Maple Leaf Memo
Telus Corp (TSX: T, NYSE: TU), the No. 2 phone company in Canada, recently announced plans to convert into an income trust. Upon completion, Telus will be the largest income trust, with an estimated market value of CD20.4 billion.
Converting will effectively provide a shelter from corporate income taxes for a company that hasn’t had to pay them since 2000, thanks to CD800 million in tax losses inherited through the acquisition of wireless carrier Clearnet Communications. That tax break expires this year, but converting provides a replacement for it: Income trusts minimize the taxes they pay by distributing most of their cash to unitholders, who pay taxes on the money individually.
Telus is a solid income trust candidate because it has the right asset mix and performance to support the new structure. Telus is converting now only because the taxman comes knocking next year (as mentioned above). If the company had become taxable last year or the year before, Telus would have hit the trust button then.
Shortly after Telus bought Clearnet for CD6.6 billion in 2000 to create Canada’s biggest wireless operation, the market lost interest in Telus. The shares went from about USD40 that year to less than USD8 in 2002. The dot-com implosion, the credit crunch and the mini recession in the US did their bit to propel the fall. But there was no doubt investors were punishing Telus for having made a highly expensive acquisition.
In retrospect, Clearnet was a brilliant deal. Telus needed to make an instant splash in the wireless market. It could do so by spending a fortune to buy wireless spectrum in a government auction. Or it could do so by picking off a company–Clearnet–that came ready-made with wireless spectrum, a managed network and paying customers.
Clearnet has been a phenomenal growth story. Telus’ wireless business now accounts for 64 percent of overall cash flow. Wireless earnings before interest, taxes, depreciation and amortization (EBITDA) is growing at 18 percent a year, and the revenue margin hit a phenomenal 50 percent in the last quarter. The company thinks it can maintain the wireless growth rates—that means the payout ratio, which may be as low as about 70 percent at the onset, potentially has room to go to 80 or 90 percent.
The Telus trust has something else going for it: the all-or-nothing philosophy. Canada’s No. 1 telecommunications company, BCE (TSX: BCE, NYSE: BCE), has pursued a piecemeal strategy. It spun out Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF), Bell Nordiq (TSX: BNQ.UN, OTC: BNDQF) and the new Bell Aliant (TSX: BA.UN, OTC: BLIAF); the main company, composed of Bell Canada’s wireless and landline businesses, was left intact as a dividend-paying corporation.
But Telus is putting all its assets into the trust, based on a belief in the full integration of network services, from Telus TV and cell phones to Internet products and home security systems. Integration can’t happen if various businesses are pieced off into various trusts, with separate management teams, separate tax structures and other problems, like determining transfer pricing between the various businesses. Inefficiencies would be created.
With a market value of about CD20 billion, the Telus trust would be three times larger than Yellow Pages, the reigning business trust gorilla, and a third bigger than Canadian Oil Sands Trust (TSX: COS.UN, OTC: COSWF), the biggest royalty trust.
Before unitholders have even had an opportunity to digest the news, let alone vote on it, speculation has already turned to whether Telus may be the object of hedge funds’ and private equity players’ advances. As multi-billion-dollar targets become fewer, these groups will move up the food chain and go after larger targets. One group is rumored to be considering an offer of CD65 per share to take Telus private, load it up with debt and watch the return-on-equity figures go through the roof.
Telus’ decision has made BCE’s future more complicated. It’s removed one of the best arguments for refusing to put the rest of Bell Canada into a trust–namely that it’s just too dangerous to be giving so much cash back to shareholders. A trust is a great idea when your business is selling phone service to retirees in Clyde River, Prince Edward Island. But fighting for urban centers with Rogers Communications (TSX: RCI-B, NYSE: RG) and Quebecor (TSX: QBR, NYSE: IQW) takes money, so why tie management’s hands?
The Telus move saps that argument of its strength. Is the competition Bell faces in the East any more intense than the rivalry between Telus and Shaw Communications (TSX: SJR-B, OTC: SJRWF) in the West? You could argue that Shaw is a more-aggressive competitor than Rogers is. In high-speed Internet access, Shaw has about 1.3 million subscribers to 831,000 for Telus. In the East, the cable companies have more total high-speed customers, but no single provider is bigger than Bell.
Telus was a natural trust candidate because its wireless unit drives about 75 percent of its free cash flow after capital expenditures. BCE has inferior cash flows, and conversion would be complex given its holding-company structure and range of operations.
BCE, parent to Bell Canada, has just done a big income trust deal of its own. Earlier this year, it combined with Aliant, moving Bell’s low-growth rural phone lines to Bell Aliant. BCE now owns 45 percent of Bell Aliant, which in turn owns 63 percent of the smaller, similar Bell Nordiq.
The Bell-Aliant deal bumped up BCE’s dividend by 6 percent but did little to the stock. Other value-creation attempts have fallen flat, including divestitures, cost cuts, stock buybacks and debt repayment. The next deal, to spin off or sell BCE’s Telesat satellite operator, is priced into the stock. Compare that to Telus’ modest effort: Converting from corporation to trust will result in shareholders, who now receive $1.10 in yearly dividends, getting between $3.90 and $4.10.
