What Happened to the Income Trusts? Part -1

This article was published in the September 2011 edition of the Canadian MoneySaver, and is posted here with permission. For more information visit www.canadianmoneysaver.ca

The Income Trusts

Part -1 …to be continued in November 2011

January 1st 2011, was the deadline for Canadian income trusts (other than REITs – Real Estate Investment Trusts) to convert to corporations.  In this two-part series, I examine the basic changes of income trusts into corporations, and what’s happened to these high-yield dividend payers. Now that almost all income trusts have converted to corporations, which ones are still worth holding?

The Cash Cow

In Canada, income trusts were created as an alternative to the corporate structure.  The first income trust was Enerplus Resources, established in December 1985. Income trusts were created to avoid taxation, by paying out all their earnings (dividends) directly to shareholders. This meant that investors would get a higher yield, in exchange for paying all the tax obligations from the company’s earnings. As a result, income trusts were able to pay much higher yields than their corporate counterparts.

This was a win for both the corporations that converted to income trusts, and for new companies which incorporated under the income trust structure. It was also a golden egg for investors who loaded up on income trusts in their RRSP’s and enjoyed dividend yields – many in excess of 10%. According to Wikipedia, by 2005 the income trust sector was worth C$160 billion dollars.

Signs of Trouble

Income Trusts

courtesy of www.raesidecartoon.com

Back in 2005 the adage of “high yield = high risk”, didn’t seem to have much concern for investors who saw stable income trusts paying generous yields. However, just like the tech bubble only a few years earlier, the income trusts were also becoming a bubble of their own. This bountiful cash cow was gaining attention from the NDP (New Democratic Party) as well as from the Canadian Finance Department. The Finance Department issued a statement in September 2005, alleging that nearly $600 million dollars of federal and provincial taxation revenue was being lost through the income trusts.

The first signs of trouble started in 2005, when the Royal Bank (RY-T), Canada’s largest bank, said it was not opposed to the idea of converting to an income trust. Throughout 2005, the Liberal government came under continuing pressure to stem the potential conversions of Canada’s largest corporations into income trusts. Announcements by telecommunications giants Bell Canada Enterprises (BCE-T) and Telus (T-TSX) of their intentions to convert to income trusts also followed suit in October and November 2006.

A Spooky Halloween 

Canadian Income Trusts

courtesy of www.getmoneyenergy.com

On October 31st, 2006, following the announcements from Telus (T-TSX) and BCE (BCE-TSX), then Finance Minister Jim Flaherty unveiled new rules for income trusts.  The Conservatives announced a new “double- tax” of 34% on income trust distributions, to commence on January 1st, 2011. These proposed new rules would effectively end the tax benefits of the income trust structure for most trusts.  The announcement was both unexpected and controversial, and went directly against the Conservative’s campaign promise not to tax the income trusts.

According to Wikipedia, the TSX Capped Income Trust Index lost 17.6% in market value by mid November 2006, and the unit price for all 250 income trusts and REITs on the TSX dropped by a median of almost 13%. This was a big hit for retirees, who loaded up on high-yield income trusts in their RRSP’s to secure their retirement.  Slowly, the income trusts would be coming to an inevitable end.

The 2011 Countdown

With the impending changes to the income trust structure, many companies began their conversions from trusts to corporations early in 2010, and others waited right until the deadline on January 1st, 2011. The problem for income trusts that did not convert, was that they would no longer receive the benefit of forwarding taxes onto unit holders. Income trusts would now be subject to a combined corporate tax rate of approximately 30% starting in January 2011. Income trusts were left with no option other than to convert to corporations, in order to minimize their taxes.

Income trusts that converted to corporations would also be required to cut their dividends, since the high-dividend yields under a corporate tax structure would not be sustainable. Many income trusts gave preliminary notice of their dividend cuts throughout 2010, and the degree to which the dividends would be cut. But even with these dividend cuts, most income trusts were still going to be paying higher yields than most corporations.  Most investors holding income trusts waited for the ticking time bomb of January 1st 2011.

Many analysts felt that the share prices were already factored in for the conversion, and that investors had little to worry about come January. To a large degree these analysts were correct. The income trusts that held good balance sheets noticed little change in their overall share price, and continued to instil investor confidence.  On the other hand, income trusts that were not doing well to begin with had their problems exacerbated after their conversions to corporations.

