Income Trusts

Amin MawaniSchulich School of BusinessYork Universityamawani@ssb.yorku.ca

Taxes matter– in timing of death!

Estate tax rates have varied across the past century– “Dying to Save Taxes: Evidence from

Estate-Tax Returns on the Death Elasticity” by Slemrod and Kopczuk. Review of Economics and Statistics May 2003.

Dying to Save Taxes

High tax Low tax

Low tax High tax

What is an Income Trust?

“An investment that pays out substantially all of the cash-flows generated from relatively mature, revenue producing assets in a tax efficient manner” Bank of Canada Working Paper: “Income Trusts – Understanding the Issues” Sept 2003

A publicly traded entity designed specifically to distribute substantially all of its pre-tax income from an underlying business to its unitholders

A Simple Income Trust

UNITHOLDERS ↓ ↓

Operating Company

Income Trust

Business

Notes (High interest rate)

Equity

Explosive Growth

1995: first income trust was Labrador Iron Ore for $200 million driven by Norcen’s need to monetize small stake in Iron Ore Corp

Feb 2006: 235 Income Trusts with market capitalization of $186 billion

Represents > 10% of total Canadian equity market

Explosive Growth - Numbers

0

50

100

150

200

250

1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

# of Trusts

Explosive Growth – Market Value $

020406080

100120140160180200

$b

1997 1998 1999 2000 2001 2002 2003 2004 2005Year

Anticipated new conversions

General Electric’s insurance assets BCE Inc’s telephone land line holdings

– expected market cap > $4 billion– But telecoms need to make strategic investments

AGF Management Ltd CI Financial Inc (stock ↑ 6.5% on news)

– “we pay out all our earnings anyway, either through share buy-backs or dividends: we’ve paid out all our earnings for the past six or seven years”

– “it will lower our cost of capital, which makes acquisitions easier and cheaper” –Bill Holland, CEO

Types of Income Trusts

Real Estate Investment Trusts (REITs)– income-producing real estate

Oil & Gas Trusts– income stream from Oil &Gas properties

Power & Pipeline Trusts– Income from public utilities

Business Trusts– Income from mfg, service or industrial

Ideal Income Trusts Predictable yield Stable cash income (margins) arising from

– Non-cyclical, contractual revenues, protection from competitive pressures, inflation protected

Low sustaining Cap. Expenditure (CAPEX)– Defensive CAPEX to maintain existing CF

High Income (and Capital) Tax-paying 100% Canadian content to reduce currency risk &

to reduce complexity of repatriating foreign income into tax-exempt Trust

Business Trusts

Biggest # of new trusts & also highest risk Cyclical, non-stable businesses getting into

trust business – e.g., Legacy REIT (owns Fairmont Hotels) – even though hotels are both cyclical (business & leisure travel dependent on economic activity) and high sustaining CAPEX (always renovating)

Legacy suspended distribution in 2003, citing SARS as main cause

E.g., Sleep Country, Aeroplan

Statistics: Trusts vs. Corporations

TRUSTS CORPORATIONS Mean Median Mean Median

Debt : Assets 0.26 0.20 0.19 0.15EBIT : Interest 5.6x 6.8x 5.6x 6.9xEBIT : Sales 0.18 0.14 0.12 0.10Volatility of CF 0.59 0.47 0.65 0.58Sales 228m 140m 479m 132mBook Value 219m 110m 414m 71mSOURCE: Klassen & McDonald; Klassen & Mescall (2005) U. of Waterloo

Risks Unique to Income Trusts

Risk of a distribution cut– Less income going forward– Value of investment falls– PHN sample of business trusts: average

distribution cut was over 50% and average drop in trust unit price was nearly 40%

Risk of under investing in core business– since greater emphasis on distributing cash than

on reinvesting in equipment Risk of new tax legislation

– Alberta suffering tax loss from Ontario unit-holders

Risks facing Income Trusts

Royalty trusts face risk of accelerated depletion of assets

REITs susceptible to downturn in real estate market – in part due to rising interest rates

Higher interest rates can increase cost of doing business and reduce distributions (and therefore reduce yields & value)

E.g., Menu Foods breached covenants with creditors and suspended distribution, reducing unit value from $14 high to $3 low

Should retirees hold business trusts?

