Trial by Fire
Even the strongest players lost ground during these selloffs, and weaker players sank into oblivion. Ultimately, however, market conditions bottomed, and the stress test’s survivors emerged meaner and leaner than ever. Buyers returned to their stocks, and the losses converted to massive gains.
Electric utility stocks, for example, have enjoyed a five-year bull market since they bottomed in late 2002. In fact, they’re currently within a fraction of their highs, which are nearly 50 percent above the late 2000 peak. Moreover, the industry is in better shape financially than in decades.
To say Canadian income trusts have been enduring a trial by fire during the past year and a half seems like the understatement of the year. Worse, as long as recession worries are rising in the US, their trial will continue.
But there are definite positives as we enter the last month of turbulent 2007. First, even after the November selloff, the vast majority of Canadian Edge Portfolio picks are still comfortably ahead for the year. We haven’t avoided all the losers—natural gas producers and energy service trusts come to mind—but all of the picks are still very much in the game.
More important, this situation has separated the wheat from the chaff in the Canadian trust sector. Times have been tough. But we can be more confident than ever in the business strength of the trusts that have had stood up to the challenges. Even on the worst trading days, they’ll keep paying their distributions and will ultimately rebound when the macro conditions improve.
With so many unknowns concerning the global markets and economy, it’s still absolutely critical to stay on top of the vital numbers. That’s the only way to know if they’re still standing tall and are, therefore, worthy holdings.
Below, I examine the causes of trusts’ ongoing trial and the risks they present to underlying businesses, distributions and share prices. I show how we can best protect ourselves as long as the trials continue and highlight a post-trials Canadian Edge ratings system based on my cornerstone value of business sustainability.
The Portfolio section discusses third quarter results in detail for all of our current holdings. How They Rate looks at the rest, and Tips on Trusts examines the nontrust universe that’s an increasing piece of our coverage.
I can’t say we’ve hit a bottom even for good trusts. The broad-based S&P Toronto Stock Exchange Trust Composite Index currently sits at about 140, versus an all-time high of 177 in April 2006. And although it’s been mostly flat for the year, there have been jagged ups and downs along the way.
What I can say is, as long as this thing lasts, great Canadian trusts sustaining businesses and distributions will hold their own. They’ll have their down days, too, particularly when recession fears reach a crescendo. But they’ve already passed one of the most severe trials by fire endured by any sector.
Moreover, they’ve priced in 2011 taxation and then some. They’re paying the highest yields in the world and clearly intend to dish out big dividends well past 2011; more than half the Canadian Edge Conservative Portfolio holdings have increased distributions at least once since Halloween 2007. And they’re cheap, as evidenced by the stream of high-premium trust takeovers we’ve seen this year.
The Trials
Most investors date Canadian income trusts’ trouble to the Halloween 2006 announcement that they’ll be taxed as corporations beginning in 2011. But the market began to face headwinds as early as mid-2006, as natural gas prices began to weaken in the face of mild weather and rising inventories.
By the time the surprise tax plan was announced, falling gas prices were already taking a toll on most natural gas-focused producer trusts. Worst hit were those that went public in late 2005 and early 2006, in the wake of the Liberal Party’s defeat in the election.
The taxation announcement, of course, triggered an immediate haircut of 20 percent or more for most trusts, both inside and outside the energy patch. As a result, trusts immediately priced in the worst case on taxation and then some—meaning a dividend cut to reflect a 31.5 percent maximum corporate tax rate.
That limits their downside risk for 2011 and even builds in some upside. The vast majority won’t pay anything close to 31.5 percent but rather something closer to the 6 to 7 percent paid by Canadian corporations.
The taxation plan has, however, affected trust businesses in one very substantial way in the past year. The government limited the number of shares a trust could issue to 40 percent of equity in 2007, with an additional 20 percent each in 2008, 2009 and 2010. Coupled with lower share prices, that slammed the door on share issues for all but the strongest trusts.
Before Halloween 2006, several dozen trusts were routinely doubling and tripling their outstanding shares each year. Some used them in a disciplined way to finance growth, but others spent on everything from operating costs to paying unsustainable distributions. For them, the shutoff of funds has been nothing short of catastrophic, as cash shortages forced distribution cuts, crushed share prices and further curtailed access to capital.
The only trusts thriving now are those with the ability to live off their own resources. That means those backed by solid, sustainable businesses.