The Post Income Trust Landscape

Most corporations that were once income trusts continue to offer high yields. However, when an investor purchases any of these previous income trusts, there is inherently more risk. One should treat many of these companies as they would any other small-cap stock.  The adage “high yield = high risk” should always be kept in mind.

Many of these previous trusts are still offering high yields that are likely unsustainable. There may be more dividend cuts coming down the line for some of these companies, and many also have very high dividend payout ratios (DPRs). When you invest in a company that is paying out all or most of its income to dividends, there isn’t much room left for that company to invest in new projects, expand its business, or pay down its debt obligations. That can lead to trouble down the road. As mentioned in my previous MoneySaver article, a high dividend payout ratio is a red flag.

Same Trust with a Different Name

Here is a summary of a few corporations that were once popular income trusts, with more to follow in Part-2. All these securities are listed on the TSX (Toronto Stock Exchange):

Bell Aliant Communications (BA-T)

Bell Aliant a subsidiary of Bell Canada is the leading cable and internet provider in the Atlantic Canada region. It converted to a corporation on January 1st, 2011, and cut the dividend from $2.90 per share to $1.90 per share.  That 34.5% decline resulted in a dividend yield being lowered from 10.9% to 7.15%, the current yield being 6.9%. That’s definitely a high yield, and under a corporate tax structure may be difficult to maintain. In July 2011, Bell Aliant earned a net profit of $82.7 -million or 36 cents a share for the second quarter, but faced declining revenue and increased capital spending. The current EPS and DPR are not positive, and the yield is high. Many view Bell Aliant as an income oriented investment with limited growth potential.

Canadian Oil Sands (COS -T)

Back in early December 2010 after converting to a corporation from an Income Trust, Canadian Oil Sands (COS-T) cut its dividend some 60% down from 8.10% yield to 3% yield. Although its share price initially plummeted some 15% as investors dumped their shares, the company was a quick turnaround with surging oil prices and interest in the oil sands sector. COS now has a dividend yield of 4.6% (nearly half of what it used to be) but with a healthy DPR of 55.8%.

Keep in mind COS has a variable dividend policy. They may cut and raise the dividend in relation to the price of oil, Syncrude projects, and other factors. I had stated on my blog back in December 2010, that COS was likely in trouble, but that was before the run-up in oil. Management at COS has shown both responsible and prudent handling of the conversion process by cutting the dividend to a reasonable yield and managing their debt. COS may represent a good investment opportunity if oil prices remain high, and interest in the oil-sands sector continues.

Davis + Henderson (DH-T)

Another cash-cow was the Davis and Henderson Income Fund, now Davis + Henderson. This is the company that causes you grief when you order new cheques at the bank, since the company has a monopoly on the cheque printing business in Canada. DH cut their dividend from $1.84 to $1.20 per share, a 34.7% decline. This resulted in a dividend yield decrease from 9.40% to 6.1%, with the current yield at 6.5%. The dividend payout ratio for DH is 67.0%, but DH also has little debt.  However Davis + Henderson has made some unusual acquisitions during 2011, financed in part through additional common shares. For example, back in April they purchased Mortgagebot, and in January they purchased Asset Inc.

Keg Royalties Income Fund (KEG-T)

I have been going to the Keg Restaurant since I was a teenager. The Keg Royalties Income fund gave notice on December 21st, 2010 it would not covert to a corporation, and remain an income trust. The Keg Royalty Income Fund (KEG.UN) is a limited purpose trust which licenses Keg Restaurants Ltd. It has rights to use the Keg name, and in return receives a royalty of 4% of system sales of Keg restaurants. That structure may seem somewhat convoluted, but KEG.UN has over $149 million dollars in assets, with a 7.3% dividend yield. The company also has virtually no debt, a reasonable PE ratio of 11.68, but with a high dividend payout ratio of 84.9%. The catch with KEG.UN is that relies solely on the success of the Keg restaurant chain. Similar to KEG.UN is Boston Pizza Royalties (BPF.UN), another royalty income trust that did not convert.

