Financial Jungle

The market tormenting me. The extra turbulence over the last few business days had taken everyone prisoner, except that they allowed the Biovail stock to revive 10% from its 52-weeks low. D’oh! I was so close in securing a juicy 10% dividend yield, my Achilles’ heel in investing, but the stock got away from me, at least for now.

Immediatelly after FDA’s thumbs down on Biovail’s studies on its formulation of bupropion, “a key component of a new antidepressant”, the market punished Biovail mercilessly sending the stock 37% lower to $17. In the process, it lifted the yield to a remarkable 8.8%.

This drug was supposed to fill the revenue hole left by Wellburtrin XL, a time-release antidepressant which accounted for 44% of Biovail’s revenues. Wellburtrin XL comes in 2 versions: the 300- and 150-milligram dosage. The 300-milligram version is already off-patent, while the 150-milligram version will face copy-cat competitions from generic producers. According to Biovail’s second-quarter financial report, generic competitions had swallowed half of the Wellburtrin XL revenues. That’s a 20% decline of total revenues.

Is the correction overdone? I think so. At the very least, I believe the stock has absorbed much of the decline and there’s plenty of value left in the post-Wellburtrin era. I know this isn’t a growth story like my superstar generic, TEVA. But, if the stock is indeed sufficiently below its intrinsic value, who will say no to free money?

Where’re the values? For starters, the company has $870 million in the bank in 2007 Q1. It means when you buy Biovail for $18/share, $5.40 is cash in the bank, so you’re really paying less than $13 for the pharmaceutical business. With the market being so volatile these days, patient investors might snap this up for a couple bucks less. Imagine one third of each Biovail share being backed by hard cash! I’d be stunned if the stock falls to anywhere near the vicinity of $5. Even cash flush stocks like Microsoft has only $2.49 on a $28.26 share.

The question that most critics enjoy picking on is can Biovail sustain the $1.50 dividend distribution policy in light of their top seller, Wellbutrin XL, going off-patent. For the sake of argument, let’s assume the misery by eliminating all revenues from Wellbutrin XL. (In real life, Wellbutrin XL should chug along residual revenues as with their other legacy drugs.) This drug is responsible for 44% of the 2006 revenues. Just to be on the conservative side, I’ll half their 2006 operational cash flow from $522 million to $261 million. Subtract $45 million for CapEx and $160 million for dividends, and that leaves $56 million of free cash, which serves as another margin of safety in my valuation.

Based on that, Biovail should sustain their dividend policy, but please help correct any flaws in my rudimentary analysis.

Possible Upsides:

• FDA’s eventual approval of bupropion.
• Successful foray into the multi-billion-dollar, global sexual-dysfunction market.
• According to their 2006 report, they have 10 new drugs in their product pipelines: 5 for central nervous system disorders, 2 for pain management, 2 for cardiovascular disease, and 1 for gastrointestinal disease.

One Objection I Heard:

Biovail relies heavily on outside collaboration/alliances with other companies, research institutes and projects for current R&D. Not having expertise in house can provide limitations over control.

Even with an army of in-house Ph.D.’s, expertise can be surprisingly difficult to find, according to a report by McKinsey Quarterly, Do You Know Where Your Experts Are - Companies need a new approach to finding their ellusive experts.

Early in the project, it needed someone with deep technical knowledge of a particular protein. We spent weeks looking for an expert — calling HR, asking around the office, scanning personnel records. Finally, we concluded the expert didn’t exist. Three days later, I’m in an elevator complaining about this to a colleague, when the woman next to me turns and says, “I wrote my doctoral thesis on that protein. What do you need to know?”

Take Procter & Gamble for example. Despite having a $1.7 billion R&D budget and 1,200 Ph.D.’s in-house, the company enjoyed a 45% success rate by outsourcing its most challenging problems to Innocentive, a market place setup by Eli Lilly to bring together solution seekers and 80,000 scientists from across the globe. I don’t view having a small R&D team as necessary a handicap for Biovail. In fact, it’s good risk management to selectively align with drug-development companies to license, develop, manufacture and market promising drugs to the market.

As always, I’m not your financial advisor. I’d be interested if anyone can point out any pitfalls with Biovail.

Disclosure: I don’t own Biovail shares, although I might start nibbling below $17.

In many ways, I’m living the deja vu of the 2006 summer correction. The skittish stock market, beleaguered by the subprime mortgage woes and the credit crunch, is lunging 1% ahead one day and plummeting 2% the next. As in the last summer, my Hotmail account is flooded with stock alerts which I setup on Globe Investors. Not that I’m pulling the trigger on every alert. It’s more for awareness than anything else, however I did nibble on few fallen stars like as Bank of America, Citigroup, Bank of Nova Scotia, Bank of Montreal, National Bank, CI Financial, Telus and Talisman, and 2 significant positions on Inter Pipeline fund and Boston Pizza Royalty fund.