Unfortunately, trusts’ misfortune didn’t end there. For one thing, natural gas prices have continued to slump, punishing producers’ cash flow and sending Canada’s gas drilling sector into a literal depression.
The surging Canadian dollar has pushed up the US dollar value of trusts’ distributions and share prices. But it’s made it very difficult for trusts exporting goods and services to the US because the Canadian dollar value of those revenues has declined.
That even applies to oil production because black gold is priced in US dollars. Producing trusts have enjoyed higher oil prices in Canadian dollars. But oil’s rise versus the loonie is far less than its rise in US dollars, muting the favorable impact on trust cash flows.
In November, the fourth horseman struck the trust sector: recession fears emanating from the US. Unlike the other blows, this one has yet to have any impact on the underlying businesses of strong trusts, as solid third quarter results show. But market reaction to fear of the unknown—mainly the impact a US recession could have on Canada’s markets and its economy—has pushed down share prices.
To be sure, past recessions in this country have been devastating to Canada. That’s because Canadian resource producers have been historically dependent on American markets.
Also, as the world’s biggest oil consumer, American demand has typically driven its price, as well as that of other commodities. Falling demand here because of a recession would no doubt take oil prices down and hurt cash flows at energy producers, including trusts.
Even trusts that covered distributions by substantial margins in the third quarter haven’t escaped the selling. Strong trusts in other industries, meanwhile, have taken on water because of concerns about Canadian banks. The chief worry is the country’s banks will tighten credit dramatically, just as US banks have done, and that trusts won’t be able to access the capital needed to sustain their businesses.
Finally, Canadian authorities have intervened to halt the loonie’s rise, which has brought the currency back to rough parity with the US dollar. That, too, has convinced some to sell their Canadian holdings. Such investors are fearful that a spreading recession will pull more money back to the greenback and depress the US dollar value of Canadian investments further.
Each of the reasons for the trial by fire continues to carry risks for investors today. Ironically, the area of least concern is the one CE readers inquire about the most: the fate of trusts when they’re taxed in 2011.
First, investors still have a three-year tax holiday before there’s any change. Any change in the Canadian government between now and then would be a positive. The odds of that are extremely speculative because they depend on the Liberals unseating the Conservatives and making good on their pledge to change trust policy. But the worst case is simply the status quo.
Second, the status quo is priced in and has been for months. That was clearly evidenced this summer, when trusts actually rallied strongly after the final legislation passed the Canadian parliament. It’s also clear from trusts’ very low price-to-book value multiples and the fact that yields would still be attractive, even if they were shaved by a third.
What’s not priced in is the fact that the average Canadian corporation pays only 6 to 7 percent of its real income in taxes and the fact that trusts have as many ways to cut their tax bill as ordinary corporations. That means a much less-than-expected impact on distributions in 2011 and almost surely upside from trusts because most investors are still expecting some kind of doomsday in 2011.
The full impact of the Canadian government’s restriction on new share issues may not be completely played out. But after more than a year of operating under the new rules, it’s almost surely darn close.
In contrast, debt is becoming a bigger issue in view of the risk of a US recession. Not surprising, the most vulnerable trusts are those that are heavily reliant on debt leverage to grow and maintain their businesses.
Most trusts have borrowed more in the past year, particularly those that have been growing their businesses with acquisitions. Most, however, have considerable room to absorb more debt if needed. The possible exceptions are those listed in the table “Debt Heavy.”
Note that some types of businesses have the ability to absorb more debt than others. For example, a debt/assets ratio of even 60 to 70 percent is OK for a well-run Canadian REIT because of the stability of its income stream. In contrast, a debt/assets ratio of just 40 to 50 percent may be a sign of trouble for an oil and gas producer, given the inherent volatility of that business.
The trusts in the table aren’t necessarily doomed. But they are at greater risk than their peers if business conditions worsen further. And that could definitely happen if a recession in this country does wind up migrating north.
It’s important to point out, however, that Canada’s economy is still running strong by all accounts and this week’s rate cut by the country’s central bank will only help. US weakness is affecting certain sectors, for example transportation, timber and raw materials exports and pulp processing. In general, however, things are still humming along, and trusts are having no problem borrowing from banks or even raising new debt offerings at reasonable prices.
To be sure, a further dip here will almost certainly affect activity there. But Canada does have an ace in the hole: Its resource exports are no longer wholly dependent on the US market. Rather, they’re being absorbed by increasingly ravenous demand from China and the developing world.