Having spent so much time, effort and money to do a big income trust this year, it would be complex and costly for BCE to undo the work and create a single income trust–given it would have to strike deals among three public entities–not to mention it would be disruptive to employees and customers and irritating to shareholders.
Or BCE could convert the rest of the operation, resulting in an income trust owning an income trust owning an income trust–an unwieldy beast with holding company discounts galore.
Plus, BCE as an income trust–much like BCE, the company–just isn’t as compelling an investment as Telus in either format. Bell is not only losing traditional residential customers to cable firms offering Internet phone service at a faster rate than Telus, it’s a laggard in wireless phone service, the hot growth area of telecom.
Telus is the hands-down winner there: Wireless made up 44 percent of its revenue and 49 percent of operating earnings in the second quarter, compared with 18 percent and 20 percent, respectively, at Bell. Despite being half the size of Bell and with fewer wireless subscribers (4.7 million compared to 5.9 million), Telus earned more revenue and operating profit from wireless. Its operating margin was 46.4 percent, a full 4.6 percentage points ahead of Bell’s, and widening year-over-year.
Because income trusts pay out most of their cash, a BCE trust would be in a weaker position than Telus to cover capital investments, which have up to now limited telecom moves into the income trust sphere.
Other potential trust candidates include Manitoba Telecom Services (TSX: MBT) and Rogers Communications.
Manitoba Telecom faces complications, most notably that it isn’t expected to pay taxes for about nine years, a shield that would be negated by the trust structure. Rogers, Canada’s biggest mobile phone and cable company, said conversion is unlikely anytime soon. Roger’s tax-loss carry-forwards could shield the company from paying taxes for about three years, so there’s no short-term incentive.
Whether or not BCE will be an income trust isn’t clear. But consider this: Telus now stands to have the better currency in the form of its stock. That puts it at a big advantage if Manitoba Telecom, which is doing a strategic review, decides to break apart or sell the company. A new, simple, faster-growing Telus trust will be able to afford to pay up in a very dramatic way for assets with its higher-valued shares compared with BCE’s stock.
The RoundupTelus’ announcement that it would convert to an income trust certainly caught the attention of the financial media as well as the investing public last week. But increased volatility in oil and natural gas prices is the biggest challenge facing the income trust market: While energy producers account for little more than 20 percent of Canada’s 266 income trusts, they represent 57 percent of the trust index on the Toronto stock market.
The sector has also seen numerous merger-and-acquisition deals so far this year, even as prolific oil and gas producing properties remain priced at a premium. It’s the natural evolution of a sector that’s grown dramatically in a short period of time. And the volatility in the markets creates opportunities for consolidation.
Here’s the roundup of news at CE-covered trusts.
Oil & Gas
Crescent Point Energy Trust (TSX: CPG.UN, OTC: CPGCF) will acquire Mission Oil & Gas, a junior explorer with a major position in the potentially prolific Bakken oil field in Saskatchewan, for about CD700 million. Crescent Point plans to issue 31.8 million units to pay for Calgary-based Mission Oil & Gas. Crescent Point is paying a high premium for Mission–the price equates to CD109,000 for each of Mission’s 5,500 barrels of daily output, more than a third higher than the average valuation of a selection of junior explorers followed by brokerage Peters & Co. The Bakken field may hold more than a billion barrels of original oil in place, which would rank among the biggest half-dozen crude discoveries in western Canadian history. Crescent said there’s “significant potential” to more than double Mission’s 14 million barrels of proven reserves in the next three years. Crescent Point remains a buy up to USD21.
Pengrowth Energy Trust (TSX: PGF-A, NYSE: PGH) is acquiring oil and gas properties and a gas-processing plant in Alberta from ExxonMobil’s Canadian unit for CD475 million (USD424 million). Pengrowth is buying ExxonMobil’s 89 percent stake in properties in the Carson Creek area that produce 5,100 barrels of oil equivalent a day. The acquisition will boost the trust’s production 9 percent to 62,500 barrels of oil equivalent a day. Pengrowth has signed a deal to raise CD400 million with the issue of 17.7 million units at CD22.60 per unit to help fund the acquisition. Pengrowth is a sell.
Shiningbank Energy Income Fund (TSX: SHN.UN, OTC: SBKEF) announced that approximately 33,836,000 common shares of Find Energy, about 91.1 percent of the issued and outstanding common shares, have been deposited to the takeover bid made by Shiningbank Energy Income Fund’s subsidiary Shiningbank Energy. Shiningbank intends to acquire the remaining common shares of Find that aren’t tendered to its offer by way of a compulsory acquisition, statutory arrangement, amalgamation, merger, reorganization, consolidation, recapitalization or other type of acquisition transaction. Hold Shiningbank Energy Income Fund.
Trilogy Energy Trust (TSX: TET.UN, OTC: TETFF) confirmed its CD142 million takeover bid for Blue Mountain Energy. The companies have agreed to a takeover for CD5.50 in cash per Blue Mountain share. Trilogy’s offer trumps an earlier all-stock offer worth about CD110 million by Diamond Tree Energy. Trilogy energy is a sell.