Rogers Sugar (RSI-T)

Rogers Sugar is another solid high yield company, with a generous dividend of 6.4%, a low PE ratio of 8.48, and a very low dividend payout ratio of 43.6%. Rogers Sugar is a household name that has been well-established in Canadian history, since B.C. Sugar was incorporated in 1890. Lantic Sugar Limited and Rogers Sugar Ltd. merged into a new operating entity now known as Lantic Inc., on June 30th, 2008. On January 1st, 2011, Rogers Sugar Income Fund converted into a conventional corporation (RSI.T) under the name of Rogers Sugar Inc.  With its established history, and annual sales of nearly $615 Million, Rogers Sugar is a solid investment for the generous 6.4% yield. It is a rare find to see both a high yield and low dividend payout ratio among the previous income trusts, but the stock price is trading at all-time highs.

Yellow Media (YLO-T)

Yellow Media (formerly the Yellow Pages Income Fund YLO.UN-T) was once the darling of the income trusts, with its generous monthly dividends and success of the Yellow Pages directory. One of its largest share holders for example was the Ontario Teachers Plan. Then in July 2007, the Apple iphone emerged, and along with Google suddenly revolutionized the way people found information online. YLO soon found itself obsolete and without a solid business plan, scrambling to complete in a tech world it was unprepared for. It launched a Yellow Pages style app for mobile devices, but the app failed miserably in comparison to Google’s powerful mobile search.

Sure enough with its high DPR, high dividend yield, and lack of business direction, YLO the once darling of income trusts was a disaster waiting to happen.  Throughout 2011, Yellow Media found its share price crashing some 87.4% from $6.26 per share on January 4, 2011 to $0.79 per share on August 11, 2011. YLO has cut its dividend to $0.15 (as of August 11, 2011), with a yield of 19.0%. Investors would be prudent to wait for the long term until YLO sorts out both its dividend policy and its business direction before investing.

In Part-2 I’ll review more of the corporations which converted to income trusts…

Disclaimer:
This article is not intended as a recommendation to buy the securities mentioned. Please do your own research, and consult with a professional advisor be investing.  Dividend cuts are always a possibility with these higher yield companies. I am currently long on RSI-T.

28 Responses to “What Happened to the Income Trusts? Part -1”

  1. MoneyCone

    Sep 16. 2011

    I did buy into this craze with Provident Energy! Didn’t lose money, but wasn’t happy with the way things turned out! C’mon Canada! :)

    Excellent coverage DN!

    Reply to this comment
  2. My Own Advisor

    Sep 16. 2011

    Killer article! Know wonder I love this site!

    I’ve never been a big fan of variable dividend policies, e.g., COS. This doesn’t mean I won’t own COS, but it is a deterrent for me as an investor.

    Rogers Sugar is a very interesting one. Solid company, generous divi, and low DPR. Lots to like.

    Yellow Media, geez, what can I say? I’m just glad I never owned it.

    One thing I’m learning more and more as an investor, stay away from “media darlings”. Too much hype often means too much risk. I prefer dull and boring companies myself. I prefer to have my fun outside of stock selection and the stock market.

    Speaking of fun, care for a cold beer Ninja? :)

    Great article, I look forward to Part 2!

    Reply to this comment
  3. The Dividend Ninja

    Sep 16. 2011

    MoneyCone, thanks! PVE looks like its doing OK, time to take some profit taking or hold out? seems to be doing better than a lot of other energy stocks.

    MOA what can I say? Thanx for the killer comment :) Yah a lot of trusts have some type of variable dividend policy or end up slashing dividends once in a while – there is more risk with the previous Income Trusts than with other blue-chip stocks. But there are also some real gems (like RSI). You really have to do your due dilligence with these companies.

    Reply to this comment
  4. The Wealthy Canadian

    Sep 16. 2011

    An awesome article Ninja, and congratulations on being featured in Canadian MoneySaver magazine once again.

    As an investor, I have been along for the ride with respect to income trusts (pre, during and post-conversion) and it’s been eventful to say the least.

    There were valuable investment lessons to be learned, and we have come to find out which companies were the true survivors.

    Aide from the new legislation, the income trust space also had the misfortune of getting pounded even further during the recession of 2008-09. For a while, it seemed as though investors were foolish to be invested in income trusts.

    With that being said, there are good companies having solid fundamentals that continue to be trusts or have since converted to the traditional corporate structure.

    Companies I own, like IPL.UN-T, CGX-T, AW-T, BPF-T, FRU-T, GNV-T, BA-T, ENF-T, and SCU-T are all companies that have weathered the storm during tough times and continue to pay strong distributions and dividends to the investor.

