That quote could easily be mistaken for something I’ve written in Canadian Edge time and time again during the last several months. Instead, it’s the view of credit rater Standard & Poor’s (S&P) on Canadian royalty and income trusts and a powerful confirmation of one of the basic themes of this advisory: Great businesses organized as trusts are sharply undervalued by a still-skittish marketplace.

S&P isn’t the only credit rater with an upbeat view on trusts, as Canada’s own Dominion Bond Rating Service has expressed similar sentiments. But it’s not just the credit raters that are bullish: Private capital, particularly from the US, is increasingly interested in buying trusts, and they’re willing to pay top dollar for what they want.

Last month, privately held Alinda Capital Partners offered CD23 per share for water heater renter and security services trust UE Waterheater (UWH.UN). That was a premium of nearly 50 percent to the trust’s average unit price for the month prior to the deal.

The UE offer is the richest yet from private capital for an income trust to date. But premiums paid for the 20 other trusts acquired since Halloween have been nearly as high. Earlier this year, for example, KCP Income Fund (KCP.UN, KCPIF) was purchased for a 25 percent premium to its pre-deal price by buyout firm Caxton-Iseman Capital. Even Thunder Energy Trust (THY.UN, THYFF)—a small oil and gas trust in a death spiral—has managed to corral a private capital offer more than 30 percent above its recent lows.

Other trusts have found themselves the beneficiaries of bidding wars. Earlier this year, Calpine Power Income Fund was acquired at a price nearly 20 percent above its prior highs by US private capital firm Harbinger. That was a deal it ultimately couldn’t refuse, though it originally resisted. The former Great Lakes Carbon was eventually purchased at a price nearly a third above prior highs after a bidding war.

Clean Power Income Fund (CLE.UN, CEANF)—a power producer on the verge of its second deep distribution cut in two years—received a generous offer from Algonquin Power Income Fund (APF.UN, AGQNF) that was trumped by an even richer deal from Macquarie Power & Infrastructure Income Fund (MPT.UN, MCQPF). And Bell Aliant (BA.UN, BLIAF) lost its bid to by Amtelecom after a private capital firm moved in with a substantially higher offer.

Since the first trusts were launched in the 1980s, their primary appeal for individual investors has been high dividends. Private capital has been drawn for a similar reason: to lock down the cash flow that makes those high distributions possible.

Private capital’s interest in trusts predates the minority Conservative Party government’s Halloween 2006 announcement that it would begin taxing trusts as corporations in 2011. The difference is, before that announcement, the only trusts willing to sell out were the destitute. The former Advanced Fiber, for example, sold out to a major Japanese industrial firm, only after it had gutted its distribution and was increasingly at loggerheads with its creditors. The fact that it sold at a steep premium to its pre-deal price testifies how difficult it was for private capital to complete these deals.

Obviously, prospective 2011 taxation gives trust managements a new motivation to sell out if the price is right. But private capital’s motivation to buy has increased as well. That’s because pressure is rising to do something with trillions of dollars these firms have raised in recent years, and the pool of available opportunities is rapidly shrinking.

For example, the attempted buyout of TXU Corp by a Kohlberg Kravis Roberts-led consortium was at one time considered the harbinger of a slew of other private deals for US utilities. But now, even that deal is facing mounting political opposition, and the likelihood of another major utility buyout getting the time of day from regulators seems increasingly remote.

In contrast, Canada remains largely an open field. Not only is the country’s economy robust, but the Conservative government has raised few objections to buyouts from private capital, including a likely deal for telecom giant BCE that includes Kohlberg Kravis Roberts’ participation. Moreover, there’s no withholding of interest payments from Canadian companies across borders. As a result, private capital can literally buy trusts and extract all the cash flow without taxation by simply levering up the entity with debt.

No one should count on a private equity firm to buy a trust anymore than we should count on the Canadian government to fix its deeply flawed 2011 trust taxation scheme. As we point out elsewhere this issue, tax changes are still possible and, if enacted, would deliver a windfall to trust investors. And given the scale of premiums we’ve seen in trust takeovers thus far, so will any takeover offer.

