash flow will be taxed just as corporations’ earnings are. That means they’ll have less cash to pay shareholders. Withholding tax on US investors will be the same as it is for ordinary Canadian equities. And most, if not all, trusts will use the full four years to make the transition.
That’s it. There will be no 41.5 percent withholding tax levied against US investors, as some US advisors have written. Neither are trusts likely to pay full corporate tax rates, as all will have an opportunity to become more tax efficient in the next four years.
Oil & Gas
Harvest Energy Trust (TSX: HTE.UN, NYSE: HTE) cut the price of trust units it plans to issue by 14 percent and more than doubled the number of units on offer as part of a USD638 million financing. It also raised the interest rate on a convertible debenture issue. All proceeds will be used to pay down debt it took on to buy the Come By Chance refinery in Newfoundland last month. Issuing more equity tends to have a dilutive effect on a firm’s investors as returns are spread out over more units. However, the 115,000-barrel-a-day refinery is generating enough new cash for the company to cushion the blow. Harvest now plans to offer 8.3 million units at USD27.25 each and another 1.24 million if underwriters exercise an over-allotment option. It will also issue USD330 million of 7.25 percent convertible unsecured subordinated debentures with an over-allotment option of USD49.5 million. Under the previous plan, announced October 25, it offered 3.15 million trust units at USD31.75 each and USD400 million of 6.3 percent convertible debentures. The financing, led by CIBC World Markets and TD Securities, is expected to close November 22. Harvest Energy is a hold.
Penn West Energy Trust (TSX: PWT.UN, NYSE: PWE) reported a 15 percent decline in third quarter profit due to costs associated with its CD3.3 billion acquisition this year of Petrofund Energy Trust. Net income dropped to CD77.8 million, or 65 cents Canadian per unit, from CD209.5 million, or CD1.27 per unit, a year earlier. Revenue rose 19 percent to CD636 million. The acquisition of Petrofund, the biggest in Penn West’s history, increased costs in accounting for depletion expenses for aging oil and natural gas wells. Those expenses more than doubled to CD207.9 million from a year earlier. Third quarter oil and gas production rose 29 percent to the equivalent of 129,059 barrels of oil a day. Profit was also damped by a drop in natural gas prices after a mild winter left an abundance of the heating fuel in storage in the US. The trust said its gas in the third quarter fetched CD5.97 per thousand cubic feet, before hedging, down 33 percent from a year earlier. Penn West expects to spend as much as CD600 million in 2007, including the drilling of 220 to 250 oil and gas wells, little changed from this year. The trust forecast 2007 cash flow of as much as CD1.4 billion based on an average West Texas Intermediate crude price of USD62.50 and Canadian natural gas selling at CD7.50. Penn West remains a buy up to USD33.
Gas & Propane
AltaGas Income Trust’s (TSX: ALA.UN, OTC: ATGFF) third quarter profit rose 67 percent to CD28.8 million year-over-year from CD17.2 million on strong power and natural gas liquids markets. Net income for the three months ended September 30 amounted to 52 cents Canadian per diluted unit, up from 32 cents in the same 2005 period. Quarterly revenue fell to CD317.9 million from CD375.4 million. AltaGas attributed the third quarter climb in profit to higher power prices and lower power-transmission costs, higher natural gas liquids fractionation spreads and lower interest expense due to reduced debt and interest rates. Those increases were partly offset by higher administrative and compensation expenses and the impact of the expiration of a contract. Chairman and CEO David Cornhill said the trust was “very disappointed” with the Conservative government’s decision to tax income trusts like corporations despite an election promise not to do so and the “significant disruption to the capital market” caused by the decision. “AltaGas has always operated with the discipline of a corporation by focusing on net income, return on equity and creation of long-term unitholder value,” he said. “Our business is strong, and we will continue to execute our growth strategy of creating long-term unitholder value. We will continue to evaluate the proposed taxation change and will work to minimize the impact to our investors.” AltaGas declared a distribution of 17 cents Canadian per unit, payable on December 15 to holders of record on November 27. Total distributions declared in the most-recent third quarter were 50.5 cents Canadian per unit. Buy AltaGas up to USD26.
Essential Energy Services Trust (TSX: ESN.UN, OTC: EEYUF) warned of lower distributions even as third quarter earnings almost doubled to CD2.4 million, from CD1.3 million a year ago, and revenue rose by 155 percent. The trust’s revenue was CD25.3 million for the three months ended September 30, compared with CD9.9 million in the same period last year, due in part to additional revenue from acquisitions. The earnings translated into 9 cents Canadian per unit for the quarter, compared with nil per unit last year. But the Calgary-based trust warned that it expects a drop in distribution payouts in the fourth quarter of 2006 and the first quarter of 2007: “The payout ratio will decline to levels comparable to our peers at current industry activity levels as Essential‘s operations are focused on production services, which helps to insulate the company from any drop in capital spending by our customers. The optimism for the winter is, however, tempered by the uncertainty created by the federal government‘s announcement on October 31 of their intent to change the tax treatment of income trusts.” Essential Energy is a buy up to USD9.
