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
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
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
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…
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.