Time for Takeovers
TAQA’s offer encountered some initial scrutiny, largely pertaining to prospective foreign ownership of Canada’s resource bounty. But since then, it’s steamrolled through needed shareholder and regulatory approvals. The projected payoff date is Jan. 11.
The PrimeWest deal is the first involving an oil and gas producer. But it’s hardly unique in the Canadian trust universe.
There have been more than three dozen separate deals since the government decided to tax trusts as corporations beginning in 2011. Some of the premiums were even higher than PrimeWest’s, notably the former United Waterheater’s buyout by a private-equity firm. And almost every deal has rewarded shareholders with immediate gains of 20 percent or more.
Deal flow slowed in the second half of 2007, partly because of tightening credit for private-equity firms. But we’ve continued to see takeovers at high premiums, including the recently concluded management-led buyout of CCS Income Trust at 21 percent above the pre-deal price.
Activity between oil and gas trusts themselves has also heated up. Aggressive Portfolio pick Penn West Energy Trust (NYSE: PWE, TSX: PWT-U) is currently on target to complete two buyouts by early February: Vault Energy Trust (TSX: VNG-U, OTC: VNGFF) and Canetic Resources (NYSE: CNE, TSX: CNE-U). Aggressive Portfolio pick Enerplus Resources’ (NYSE: ERF, TSX: ERF-U) takeover of Focus Energy Trust (TSX: FET-U, OTC: FETUF) is also expected to close in early 2008.
Meanwhile, energy services trusts Peak Energy Services Trust (TSX: PES-U, OTC: PKGFF) and Wellco Energy Services Trust (TSX: WLL-U, OTC: WLLUF) announced in late December that they’re joining forces. That all-stock deal is projected to wind up by March 31, 2008.
More Ahead
Looking ahead to 2008, all signs point to more deal making, both between trusts and by outside parties looking to buy valuable assets. First, there’s price. More than a third of the trusts in the Canadian Edge universe currently trade at or below book value, and another third trade below annual sales. Assuming the underlying business is healthy, that virtually guarantees any deal will enrich the acquirer.
Some trust managements are less anxious to listen to offers than they were last summer. That’s evidenced by the number of companies canceling offers to auction themselves to the highest bidder, including Aggressive Portfolio holding Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF).
In some cases, management has decided the underlying companies are worth more than the market is now willing to pay. Others are charting courses to operate as independent entities well past 2011 and are more interested in acquiring than selling out.
Virtually all of them, however, have stated they’re willing to listen to offers. And most would find it very hard to turn down the right price, at the very least given their legal obligation to answer to independent trustees.
A return of North American private capital to the bidding wars will likely require at least a bottom to the current US credit crunch. That may be some months off. Once money does loosen up, however, the secure nature of trusts with strong businesses should unleash buyers to take the plunge.
Meanwhile, not encumbered by US credit concerns, buyers from Europe, Asia and the Middle East will have the field to themselves if they feel the price is right. China in particular has been on the hunt for natural resource assets globally, and its companies have been willing to pay whatever it takes.
Canada has enhanced government oversight of purchases in recent months, particularly in energy. But the rules aren’t draconian by any stretch and won’t impede any well-structured offer, even in the energy patch. And the Conservative Party government remains favorably inclined to let market forces run their course.
As for mergers between the trusts themselves, these are driven by many motivations. In the case of weak trusts such as Peak and Wellco, the primary concern is survival.
With Canada’s natural gas patch still in a state of depression, both trusts continue to see massive chunks of their assets idled by lack of interest from prospective drillers. Together, they’ll be able to pool resources to cut costs, dramatically enhancing their ability to weather the current slump.
Penn West and Enerplus, meanwhile, are looking to build their reserves at low prices in advance of 2011. After its purchases, Penn West will have total production of more than 200,000 barrels of oil equivalent (boe) per day, while Enerplus will have more than 100,000 boe per day. Both have potential to build substantially on that with their investment in the oil sands. (See Canadian Currents.)
One of just two deals we’ve seen between trusts outside the energy patch so far is Conservative Portfolio pick Macquarie Power & Infrastructure’s (TSX: MPT-U, OTC: MCQPF) buyout last year of the former Clean Power Income Fund. That deal actually broke up a prior transaction between Clean and Conservative Portfolio pick Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF). The other was InnVest REIT’s (TSX: INN-U, OTC: IVRVF) purchase of some of the assets of the former Legacy Holdings.
Both deals were made to bulk up businesses by adding cash-generating assets. In Macquarie’s case, the motivation was to increase the power portion of its asset base, as well as its presence in carbon-neutral generation. InnVest, meanwhile, added Legacy’s signature resort facilities to its own.
