Maple Leaf Memo
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Last week, the Conservative government officially included the “Tax Fairness Act” in its official budget, along with taxation of income trusts as corporations beginning in 2011. Moreover, it’s all but ensured passage, winning the Bloc Quebecois’ support with billions of new money for Quebec.
A funny thing happened afterward, however. Rather than selling off again, as the consensus had forecast, trusts have been rallying, some of them quite hard.
Some of the gains have been torrid one-day affairs, such as last week with Keyera Facilities and TimberWest Forest Corp. For others–particularly oil and gas producers–the buying has been sustained.
We draw two clear conclusions from this. First, as we’ve said for several months, the Flaherty plan is more than priced into this market and has been since mid-November. Savvy investors are now starting to realize that the bad news is old news, and they’re snapping up the values.
Second, with the trust taxation more than factored in, the key driver of share prices is business fundamentals. As pointed out in the March issue of Canadian Edge, the story for the battered oil and gas trusts is simply energy prices.
Some of the smallest and weakest still appear to be in a death spiral. But if oil and gas rally in coming months and years as I anticipate, the good are going a lot higher from here, regardless of what happens in Ottawa.
That’s because they’re ultimately valued on what’s in the ground. In the aftermath of the taxation announcement and big early winter drop in oil and gas prices, producers’ share prices had fallen ridiculously low relative to those asset values. Now we’re starting to see things come back into balance, and producers’ unit prices are rebounding once more.
Outside the energy patch, business fundamentals are also critical, though success or failure is determined by other things besides energy prices. Again, our key criterion is whether or not a trust’s business is going to keep generating cash flows to support a high dividend in 2011 and beyond. And a growing number are indicating they will.
Yellow Pages Income Fund’s management, for example, states that it’s now focused on boosting distributable cash in the next three-plus years to a level equal to the taxes it will have to pay beginning in 2011. In other words, it intends to continue dishing out in 2011–when it will be taxed–what it’s paying now without tax.
Yellow’s ability to do that, of course, will depend on the success of its print and online directories business. But the fact that it’s making the commitment now is a clear indication it understands its place in the investment universe: that it intends to continue as a going concern and that the way it will attract capital in the future is as a high dividend-paying security.
Several other trusts have already made similar de facto pledges to continue paying big dividends, including Arctic Glacier Income Fund. We look for many more to follow; though again, a trust’s ability to continue paying big will depend on its ability to run its business well.
Conservative budget victory notwithstanding, there’s still a good chance we’ll see positive changes to the ultimate shape of trust taxation and possibly well before 2011. But as we wrote back in November, no prudent investment strategy should be based on that possibility.
Rather, we’re going to continue looking to quality businesses that will do well no matter how they’re taxed. The market action since the Conservatives’ budget was introduced clearly shows higher future taxes are already reflected in the prices of good trusts and then some.
More Happy Surprises
It was no real surprise that the budget–despite the inclusion of trust taxation–was packed to the gills with goodies. The Canadian economy is now the healthiest of the Group of Seven (G-7) countries, and the government has plenty of money to throw around.
Moreover, the Conservative Party had every incentive to play Santa Claus in March. For one thing, it needed to prevent a no-confidence vote, which a failure of the budget would have triggered. For another, it’s trying to become a majority government, and buying a few votes in Quebec and Ontario could make all the difference.
Political advantage is often fleeting. But recent polling suggests Prime Minister Stephen Harper got what he wanted: a little momentum toward a majority.
An Ipsos-Reid survey put the Conservatives at 40 percent, the Liberals at 29 percent and the New Democratic Party at 14 percent. Just prior to the budget unveiling, Ipsos showed only a two-point Conservative lead. A Strategic Counsel poll showed the Conservatives at 39 percent, up three points, and the Liberals unchanged at 31 percent.
Parties traditionally need at least 40 percent of the popular vote to win a majority of seats in the Canadian Parliament. An election technically doesn’t have to be held until 2011, though it’s expected to happen before then.
What’s a surprise is that a broader look at the budget, beyond the Tax Fairness Plan, reveals a couple of encouraging developments for US-based investors.
For starters, the Conservative budget also described a plan to tear down the complicated, antiquated system of provincial securities regulations and laws and replace them with a single, federal regulator for capital markets. Flaherty has told reporters that his department had made significant progress on that front and should be able to get it done within a year or two. The International Monetary Fund (IMF) and its G-7 partners have advocated that Canada make such moves to encourage foreign investment.
And Flaherty plans to push again for the removal of restrictions on cross-border securities trading when he meets with US Treasury Secretary Henry Paulson in Washington April 14 to 15 during the IMF and World Bank meetings.
Flaherty began his campaign with Paulson for a North American free securities trade agreement–a North American Free Trade Agreement for investors, if you will–last month in Germany. This comes on the heels of reports that Securities and Exchange Commission (SEC) staff is pushing proposals to allow stock exchanges and brokers outside the US to service US investors directly without having to submit to regulation by the SEC.
Should such changes take effect, US exchanges could compete for business in Canada under US rules and vice versa.