It’s nerve racking to watch some of my holdings tumble, but I’m thrilled at the same time as I need to deploy new savings to high-quality but inexpensive businesses, and most stock screens always seem to bring me back to the same stocks in my portfolio. If I have it my way, we’d have a correction every second day, and Bank of Montreal would remain at $61 for the rest of my life, because a cheaper stock means more shares, more dividends and more importantly, a shorter road to financial freedom. I bought BMO in 2006 at $60.40. It rocketed to $72 before falling back to my purchase price momentarily on Wednesday. Fantastic! Same price as last year, but with a phenomenal 4.4% yield that will knock your socks off - they increased their dividends by 28%. It’s not just BMO, the other Canadian banks are teasing me with their dividends too.

If I learned anything from the 2006 correction, it’s that the moody market rewards contrarian dividend investors who have the conviction to become net buyers in a tough market. Looking back, I’m laughing myself silly that I peed my pants (not literally) when I bought IGM below $45 at a time when other investors were cringing under the falling sky. No, I wasn’t a genius. I was simply good at following instruction out of any sensible dividend investing book such as “Stop Working” by Derek Foster. Since that time, IGM’s quarterly dividends surged from 37 cents to 46 cents per share — a 24% hike! I need to have a talk with my boss about matching that pay raise.

Alas, I’m still a rookie investor. Some of my purchases have been premature; most notably DR. Horton. This time, I suspect it’ll take longer than a year before l laugh myself silly. Although my batting average is far from perfect, over the long-term, I feel that the aggregate of all the dividend-paying positions will do marvelously. Aspiring dividend investors who hang tough in this ordeal won’t come out empty handed, especially when corporate balance sheets are strong, profits are rich and unemployement rate is at a 33-year low.

In order to elevate fundamentals over the long-run, short-term pains are necessary to prune out dead weights, such as questionable structured commercial papers, loose lending standards and as ThickenMyWallet put it, NINJAs (no income, no job, no asset). Once these excess baggages are out of the way, the path to prosperity is paved for many decades to come.

Jungle Guy’s shopping list: all Canadian banks, REITs, Yellow Pages, Reitmans, pipelines (TRP/ ENB/IPL.un), insurance (MFC/SLF), CML Healthcare and CI Financial.

I’ve recently picked up a couple of non-financial income trusts: Inter Pipeline and Boston Pizza Royalty Income Fund.

Inter Pipeline Fund

You can read about Inter Pipeline in my How To Pick Pipeline Trusts post, where I highlighted their key assets as well as their strong and growing free cash flow. Interestingly, The Vancouver Sun has an article on Not enough pipeline for surging oil production, regular says.

The National Energy Board said the pipeline industry may face a capacity crunch as oil output this year rises to 2.9 million barrels a day, nine per cent more than in 2006. Almost all new Canadian oil comes from the oilsands region of northern Alberta, where more than $100 billion worth of projects to exploit reserves are planned or underway.

Boston Pizza Royalty Income Fund

Onto Boston Pizza Royalty Income Fund, this is my very first restaurant investment. The fund owns the Boston Pizza trademarks and licenses them to a private corporation, Boston Pizza International (BPI), for a 99-year term. In return, BPI compensates the fund with 4% of franchise revenues from 266 Boston Pizza restaurants across Canada. The beauty of this “top-line” funneling is that the fund enjoys a stable and consistent cash flow with no dependency on the restaurants’ profitability. Their cash flow statements are an eye-opener — no capital expenditures! BPI and their franchisees incur all the maintenance and expansion costs, while the fund gleans 4% off their total sales.

There are few contenders in the restaurant royalty space, which includes A&W Revenues Royalties, Pizza Pizza and The Keg Royalties Income Fund. However, Boston Pizza Royalty stands out of the pack with their higher liquidity (about 4x the others), generous yield (9.5%) and best-in-class same-store-sales-growth (6.5% over 10 years).

Same-store-sales-growth (SSSG) is crucial because that’s the main driver behind the fund’s distribution increases. The fund went public in 2002 with an initial monthly distribution of $0.0833, but has since risen it 12 times to $0.1130 for an annualized 6.36%, which is in line with the 6.5% SSSG.

Between the 9.5% yield and 6.36% growth, my expected internal rate of return is 15+%. The trust is trading at around $14.50 while distributing $0.113 per unit per month. This is a much better value than when it was trading at over $20 before Halloween. Back then, it was distributing only $0.109 per unit per month.

The distribution is about 84% taxable, so it’s more tax-efficient to hold the fund inside RRSP. Short of that, the second best option is to hold it under the spouse with the lower tax-bracket.

Reference:

• Boston Pizza Royalties Income Fund Fact Sheet
• Frequently asked questions

Alright. Maybe I can fit a little sequel to the income trust series.

I’m not sure if anyone noticed, but there is a distinct divergence between prosperous and crummy trusts in the aftermath of the income trust tax ruling. The prosperous ones continued to flourish, while the crummy ones never quite recovered to their roaring days.

You heard of the old saying:

A rising tide lift all boats

As long as everyone was happy about receiving their 10+% yield, no one was questioning the sustainability of the underlying foundations that supported these yields. Alas, all good things must come to an end. The tide came and went. The Halloween upheaval exposed so many little elusive holes beneath some of the rottenest boats. The tax ruling announcement turned investors’ stomachs, and sure enough, most trusts retreated 15-20% the next morning.