The desire to get bigger is a motivation that’s likely to lead both trusts to acquire again in the trust sector at attractive prices. It’s also likely to spur similar deals between trusts in a range of other sectors.
In addition, mergers between trusts don’t count toward the 20 percent limitation on potential increases in trusts’ shares set for 2008, 2009 and 2010. Instead, they create a larger base to issue on, meaning more can be issued without breaking the 20 percent mark. In short, they’re the easiest way to bulk up to meet the challenges to 2011 and beyond.
What’s Worth Buying
Nearly every private capital or foreign buyout of a trust will generate a sizeable capital gain for investors. Trusts’ structures make it difficult to impossible to launch hostile bids. And winning management/shareholder approval requires offering a high enough price. Moreover, the offers are all cash, which locks in the price no matter what the market does.
Mergers between trusts themselves will create larger, more-stable entities. That adds up to greater dividend safety and potential for long-term growth. And the combined entity becomes a more attractive takeover target as well. None of the deals to date, however, have involved more than a modicum of cash, even those between large buyers and relatively small targets.
That’s in large part because of the difficulty issuing large blocks of shares for cash. But even in the days before Halloween 2006 placed restrictions on new issues, trusts still preferred to trade in stock rather than cash. The forging of Penn West with the Petrofund merger, for example, was all stock. So was the union of Acclaim Energy Trust and StarPoint Energy Trust to form Canetic, as well as the similar deal that created the present day Harvest Energy Trust (NYSE: HTE, TSX: HTE-U) from the former Harvest and Viking Energy Royalty Trust.
As I pointed out last issue, the Enerplus/Focus merger involves a de facto 27 percent dividend increase for Focus shareholders, as Enerplus increases the payout on its assets. But it, too, is an all-stock deal, as are the Penn West/Vault/Canetic mergers and the Peak/Wellco union.
Where stock swapping is concerned, there’s absolutely no guarantee of an ultimate premium for shareholders of the acquired company. PennWest shares, for example, have slid since the Vault and Canetic deals were announced, wiping out the modest premiums in the initial offer. Enerplus shares now trade about where they did when it offered for Focus, but there’s no assurance they will when the deal closes.
To be sure, all of these mergers continue to make sense for the acquired trusts. And their shareholders will be best served by approving them, as their trustees have recommended repeatedly. On their own, both Canetic and Focus lack the financial strength to develop their considerable resource holdings. Vault alone would have no choice but to lever up in the short term and would likely ultimately file Chapter 11.
Each of these deals, however, makes a very clear point. Here in early 2008, the only sure benefit to shareholders of either party in a trust-to-trust, stock-for-stock merger is long-term strength. In contrast, all-cash buyouts by private capital and foreign entities offer the potential for big short-term gains, though at the price of no long-term payoff because the shares are called away.
That leads me to my main rule for shopping for takeover targets: Buy only trusts that you wouldn’t mind holding if no deal were to occur. In other words, takeover potential is the icing on the cake for owning high-quality trusts.
Eventually, the weak will be gobbled up. In the oil and gas patch last year, we saw Sound Energy saved from its death spiral by Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) just as Vault was rescued from potential oblivion by Penn West.
Neither of these deals was at any real premium to pre-offer prices. My view is they’ll pay off in the long haul as these trusts get stronger and even potentially are taken over for real premiums. But you’d have been far better off buying either Advantage or Penn West and sticking with them rather than betting on their ultimate targets.
That was also the case for Shiningbank Energy Income Fund in its takeover by PrimeWest earlier this year, though its shareholders have benefited from the TAQA takeover. Even the all-cash deal for Thunder Energy Trust by a private equity firm went off at virtually no premium.
The same is almost certain to hold true for any prospective deals for the remaining basket cases in the energy patch, including Enterra Energy Trust (NYSE: ENT, TSX: ENT-U), Trilogy Energy (TSX: TET-U, OTC: TETFF) and True Energy Trust (TSX: TUI-U, OTC: TUIJF). All are likely to be taken over.
Enterra and True each sell for less than half of book value, a fact that would seem to invite a sizeable bid. Unfortunately, their weaknesses are too well known. And with the betting on their bankruptcy, they don’t have a whole lot of bargaining power.
The same goes for weakened trusts outside the energy patch. Clean Energy owners, for example, captured only a fraction above book value from the Macquarie Power & Infrastructure takeover. Worse, they also had their dividends cut.
In balance, it was the best move management could make because Clean was headed nowhere on its own. But again, shareholders would have been better off holding the Macquarie trust all along.
The good news is there are plenty of high-quality trusts here in early 2008 that are selling for a song. If no suitable offer comes their way, their growing businesses will produce a rising stream of distributions that will ultimately lift their share price. And when they’re taken out, the payoff will come much faster.