Eliminating the border for purposes of trading securities could reduce commissions by as much as 60 percent; investors wouldn’t have to pay a broker in each country. The key now is working out an information-sharing agreement that enables enforcement of the respective countries securities regulations.
The 2007-08 budget would also allow the Canadian government to remove withholding tax on arm’s-length interest payments under the Canada-US Tax Treaty–a move that should boost capital inflows from the south, as well as stoke mergers-and-acquisitions activity. US investors would enjoy favored status relative to other foreigners in this respect.
Flaherty proposed to close a tax loophole that allowed firms to deduct the interest payments on borrowed money used to acquire shares of foreign affiliates, saying it had allowed some companies to abuse the tax system unfairly.
Other measures that could boost US-Canada cross-border investment include the recommendations set out in a Nov. 23, 2006, Finance Department release, “Advantage Canada,” that would attack tax rules blocking the flow of foreign cash to Canada’s private equity sector. Those recommendations weren’t included in the proposed budget.
Finally, Flaherty renewed his promise–though it wasn’t realized through any concrete measure in the current proposal–to reduce capital gains taxes for taxpayers reinvesting profits in future budgets.
The Roundup
Oil & Gas
Advantage Energy Income Fund (AVN.UN, NYSE: AAV) reported net income for the fourth quarter declined 66 percent to CD8.7 million (8 cents Canadian per unit) from CD25.9 million (45 cents Canadian per unit) a year ago. Revenue for the period was up 16 percent to CD127.5 million from CD110.2 million. Net income for 2006 was CD49.8 million (62 cents Canadian per unit), down from CD75.1 million (CD1.33 per unit) in 2005.
Annual revenue increased 11 percent to CD419.7 million from CD376.6 million. But revenue per barrel of oil equivalent (BOE) was down 7 percent to CD47.80, and revenue per unit declined 22 percent to CD5.18. Production for the year was up 18 percent to an average of 23,754 BOE per day, with natural gas constituting two-thirds of it. Advantage ended the year with proved and probable reserves of 121.3 million BOE, up from 84.1 million at the end of 2005, for a reserve life of 11.4 years.
Bank debt was CD410.6 million, up from CD252.5 million, and there were CD180.7 million in convertible debentures outstanding, up from CD135.1 million. Advantage said its hedging program has secured almost half its gas production at an average floor price of CD7.55 per thousand cubic feet. Responding to the Canadian government’s move to tax income trusts like corporations, Advantage said that, as a taxable corporation, it will have a tax pool of CD1.2 billion to shelter future profits, and guidelines on trust taxation allow it to issue up to CD1.6 billion of new equity between now and 2011.
Advantage’s capital expenditure budget for 2007 is CD120 million to CD145 million. Hold Advantage Energy Income Fund.
Enerplus Resources Fund (ERF.UN, NYSE: ERF) has reached into the Alberta oil sands with an agreement to buy 90 percent of privately held Kirby Oil Sands Partnership for CD182.5 million in cash and shares. Enerplus will become the managing partner and the operator of the Kirby project, which encompasses 17,500 hectares in a “highly prospective” area of the Athabasca region.
Enerplus said it will raise CD200.7 million through the issue of
4.05 million units through a bought deal, financing at CD49.55 each to
fund the deal and pay down debt. The deal is expected to close on or
about April 10. Buy Enerplus Resources up to USD50.
Enterra Energy Trust
(ENT.UN, NYSE: ENT) reported a fourth quarter loss of CD69.2 million
(CD1.40 per unit), attributing the bleeding to write-downs on the value
of reserves because of falling natural gas prices and higher interest
expenses. Enterra reported a CD12.9 million (37 cents Canadian per
unit) loss for the fourth quarter of 2005.
Depletion and depreciation costs totaled CD44.5 million for the period ended Dec. 31, 2006. The trust’s average production for 2006 increased by 60 percent to 12,352 BOE per day on the August 2005 High Point Resources acquisition and the early 2006 purchase of assets in Oklahoma, producing 5,700 BOE per day.
For 2006, Enterra lost CD64.2 million (CD1.46 per unit), swinging from a 2005 net income of CD970,000 (3 cents Canadian per unit). Revenue increased 55 percent to CD244.4 million from CD158.1 million. The Oklahoma assets pushed sales volumes, but Enterra’s average realized price for natural gas declined 10 percent. The trust is now weighted 60 percent to natural gas, a huge turnaround from the 70 percent oil bias for 2005.
Expenses ballooned 97 percent to CD20.4 million–CD4.52 per BOE–because of “the expanded size of the trust and the associated increase in the number of staff to manage and administer its assets and operations.” Sell Enterra Energy Trust.
Harvest Energy Trust (HTE.UN, NYSE: HTE) CFO Robert Fotherington told the Canadian Press that Harvest may look southward to the US for a structure “more favorable to the majority of our shareholders.” Foreign ownership of Harvest climbed to 54 percent from 48 percent after the income trust tax plan was introduced last fall. Harvest Energy Trust is a hold.