As painful as it may be, I think Ottawa’s decision to plug the tax leakage was a blessing in disguise as it forced out the excess speculation in the trust market. Even the most relentless critics must admit; investors today (including myself) are more attentive to the quality of trusts. This is good! It serves as a wake-up call. Fussy unitholders put their trusts in a spotlight and make management more accountable to their actions. Wouldn’t you rather suffer a healthy 20% haircut today, than having your 10% yield tab shut tight during your golden years?

What do I mean by prosperous and crummy trusts? To illustrate, let’s contrast 2 strikingly different trusts: Canadian Oil Sand and Vault Energy Trust .

Now scrutinize Vault Energy 2006 cash flow statement and balance sheet. Folks, this is a textbook income trust that forensic accountant, Al Rosen, would love to hate!

• The $45.61 mil cash flow from operations is too cute when standing next to the $88 mil from capital expenditures and cash distribution.
• Switching over to their balance sheet, total assets are falling, total liabilities are rising, thus book value is falling.
• Outstanding shares are rising, which further dilutes the existing shares.

Still think all trusts are created equal?

One great reward about being a blogger is the new insights you gain from researching and presenting articles. It’s one thing to skim over the Internet for the lowdown of income trusts, but quite another to articulate them to an audience. So much to learn still despite spending a couple of evenings on O&G trusts. Well, this post wraps up my part on the income trusts series initiated by Thicken My Wallet. I hope you’re enjoying it so far.

Saving the worst for last, oil and gas trusts are probably the most provocative group of all.

O&G trusts are holding structures that own the right to royalties on the production of natural reserves. These trusts do not engage in explorations. Instead, they negotiate and buy royalties from exploration companies. These exploration companies will generally stay behind to manage the production, but the trusts and their unitholders own the right to the stream of profits from the reserves. The one key difference between investing in O&G trusts and most other investments is that at the end of the day, your equity vanishes! Poof! Your objective is to squeeze every drop of your money back from the reserves, and hopefully a little more to compensate you for the risk-taking.

On the surface, O&G trusts have few bright spots:

• No exploration risks
• Reserves are well known
• Productions are well known
• Operation costs are well known

Alas, these trusts also come with a number of caveats; one being the limited lifespan of these reserves, many of which will not survive more than 10 years. In order to nourish the cash distributions to unitholders, the trusts must continuously replenish depleting reserves through new acquisitions. Huh? New acquisitions? Where are the down payments coming from? Through share issuances and debt financing of course. This part bugs me the most. This arrangement is reminiscent of the Ponzi scheme, where money from new investors is scrounged to maintain distributions to existing unitholders. The tale doesn’t end here, because the new reserves, as their predecessors, also have a limited lifespan. Saving investors from the agony of waning income, the trusts must dig themselves into deeper holes by tallying up even more investors and even more money to fund even more new reserves.

This illustrates the fundamental flaws of this trust model. No rational investor will want to share her profits when she’s the one risking her money on the line. If she’s the rightful owner of the new oil wells, she deserves all the cash flow produced from it.

Our anxieties shouldn’t end here. In addition to the dwindling reserves, investors must be conscious of future oil and gas prices. For instance, the price of crude oil today is $75 which is near its historical high. If the production cost per barrel of oil is $45, one may project a margin of $30 per barrel until all the reserves are depleted, but this is not a sure thing. A mere $10 drop per barrel would evaporate 33% of the profits. Even a cursory understanding of the intricacies behind oil and gas trusts explains why cash flows from O&G trusts can be erratic over time when compared to bonds. Oil trusts achieve high levels of operating leverage as their production costs are largely fixed no matter what the crude oil price is. Profits are a function of the prevailing crude oil price. As oil price diverges from costs, profits expand. Conversely, as oil price gravitates toward costs, profits erode. The lowest cost producers have the best competitive advantage against price volatility.

Finally, O&G trusts are very interest rate sensitive, as with all income trusts. This is a given.

With these caveats in mind, I’ve compiled the following criteria to help jump start your search if you’re extremely bullish on energy prices.

• Long-life reserves - Keep the distributions coming longer.
• Low(est) cost producer - Profits from the lowest cost producers are the least sensitive to energy prices. Likewise, a small dip in oil prices can wipe out all of profits from the least efficient producers.
• Clean balance sheet - The less debt on the balance sheet (low Debt/Equity ratio), the less sensitive it is to interest rate fluctuations.
• Low payout ratio - This is especially true for O&G trusts that engage in Pac-Man acquisition sprees.

Example: Canadian Oil Sand

If I were to invest in an oil trust, it’d probably be Canadian Oil Sand. It owns a 37% interest in the Syncrude project, a pure play in an oil sand that has stunning reserve life of 40+ years. I believe the slow depletion rate is confirmed by the miniscule 3% in of Return of Capital. The trust also sports a healthy 0.36 Debt/Equity ratio and 55% payout ratio, notwithstanding a weak 4.9% yield. Based on some preliminary readings on their web site and StockChase.com, they have just completed the third and final stage of their Syncrude 21 expansion. With capital spending behind them, analysts expect distributions to rise this and next year subject to oil price remaining at a high level.

