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
January 1st, 2011, was the deadline for Canadian income trusts (other than REITs – Real Estate Investment Trusts) to convert to corporations. 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
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 were 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
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 unitholders. 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 instill 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 is 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 convert 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 shareholders 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.
The Illusion of High Yield
The low returns of GIC’s (guaranteed investment certificates) over the years have pushed income-oriented investors, many of whom are retirees, into higher yielding securities. Income trusts had fit the bill perfectly because they offered generous yields – many in excess of 10%. Many were deemed safe and secure investments, and possibly investors didn’t question the fundamentals of the companies they were investing in. According to Wikipedia, by 2005 the income trust sector was worth C$160 billion dollars. For a period, Income trusts were gigantic cash cows which rewarded investors handsomely.
However as I showed in my previous article, the Income trust sector was a bubble of its own. After the 2006 Halloween Budget, the Income trust sector began to unravel. Investors who held the course were again pummelled during the 2008 and 2009 financial crisis. However, during the ensuing recovery in 2009, investors became enamored again with Income trusts and their high yields. Many of these companies saw huge capital gains in their share price from 2009 to 2011. After their conversions into corporations, many income trusts remained solid corporations and continued to offer above-average dividend yields. The real question is, are these yields sustainable?
Cash Flow versus EPS
One measure to determine a sustainable dividend yield is to look at the DPR (Dividend Payout Ratio). I covered this measure in a previous article for MoneySaver – The Dividend Payout Ratio. For most companies and blue chip dividend payers, the DPR gives you an accurate measure of a company’s ability to pay its dividend. It’s pretty easy to calculate since you can find that information easily on most financial sites. When using the DPR to evaluate a company, the usual measure is calculated from the Earnings per Share (EPS):
Dividend Payout Ratio (DPR) = Annual Dividend / EPS * 100
However, many of the previous Income trusts and REITs do not use EPS to measure their payout ratios. They use a cash flow measure such as Distributable Cash Flow1:
Payout Ratio = Annual Dividend / Distributable Cash Flow1 * 100
This becomes readily apparent when you calculate the Dividend Payout Ratio for these companies using EPS and find the payout ratio is over 100%. The first question that comes to mind is, “how can a company pay out more than it earns?” The simple answer is they are basing their distributions on cash flow and not EPS2. Oil and Gas companies may use Funds Flow from Operations. REITs do not use EPS either. REITs base their distributions on the AFFO (adjusted funds from operations):
Payout Ratio = Annual Distribution / AFFO (Adjusted Funds from Operations) * 100
The point being, EPS is not the only measure used to calculate a payout ratio. How do you know when to use EPS or cash flow to measure the payout ratio? Generally, big blue-chip dividend payers will use EPS to measure their payout ratios. For smaller companies, you need to do some digging and research into the financial statements and annual reports and find out what measure the company is using. More than likely among the previous income trusts, it is a measure of cash flow. For REITs, it is going to be AFFO (Adjusted Funds from Operations).
Since almost all of these companies are publically traded most will be more than willing to tell you how they measure their payout ratio, and what figure they have arrived at. These are some pretty complex calculations that certainly require an accounting background to understand. Whether the balance sheet is solid or not is another matter. I’m certainly not a CFA or expert in this area, only to reiterate the point you can’t just take the numbers of a financial website and make a quick conclusion for the payout ratio with EPS (earnings per share).
In an upcoming post, Henry Le who has already written two stellar posts for the Dividend Ninja on analyzing financial statements will discuss how to read the Cash Flow Statement. So you will have a much better idea of how to pull out the cash flow numbers to measure payout ratios…
Same Trusts with a Different Name
In Part-1 of this series, I reviewed the following companies: Bell Aliant Communications (BA-T), Canadian Oil Sands (COS-T), Davis + Henderson (DH-T), Keg Royalties Income Fund (KEG.UN-T), Rogers Sugar (RSI-T), and Yellow Media (YLO-T). One advantage of these previous income trusts is that many continue to be monthly dividend payers. Here are a few more corporations I have been following, which used to be income trusts (all are traded on the TSX).