    Of those you mention in Part 1 of this series, I have positions in both COS-T and BA-T.

    If there’s one sector that doesn’t offer the investor a lot of consistency in terms of dividends, it’s the Oil & Gas sector.

    From a personal standpoint, I have positions in SU-T,CNQ-T, and XOM-N. Since these are the large-cap, big-time players in the sector, we can expect consistency with the dividends; but on the other hand, the investor generally receives a lower dividend yield.

    With higher yielding Oil & Gas plays such as PWT-T, PGF-T, ARX-T, and COS-T, we’ve come to realize that consistency in terms of dividend payments is much less reliable.

    Great post – looking forward to Part II!

    TWC

    Reply to this comment
  5. The Dividend Ninja

    Sep 16. 2011

    TWC thanks for the kudos and for the awesome comment!

    The previous income trusts are really companies which are small-cap stocks with a higher yield, and therein lays the risk vs reward to own them. They are a much different animal (as you know) than the big blue-chip dividend payers, that solid dividend investing is based on. I think many investors until recently were purchasing stocks on yield alone before fundamentals.

    Strong dividends and distributions don’t remain so if the company has a high dividend payout ratio, high debt, or high beta. Right? For example I own a small position in PGF-T, but not a day goes by I am not concerned about its dividend payout ratio, and its ability to continue paying its dividend.

    I’ll be covering many of those companies you have listed in Part-2.

    Cheers, thanx for posting! :)

    Reply to this comment
    • The Wealthy Canadian

      Sep 17. 2011

      Hey Ninja,

      What you really bring to light in your comment is the difficulty that is presented to the dividend investor.

      Choosing stocks is one thing, but finding dividend paying companies that will generously increase your monthly cash flow stream while minimizing risk is another.

      Although my preference is large-cap stock, investing in companies like SAP-T, SU-T, CNR=T, and WN-T (which I have positions in) will give you a lot of stability, but the dividends received are quite low. By following this route only, the investor is well poised for long-term appreciation; however, in the short-to-mid-term, the lack of investment income may hamper your objectives.

      Take the DPR. If I were to choose stocks exclusively on dividend payout ratio, there would be a number of stocks that I wouldn’t own.

      For example, take an example with an investor named Johnny. If Johnny only has a few thousand dollars to invest, and wants exposure to the financial services sector, Laurentian Bank would make the top of the list. But should he invest his hard-earned dollars in this bank while there are others, despite the higher DPR’s that likely offers more growth and increasing dividends prospects?

      I guess what I’m trying to get a across is that you nailed it on the head in that the investor has to take into consideration more than just one factor in stock selection, and this comes with additional risk.

      Cineplex Inc. (CGX) is also worthy of mention. Despite the high DPR, the company has a virtual monopoly and is a great cash flow generator. For a 5% yield (my entry points have been considerably higher), it’s a company that also allows you to diversify in an interesting space.

      Boston Pizza Fund has also been a darling in my portfolio, and the company has never missed a distribution – even during the financial crisis.

      What’s interesting about MOA’s comments, is that he mentioned how COS doesn’t offer the investor consistency in terms of dividends, yet it ranks among the highest on the great list you compiled.

      I guess what I’m trying to say is that this post really highlights how an investor’s risk tolerance and perspective of a company’s real value comes into play.

      Over the past many months, I’ve been plowing more of my hard-earned dollars into large-cap dividend paying stocks, but I can assure you, in previous years, I was comfortable with some risk by choosing several income trusts, and many have them have paid me handsomely.

      All the best,
      TWC

      Reply to this comment
  6. The Wealthy Canadian

    Sep 17. 2011

    BTW- when I mentioned “great list you compiled”, I meant that sincerely and not sarcastically. I loved your Dividend Payout Post and the criteria you selected. Just wanted to make sure in case the sentence came off a little weird. :)

    Reply to this comment
  7. The Dividend Ninja

    Sep 17. 2011

    Hey TWC, no problem and no offence taken whatsoever! That’s the discussion about blogging that allows everyone to contribute – anyway be nice if there was one sure way to determine when a stock is an ideal investment. But its really not that simple is it?? For example higher yield = higher risk, and for the most part that is true, but not always.