Electric Power
Atlantic Power Income Fund (TSX: ATP.UN, OTC: ATPWF) has indirectly acquired 100 percent of Trans-Elect NTD Path 15 LLC, which owns approximately 72 percent of the transmission system rights in the Path 15 transmission project located in California. Atlantic paid CD85.5 million in cash for Path 15, which has approximately CD145 million in non-recourse project-level debt. Path 15 is an 84-mile, 500-kilovolt transmission line built along an existing transmission corridor in California to help alleviate what had been a chronic transmission congestion point in the state’s north-south capacity. It went into service in December 2004. The revenue stream is regulated by the Federal Energy Regulatory Commission (FERC) on a cost-of-service rate base methodology, which insulates cash flows from any impacts of power prices or actual line usage. The approved rate base includes all costs and earns an allowed rate of return that FERC reviews every three years, and the rate base is depreciated over 30 years. The acquisition strengthens Atlantic’s ability to generate stable, sustainable and predictable cash flows. Atlantic also announced it will increase its cash distribution to shareholders by an annual rate of 3 cents Canadian, commencing with the September distribution. Buy Atlantic Power Income Fund up to USD10.
Boralex Power Income Fund (TSX: BPT.UN, OTC: BLXJF) has filed with FERC an application to approve a transaction that would result in the monetization of the renewable energy US production tax credits to which its US subsidiary, Boralex Industries, is entitled over the period beginning at closing of the transaction and concluding Dec. 31, 2009 (the date of the conclusion of the program). The tax credits are awarded under Section 45 of the US Internal Revenue Code to qualified wood-residue thermal power stations based on their generation of electricity. Boralex expects to complete this transaction before the end of the year. Boralex Power Income Fund is a buy up to USD9.
Gas & Propane
CCS Income Trust (TSX: CCR.UN, OTC: CCRUF) completed the acquisition of ARKLA Disposal Services, an industrial wastewater treatment plant operating in the Port of Shreveport, La. The plant treats both produced water from area gas wells and various industrial waste streams. CCS Income Trust is a buy up to USD33.
Duke Energy Income Fund (TSX: DET.UN, OTC: DUYIF) unitholders have approved the acquisition of Westcoast Gas Services for approximately CD145 million. The acquisition and related sale of subscription receipts were announced on August 1, and the closing of the sale of subscription receipts was announced on August 22. The subscription receipts will be exchangeable into Duke units on a 1-to-1 basis upon the closing of the purchase of Westcoast Gas Services, which holds interests in four raw gas-processing plants and related gas-gathering systems located primarily in British Columbia. The acquisition is expected to close on or before Sept. 29, 2006. Duke Energy is also increasing its monthly cash distributions from 6.7 cents Canadian per unit to 7 cents Canadian per unit, or 84 cents Canadian per unit on an annualized basis. Buy Duke Energy Income Fund up to USD11.25.
Essential Energy Services Trust (TSX: ESN.UN, OTC: EEYUF) has closed on the acquisition of the assets and business of JaCar Hot Oil Service. Alberta-based JaCar has a fleet of 57 revenue-generating units that provide a range of production services to oil and gas operators across southern Alberta and into southwest Saskatchewan. JaCar also provides chemicals, such as methanol and potassium chloride solution, to the oil and gas industry and maintains facilities for mixing, storage and transport of these chemicals. The JaCar assets compliment Essential’s service rig, coil tubing, swabbing and flush-by operations and expand the range of production services it can offer. The purchase price of approximately CD17.5 million consists of CD13.1 million in cash and 544,053 Essential units. The cash to fund the transaction was drawn from existing credit facilities. JaCar is expected to add approximately CD4 million to CD4.5 million in EBITDA on an annualized basis. Essential is a buy up to USD9.
Trinidad Energy Services Income Trust (TSX: TDG.UN, OTC: TDGNF) has received approval from the Toronto Stock Exchange to buy back up to 7,336,882 units of the trust, which represent approximately 10 percent of the public float. Buy Trinidad Energy Services up to USD16.
REITS
Calloway REIT (TSX: CWT.UN, OTC: CWYUF), citing the pace of growth through its acquisition and development program, has increased its monthly distribution to 12.5 cents Canadian per unit. The real estate investment trust’s (REIT) previous distribution was 12.083 cents Canadian. Calloway is a hold.
RioCan REIT (TSX: REI.UN, OTC: RIOCF) is increasing its monthly distribution to 11 cents Canadian per unit. The new rate, a hike of 3 cents Canadian per unit on an annualized basis, will start with the October distribution. RioCan is a buy up to USD22.
Natural Resource Trusts
Labrador Iron Ore Royalty Trust (TSX: LIF.UN, OTC: LBRYF) declared a special dividend of 25 cents Canadian per unit payable to holders of record at the close of business on September 30. For tax purposes, this distribution will be considered 100 percent dividend income. Buy Labrador Iron Ore up to USD24.
Roger Conrad and David Dittman are editors of Maple Leaf Memo. Conrad is editor of Canadian Edge; Dittman is associate editor of CE.