Ultimately, however, these are factors beyond our control. All we can really do is buy good businesses with strong, growing cash flows that are attractive to us as individual investors and, therefore, to a prospective private capital buyer as well.

Below, I look at the current state of takeover mania in the Canadian trust sector. I identify trusts that are setting themselves up to be bought, as well as others that are likely to command big premiums in any prospective deal. This is by no means an exhaustive list of trusts that are ripe for a deal. But more important, all of these picks meet my fundamental rule for takeover investing: Never own anything you wouldn’t want to stick with even if no deal materializes.

Eager Sellers

Despite the restrictions laid on their expansion by the Harper/Flaherty government—i.e., no more than a doubling of the equity base by 2011—trusts are still willing buyers of assets, including other income trusts. Clearly, however, capital restrictions have made it considerably more difficult for trusts to pull off deals of the magnitude, for example, of last year’s Penn West Energy (PWT.UN, NYSE: PWE)/Petrofund merger or even the Acclaim/Starpoint union that formed Canetic Resources (CNE.UN, NYSE: CNE).

We’ll still likely see some trusts make aggressive expansion moves. Despite losing Amtelecom last month, for example, Bell Aliant is likely to keep pursuing opportunities. Enerplus Resource’s (ERF.UN, NYSE: ERF) acquisition in the oil sands last month is unlikely to be its last, and other energy trusts will probably make similar moves to extend their lifespan, particularly outside Canada where 2011 taxation rules won’t apply.

GMP Capital Income (GMP.UN, GMCPF) has one of the more unusual routes to expansion. It’s putting together a giant private capital unit of its own for the expressed purpose of acquiring oil and gas producing assets, including income trusts. In effect, management says it will take advantage of its trust status to put its greater cash flow to use making these deals. That kind of innovation is why GMP Capital Income rates a buy up to USD22 and is a takeover target in its own right.

Far more trusts, however, are becoming eager sellers. At this point, managements of a dozen trusts are conducting strategic reviews to determine their long-run plans in view of prospective trust taxation in 2011. We’re still waiting for the outcome of most of them, but the majority thus far has concluded their best course of action is to find a buyer.

KCP’s recent takeover, for example, was the result of what was essentially an auction process that began in mid-November. Ditto goes for Thunder Energy’s buyout last month, which resulted from management’s March announcement it was considering its options.

Of the companies currently conducting such reviews, my favorite remains Boralex Power Income Fund (BPT.UN, BLXJF). Despite a solid rally in recent weeks, the fund continues to trade at a steep discount to the price and book value multiple of its closest relative Boralex, also an owner of clean power plants but which is organized as a corporation rather than a trust.

The most-likely work out of its situation is for the corporation to take over the income fund, which it could do at a sizeable premium to the fund’s current price and still add to earnings. The income fund’s trustees have apparently concluded the opening round of the review, with a decision to try to auction it. In view of the sizeable premiums garnered by Calpine Power and Clean Power Income Fund in their takeovers, far-stronger Boralex should do even better. I’m raising my buy target for Boralex Power Income Fund to USD9.50 per share.

Canadian real estate investment trusts (REITs) were popular targets for private capital long before other trusts appeared on the radar screen. Last year, for example, light industrial properties magnate Summit REIT was bought out for CD30 by a unit of ING Capital, nearly 30 percent above its prior all-time high. Floundering Retirement Residential REIT, meanwhile, was taken out at a premium despite a protracted decline in its share price because of a series of dividend cuts.

As the Canadian economy continues to heat up, interest in Canadian property continues to expand. Last month, ING announced a major plan to enter the country’s seniors housing market. One reason: Values that have emerged in the sector, following Flaherty & Co’s refusal to include owners of senior housing or hotel/lodging property owners in the ranks of qualified REITs.

ING’s current preferred partner is Chartwell Seniors Housing (CSH.UN.UN, CWSRF). Last month, the pair inked a deal to ramp up expansion in senior homes in Canada and the US. That may or may not be the prelude to an outright offer for all of Chartwell. But it is a clear indication that Chartwell is a solid REIT that will be able to grow going forward. The REIT is also cheap, yielding around 7 percent. Buy Chartwell Seniors Housing up to USD14.