According to Syncrude, their operating cost per barrel is $26.46 in 2006. That’s pretty cheap! Perhaps I’m missing something, but there is an enormous margin between the operating cost and the market price of $75 per barrel. The dual of low debt obligation and efficient production should yield some breathing room from external crisis such as deteriorating oil price and soaring interest rates.

Other Oil and Gas Trusts

• PenGrowth Energy
• EnerPlus Resource
• Bonavista Energy
• Crescent Point Energy
• Harvest Energy

Additional Resources

• In case you’re interested, a video of the oil sand production process is available here: “How We Make Oil at Syncrude”
• Hot idea fuelled energy trusts - A nice history on energy trusts.
• To keep abreast on the current energy prices, visit Bloomberg.

Pipeline trusts are terrific additions to any diversified portfolio; their cash flows are generous, predictable and sustainable. When you buy a pipeline trust, you’re buying a combination of long-lasting energy infrastructure cash-cow machines used to transport and store oil and gas. Many pipeline trusts are involved in some of the largest and longest-lasting oil projects in North America, thus enabling them to secure long-term contracts to transport oil from productions to refineries.

What are some of the key characteristics of pipeline trusts?

1. Strong competitive advantages from high barriers to new competitions due to hefty capital costs, government regulations and brands.
2. Pipelines have longevity and low maintenance.
3. Revenues are largely fixed while capital expenditures are minimal. (Translation: reliable cash flows)
4. Not much growth potential. Buying at the right price is crucial, because you don’t want to be stuck with a low yielding and slow growing investment.
5. Unlike oil and gas production trusts, pipeline trusts’ transportation revenues are generally decoupled from commodity prices.
6. Since pipeline trusts must compete with other income-based securities, share prices are sensitive to the prevailing interest rates.

What to look for in a pipeline trust?

• Squeaky-clean balance sheets - We want to turn away trusts burdened with massive debts on their balance sheets. Trusts with conservative capital structures desensitize themselves from rising interest rates, and give them little wiggle room to expand. The key ratio to look for is the Debt-to-Equity ratio. Here are several examples: Inter Pipeline (0.56), Pembina Pipeline (0.75) and Fort Chicago Energy Partners (1.99 - ouch!)
• Positive cash flow - As with all income trusts, ensure the pipeline business generates enough money to maintain existing infrastructures and to pay us cash distributions. Normally, I’d glance over the cash flow statement from MSN Finance, but there underlies a problem; capital expenditures lump both maintenance and expansions together. Since a few of the major pipeline trusts, likeInter Pipeline and Pembina Pipeline) are currently in expansion mode, I have to discern maintenance from other growth initiatives. Otherwise, MSN Finance will confuse me into thinking that these trusts are bolstering the distributions with new shares and debts — a very yucky situation. There are no short-cuts. Investors must download and soak up the annual reports to separate out the maintenance expenses.
• Payout ratios - This goes hand-in-hand with the positive cash flow criterion above. The lower the payout ratio, the safer the distributions. Do not blindly accept the payout ratios from third-party sources, such as MSN Finance, due to discrepancies in how distributable cash flows are calculated. It’s best to crunch the payout ratio yourself. An example is coming.
• High S&P Stability Rating - A trust with a high S&P stability rating has a better chance of sustaining the distribution. Most of the high quality individual trusts have an SR-2 rating, whereas “portfolios of funds” tend to have the SR-1 rating. Some of the SR-2 rated trusts include CML Healthcare, Pembina Pipeline, RioCan and Yellow Pages. It’s too bad that S&P doesn’t rate all the available trusts. However if a trust is listed and it’s below SR-2, don’t bother investing.

Example: Inter Pipeline

There are several popular pipeline trusts at your disposal, but I’ll pick Inter Pipeline since Money Gardener has been nagging me a couple of times. When you buy Inter Pipeline, you become part-owner of the following enduring assets:

• 5,900 kilometres long of petroleum pipelines (Four conventional oil pipelines, and two oil sand pipelines).
• 3.6 million barrels of storage in western Canada.
• The above assets pipe 822,000 barrels per day of oil sands bitumen, conventional crude oil and gas plant condensate, with a market share of 18% in western Canadian conventional volumes and 50% of oil sands volumes. These represent 44% of earnings.
• 3 major natural gas liquids extraction facilities in southern Alberta on the TransCanada system. These facilities are processing 4.2 billion cubic feet/day of natural gas and producing 142,100 barrels/day of natural gas liquids for now, but have the capacity to process 6.2 bcf/d of natural gas, and 195,000 b/d of natural gas liquids. (Don’t ask me what these numbers mean. ) These represent 41% of earnings.
• More impressively, their natural gas extraction facilities are responsible for processing 40% of Alberta’s natural gas export.
• 9 bulk liquid storage terminals in UK, Germany and Ireland. These represent 15% of earnings.