EnerCare Inc. (ECI-T)
Enercare Inc. (ECI-T) owns a portfolio of approximately 1.3 million installed water heaters and other assets, rented primarily to residential customers in Ontario. They also have metering contracts for condominium and apartment suites throughout Canada. Enercare used to trade under the Consumer Water Heaters Income Fund (CWI.UN-T), and was one of the most popular income trusts in Canada.
The company has 133 million in assets, 63 million cash on the books, but does carry significant long-term and short-term debt totalling about 600 million. Enercare indicated to me that their resources on hand are more than enough to cover their first debt maturity (if required). I wrote about Enercare’s debt load back in February, in Time to Sell EnerCare? While the fundamentals haven’t changed, the stock price continues to rise. Coincidently, Benj Gallander discussed Enercare in the same MoneySaver issue, he is far more bullish.
After converting to a corporation, Enercare did not cut the dividend, paying a distribution of $0.648 (annualized). Currently, their dividend yield is 9.2%. Enercare (ECI-T) uses distributable cash, not EPS, to calculate their payout ratio. According to Enercare their current payout ratio is at 53%, and during the second quarter of 2011, it stood at 50%. Enercare is a monthly dividend payer.
K-Bro Linen Inc. (KBL-T)
When Alberta privatized their health care laundry and linen services this year, and B.C. followed suit,
K-Bro Linen was the company which was awarded the contracts. K-Bro Linen is Canada’s largest operator of laundry and linen processing and distribution facilities for healthcare facilities, hotels, and other commercial venues. K-Bro currently has 7 processing facilities in 6 Canadian cities including Toronto, Edmonton, Calgary, and Vancouver.
This is a small-cap company that has only 123 million in assets, but with a reasonable debt level, with a liabilities-to-equity ratio of 0.51 (not to be confused with the debt-to-equity ratio). K-Bro trades at $17.55 per share, with a generous dividend yield of 6.3%. After converting to a corporation on January 1st, 2011, K-Bro Linen paid monthly dividends at the same rate of $0.09167 per share. According to K-Bro Linen, using distributable cash flow, their current payout ratio closer to 50%. K-Bro is also a monthly dividend payer.
Liquor Stores (LIQ-T)
You can’t go far wrong investing in Alcohol, that’s a given. Liquor Stores N.A. indirectly operates 236 retail liquor stores in Alberta, British Columbia, Alaska, and Kentucky. The company has a market capitalization of 294 million, a P/E Ratio of 12.41, and a low liabilities-to-equity ratio of 0.59. After converting to a corporation on December 30th, 2010, LIQ reduced the dividend from $0.135 per trust unit to $0.09 per common share. This was a 33% reduction in the dividend and was similar to many income trusts which converted to corporations. The current dividend yield is 8.3%. Liquor Stores is also a monthly dividend payer, which pays dividends around the 15th of the month.
Pengrowth Energy (PGF-T)
Pengrowth Energy is a dividend paying oil and gas company with a focus on low cost, and low-risk drilling operations. Pengrowth’s asset base includes large-scale, long life resources in six of the nine largest original-oil-in-place pools in the Western Canadian Sedimentary Basin (northern B.C. and Alberta).
Pengrowth has over 3 billion in assets, a P/E Ratio of 12.9, and a current dividend yield of 9.1%, and a reasonable liabilities-to-equity ratio of 0.68. Pengrowth’s dividend payout ratio is based on Funds Flow from Operations, which is reported on a quarterly basis. According to Pengrowth, for the second quarter dividends paid were $0.21 / $0.46 per share (funds flow from operations), making the dividend payout ratio approximately 46 percent for Q2. For U.S. investors, Pengrowth also trades on the NYSE under the ticker PGH-N. Pengrowth is also a monthly dividend payer, but its yield has already climbed to 9.0% at the time of writing.
1. For those who really want to dig into the financials, Distributable Cash Flow is basically calculated in the following manner: Distributable Cash Flow = Net Income + Depreciation – Capital Expenditures.