The million-dollar question is if a US recession will become so severe that it brings down even these robust growth engines. There are signs of growing weakness here, i.e., rising unemployment insurance claims, the housing slump and slowing consumer spending. But the Federal Reserve is equally determined to avoid a major calamity. And anything short of that won’t bring down the rest of the world.
All trusts’ share prices have been hit by recession worries to some extent, and they’ll almost surely be again on the market’s worst days. But again, the only really vulnerable trusts to a potential credit crunch in Canada are those that are most heavily reliant on debt. The numbers tell the tale.
Energy Worries
Undoubtedly, the biggest drag on the greatest number of trusts’ business fundamentals is still-weak natural gas prices. This is an area I’ve been flat out, dead wrong on for well more than a year.
I’m still convinced a rebound is coming. But it’s impossible to predict when it will occur. And until it does, virtually every energy trust is going to suffer lagging cash flows, with gas-focused producers and energy service trusts taking the worst of it.
It’s hard to see how even a US recession could seriously damage natural gas prices from here. On the supply side, the sector remains in a virtual depression, as producers have curtailed output across North America. Cheap liquid natural gas imports aren’t as plentiful as they’ve been, owing to rising overseas demand.
As for demand, it’s far more weather-dependent than it is economy related anyway. People are going to drive up demand and pay their bills if there’s a cold winter—whether the economy is running full out or is stuck in neutral—just as they haven’t the past two years because of mild temperatures.
As a result, producer trust cash flows aren’t likely to suffer much on the natural gas side even if the US economy does weaken further. The situation, however, is considerably different when it comes to oil.
In sharp contrast to gas, oil prices have been trading in the stratosphere this fall. In the past couple weeks, however, the fuel has sold off sharply from its highs of nearly $100 a barrel, largely on worries a US recession will spread and kill global demand.
How bad could things get for oil? My colleague Elliott Gue, editor of The Energy Strategist, believes we could see downside to the $60 to $70 per barrel range in 2008 if worries of a severe worldwide recession really do take shape.
A lot could keep that from happening. If the Fed keeps the US economy out of recession, demand won’t drop nearly enough globally to bring prices that low. Also, we still don’t know how much a US recession would affect demand in other parts of the world, particularly China.
Chinese industry does export a substantial amount to this part of the world. But although oil demand in other developing nations fell off a cliff in the early 1980s—when Paul Volcker ratcheted up interest rates to kill inflation and sent the US economy into a deep recession—Chinese demand didn’t drop. It may be even more independent this time around.
In any case, it’s a good idea to get a read on how vulnerable our oil and gas producer trusts’ cash flows are to such a drop in oil prices. Happily, third quarter earnings reports have all the facts we need to make a judgment.
The key is realized oil prices. Like all energy companies, oil and gas producer trusts sell only a fraction of their output at most on the daily spot market. That’s because doing more would subject cash flow to extreme volatility, making it virtually impossible to do intelligent business planning. Rather, they lock in selling prices for most of their output in advance, either by hedging with financial instruments like futures and standard forward contracts or by pre-selling it to buyers.
As a result, realized selling prices move far more slowly than the current spot price of oil, and they vary from producer to producer. When spot prices rise, realized prices tend to lag. When spot prices fall, realized prices take a while to settle back with them.
The table shows the realized third quarter selling price for oil for the producer trusts in the Canadian Edge coverage universe. The first thing to notice is that these prices are well below—in some cases $25 to $30 per barrel below—recent spot prices for crude oil.
Should oil prices fall to, say, $70 from here in 2008, that would still be above what many trusts have been selling it for. Assuming normal hedging and forward sales—and that costs remained roughly the same—that means trusts could actually see their cash flow from oil sales rise, at the same time spot oil is plunging to recession levels.
The second thing to notice is that the realized prices in the table are what’s behind current trust payout ratios. For example, ARC Energy Trust (AET.UN, AETUF) sold its oil at an average price of $73.40 a barrel in the third quarter and had a payout ratio of 70 percent. As long as oil stays at $73.40 or higher, it should be able to maintain a payout ratio at a similarly low level.
There are two variables in this equation. The first is production costs, which have risen sharply in the past two years. These, however, appear to be tapering off amid the slowdown in drilling activity. The second is trusts’ ability to sell oil at any price in a very weak economy. But things would have to get pretty bad indeed in the US for that to be a serious risk.