In the December issue, I highlighted several criteria for determining the strength of a trust’s underlying business, which are used in setting Canadian Edge safety and stability ratings: business strength and growth, business cyclicality and stability, debt and dependence on outside capital, and distribution coverage and consistency.
Each of these are critical for sustaining and growing a trust’s distributions over the long haul. Trusts’ share prices are frequently volatile in the near term but religiously track distribution streams over the long pull. That hasn’t changed with potential 2011 taxation because that’s been priced in since November 2006.
How much cash flow a trust can generate for dividends is the most important factor for whether or not it’s attractive to individuals. It’s also the key to how much an outside buyer will pay to acquire the business.
As I stated last issue, the best possible sign of strength for any trust now is at least one distribution increase since Halloween 2006. That’s clear evidence that the trust is still thriving in a very challenging environment.
It also demonstrates management’s will to keep paying outsized yields well past 2011. That’s the best possible confirmation for any would-be acquirer that this is a good business to buy and lock away.
Last issue, I presented a table showing 37 Canadian income trusts that have increased distributions at least once since Halloween 2006. This month, five more joined the list. The result is 42 high-quality Canadian trusts backed by strong businesses that will run well on their own and are likely to attract attention from cash-hungry private equity as well.
Note that only two oil and gas producer trusts have increased distributions over that time frame: Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF) and Vermilion Energy Trust (TSX: VET-U, OTC: VETMF). Their ability to boost payouts is directly attributable to not relying on Canadian natural gas production.
As its name suggests, Canadian Oil Sands produces no gas. In fact, it wins from lower gas prices, which reduce electricity costs. In Vermilion’s case, it sells primarily in foreign markets, which has the side benefit of virtually immunizing its distribution against prospective 2011 taxation.
Because natural gas prices are beyond their control, lack of recent distribution increases doesn’t disqualify oil and gas trusts from the list of potentially profitable takeover targets. Neither, in fact, do dividend cuts. But it does mean that, with the exceptions of the select few highlighted below, acquirers—not the acquired—will be the primary beneficiaries of deals in the energy patch.
Now that we have our list of top-quality trusts, the next question is whether they trade at levels that would produce a suitable premium in a takeover. Beauty is often in the eye of the beholder. An acquirer familiar with pulp producers, for example, is much more likely to pay up for one than is a potential buyer whose expertise is oil and gas.
Trying to anticipate who’s going to buy who is highly speculative and requires a certain amount of clairvoyancy that most of us (myself included) don’t possess. We can gauge relative value, however, and two gauges seem to work best when it comes to income trusts: price-to-book value and price-to-sales ratio.
The two tables titled “Priced to Book” and “Priced to Sales” show six trusts with very low price-to-book value ratios and price-to-sales ratios. The intersection of these lists and the dividend increasers is a pretty good starting point to look for deals.
Prime Picks
So who’s most likely to be taken over in 2008? The prime candidates basically fall into two groups.
The first are trusts outside the oil and gas production business that meet the criteria for dividend growth and quality as well as low price. Given that we’ve already seen one deal among the power trusts, we’re likely to see more.
Boralex Power Income Fund’s mighty drop in recent months logically should put it in play. Any deal, however, is going to require the acquiescence of management, which was apparently reluctant to sell out even at a price in the USD9-per-share range.
It’s still possible the income fund will ultimately be acquired by parent Boralex, which owns 23 percent of the shares and manages the plants. My view has been that the parent company would be able to profit from any deal valuing the trust at less than its price-to-book value (2.27 times approximately). That leaves a lot of room to maneuver because the income fund now trades at just 92 percent of book value.
I’m sticking with battered Boralex Power Income Fund as a buy up to USD8. But my view is we probably won’t get a takeover here. We’re going to have to wait for recovery, though collecting dividends along with way makes that a lot less painful.
A better bet based on our criteria is Macquarie Power & Infrastructure, which last month hiked its distribution by 2 percent and sells for just 1.19 times book value. The trust, however, is run by Macquarie Bank and has definitely established itself as an acquirer. Macquarie Power & Infrastructure is a buy up to USD12 but, again, it’s an unlikely takeover target.
Ironically, my most likely target in the power patch has neither raised its distribution since Halloween nor shows up as one of the lowest for price-to-book or price-to-sales: Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF). It does, however, trade at a modest price of 1.39 times book value, has a solid base of carbon neutral power and water assets in the US as well as Canada, and covers its payout by a secure margin.
The US assets should ensure that two-thirds of income escapes 2011 trust taxation. Buy Algonquin Power Income Fund up to USD9.50 and enjoy the 11 percent yield until a deal does appear.
Two energy infrastructure trusts are worthy of takeover consideration. AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) has been steadily building a diversified portfolio of fee-generating assets, ranging from wind power plants to gas-gathering pipelines. The result has been consistently strong growth in cash flow, which continues to fund both more expansion and distribution growth.