2. It has been explained to me that this distortion when using EPS for the payout ratio, occurs when Depreciation is greater than Capital Expenditures. This is what often occurs in REITs (Real Estate Investment Trusts) since they have huge amounts of depreciation on their properties. It also occurs in matured businesses, where there is less room for growth and higher cash flow (such as many previous income trusts).
Last week COS.UN (Canadian Oil Sands Trust) announced as it was converting to a corporation, and it would be cutting its dividend some 60%. This essentially reduced its effective dividend yield to 3%. As a result, the share price of COS has plunged some 15% as investors dumped their shares. Is COS the new future and landscape of Income Trusts, which convert to corporations?
For investors who love high dividend yields, Income Trusts have been a gigantic cash-cow. Generating staggering yields of 7% to 13%, with a hefty return on share price, these Income Trusts have paid dividend investors more than handsomely. But are the good times over? Are Income Trusts another bubble waiting to pop?
Everyone is aware of the looming January 1st, 2011 deadline when Income Trusts must convert to corporations, excluding REITs which are exempt. But some Trusts haven’t converted, some have kept their unsustainable high yields, and yet others are going to experience what COS experienced last week – a plunge in share price when the dividend is cut. For investors who are still holding a portfolio of Income Trusts with those high dividend yields, it may be time to sell and take profits, and avoid surprises.
Some analysts believe the trust to corporation conversion has already been factored in the share price, but in reality, that’s excluding a lower dividend yield. If it wasn’t for the high-income yield that many of these trusts offer, then it is unlikely investors would have flocked to these companies in the first place.
Under the corporate tax rules, these recently converted corporations won’t be able to pass the taxes they pay onto shareholders, as they did under Income Trusts. So they will really have no choice but to cut their dividend yield to keep their cash flow. That means investors will question the fundamentals of these companies, or more than likely sell and move to larger blue-chip stocks.
Some examples of the post Income Trust landscape:
BA.UN – Bell Aliant Communications
Bell Aliant has declared it will be converting to a corporation on January 1st. As per info on their website, they will be cutting the dividend from its current $2.90 per share to $1.90 per share. That 34.5% decline will result in a dividend yield being lowered from 10.9% to 7.15%. That’s definitely a high dividend yield, but with its excellent balance sheet may keep its current investors loyal.
COS.UN – Canadian Oil Sands Trust
COS hasn’t exactly been a great stock to invest in, other than the 8.10% yield which it provides. Once COS stated it was cutting its dividend, shareholders obviously realized the 17.7% P/E ratio and other problems the company was experiencing wasn’t worth the $28.41 per share price tag, or a 3% dividend yield. This stock will likely continue to decline with its Price to Book ratio of 3.03. Obviously, the only value in this company was the dividend yield, but time will tell.
DHF.UN – Davis & Henderson Income Fund
Another cash-cow is the Davis and Henderson Income Fund. 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. DHF proposes to cut their dividend from $1.84 to $1.20 per share, a 34.7% decline, or drop in yield from 9.40% to 6.1%. The company does have an excellent balance sheet, however, so as with BA.UN that may keep its current investors loyal.
SCU.UN – Second Cup Income Fund
Second Cup has also declared they will be converting to a corporation at the beginning of 2011, and that they will also be keeping the current dividend yield of 8 cents per share until year end. With a current dividend yield of 11.30%, which is unsustainable as a corporation, you can most certainly expect a dividend cut in 2011. The company does have an excellent balance sheet, however, so it’s worth buying if and when the share price declines.
YLO – Yellow Media
When Yellow Media converted to a corporation on Nov. 1st, 2010, a statement was made that the dividend would be cut some 40% from $0.80 to $0.65 per share in January 2011. That essentially creates about a 6% to 5.5% dividend yield – which I’m skeptical is sustainable. Come January, we will see how YLO does on the lower dividend payout. While the company has a low PE Ratio and low debt to equity ratio, many analysts and investors question its ability to be a viable business in the post Yellow Pages era. That along with a lower yield come January may be enough to send investors running for the door.
Acknowledgments: I would like to thank the companies which were kind enough to answer my questions on short notice: Enercare (ECI-T), K-Bro Linen (KBL-T), and Pengrowth Energy (PGF-T).
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 LIQ-T, and PGF-T.