High Yield of the Month
For the past several years, Enerplus has focused on growing a range of new development opportunities, notably a light oil reserve in the Baaken region and the Kirby and Joslyn oil sands properties. Both remain very promising for future cash flows, despite higher royalty rates in Alberta that kick in starting in 2009. For the next several years, however, the trust’s biggest returns are likely to flow from its latest coup: the CAD1.38 billion takeover of low-cost, natural gas-focused producer Focus Energy (FET.UN, FETUF).
Focus’ operating costs of just CAD4.65 per barrel of oil equivalent (boe) rank among the lowest in the business. Its balance sheet, meanwhile, rates as one of the very strongest, with debt only 17 percent of capital. Alone of gas trusts, it boasts an extremely low payout ratio of 55.3 percent and held third quarter funds from operations basically flat despite a drop in gas prices.
The problem is size. The passage of 2011 trust taxation into law dramatically pushed up Focus’ cost of capital. Meanwhile, mild winter weather pushed down the price of natural gas, which accounts for 90 percent of output. As a result, management was forced to reduce the distribution—though by a very modest 12.5 percent—to ensure it had the capital for development.
The move has paid off with the relative stability of the past year, particularly coupled with a very successful price-hedging program. But with gas prices still weak and capital markets mostly shut, Focus today has few avenues for growth on its own. Moreover, there’s potential for another drop in cash flow and distributions as hedges start to expire, unless gas prices do recover.
Enter Enerplus as Focus’ knight in shining armor, though with a clear self-interest. Its offer entails basically no premium to Focus’ pre-deal price. And it’s entirely equity-based (0.425 Enerplus shares per Focus), so there’s no financial risk to the acquirer while the deal’s in progress. Enerplus holders will own 79 percent of the combination, Focus owners 21 percent.
The chief appeal for Focus owners is twofold. The long-term benefit is being part of an infinitely more sustainable trust. But there’s also an immediate windfall: the 27.5 percent dividend increase, which is factored into the exchange ratio.
At first glance, this would seem to reduce the appeal of this deal for Enerplus, given the increased demand on cash flow. In reality, however, Focus has been holding its payout at an artificially low level because of concerns about raising capital. With the merger eliminating this uncertainty, it makes sense to ratchet up the payout to that of Enerplus’ other assets.
Second, Enerplus is getting Focus for less than 1.2 times book value. That’s a substantial discount to its own price-to-book ratio. Moreover, that’s cheaper than you’ll find high-quality oil and gas assets anywhere.
Most important, with its far larger capital base, Enerplus will be able to exploit Focus’ rich assets and development potential in ways its quarry could only dream of. The combination will have a market capitalization of CAD6.5 billion on which to issue additional shares and still remain within the government-imposed limits for trusts. It will also have one of the lowest debt-to-cash flow ratios in the business at roughly 1-to-1, as well as a rock-bottom debt-to-assets ratio in the high teens.
Focus’ reserves are two high-quality gas properties, one in Saskatchewan and the other in British Columbia. Buying them gives Enerplus another stream of financing to develop the Baaken and oil sands properties, both of which will consume considerably more cash than they generate in the next few years. As a side benefit, these properties are outside Alberta, meaning lower royalty rates for Enerplus on the whole.
One of the biggest problems for resource development in late 2007 is a shortage of qualified technical and leadership personnel. Merging with Focus gives Enerplus access to one of the richest talent pools in the business. Most senior executives are expected to leave after the transition period, though two key board members have already agreed to stay on.
Overall, the deal is expected to cut Enerplus’ 2008 operating costs per boe from a projected CAD9.50 to CAD8.50. Other costs are expected to fall from CAD2.60 to CAD2.20. Synergy opportunities include pooling efforts in shallow gas drilling and deep tight natural gas. Combined reserve life based on proven reserves is projected at 9.9 years, allowing management a great deal of flexibility managing capital spending. And the trust will have some CAD2.1 billion in tax pools, with which to help minimize 2011 trust taxes.
Without Focus, Enerplus would still be one of the very strongest and most sustainable oil and gas trusts. With those assets, it will be just that much more powerful. Predictably, the shares have slid the past several weeks, as the market has followed the cliche of selling the acquirer. That’s handed investors a chance to buy the trust at its lowest price in more than two years.
Like all oil and gas producers, Enerplus shares could fall further should oil prices drop precipitously on recession fears. The trust, however, covered its distribution with a comfortable 70 percent payout ratio by selling oil at less than USD70 a barrel in the third quarter. That’s a lot of downside cushion from volatile oil prices.
Meanwhile, there’s tremendous upside from selling gas at more than the third quarter’s USD5.59 per thousand cubic feet. Buy Enerplus Resources up to USD50.
A major Bay Street investor house turned trust in late 2003, GMP Capital Trust has since been reaping a steady fortune by playing a different side of the merger game: facilitating deals. The trust wasn’t involved in the Enerplus deal, but it advised on 11 completed takeovers, worth CAD4.88 billion. That was up from six deals worth CAD3.45 billion it advised on a year earlier. The trust also managed three secondary stock deals and the initial public offering (IPO) of Edmonton-based construction outfit Lockerbie and Hole.