I’ve never been a big fan of lodging REITs. But Legacy Hotel REIT’s (LGY.UN, LEGYF) strategic review—which has been endorsed by 22 percent owner Fairmont Hotels—is likely the prelude to some kind of shareholder value unlocking. Moreover, though it clearly fails the government’s REIT test, the trust’s 2006 payout ratio of just 62 percent is certainly low enough to absorb some taxation. As a result, this is still likely to be a solid producer, even if there’s no change in trust taxation and no takeover offer. On that basis, Legacy Hotel REIT is now a buy up to USD13.

Another REIT undergoing a promising strategic review is IPC US REIT (IUR.UN, IPCUF). With all of its properties in the US, IPC is clearly outside Flaherty’s boundaries for what will qualify in 2011 and beyond. As a result, it yields a couple of percentage points above other Canadian REITs and nearly three times the average US REIT as well.

The irony is the REIT’s pure US investment strategy should make virtually all of its income off limits to prospective Canadian taxation. Moreover, it would be well positioned to simply reorganize as a US REIT or be taken over by one. IPC’s shares have ticked up a bit since the review in anticipation that good things may be about to happen. The fourth quarter payout ratio was a little too high for comfort, but it was due to ephemeral factors and should come down as this year goes on. Though a bit more aggressive than the Canadian Edge  Portfolio REITs, IPC US REIT is a buy up to USD13.

In the business trust group, Chemtrade Logistics Income Fund (CHE.UN, CGIFF) is continuing with its strategic review process. As I wrote some months ago when I first upgraded the shares to a buy, management appears to have put things in place to at least maintain its current distribution against the impact of 2011 taxation. The strategic review, however, raises the strong possibility of a profitable takeout at a solid premium to the trust’s current share price. Chemtrade Logisitics Income Fund is a buy for more-aggressive investors up to USD9.

Incremental Buyers

Another group I’m scanning for possibilities are trusts in which certain entities have bought a large enough share to require making legal filings with provincial authorities. Reporting requirements for these transactions are less strict in Canada than in the US, where anyone buying 5 percent or more of a company must make an official Securities and Exchange Commission filing. But when someone does show up as a major buyer, it’s a safe bet they have more than just a cursory interest in the trust.

Obviously, the more units a prospective acquirer can garner without a formal bid for a trust, the better buyout terms it’s likely to get. In fact, a stealth buy can often gain enough shares to get control of the board of trustees, making it very difficult to block whatever they want to do.

That’s what trustees of PRT Forest Regeneration Fund (PRT.UN, PFSRF) have discovered in their current battle with the management firm hired to run the fund’s assets. Rather than an outright takeover, the management company has instead enlisted Toronto merchant bank CA Bancorp to take the trust in an entirely new direction—rapid growth in a series of diversified ventures outside the traditional core seedling business.

The trustees raised objections to the new plan as reducing the fund’s focus—which it’s pursued in a disciplined fashion for a decade-plus—and, therefore, increasing risk to its financial health and ability to pay distributions. In response, the management company and CA Bancorp have demanded the trustees’ resignation and have enlisted the support of two large shareholders, representing 28 percent of the units.

Bancorp itself has now acquired 5 percent of the units. If it’s successful in ousting the trustees and winning approval for the strategic shift, it would be issued units accounting for about a 50 percent interest in the trust in exchange for providing capital for the new expansion plans. 

This is a clear-cut case of a private capital entity having an interest that’s diametrically opposed to that of PRT’s ordinary unitholders. And unitholders are best off voting against their designs and in line with the trustees. A Bancorp victory would be a good reason to sell PRT Forest Regeneration Fund.

To head off similar situations, other trusts have initiated shareholder rights provisions in their charters. Chief among these is a requirement for anyone buying more than a certain percentage of a trust to make an offer for all the shares. That’s the central provision of a measure introduced for shareholder approval by Consumers’ Waterheater (CWI.UN, CSUWF) and recently endorsed by leading independent advisory service Institutional Shareholder Services of Canada.