The bottom line here is smaller oil and gas trusts are still very much at risk to further losses, as are highly leveraged ones. Stronger producer trusts, however, are pretty well protected against most reasonable downside scenarios. And the same holds true for the best of other sectors.
How They Rate
The best strategy for surviving a trial by fire in the markets is to jettison the weak and stick with the strong. That was my objective a year ago in the December 2006 issue, when we swapped suspect trusts for stronger fare. That’s my goal again this month, as we get ready to ring in another year at Canadian Edge.
CE Safety Ratings are designed to measure the basic business sustainability of every trust we cover. The cornerstones are the same as they were with our first issue in mid-2004: financial strength and distribution coverage, business sustainability and growth potential.
Times change, however, and so do challenges. As a result, I’m slightly revamping my criteria. Below I give the parameters.
See the How They Rate Table to see how individual trusts stack up. Note the system is still based on five criteria. Trusts meeting all of them receive a “1” rating. Those meeting none get a “6.”
Business Strength and Growth—A growing business is the best defense against both credit risk and inflation risk for any income investment. We haven’t seen much of the latter recently, and recession fears have been a growing threat to share prices.
But trusts that have been able to continue growing their businesses throughout the trouble of recent years have proven their resiliency in the face of some very difficult challenges. That’s no guarantee they’ll continue to do so in the long run. But there’s no better indicator that any investment will.
Business Cyclicality and Stability—Oil and gas producers, energy service providers and natural resource trusts always score worse than other trusts on this score for one basic reason: Their profitability depends heavily on factors beyond their control, namely volatile commodity prices. Some trusts, such as ARC Energy, have made business sustainability their most important objective and clearly manage themselves that way. But even ARC is affected by slumping natural gas prices.
In contrast, power generation trusts and other essential service businesses undergo very few real ups and downs with demand or pricing for their products and services. As Boralex Power Income Fund’s (BPT.UN, BLXJF) second and third quarter earnings shortfalls show, there are things outside its control that can affect performance, such as water flows to its hydroelectric power plants.
But these tend to be anomalies in an otherwise highly stable business environment. Note that most trusts tend to fall somewhere in between these two extremes, so this criterion conveys a total of two points in the ratings system.
Debt and Dependence on Outside Capital—The abrupt shutoff of capital markets for many trusts over the past year has given us a pretty good idea of where the vulnerability lies in this area. Happily, my focus away from trusts with high rates of growth in outstanding shares before Halloween 2006 has limited this risk. But as I point out above, high levels of debt remain a potential problem for more than a few trusts. Moreover, this remains an important area to watch even for trusts that don’t have a lot of debt now but that have levered up.
One of these is gas-focused and, as of now, top-quality producer trust Peyto Energy Trust (PEY.UN, PEYUF). Debt levels at this point are no where near a danger zone, considering the trust’s extremely low operating costs and rich 14-year reserve life—equal to ExxonMobil’s.
But if debt were to continue to rise at the rate of recent quarters throughout 2008, I’d become increasingly nervous. And the same goes for any trust adding debt that can’t demonstrate commensurate expansion in cash flow. Note I still recommend Peyto Energy Trust as a buy up to USD20.
Distribution Coverage and Consistency—Sustaining distributions is the ultimate goal during a trial by fire. Trusts’ share prices are frequently volatile in the near term. But over the long term, they track their distribution streams pretty religiously.
That hasn’t changed in the light of prospective 2011 taxation either because investors have long since chopped share prices down to reflect an increasingly unlikely one-third reduction across the board. In a very real sense, the ratings criteria discussed above are all critical to consistent distribution coverage over the long pull. But looking at the current numbers is also very important.
In my view, the best possible sign for a trust now is to have increased its distribution at least once since Halloween 2006. That’s not only evidence that a trust is still thriving in a very challenging environment, but there’s no better sign management intends to keep paying outsized yields from here to eternity—and that means well past 2011, provided its business stays healthy.
The weak pricing environment has prevented most oil and gas trusts from hiking their payouts. The best test for these—as well as other trusts that haven’t hiked payouts—is being able to consistently post a payout ratio in the range prescribed by sector in the How They Rate Table key. I’ve also compared an average of third quarter payout ratios for the past three years with how our picks did in the most recent reporting period.
Note I do occasionally recommend some trusts that have cut their distributions recently or are in danger of a future reduction. These are bets on recovery and are always highlighted with the caveat that they entail more risk than our typical holdings.