You can find Inter Pipeline’s distribution history here. As of this writing, the trust is trading at $9.51 with an 8.85% yield. The distribution is 85% taxable with remaining as tax-deferred capital gains (return of capital). Do keep in mine that although unitholders have been indulged with a bountiful yield, in exchange, they settled with an uninspiring 3.2% distribution growth rate.

Inter Pipeline has a positive cash flow. According to the cash flow statement, operational cash flow in 2006 is $201 mil. At first glance, this cash flow doesn’t cover the $160 mil cash distributions to unitholders and the $65 mil in capital expenditures, but wait. As I alluded to earlier, part of the capital expenditures is assigned to growth. According to page 40 of their 2006 annual report, only $5.6 mil was “sustaining capital expenditures”. The effective payout ratio after sustaining capital expenditures is around a healthy 82% ($160 / [$201-$5.6]).

Unfortunately, S&P doesn’t have a rating on Inter Pipeline.

Valuation wise, the best two times to buy Inter Pipeline were in 1999 when investors were flocking to growth oriented technology stocks, and in Nov 2006 when Finance Minister, Mr. Flarity, detonated the Halloween bomb on taxing income trusts. Moving forward, I don’t see any more corrections in the horizon unless Bank of Canada hints further hikes are lurking beyond Sep 2007. The units have settled in the range of $9.00 and $9.80 and trending upward. The trust is suited for RRSP, because the tax on distributions can be deferred inside in registered accounts.

Disclosure: I don’t hold Inter Pipeline nor any other pipeline trusts. As always, I’m an amateur investor. Do not buy or sell securities based solely on the information provided on this site.

Examples of other pipeline trusts:

• Inter Pipeline
• Pembina Pipeline
• Fort Chicago
• AltaGas Income
• Gaz Metro
• Keyera Facilities

I’m collaborating with Thicken My Wallet and Million Dollar Journey to compose a series of posts on income trusts investing. Thicken My Wallet is leading the series with a bird-eye’s view on the financials such as payout ratios, cash-flows, capital expenditures and financing. I recommend you visit his introductory post, and then follow his links to the different categorizations of income trusts by Million Dollar Journey and me.

The traditional sense of business trusts is slow-growing mature businesses in the manufacturing, service or general industrial sectors. They typically produce stable cash-flow and distributions to trust-holders, which is why yield-starving investors are finding the distributions from business trusts irresistibly tempting. However, critics are warning that a majority of business trusts are sprinkling only small amounts of genuine income from operations, while a significant amount (over a third) of the distributions are simply return of equity.

Return of equity is the original capital returned to investors. For instance, suppose you invest $10 in my business. When I take $1 out of the pool and give it back to you, that’s a return of capital. You get your dollar back, but your investment is now worth only $9. Obviously, this magic show can only sustain until there’re no more rabbits in the hat. It’s crucial for investors to scrutinize the distributions beyond the yield percentage. Often, a trust yielding 6% has fortified growth profile and solvency, but another is upholding its 15% yield using cash from new share issuances. Some people call this scheme Ponzi, where the business tallies up cash from new investors to maintain the distribution.

Here at Financial Jungle, we shun away from return of capitals, and favour only exceptional business trusts that produce sufficient cash-flow to fund all of maintenance expenses, income distributions and growth. One such fabulous trust is North West Company fund (NWF.un), which constantly brings me tears of joy whenever I admire its filthy rich cash flow statement. Here are some criteria I’m looking for:

• Cash from Operating Activities - This is a summation of all the cash generated from the business’ operations. Although an up trend is a must, investors must ascertain the quality of the operational cash-flow to rule out any anomalies within. For examples, is the trust producing a humongous cash-flow by deferring tax obligations and/or not replenishing working capital? Investing Skeptically lead me to this article by the ferocious Al Rosen. In his words,
  
  

  We tell our institutional money-managing clients that all cash flow mistakes result from the arbitrary timing or classification of management actions or inactions.

  I believe one method of rectifing the disparity of timing is to measure the trend over multiple fiscal years instead of snapshotting one year. Looking at North West Company fund, the operational cash flow looks reasonably clean: income is rising, depreciation is stable, and working capital evens out over time.

• Cash from Investing Activities - The crucial factor is capital expenditures. Capital expenditures are investments made by the trust to maintain or grow the operations through purchases of physical assets such as property, industrial buildings or equipment. Trusts with capital expenditures greater than depreciation indicates that they’re replacing depleted assets as well as increasing capacity to stimulate operation growth.
  
  

  North West Company fund depreciated their assets by $120 mil over the previous 5 years. During this time, they reinvested $130 mil back to the business.

• Cash from Financing Activities - Total Cash Dividends Paid is arguably the most cherished figure by income investors; this is the actual cash distributed to trust holders. Any high-caliber business trust will fund this distribution internally with surpluses from operation after replacing depreciation.
  