Keyera Facilities (TSX: KEY.UN, OTC: KEYUF) reported third quarter distributable cash flow of CD22.6 million, down slightly from the second quarter and lower than the third quarter of 2005. Keyera’s gathering and processing segment contribution was CD19.5 million, 7 percent lower than the same quarter last year. Natural gas liquids infrastructure contributed CD11.7 million, a 27 percent increase from the same period last year. Although natural gas drilling activity in the western Canadian sedimentary basin declined in the third quarter as a result of lower natural gas prices, the majority of the decrease related to shallow gas drilling in the central and eastern areas of Alberta. On the western side of the province, where the majority of Keyera’s facilities are located, drilling of medium depth and deeper wells continued to be active throughout the quarter. Keyera had the following comment on the change in trust taxation:
“On October 31, 2006, the Government of Canada unexpectedly announced a proposed tax on the income of Canadian income trusts which, for Keyera, will not become effective until 2011. This announcement was made without consultation with stakeholders. We believe this tax change could have a detrimental impact on the Canadian energy industry at a critical time for North American energy security. The Government has suggested that income trusts are creating an economic distortion that is threatening Canada’s long-term economic growth. Since becoming a publicly traded income trust in 2003, Keyera has invested over $400 million to grow our business in Canada, increasing distributions to our unitholders by 31%. We have contributed to economic growth and increased employment in the communities where we operate, as well as higher tax revenues for the Canadian government resulting from the repatriation of ownership of our business from foreign control. I would like to remind unitholders that this tax does not become effective until 2011. With our strategic asset base, experienced management team and depth of internal growth opportunities, we are well positioned to weather this period of uncertainty and continue to deliver value to our unitholders.” Keyera remains a buy up to USD18.50.
Real Estate Trusts
Northern Property REIT (TSX: NPR.UN, OTC: NPRUF) reported that total rental property revenue in the third quarter increased 35.7 percent to CD22.6 million from CD16.4 million in the third quarter of 2005. Net operating income increased to CD15.4 million from CD10.7 million, an increase of 41.9 percent. The total assets of the real estate investment trust (REIT) increased 42.9 percent year-over-year to CD610.5 million from Sept. 30, 2005. Market vacancy loss in the portfolio was somewhat improved for the quarter at 2.7 percent, while renovation vacancy declined to 1 percent of revenue. Net earnings of CD4.9 million were up 38 percent from CD3.5 million in the third quarter of 2005. Overall distributable income increased 35.6 percent to CD9.3 million from CD6.8 million for the same quarter in 2005. Buy Northern Property REIT, which is immune from the Canadian government’s proposed tax changes, up to USD23.
Pipeline Trusts
Pembina Pipeline Income Fund (TSX: PIF.UN, OTC: PMBIF) said that construction will start this month on the CD338 million (USD300 million) pipeline for Canadian Natural Resources’ Horizon oil sands project. The 250,000-barrel-per-day line will connect Canadian Natural’s oil sands operation, now under construction, to Pembina’s Athabasca Oil Sands Pipeline. That line carries most of the output from the oil sands region near Fort McMurray, Alberta, to Edmonton, the provincial refining center. Costs for the line are 17 percent above Pembina’s estimate of CD290 million made in August 2005, when it announced the agreement with Canadian Natural. The 73-kilometer (45-mile) line will be built in three phases and is expected to be in service on July 1, 2008. Horizon is expected to begin oil production in the third quarter of 2008. Pembina Pipeline is a buy up to USD16.
Electric Power
Primary Energy Recycling Corp (TSX: PRI.UN, OTC: PYGYF) reported third quarter revenue of USD21.2 million, down 3.3 percent from the previous quarter and up 9.5 percent from the third quarter of 2005. Energy service revenue, while up in comparison to the third quarter last year, was down compared to the previous quarter. Total operating expenses were USD19.6 million for the quarter. Operating and maintenance expenses were USD7.2 million, down USD1.5 million compared to the previous quarter and up USD1.3 million compared to third quarter of 2005 due to additional operating and maintenance expenses. Distributable cash for the third quarter was USD8.3 million, or 22 cents per share. Primary Energy declared total distributions of USD9.2 million, or 25 cents per share, for a payout ratio of 111 percent for the quarter. Primary Energy is a buy up to USD9.