Maple Leaf Memo
One of the knock-on effects of the Conservative government’s move to tax income and royalty trusts is the potential for consolidation via mergers and acquisitions, buyouts and private equity scooping up attractive assets at low values. To whatever extent that plays out, and absent new issues (see below), the number of publicly traded trust units will probably shrink during the next four years.
A record amount of shares evaporated in 2006 because of leveraged buyouts and share repurchases. And major stock indexes are near six-year highs in the US. Last year was one of the best for US stocks in the last half decade. The S&P 500 was up more than 13 percent and has gained during each of the last four years.
Some market observers–focusing on basic supply and demand–have noted that if equities continue to dry up and retail investors also rediscover US mutual funds, the market could run a lot further in 2007. Supply has declined while demand–as reflected in investor optimism–has stabilized or even increased.
The number of outstanding shares in US markets shrank by more than 3.1 percent in 2006, surpassing the 2 percent shrinkage for 2005 and the 0.1 percent contraction in 2004. Cash buyouts totaling $400 billion occurred, and $600 billion in common stock was bought back by companies. New share issues and secondary offerings totaled $230 billion, while executives and company insiders sold $120 billion in stock.
That company insiders are buying their own stock is some indication of confidence in future prospects. The situation in 2006 contrasts nicely with 2000, when retail investors dumped buckets of cash into the market while insiders were pulling the plug; the market was up in 2006 but sank in 2000. When the market shrinks through buyouts, money is put back into people’s pockets, and in a bull market, they’re likely to reinvest it.
You can pick apart changing demand for stocks in the context of global supply and interests in other markets. But it’s safe to say the balance is tipped toward short supply in the US.
And what’s happening in the US could offer some clues about the future of the Canadian market, now that new taxes are going to be imposed on income and royalty trusts in 2011.
Buybacks and buyouts, mergers and consolidations will reduce the number of public units. Continued performance from solid businesses will lead to distribution increases and, therefore, attract investor demand. In a low-interest rate environment, income trusts paying 8 to 10 percent offer value even if those distributions continue as is for only four more years.
Investors need opportunities to purchase ownership in companies that generate cash flow for paying out their returns to owners or to reinvest for growth. There could be more upward pressure on trust prices in 2007 than recent history suggests. A lot of people still crave the cash flow they provide, and there’s simply no other game in town. Neither 4 percent dividends nor 4.5 percent bonds will cut it.
The drop in trust prices means that yields on some big-name business trusts–CI Financial Income Fund, Yellow Pages Income Fund, Bell Aliant Income Fund–are 8 percent or better. Numbers like that will attract large numbers of income investors; take a look at the over-55 populations on both sides of the border. You don’t create a $200 billion asset class if it doesn’t serve an investor need.
From November 2 through December 31, the S&P/Toronto Stock Exchange Capped Income Trust Index rose 7.1 percent. Sixteen trusts in that group actually gained during the last two months of 2006. The trust market has stabilized.
The questions now are about the global economy and the future of interest rates.
IPOs KO’d
The outlook for Canada’s 2007 initial public offering (IPO) market “looks very dim” after sales all but stopped in the final three months of 2006, according to a January 4 report by PricewaterhouseCoopers Canada. For the past three years, IPOs raised an average of CD6 billion annually, with income trusts accounting for about 60 percent.
“Without any new income trusts in 2007 or any new equivalent, the 2007 IPO market could move down to less than CD3 billion,” said Ross Sinclair, national leader for IPO and income trust services at PricewaterhouseCoopers.
Sinclair added, “Without a clear view of where the market for new issues is headed, companies have shelved plans for equity financing through the capital markets. Investors are still looking for a place to invest and companies still need capital to grow. They’re just not meeting on the (Toronto Stock Exchange).”
PricewaterhouseCoopers provides further context for the economic implications of the decision to tax trusts. The IPO outlook for 2007 is “very dim” because the new taxes make the cost of accessing public money through the trust structure prohibitive for small and medium-sized companies.
The range of choices for investors has further narrowed because of the collapse in new issues. Some existing trusts have been, and many more will be, taken private. Companies that seek financing may now find it more affordable to seek foreign or private investors than to undertake the costly process of issuing shares as a regular corporation.
The Roundup
The onset of earnings season is still a couple weeks off, and news continues to be relatively light.
Trusts are trading according to the familiar influences of fundamental business factors and the vagaries of human emotions, a welcome change after the digestion of the move to tax trusts.