    You bring up some really excellent points in your comments. Sounds like you found a topic for next weeks post :)

    TWC, awesome comments btw, thanx for taking the time! And have a great weekend – it’s raining in Vancouver today (like that never happens) :)

    Cheers
    The Dividend Ninja

    Reply to this comment
    • The Wealthy Canadian

      Sep 17. 2011

      You’re absolutely right Ninja in that many income trusts (or companies that have converted) aren’t safe havens by any means.

      I just meant to say that I’m able to tolerate some of the extra risk that comes with owning certain companies because I believe in them. I can certainly see how many investors avoid them like the plague, but there are some good companies worth investing in – at least in IMO.

      Although you’ve given me a great idea for a post for next week, I’d rather wait for Part 2 of your series. You’ve got things covered just well. :)

      Have a great weekend! Sun in my neck of the woods ;)

      Reply to this comment
      • The Dividend Ninja

        Sep 17. 2011

        Hey TWC I’m going with a different focus on Part-2 of the Income Trust series, and it will be a while before it’s published in November. Why don’t you go ahead with your post, I’d love to read it :)

        Reply to this comment
  8. Oculista

    Sep 18. 2011

    I wonder if the same thing will happen with USA MLPs sooner or later …

    Reply to this comment
    • The Dividend Ninja

      Sep 18. 2011

      Hey Oculista thanx for dropping by!

      I’m not an expert on U.S. securities by any means. But with any investing strategy keep to a solid plan of asset allocation, and keep the core of the holdings in conservative dividend paying stocks, bond holdings, and/or index ETFs.

      If these MLP holdings are a large chunk of your portfolio, then consider profit taking and rebalancing.

      Cheers
      The Dividend Ninja

      Reply to this comment
  9. Vangrl

    Sep 18. 2011

    Wealthy Canadian:
    “I just meant to say that I’m able to tolerate some of the extra risk that comes with owning certain companies because I believe in them. I can certainly see how many investors avoid them like the plague, but there are some good companies worth investing in – at least in IMO.”

    I feel the same way as Wealthy Canadian. Some of the income trusts or former income trusts that I hold that might be a bit riskier but I feel confident in are:
    Northland Power, Brookfield Renewable Energy, Vermillion, Keyera, Atlantic Power and Inter pipeline.

    A few that I hold and are feeling much less confident in are: Daylight, Canfor Pulp and Just Energy.
    Your opinion on any of these in your next post would be great!

    And thanks for all the hard work you put into your blog, very much appreciated!

    Reply to this comment
  10. The Dividend Ninja

    Sep 18. 2011

    Vangral thanx for the support btw! It means a lot for us bloggers when people take the extra time to say thank you. :)

    I agree with TWC as well, there are some good income trusts which are still solid corporations. But most of them are small-cap companies, and many of them started as Albertan Oil and Gas Juniors. So due-diligence is neccessary. You can buy WalMart or JNJ without a worry, but with these smaller higher-yield companies, you can’t take anything for granted. IMO Brookfield is one of the best management companies. I’ll make an extra point to cover the companies you mentioned.

    Cheers
    The Dividend Ninja

    Reply to this comment
  11. Wow, great post Ninja! Very well researched. Because the media has moved on to other news, most people have forgotten about income trusts since the Finance Minister’s announcement on Halloween day in 2006. In fact his announcement scared people away from income trusts, and most have not come back.

    Like you said lots of things to consider when making a buying decision and don’t just focus on the dividend yield.

    Reply to this comment
    • The Dividend Ninja

      Sep 19. 2011

      Kanwal thank you very much! I purcahsed some Income Trusts back in 2010, and have done quite well. However as I keep saying higher yield = higher risk.

      Cheers
      The Dividend Ninja

      Reply to this comment
  12. 101 Centavos

    Nov 22. 2011

    Fascinating highlight on Rogers Sugar. I did some background reading, and it seems that the Canadian sugar market is not protected by high government tariffs. It competes on its own strengths in the world sugar market.

    Reply to this comment
    • The Dividend Ninja

      Nov 23. 2011

      101 Centavos thanks for posting! Yes Rogers Sugar is a very interesting company with a very long history in Canada. Even when I was a little kid I remember Rogers Sugar on the store shelves. So when I started dividend investing I was surprised to see it was a smaller cap company with a higher yield, but the fundamentals looked good ;)

      Reply to this comment

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