  

  For instance, North West Company fund has $81.49 mil from operational cash-flow in 2006. Depreciation is $26.17 mil. That results in a surplus of $55.32 mil, which is more than enough to satisfy the $38.7 mil distribution. In fact, the trust has enough cash left over to expand its stores (capital expenditures > depreciation), buy back some shares (retirement of stock by $1.53 mil ), and repay some debts (retirement of debt by $5.57 mil).

Needless to say, I’m giving North West Company’s cash-flow statement a clean bill of health. I’d love to know what you think of this post, and learn your unique angles on business trusts investing. What other criteria do you fancy in business trusts?

Examples of business trusts

• Restaurants - A&W Royalties (8.7%), Boston Pizza (9.2%) and The Keg (8.8%)
• Transportation - Transforce Income (11.0%) and Contrans Income (11.0%)
• Retails - North West Company (5.6%) and Sleep Country (5.9%)
• Health Care - CML Healthcare (6.5%)
• Specialities - Versacold Income (8.2%), SFK Pulp Fund (11.8%)
• Media and Telecommunication - Yellow Pages Income (7.6%) and Bell Aliant (8.8%)

One man’s garbage is another’s treasure. Sometimes it’s quite fruitful to snoop around other people’s dumpsters salvaging disgraced stocks.

Lo and behold, I may be gaping at the rottenest of all: Homebuilder stocks. The S&P Homebuilders index has been nailed and hammered over the past couple of years, and is already plummeting 20% six-months into 2007. Many Homebuilder stocks are teasing their historical low price/book ratios, but who can blame the market when you consider:

• The National Association of Realtors is reporting a nine-month worth of home inventory waiting to burn through. This is a 15-year high.
• The sub-prime fiasco is forcing lenders to tighten their mortgage lending practice, thus reducing housing demand.
• Homebuilders are lowering their prices and enticing buyers with perks in order to clear the excess inventory.
• Homebuilders are expiring and writing off their land options.

I know this may sound counter-intuitive, but bad news is good news for value investors, because the stocks have already absorbed much of these glooming expectations. (For full disclosure, I purchased a half position in DR Horton, which I’ll get to later.)

On Monday, Citigroup slapped nasty downgrades against many Homebuilder stocks:

Analyst Stephen Kim downgraded to “Hold” the shares of D.R. Horton Inc., Hovnanian Enterprises Inc., KB Home, Lennar Corp., Pulte Home Inc., Toll Brothers Inc. and Ryland Homes Inc.

What happened to the DR Horton stock? It dusted off a miniscule 1% over the next 2 sessions. Shareholders are so accustomed to pessimistic forecasts that they barely flinched after the downgrades. When the stock is already priced for disaster, the low expectations along with a higher dividend yield bolster the current price point.

Since homebuilding, by nature, is a cyclical sector, price-to-earning and price-to-sales are deceptive valuation matrices due to the fickle earnings and sales figures. A more reliable valuation matrix for cyclical stocks is the price-to-book ratio, assuming the company can hold its book value steady. Please visit MoneyCentral to appreciate how DR Horton vigorously maintained a modest equity growth even during these difficult times, and then compare what it’s trading now in relation to its historical price-to-book ratios.

Current P/B = 0.96

The question now isn’t if a recovery is looming, but when. Most of the industry experts are projecting a revival of the housing sector within the bottom half of 2008, so securing a HomeBuilder stock at this time may appear premature. However, the market tends to factor in future expectations into today’s price. Accordingly, the stock should rebound ahead of the sector. To quote Brett Arends from TheStreet.com:

[The current valuation] is a fraction of where the stocks usually trade. The last time we saw valuations this low was in late 1990, and that was in the depth of the last real-estate crash. And that time around, the shares quickly rallied — even though the housing market itself took years to get back in the swing.

There are two ways to participate in the Homebuilding sector. The diversified approach is to buy an ETF, such as XHB. The other approach, my preference, is to bypass the MER and snap up a stock directly, since Homebuilders tend to swing in lockstep with each other. DR Horton(DHI) is a reasonable choice because it is the largest US Homebuilder, and the company is buying you beer (3% dividends) while you wait for the inevitable vengeance.

DR Horton traded as high as $42 before tumbling down to $19.75. I haven’t decided when to double-down yet, but I suspect the next cyclical peak will likely surpass the previous high.

Disclaimer: I’m an amateur investor. This is not a recommendation to buy. I welcome any constructive feedback.

Folks, I’m on a quest to nail down a checklist for income trust investing. The checklist itself is an evaluation, and one reason for this post is to solicit your feedbacks and hopefully morph the list into something functional.

The unfortunate reality is that our Canadian common share market is quite narrow when it comes to selections, but the income trust market opens a door to a new dimension of diversification. I maintain a small watch list of income trusts, and it’s quite intriguing watching most of them going against the TSX movements on a regular basis. You know you have a healthy portfolio when all your securities are weakly correlated with each other.

Although I’m not one to stereotype, somehow there’s a stigma and prejudice against income trusts as being no growth businesses that keep chugging steams of cash while draining down their assets. Since I’ve not analyzed every single trusts out there, I can’t confirm if the majority of trusts are indeed decaying businesses, nor would that stop me from investing in this space.