Consumers’ Waterheater has recently been the target of takeover speculation, following the unexpected buyout of UE Waterheater. Like UE, Consumers’ Waterheater’s focus is the extremely lucrative business of renting water heaters. UE’s buyout signals private capital interest in the kind of cash flows such operations can generate. The rights won’t prevent the trust—which has affirmed it will keep paying big dividends after taxation in 2011—from being taken over. But it should ensure any offer for Consumers’ will resemble the deal for UE and not the mess that threatens to engulf PRT.

Several other trusts have been the targets of large buying by certain well-heeled individuals and entities. Four that rate buys are Acadian Timber Income (ADN.UN, ATBUF), Oceanex Income Fund (OAX.UN, OCNXF), SFK Pulp Fund (SFK.UN, SFKUF) and TransForce Income Fund (TIF.UN, TIFUF).

Acadian has the good fortune to operate a lucrative timber business in Atlantic Canada, an area not ravaged by beetle infestation. Its parent, Brookfield Asset Management, is likely to prevent any hostile deal that isn’t in shareholders’ best interest, and it continues to enjoy good cash flows. One possible exit strategy in 2011 would be for Brookfield itself to buy it out. In the meantime, Acadian Timber Income continues to pay a substantial distribution of around 7 percent and is a buy up to USD11.

Oceanex’s principal assets are ships that service Canadian ports. The trust used its favorable access to capital to expand its fleet last year and is now enjoying the benefits through greater cash flows. Clarke—which owns stakes in several other trusts—now holds 10.2 percent of the total units after a recent purchase. Oceanex, with its nearly 8 percent dividend, rates a buy up to USD14.

SFK Pulp operates in a business that’s been severely challenged by competition, the rising Canadian dollar and the soaring price of forest products that are its primary inputs. The trust, however, has managed to take advantage of its rivals’ woes by virtue of being a low-cost producer. As a result, it’s enjoying rising cash flows and distributions and getting the interest of private capital.

SFK’s largest owner is currently Fairfax Capital, which owns nearly 20 percent of its units after recent purchases. Odyssey America, however, recently purchased a large stake, possibly setting up a battle for this trust, which trades for just 78 percent of its book value despite a recent surge. That leaves plenty of room for rival bidders to go should we see a war for control emerge. In the meantime, this is a solid trust yielding more than 11 percent with a bright future, whether its business is organized as a trust, corporation or a unit of a private capital group. Buy SFK Pulp Fund up to USD5.

TransForce was a Portfolio holding until I became concerned about the impact of a potentially slowing US economy on Canada’s dispersed trucking industry. Recent robust earnings for the trust, however, have laid that worry to rest.

Meanwhile, the transporter continues to be the target of buying by Jolina Capital. I’ve long thought this would be a good merger candidate for another large trucking firm. But the trust appears to have carved out a solid niche on its own, making it attractive for private capital owners as well, and it should command a solid premium. TransForce Income Fund, which has recovered well off its post-Halloween lows, is a buy up to USD13.

Harder Targets

As the 50 percent premium paid by Alinta for UE Waterheater attests, the most-lucrative takeovers going forward will be in trusts where management isn’t looking to sell. Rather, the only way they’ll be bought is if someone makes an offer that’s just too good to refuse.

Unless you’re a bona fide mind reader (I’m not), there’s no real way to forecast this kind of a deal. The good news is you don’t really have to. All that’s necessary is to buy the highest-quality trusts you can when they sell at good prices—in other words, what we’re supposed to be doing anyway.

If a deal does materialize, you’re guaranteed a huge windfall. But if one doesn’t, you’ll still profit as the business becomes more valuable over time and pays you a solid distribution along the way.

All of the Conservative and Aggressive Portfolio trusts have this potential. That’s because they’ve been chosen precisely for their ability to generate stable, powerful, long-term cash flows, the kind of business that’s primarily attractive to private capital. Some, however, are more likely to command sizeable premiums in the market place more quickly than others.

Energy service trusts are one such group. The sector has been battered by a sharp drop-off in drilling activity, primarily shallow drilling in Canada’s Western Sedimentary Basin. The trust taxation change hasn’t helped. But the primary reason for the drop-off in business has been the sharp decline in energy prices, coupled with the soaring cost of the services they provide during the past couple years, which has forced their primary customers to cut back on drilling activity.