Business Trusts
Arctic Glacier Income Fund (AG.UN, AGUNF) posted a deeper fourth quarter loss but reported record revenue on the back of a number of acquisitions. The ice maker lost CD6.2 million (19 cents Canadian per unit) for the three months ended December 31, compared with a loss of CD1.8 million (6 cents Canadian per unit) a year ago. Acquisitions made in 2006 and late 2005 boosted sales 83 percent to CD39.9 million from CD21.8 million, but Arctic Glacier’s cost of sales also rose, climbing to CD39.2 million from CD22.3 million in the fourth quarter of 2005.
The fourth quarter is seasonally weak for Arctic Glacier because cold weather reduces demand. The trust’s recent expansion into the US has reduced the seasonality but not entirely eliminated it. The important thing is that sales for 2006 increased 40 percent to CD219.2 million from CD156.4 million in 2005, while the overall payout ratio came down to just 87.2 percent for the year based on distributable cash. Buy Arctic Glacier Income Fund up to USD12.
Great Lakes Carbon Income Fund’s (GLC.UN, GLCIF) fate will be determined a week from today. Rain Commodities USA, a unit of India-based Rain Commodities Ltd, has until next Tuesday to respond to the CD14 per unit offer by Oxbow Carbon & Minerals Holdings, which has been agreed to by the trustees of Great Lakes Carbon. Rain will take a CD17 million breakup fee if it leaves the table. Hold Great Lakes Carbon Income Fund through the bidding.
Jazz Airline Income Fund (JAZ.UN, JAARF) and Aeroplan Income Fund saw a volume spike on the Toronto Stock Exchange while both trusts’ parent ACE Aviation Holdings sold millions of shares in order to pay cash distributions to American investors. Canadian investors are receiving 0.177 of a unit of Aeroplan Income Fund and 0.219 of a unit of Jazz Air Income Fund for each Class A or B share of ACE that they own under a plan announced earlier in March by ACE.
But US securities regulations dictate that American stockholders receive cash instead of units in the two ACE subsidiaries. Jazz Airline Income Fund is a buy up to USD8.
Menu Foods Income Fund’s (MEW.UN, MNUFF) pet food recall has been expanded to include all varieties of its wet dog and cat food. The company has asked retailers to remove all wet food items as a safety precaution, regardless of the date code, according to the Toronto Globe & Mail.
In a weekend press release, Menu Foods said that even brands not on the official recall list should be removed from the shelves, days after the initial discovery that some of the products it processes were contaminated with rat poison. Menu Foods has stated that it would take responsibility for pet medical expenses incurred as a result of the tainted food but would not admit to negligence in the matter.
The company, already facing lawsuits, said Friday it’s testing all the ingredients that go into the food but it will continue to produce food at the two affected plants, in Emporia, Kan., and Pennsauken, NJ. Menu Foods is standing by its initial cost estimate for the recall of CD30 million to CD40 million. Menu Foods Income Fund units, after recovering some of what they lost last week, are a hold.
<b>Royal LePage Franchise Services Fund (RSF.UN, RYPGF) reported a slight dip in fourth quarter earnings from CD865,000 (9 cents Canadian per unit) in 2005 to CD839,000 (8 cents Canadian per unit). Royalty revenue increased 3.7 percent to CD6.8 million in the three months ended December 31.
For full year 2006, earnings declined 27.5 percent to CD3.5 million (35 cents Canadian per unit) from CD4.8 million (48 cents Canadian per unit) because of increased management fees and increased amortization charges related to franchise contracts acquired at the beginning of 2006. Royalty revenue was up 9.1 percent to CD29.7 million on an expanding network of realtors and strength in the housing market. Royal LePage Franchise Services Fund is a buy up to USD13.
Pipeline Trusts
Westshore Terminals Income Fund (WTE.UN, WTSHF) cut its distribution by 22 percent, from 29 cents Canadian per unit to 22.5 cents Canadian per unit. The new amount will be paid on or before April 15, 2007, to unitholders of record on March 31, 2007.
The fund also announced a special distribution of 3.5 cents Canadian per unit payable on or before April 15, 2007, to unitholders of record on March 31, 2007. This represents a portion of the discrepancy between taxable income allocated to unitholders for 2006 and cash distributions in that year, which resulted principally from a combination of better-than-expected performance and a number of year-end adjustments.
Westshore is anticipating a slight uptick in tonnage throughput for the first quarter, but bad weather during midwinter hindered production for Fording Canadian Coal Trust (FDG.UN, NYSE: FDG), the fund’s main customer. Westshore is forecasting 2007 throughput numbers similar to 2006 at lower average rates, but Fording hasn’t yet announced its average coal sales price.
Westshore anticipates shipping 22 percent of throughput at fixed
rates, 32 percent at variable rates subject to annual caps and 46
percent at full variable rates. Based on current information on
throughput, coal prices and exchange rates, as well as economic
forecasts for the year, the fund anticipates paying a lower
distribution in 2007. Westshore Terminals Income Fund is a buy up to USD10.