What Happened to the Income Trusts? Part -2

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

The Income Trusts

I’ve added some additional copy to my original MoneySaver article and highlighted in blue text.

Back in the September Canadian MoneySaver, I reviewed the once prevalent Income trust sector in, What Happened to the Income trusts? Part-1. I provided a review of the conversion of these Income trusts into corporations for the January 1st, 2011, deadline. I also provided a historical reference to why these trusts paid such high dividend yields, and why the dividend yields continued to remain so high, even under a corporate structure.

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 enamoured 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.

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).

Acknowledgements: 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.

13 Responses to “What Happened to the Income Trusts? Part -2”

  1. Le

    Nov 29. 2011

    Great article. I like how you dive deeper into subjects and seem to take a conservative approach to your writing. As for LIQ, it is currently distributing more than it earns. Otherwise it seems like a fairly good stock for the times.

  2. The Dividend Ninja

    Nov 30. 2011

    Le Thanx for posting! I’m glad you liked the article. Yah LIQ-T is a company I would prefer to sell than to hold 😉

  3. My Own Advisor

    Dec 01. 2011

    Great article. Loved in MoneySaver, loved reading it again here as well Ninja.

    I like KBL, great niche company. I need to find some cash to own him 🙂

    Maybe 2012 TFSA pick.

    Keep up the great work!

  4. The Dividend Ninja

    Dec 01. 2011

    MOA Cheers!

  5. youngandthrifty

    Dec 02. 2011

    I used to own LIQ but then sold it when they announced the reduction in distributions. I haven’t thought of them since, thanks for the reminder. I may take a look at them again this weekend 🙂

    KBL sounds very interesting, especially with the generous payout!

    • Christopher

      Dec 05. 2011

      Interesting article, thanks for the insight. I have been tracking dividend stocks lately trying to decide which ones to buy next and had been noticing that a lot of them do seem to pay out more dividends than their earnings per share which seems to be a warning sign. How can you tell which formula/statistic a company is using for paying its dividends? In particular I’ve been watching JE, NAE and RSI which seem to be paying out way too much based on their EPS.

  6. The Dividend Ninja

    Dec 05. 2011

    Christopher Here is what I have been told by someone in the accounting profession. For this sector (all previous income trusts, REITs, etc.) cash flow and not earnings is the correct way to analyze this sector.


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