Being a (wannabie) value investor, I believe it’s safer to hold only a handful of high-caliber trusts than buying the entire spectrum, which may potentially include a number of ugly cousins. By high-caliber, I mean trusts that offer at a minimum, the one-two-three knockout punch: sustainable distribution, strong growth profile, and sound fundamentals.

Without further ado, let’s sharpen our process! Please visit Canadian MoneyCentral for financial summaries, but it’s imperative that you peek under the hood by visiting the individual trust’s website. Many of which have an “Investor Relation” link to hunt down financial reports and distribution histories. For this checklist, I’ll reference CML Healthcare Income Fund, which is a leading provider of laboratory testing services in Ontario and the largest private provider of medical imaging services in Canada. (By the way, since the TSX is a Healthcare challenged index, most Canadians should consider opening their arms for home grown Healthcare stocks/trusts like CML Healthcare.)

1. Sustainable Cash-Flow - The trust must generate enough cash to cover both distributions and capital expenditures. This is one hallmark of sustainable trust distributions. If the internal cash flow doesn’t cover its distribution and capital expenditure obligations, the business must seek external funding (debts and share issuance) which is a major warning sign. Looking at their 2006 cash flow statement, the CML earned $98.4M cash from operations. In the process, they depreciated and depleted their assets by $3.28M. They have enough operational cash flow to cover both the $3.28M as well as the $78.81M distribution to shareholders without resorting to debts and share issuance.
2. Strong Growth Profile - The trust must have a strong growth profile. We’re not looking for the “good enough” trusts. To quote my ex-Marketing Director:
   
   

   We’re not in the business of pain-killing. We’re not the Tylenol; we’re the Viagra!

   Just meeting the minimum cash flow requirement isn’t good enough. We want exceptional trusts that not only reward investors with reliable distributions and, but retain the excess to propel and grow the business well into our retirements. CML’s cash-flow didn’t merely meet the depreciation/depletion and distribution, they exceeded them. What are they doing with the extra cash? Their spent $10.9M on “Cash From Investing Activities”, which is more than enough to replenish the $3.28M depreciation/depletion. In addition, they paid back $1.12M in debts and retained $2.54M in the bank. I probably didn’t pick the best example since CML’s distribution is relatively short(since 2004) but they had raisen their distribution twice.

3. Strong Fundamentals - The overall business must be sound. For instance, both the Profit Margin and Return On Capital should be higher than peers, and Debt/Equity should be manageable for the industry. There are always exceptions to the rule. For instance, it’s reasonable for REITs to have higher Debt/Equity ratios, because they can match long-term fixed mortgages with their long-term tenant contracts. CML’s Return on Capital and Net Profit Margin are 13.7% and 34.4% respectively, which are stellar for income trusts. Meanwhile, their 0.36 Debt/Equity ratio is much more conservative than the industry’s 1.39.

I have no doubt that there are gaps in my analysis. Consider this draft one. If I receive enough feedbacks, I’ll post version 2 of the checklist.

Being a Telus shareholder, I’m fascinated by the seemingly lopsided skirmish between Telus and 3 other private equity suitors in bids for a BCE takeover. According to Derek Decloet, speed is of the essence for Telus CEO, Darren Entwistle, who is doing everything he can to sweet talk regulators into a swift approval in-time for a concrete bid:

Despite the happy talk from Mr. Entwistle about how a Telus-BCE combo is best for shareholders, bondholders, customers, taxpayers, bankers, brunettes, vegetarians - have we forgotten anyone? Oh yes, kitten lovers - he knows that this scenario could be his undoing. In an interview with the The Globe and Mail on Tuesday, he invoked the Inco name at least twice and, in essence, pleaded for a better deal from regulators than Mr. Hand got. European Union apparatchiks dragged their heels for months on the Inco-Falco proposal, a delay that gave plenty of time for other bidders to plan their (successful) assault.

BCE has a reputation of squandering free cash flow on horrendous acquisitions, but they do have quite a decent wireless division (~28% market share) in addition to their decaying landlines. Is this a case of great assets with bad management? A Ferrari with me behind the wheel? Maybe Darren Entwistle is the Michael Schoemaker that BCE shareholders have been crying for; a new leader to zoom with their assets at full throttle. The word on the street is that a Telus-BCE merger would shave $800 millions to $1 billion off operating costs. To put that into perspective, the Telus and BCE earned $1.1 billion and $1.9 billion last year respectively. This is a substantial saving! In other words, BCE is worth more in the hands of Telus than the other bidders, thus enabling Telus to bid for $44/share, and topping the runner up bid of $42/share. As Ian Nakamoto puts it:

The others can bring financial muscle but not synergies.

Amidst all the merger talks, I’m curious if a Telus-BCE merger would serve as a catalyst to spark a few pertinent securities, namely BCE preferred shares and the Canadian banks.

