Financial Jungle

You have to be a Vulcan to remain unrattled by the November blizzard that knocked the TSX index off by nearly 8%. All of a sudden, the market has become pessimistic, and rightfully so as many indicators are foreseeing a recession looming. It will suck if a recession storms in uninvited. After all, who will spoil us with dividend increases when cash flows aren’t there?

While many investors have their tongue frozen to the credit crunch pole, the conservative ones are now keeping their portfolios warm and toes-curled under a blanket of utility, consumer stable and health care stocks; ones that deliver essential products and services to the general population irrespective of the market cycle we’re in.

What are some of our basic needs? Food, water, electricity and heating. Last week, I highlighted Borelax Power Income Fund, which owns 10 power plants in Quebec and the state of New York. Staying on a similar theme, I recently invested a position in the Consumers’ Waterheater Income fund (CWI.un).

If you live in Toronto, you recognize that heat and hot water are two of the most elementary needs. CWI rents out 1.4 million natural gas-fired water heaters to 83% of residence in the Enbridge Gas Distribution network within the Greater Toronto area. A boring business, isn’t it? Which is why this investment is so exciting in my view, because mundane businesses tend to come with less baggage, and it’s easier to evaluate if they’re cheap.

CWI’s rental fees are bundled in the customers’ natural gas bills. Brilliant! Not only do they provide essential services, the fees are buried deep inside the monthly gas utility bills which everyone almost always pay in auto-pilot mode. Very few businesses are more vital and stable than CWI; S&P agrees. The trust receives a AAA credit rating and SR-2 stability rating given its conservative balance sheet and recession proof character.

CWI’s minimal capital expenditures are mostly geared toward renewing 5% or 6% of its asset base in a given year, because a typical waterheater has a 15-year lifespan. In addition, CWI has little operating risks. A partnership agreement with Direct Energy Marketing Limited means that nearly all of CWI’s service support is outsourced in exchange for 35% of the aggregate rental revenues.

What more can you ask for in an income trust? Capital expenditures are minimal, revenue stream is stable, customer base is growing, share count is in check, and bank balance is growing.

In fact, between 2003 and 2006, CWI’s vault swelled steadily from $17 millions to $39 millions without diluting shares or eroding debt-level. With the business flush with cash, CWI recently plunked down $10 millions as a 25% down payment to acquire Toronto Hydro Energy Services units for $41 million. This represents a 6% increase to the total installed waterheaters.

The growth potential doesn’t end there. According to their website:

Beyond the existing service arrangement, the Direct Energy relationship has the potential to bring new growth opportunities to the Fund. As Direct Energy expands its home services footprint, the opportunity arises to rent water heaters to these customers. In addition, should Direct Energy successfully establish a significant base of rental water heater customers elsewhere in Canada, the Fund has right of first refusal to acquire it.

Management foresees the rental rate to rise in tandem with the rate of inflation. Between that and the growing asset base, distribution should improve by about 5% a year. Each CWI unit delivers an annual distribution of $1.29. Based on Friday’s closing of $14.93, that’s a yield of 8.64%. Anything above a 9% yield for CWI is cheap in my book.

If you happen to purchase CWI, consider the tax consequence: CWI’s distributions are not as tax friendly as most other trusts. 97% is treated as interest income with only 3% is return of capital. It’s better to hold the trust in a tax-deferred account such as RRSP. Short of that, you could hold the trust in a non-registered account of the spouse in a lower tax-bracket.