The shares trade at just one times annual sales and yield more than 8 percent. AltaGas Income Trust is a buy up to USD28. I would look for an offer in the USD40-per-share range.
The other prime prospect is Keyera Facilities (TSX: KEY-U, OTC: KEYUF). This trust’s primary strength is its gas midstream assets, located in what’s still a very prosperous segment of Canada’s energy patch. The trust’s crown jewel is natural gas liquids (NGL) infrastructure that includes pipelines, terminals, and processing and storage facilities in Edmonton and Fort Saskatchewan, Alberta.
NGLs’ primary input is natural gas, and they sell for oil-like prices. As a result, they profit when gas prices are low and oil is high, as has been the case for the past few years.
That infrastructure alone would make Keyera an attractive takeover play, particularly considering recent dividend growth of 5 percent and a share price of just 84 percent of sales. Buy Keyera Facilities up to its new target of USD20.
Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) is still heavily owned by its former parent BCE. But with BCE itself soon to be taken over by a private-capital consortium, that may change quickly as the new owners look to sell off noncore assets to repay takeover debt.
At that point, a raft of potential buyers will likely take a look at Canada’s leading rural telecom service provider, its rapidly upgrading system, secure customer base (much of which faces no competition) and strong balance sheet. The trust sells for just 86 percent of book value and boosted its distribution 2.9 percent over the past year. Buy Bell Aliant Regional Communications Income Fund up to USD33.
I last recommended Jazz Airline Income Fund (TSX: JAZ-U, OTC: JAZFF) and TransForce Income Fund (TSX: TIF-U, OTC: TIFUF) in the November issue as selected super-high-yield trusts. Both had been hit by concerns about Canada’s economy possibly following the US lower in 2008, despite posting robust third quarter results and dividend growth.
Jazz, for example, hiked its payout 15 percent over the past year, reflecting very rapid growth in Canadian air traffic and its deal with Air Canada to limit trust risk and maximize cash flows. TransForce, meanwhile, proffered its shareholders a 5.5 percent boost as it continued to add new business strategically through takeovers and organic growth despite a weak overall market for transport.
It’s entirely possible the market’s fears will prove correct and both of these trusts will eventually see their cash flows and distributions shrink in 2008. But it’s very hard to argue that such possibilities aren’t already more than priced in.
TransForce, for example, currently pays a yield of more than 17 percent and sells for just 1.43 times book value and 41 percent of annual sales. Jazz, meanwhile, pays more than 13 percent, while selling for 96 times book value.
If these trusts are forced to cut distributions in coming months, they could take on a little more water. But if they hold or even increase them until investor fears on the economy start to wane, both could be headed for a double.
In the meantime, both are looking very attractive for possible takeovers. Buy Jazz Airline Income Fund up to USD10 and TransForce Income Fund to USD14.
Cheap Energy
Back in August, I highlighted a pair of energy trusts as ripe for possible takeovers based on reserve quality and financial strength. They continue to hold steady as my top candidates for high-premium takeovers: oil-weighted Crescent Point Energy Trust (TSX: CPG-U, OTC: CPGCF) and natural gas-focused Progress Energy Trust (TSX: PGX-U, OTC: PGXFF).
Crescent Point Energy Trust is a buy up to USD26, and Progress Energy Trust is a buy to USD15. Both will be just fine on their own whether there’s a takeover offer in their future or not.
A couple Aggressive Portfolio trusts, however, may capture deals before they do because of much lower selling prices. One is Advantage Energy. The other is Penn West, destined to be the largest of all conventional oil and gas trusts by a 2-to-1 margin when it completes two ongoing takeovers later this month.
Of all the remaining independent trusts, Advantage best resembles soon-to-be acquired PrimeWest. The trust has deep reserves strongly weighted toward natural gas. It has substantial tax pools that ensure it can continue to pay a big dividend well after 2011. And after a dividend cut last month to bring the distribution back into balance with cash flows, it’s also extremely cheap.
Even after the cut, the yield is still well more than 16 percent. Meanwhile, the shares sell for just 86 percent of book value. Weak gas prices are likely to remain a drag on the share price until they turn up. But at this price, the risk of owning Advantage is very low and temptation could wind up being too great to resist. Buy Advantage Energy Income Fund if you haven’t already up to USD12.
As for Penn West, its most likely potential suitors are foreigners with very deep pockets who are anxious to lock down producing properties and promising potential reserves. The trust has both in plentiful supply.
Moreover, it trades for just 1.34 times book value, some of the cheapest energy you’ll find anywhere. Buy Penn West Energy Trust up to USD38, but don’t average down in it or any other trust or investment.