Since the bidding story broke out, BCE preferred shares have been on a dire streak - falling about 15% - in anticipation of private buyers “loading the company with debt to pay for the buyout and thus compromise its ability to pay its dividends”. Since the glooming prediction is largely priced into the shares, there should be minimal downside from this point. But if competition regulators do give Telus the green light to merge with BCE, wouldn’t this mitigate the need for BCE to load up with debts, as Telus would most likely raise shares to fund this takeover? I’m soliciting opinions here. Of course the worst case scenario is regulators reject the Telus-BCE merger when every bidder has already upped their offer, thus further jeopardizing BCE’s ability to pay its dividends. In this scenario, preferred shareholders would be in a slightly worse situation than before. Nonetheless, it’s worth it to monitor preferred shares’ prices, while watching the events unfold.

Some Canadian banks may benefit as well, especially the ones with lower price/book ratios like National Bank and Bank of Montreal. Each of these banks already offers a superior yield when compared to long-term bonds, but now there’s a catalyst for price appreciation should the government becomes receptive of bank consolidations. In almost all acquisitions, the acquirers tend to fall and the acquirees tend to rise. If one of these banks gets taken out, we have an opportunity to sell at an inflated price, and load up the acquirer at a deflated price, however we are sailing into speculative territories.

At $68, BMO is a mighty compelling investment despite competing against raising bond yields. Minus the recent hiccup with the derivative trading losses, BMO has done an admirable job over the past 10 years, when they bought back shares, paid back 30% of their long-term debts, doubled their earnings, and more than tripled their dividends. Check out their dividend history:

In this post, we’ll find out how BMO stacks up against the Canada 10-year bond. However, just to be on the conservative side, let’s assume zero growth for BMO over the next 10 years, and that investors can purchase the bond without a spread.

Currently, BMO is sporting an attractive 4% dividend yield and a cheap P/E ratio of 13. In other words, for every $100 invested in BMO, the stock earns $7.70. Contrast that to only $4.68 for the 10-year bond.

Out of the $7.70 earnings, BMO distributes $4 to shareholders in the form of dividends. A Vancouverite in the 30.65% tax-bracket receiving the dividends would pocket the $4 entirely tax-free, and that’s in addition to a modest tax-refund from the dividend tax credits. On the other hand, the same Vancouverite receiving $4.68 from the bond must surrender $1.43 in taxes, and wind up with a paltry $3.25.

What’s more, after rewarding shareholders with dividends, the company still retains $3.70 of earnings. So, not only is BMO yielding higher than the bond after-tax, the company still has the means to stimulate futher capital growth over the next 10 years.

Please realize that I’m not forecasting a surging share price, but merely taking a snapshot of the present valuation. Comparatively speaking, I’m favouring BMO over the 10-year bond if my time horizon is 10+ years.

The market is weird. Every time one guy sells, another one buys, and they both think they’re smart.

Being a stock picker, this is one statement that I dread the most. How do you respond when you’re cornered into a no-win rhetorical statement? Do you pretend snobbishly that you’re smarter than the other guy? Otherwise, why become a stock picker at all?

My typical response is, even though the market is smarter than I, behaviour science teaches us that the market is perpetually stuck in a moody state where traders tend to exaggerate positive and negative news. The idea of stock picking is to avoid the herd mentality, and think independently.

The point of this article isn’t whether the market is efficient. Rather, even assuming all stocks are priced at equilibrium, market participants can still reap tangible value because stocks are priced inefficiently relatively to the individuals’ objectives and holding structures. Maybe a few examples will clarify things.

I picked up 100 BMO shares a few weeks back when they announced some derivatives trading losses. Someone must have sold the 100 shares to me, but I have no clue who that was. Maybe it was an American*, which would make perfect sense due to the lack of preferential tax treatment — BMO is worth more in my hands because Canadians receive the dividend tax credit.

Or, perhaps the seller was a Torontonian. Once again, BMO is worth more in my hands since Vancouverites benefit more from a higher dividend-tax-credit rate than Torontonians.

The seller could also have been a retiree who has a much shorter time horizon and looking to swap his BMO holding to something more conservative like bonds.

How about income trusts that distribute ample of interest incomes? As most know, the government will strip the preferential tax treatment for most income trusts by 2011. In the meantime, income trusts avoid paying the corporate tax as long as they distribute all earnings to shareholders. This delights RRSP shareholders more because the resulting pre-tax distributions are generally higher and tax-deferrable, while non-registered shareholders must report the distributions as regular income for the year.

Once the rule changes in 2011, the opposite is true. Income trusts must pay corporate tax on all reported earnings, however the trusts can distribute dividends to shareholders, who can then claim the dividend tax credit. The new rule favours non-registered holders because the after-tax distributions are essentially the same as prior to the rule change. On the other hand, the new income trusts are worth less in RRSP holders’ hand because the corporate tax reduces the distributable cash, and the dividend tax credit is lost inside RRSP.

As you can see, there are scenarios where win-win transactions can take place, and I haven’t even touched on portfolio rebalancing or hedging yet. The only time when it’s a zero-sum transaction is when it’s between two investors with similar goals.

For my own purchases, I don’t worry about who’s at the other end of the trade, because we can both be right.

* Since BMO is inter-listed on both Toronto and New York, I’m not sure if Americans receive preferential tax treatments if they purchase BMO from New York.