Commissions and fees from stock trading, another of its businesses, rose 67 percent. Meanwhile, revenue at its asset management division doubled as assets rose 77 percent. The only downer was a 20 percent drop in income from the trust’s private client business, only a tiny sliver of the organization.
GMP eschews debt sales, credit derivatives and money market securities deals. As a result, the trust has avoided the woes now afflicting larger financial firms globally. Meanwhile, it continues to profit from the frenetic activity in Canada’s mining and energy sectors, which together provide about 75 percent of its investment banking revenue.
With those sectors likely to remain hot for years, GMP looks set to prosper as well. However, it’s also positioned to move on when it’s time, a skill it demonstrated in 2007, posting record profits despite the collapse of one of its most promising growth areas: public offerings of income trusts.
GMP’s competitive advantage is personnel. Here in late 2007, it’s having no trouble attracting and keeping first-rate talent. The main reason: Its activities are generating generous bonuses for those who put together deals, even as other houses on Bay Street are pulling in their horns. The trust also doesn’t guarantee salary for its dealmakers, keeping down overhead and providing a powerful incentive to keep moving.
One particularly promising growth area is GMP’s Edgestone Capital unit. Edgestone is a private equity firm formed to take advantage of the multitude of undervalued Canadian corporations and trusts, following the government’s Halloween decision to tax trusts. The fund has committed in excess of CAD2.5 billion of funds from institutional and high net worth clients, forging a major Canadian film company and most recently a life reinsurance company to shore up an industry lately battered by poor investment decisions.
GMP’s powerful third quarter results are a clear sign its strategy continues to pay off. The trust boosted distributable cash flow per unit an astronomical 60 percent on a 67 percent jump in revenue. Return on equity came in at 50 percent. Meanwhile, the trust issued virtually no new debt and increased outstanding shares by only 1.3 percent over year-earlier levels.
After its IPO in late 2003, GMP shares languished for about a year before nearly tripling in 2005. Since early 2006, it’s back to running in place again, with the shares trading consistently between CAD20 and CAD25. That’s despite the torrid growth of the underlying business and generally bullish analyst opinion.
Not even this month’s return to robust distribution growth has been able to move the shares off the mark. Reflecting the trust’s good fortune, GMP hiked the regular dividend to a rate of 14 cents Canadian from the prior 12.5 cents Canadian rate that had held since the last distribution hike in June 2006. Further, this 12 percent boost only took the payout ratio to 52.1 percent, leaving the door open for further growth. And management plans a special year-end cash payment of 65 cents Canadian as well.
One reason GMP may be lagging is concern that its business is cyclical and that an end to the resource bull market would dramatically curtail growth. There were signs of slowing in the third quarter, including a 7.8 percent drop in average equity trading volume on the Toronto Stock Exchange and fewer merger and acquisition deals overall. As noted above, however, GMP had a bang-up quarter, thanks in large part to its flexibility.
For example, its three fastest-growing investment banking areas by far in the third quarter were industrial companies, technology/healthcare and nonbank financial services. Together, they now represent between 20 and 25 percent of total investment banking revenue, up from about 2.4 percent a year ago.
Rather, the greater danger to the franchise is likely to be if there’s an exodus of key personnel that limits the trust’s ability to bob and weave in difficult markets. That’s a risk to watch out for, but it’s certainly not in evidence today. In fact, GMP’s wealth of human capital makes it a perpetual takeover target for a larger house, with several potential suitors in the US alone.
Barring a loss of personnel, there are few hurdles to GMP’s growth. Sooner or later, that means the share price will catch up to continuing distribution increases. In the meantime, new Conservative Portfolio addition GMP—the highest-yielding brokerage company in North America and without any subprime exposure—is a buy up to USD24.
For more information on both GMP and Enerplus, visit the How They Rate Table. Click on the “.UN” symbol to go to the Web site of our Canadian partner MPL Communications for press releases, charts and other data. These are substantial companies, so any broker should be able to buy them, either with their Toronto or New York Stock Exchange/over-the-counter symbols. Ask which way is cheapest.
Note that both trusts pay qualified dividends in the US and 15 percent of distributions are withheld at the Canadian border. Tax filing information is listed on the Canadian Edge Web site, under the menu item “Income Trust Tax Guide.” Canadian withholding can be recovered by filing a Form 1116 with your US income taxes.
| Enerplus Resources & GMP Capital Trust | ||
| Toronto Symbol | ERF.UN | GMP.UN |
| US Symbol |
NYSE: ERF
|
GMCPF
|
| Recent USD Price* |
39.25
|
10.73
|
| Yield |
12.7%
|
7.2%
|
| Price/Book Value |
1.91
|
4.53
|
| Market Capitalization (bil) |
CAD5.159
|
CAD1.465
|
| DBRS Stability Rating |
STA-5 (high)
|
none
|
| Canadian Edge Rating |
3
|
3
|