That means factors like energy prices and interest rates and the health of the global economy will largely tell the trust tale for 2007. More clarity on the taxation issue will come as a Canadian parliamentary election draws near. (All signs point to spring voting, though none of the major party leaders seems to want to get it on.)
In the meantime, here’s the roundup.
Oil & Gas
Canadian Oil Sands Trust (COS.UN, COSWF) unit Canadian Oil Sands Ltd completed the purchase of an additional 1.25 percent stake in its Syncrude joint venture from Talisman Energy for CD407.6 million. Canadian Oil Sands agreed in November to purchase the additional stake for CD475 million, including CD237.5 million (USD203.8 million) in cash and 8.2 million shares of Canadian Oil Sands Trust. Canadian Oil Sands is Syncrude’s largest stakeholder with a roughly 37 percent interest. Buy Canadian Oil Sands Trust up to 27.
Electric Power
Calpine Power Income Fund’s (CF.UN, CLWIF) board of directors urged unitholders to reject a hostile CD756.3 million (USD644 million) takeover bid from Harbinger Capital Partners and is soliciting competing offers. Units of Calpine Power have jumped 25 percent since Harbinger announced its offer of CD12.25 per unit on December 19. Calpine Power, which had refused to negotiate with Harbinger, said it was advised by BMO Capital Markets that the offer was too low. The trust has signed confidentiality agreements with an undisclosed number of parties as part of its efforts to get a better deal. Harbinger made its offer directly to Calpine Power unitholders after being rebuffed by the trust. The fund last month said it owned about 5.4 percent of Calpine Power’s outstanding units. Harbinger stressed the risk to unitholders from claims against Calpine Corp, which created the income fund in 2002 to raise cash as US credit markets tightened. Calpine Corp walked away from a long-term contract to buy power from Calpine Power’s 300-megawatt plant near Calgary, Alberta, the trust announced in January 2006. An affiliate 70 percent owned by Calpine Power plans to amend its court claim for the repudiation to CD280 million. It had earlier claimed as much as CD769 million. The claim was lowered after Calgary’s municipal utility agreed to buy power from the Calgary plant for 20 years, reducing the impact of the loss of the Calpine Corp contract. Calpine Power may sell the claim at a discount in return for cash. Hold Calpine Power Income Fund through the bidding process.
Business Trusts
Chemtrade Logistics Income Fund (CHE.UN, CGIFF) is cutting distributions to unitholders, restructuring its debt arrangements and investing in “modest” expansion opportunities, the industrial chemicals producer announced. The fund said it will reduce its annual distribution rate by 16.7 percent to CD1.20 from CD1.44 per unit because of operational disruptions, higher costs and in anticipation of the long-term impact from tax reforms for income trusts. The new payout rate will take effect with the January monthly distribution, payable on February 28. Chemtrade expects earnings and cash flow in the first half of 2007 to be lower than in the first half of 2006 because maintenance of two of its plants will coincide with a once-every-four-year shutdown of a major customer. The fund‘s fourth quarter results were also hurt by a disruption of salt supplies to Chemtrade‘s sodium chlorate plant in Prince George, British Columbia, in December. In addition, the bottom line will be hit in 2007 by significantly higher costs for freight and salt and an anticipated reduction in its international earnings because of competition in the European markets. Sell Chemtrade Logistics.
CI Financial Income Fund (CIX.UN, CIXUF), Canada’s No. 3 mutual fund operator, reported 2006 net sales of CD2.2 billion and said assets under management grew 15.4 percent during the year to CD62.7 billion. CI had December net sales of CD292 million in its CI Financial operation and United Financial Corp unit. Assets grew 1.9 percent for the month. Hold CI Financial.
Specialty Foods Group Income Fund’s (HAM.UN, SFGUF) listing is under review by the Toronto Stock Exchange to determine whether the company’s stock meets the requirements for continued listing. The troubled food producer has 120 days to regain compliance. The Toronto-based trust, which indirectly holds a 56 percent stake in Specialty Foods Group, announced last month that it’s looking at strategic options, including the possible sales of one or more of its divisions. Specialty Foods Group produces products under the Nathan’s Famous, Swift Premium, Liguria and Scott Petersen labels, as well as to private-label buyers. Specialty Foods Income Fund, which lost USD129.4 million in 2005, reported a third quarter loss of USD5.3 million as sales declined 3.3 percent from a year earlier. Sell Specialty Foods.