Declining activity has already triggered distribution cuts at several trusts in the sector, and it threatens to depress cash flows further at least to mid-2007. The good news is the sector’s major players have already adjusted to the worsening macro conditions. Earlier this year, for example, Precision Drilling (PD.UN, NYSE: PDS) cut its distribution and was consequently well prepared for its dip in activity and revenue in the first quarter.

In addition, several years of strong activity and enhanced ability to access capital markets have enabled high-yielding driller trusts to build state-of-the-art asset bases. As a result, they’re very leveraged for growth as energy prices inevitably turn up again. And selling for big price to book value discounts to drillers organized as corporations, their assets make them an easy way for other drillers to add to their earning bases cheaply.

My favorite bets in the drilling sector are still Precision and Trinidad Energy Services Income Trust (TDG.UN, TDGNF). Precision is the biggest and has a growing presence in the US. Trinidad is smaller but highly focused on deep drilling, which has so far mostly escaped the slowdown. Moreover, its equipment is mostly tied up under long-term contracts that ensure strong cash flow streams even in tough environments.

Both trusts have bounced well off their lows but remain quite cheap. Precision Drilling is a buy up to USD30; Trinidad Energy Services, already up substantially from my recommendation in December, is a bargain up to USD16.

Speculators may want to take a look at Peak Energy Services Trust (PES.UN, PKGFF). A former Portfolio member, the trust may still have another distribution cut ahead. But it was able to build a valuable base of assets in the past couple years, limiting future capital needs. As a result, downside is low and the trust is very leveraged to growth as energy prices resume their uptrend.

The trust is dirt cheap, trading at just 67 percent of book value. That leaves a lot of room for someone to pay a big premium. Peak Energy Services Trust is now a buy up to USD4.50.

The bidding war for Clean Energy and takeover of Calpine at a high premium have highlighted the power sector as a fertile field for takeovers. And most are likely to go at some point, given their steady cash flows, depreciable assets and ability to service large amounts of debt.

The question is which ones will get the best offers. At this point, Countryside Power (COU.UN, COUUF) appears by far the most eager to sell itself, having initiated a strategic review in the wake of a battle between the trustees and major shareholders over what direction it should take. It may cobble together a solid deal.

But Algonquin Power Income Fund is a far better bet to make it on its own and, therefore, will command its ultimate takeover price. Management won kudos from the investment community by walking away from the purchase of Clean Power, rather than get into a protracted bidding war with Macquarie. In return, the trust will recover all its merger expenses as well as a generous breakup fee.

Dodging the deal also reduced operating risk, as Clean’s latest results indicate its turnaround is still a work in progress. And it leaves the trust very cheap at just 1.5 times book value.

Looking ahead, the power trust’s portfolio of clean energy and water treatment assets promises to become more valuable on both sides of the border, as environmental concerns grow. And last quarter’s record results point to a management strategy that’s working and running its facilities well. Buy Algonquin Power Income Fund up to USD9.

Pembina Pipeline Income Fund (PIF.UN, PMBIF) never got as cheap as most trusts last year, mainly because of the market’s recognition of its lock on oil sands pipeline infrastructure. First quarter profits again demonstrated strength at all of its segments, including the midstream processing assets. The trust’s robust distribution increase immediately following the 2011 taxation announcement is a clear sign it intends to continue sharing cash flow with unitholders, regardless of Ottawa’s actions.

And its projects in the oil sands region continue to progress. Pembina Pipeline Income Fund is a superb buy up to USD16, whether it remains independent or is ultimately taken over at a stiff premium.

Bell Aliant’s failed attempt to take out Amtelecom last month signals it wants to grow, acquisitions included. But the trust’s lock on rural phone systems and reliable formula for generating robust cash flow make it a takeover target as well. Potential suitors could include another major Canadian telecom or simply a private capital outfit that would load it up with debt and repatriate the cash flow.

The shares still trade at 96 percent of book value, just a fraction of where, for example, US rural telephone companies trade. Meanwhile, with Canadian deregulation allowing the trust to become ever-more aggressive in operating its business without restrictions, its franchise will only become more valuable. Buy Bell Aliant—which has almost recovered all the ground lost to the Canadian trust taxation announcement—up to USD30. It still yields nearly 9 percent.

There are literally dozens of solid business trusts selling cheaply that could command hefty takeover premiums. One is GMP, which is highlighted above and is one of the easiest ways for a foreign brokerage or investment house to gain an instant, savvy, powerful presence in the Canadian financial markets.

Another is FutureMed Healthcare Income (FMD.UN, FMDHF), whose medical products business has overcome some growing pains to become highly profitable. The upside for the business is greater than ever, and the shares are extremely cheap. Buy FutureMed Heathcare Income—a frequent buy recommendation since we picked it up as a new issue in late 2005—up to USD12.

Targeted Energy

Thunder Energy’s buyout by a private capital firm was the first in the oil and gas trust sector, which so far has hung together in opposing the government’s taxation scheme rather than take dramatic action. But it certainly won’t to be the last. And given the premium the trust garnered—despite its death spiral—the prices paid are likely to be well above what we’re seeing today in the market place.

Some have postulated the likes of ARC Energy (AET.UN, AETUF) and Enerplus Resources, and others are still trading at steep premiums to valuations of non-trust energy producers. Comparing assets to assets, however, that’s way off base. In fact, trusts actually trade at huge discounts to book and net asset value.

As I’ve pointed out, oil and gas producer trusts are fundamentally different from other types of energy companies in that they produce from reserves that are known and stable. As a result, capital costs and risk aren’t nearly as high and they can afford to pay out a huge percentage of cash flow to shareholders.

As individuals, we’ve loved their yields. Private capital will love them for the cash flow behind those yields, which it can grab in a number of ways, including limited partnerships.

The most likely oil and gas trust targets in the near term are likely to be the battered weaklings. Several of these are trading at half book value or less, and a private capital firm crunching the numbers will likely find value at some level, particularly with the sellers so willing to part with their shares.

On the other hand, the offer price for Thunder is still 50 percent below its price of a year ago and less than a third of its 52-week high. And anyone who bought it for a takeover just a few months ago—as more than a few Wall Street houses were recommending at the time—is still deep underwater. In short, if you shop in the junk pile, you may get taken out. But there’s no assurance that what you’ll receive will even cover your initial cost.

In contrast, the strongest oil and gas trusts have weathered the worst in good form and are now poised to head higher on their own as energy prices recover. Only one of the seven oil and gas producers in the Aggressive Portfolio were forced to trim their distributions when energy prices were falling. That’s because they kept debt levels, payout ratios and share issues to a minimum in the good times. Reserve lives are comfortable—Peyto Energy Trust’s (PEY.UN, PEYUF) is as long as ExxonMobil’s—and operating and finding costs are low.

All of the picks are bona fide takeover targets, particularly if there’s no change to the 2011 trust taxation law. The most likely to be tapped are those traded on the New York Stock Exchange and, therefore, most heavily owned by American investors.

Buying Enerplus, for example, would land the new owner a reserve base with a proven life of 10-plus years. There’s also the potential for substantial growth in the oil sands region, where it’s just made a major purchase. And some 70 percent of units are already held in the US, opening the possibility of relisting here as a US limited partnership.

The oil sands venture may signal a lessened focus on distributions in 2011. But it will also make the trust more valuable with energy prices moving higher. Enerplus Resources remains a buy up to USD50.

I’ve cited Penn West Energy as a potential takeover target in prior issues. And despite the recent recovery in the shares, it still sells for only around 1.5 times book value, a steep discount to other producers with far-less substantial or reliable reserves. Penn West Energy is a buy up to USD33.

Last month, I added Provident Energy Trust (PVE.UN, NYSE: PVX) to the Aggressive Portfolio for several reasons. Its thriving midstream business makes its cash flows far-less volatile than other oil and gas producer trusts. Its US-based oil and gas operations (a third of operations) are exempt from prospective trust taxation in 2011 and are growing rapidly through the BreitBurn limited partnership it controls. It has solid Canadian operations anchored by long-life reserves, including the Capitol Energy acquisition announced May 3. And its payout ratio has dropped over the past year, even as most trusts’ payout ratios have risen.

To these strengths, let me add one more: It’s majority owned by US investors, which should make the trust relatively easy to restructure if needed here or be acquired. Buy Provident Energy Trust up to USD13.