Business trusts are like highly leveraged equities that retain little capital for reinvestment (or rainy day)

Trusts are not just high-yielding equities, but also high-risk equities (i.e., no free lunch)

Offer less safety of principal compared to corporations who retain some capital

Offer limited organic growth potential Many don’t have the strength & stability to

maintain distributions in bad times

Blackmont Capital on Business Trusts Even modest increases in interest rates

may reduce trust unit values by 5-10% 1 in 4 business trusts < $10 IPO price Prediction: 50% of business trusts

expected to fall below IPO price Only 15% of business trusts have

sufficient quality to be held by retirees

Good vs. Bad Business Trusts

Monetized spin-offs from larger corps led by management were up by 8% in 2005

Trusts sold by private equity funds were down by 8%; trusts sold by private corp. down 4%

Subordination by seller retaining 20% chunk of corporation and agreeing to not receive cash distributions signals higher than normal risk; subgroup down by 14%

Debt capacity and flexibility in debt covenants Retained earnings: compare with corporation

REITs

(-) Low interest rates means more home-buyers and few renters

(-) Hotel REITs susceptible to strong Canadian dollar with its corresponding fewer tourists

(+) Higher interest rates means economy expanding & firms renting more space

(-) Higher rates means higher discount rate applied to REIT valuation (higher capitalization costs)

(-) REITs (like bonds) have an inverse relationship with interest rates

Real estate considered sound hedge against inflation

Income Trusts curtail Agency Costs

Agency costs: loss to shareholders or unitholders due to abuse of discretion by management hired to run the firm– Insufficient effort– Self dealing (perks and theft)– Entrenchment strategies (e.g., poison pills)– Extravagant investments (NPV < 0)

Some agency costs reduced by Trusts If distributions ↓, agency costs may reappear

Two Options

(+) Shareholders get the option of keeping management’s feet to the fire by forcing higher distributions

Options forced by tax legislation

(-) Shareholders give up the option of allowing mgmt to retain cash flows

Income Trusts vs. Stocks & Bonds

Income Trusts, Stocks and Bonds all span a wide spectrum of risk and return

Like Bonds & Equities, Income Trusts should be judged on risk versus return

None in high-tech fields, and generally do not make risky capital expenditures

Tax motivation for conversion from corp to income trust largely diminished

Income Trusts are like

BONDS Periodic payments (but

not contractually fixed) Yield increases with risk Market value sensitive

to changes in interest rates (due to higher yields)

STOCKS Distributions not

contractually guaranteed and can fluctuate

Returns and Price depend on underlying business profits

Unitholders have residual claim on earnings

Income Trust IPOs

IPOs consist of small companies that would not see light of day because they are boring

Now market likes them because they are boring

Trusts are crowding out corporate IPOs High Tech IPOs not getting much attention Trusts ≈equity for commissions, IPO liability…

New Issues in Progress

Total Issues in Progress in Aug/05: $860mm 5% Underwriter Fees in Progress ≈ $40+ mm Plus large fees for accountants & lawyers Plus no competition from US underwriters Provinces (especially Alberta) still thinking

about taxing Income Trusts Trusts domiciled in Alberta pay large

distributions to unitholders in Ontario

Yield major determinant of pricing

Trust valuation depends on business risk, financial risk (leverage), quality of management, governance,…& YIELD

↑ demand from GIC & equity refugees Dedicated new $$$ from retail investors $1.5 billion of new money in July 2005 ↑ Growth after tech bubble burst in 2000

Valuation: Priced to Yield

Distribution yield = key performance metric Risk premium for REITs in 1998: 350 bps Unit Price ≈Dist / (10-yr GOC yield + 350bps) H&R REIT issued @ $11.75 in May 1998 Annualized distribution: $1.044 10-Yr GOC yield =5.4%; +350 bps = 8.9% Therefore, Price = $1.044 / 0.089 = $11.73

Shrinking Risk Premium & Yields

H&R REIT on Feb 25/05 = $19.10 Annual Distribution =$1.244; Yield =6.51% 10-Yr GOC=4.24%, Risk premium=2.27% Risk premium and yields have been largely

declining with maturity of sector Increased liquidity also reduces risk premium IPOs promise 100% payout ratio (of

distributable cash flow) to maximize proceeds

Adjusted Funds From Operations Return of Capital priced increasingly lower

by investors than Return on Capital E.g., Retirement Residences REIT (RR) Analyst notes that RR distributing more than

DIPU (distributable income per unit) Analysts prefer AFFO per unit since more

closely related to GAAP DIPU = $0.88; AFFO = $0.66; Therefore Return of Capital = $0.22

Price/Earnings vs. Price/Free EBITDA

Price / Earnings Ratio for Stocks Price / Free EBITDA for Trust Units Free EBITDA ≈ measure of cash flow = Earnings Before Interest, Taxes,

Depreciation & Amortization less anticipated Annual Capital Expenditures

Compare your Income Fund with other similar Income Funds

Higher valuation than shares reduces the cost of capital, & thereby ↑ competitiveness

Dividend Valuation Models Perceived as flattening of growth Myron Gordon’s Growth Valuation Model:

Price = DIV / (r - g)e.g., $1.24 / (0.11 – 0.03) = $15.50

Low growth rate (g) lower prices “Stable cash flows” or “mature” may not be

compliments in any valuation model “lazy capitalism” or “opposite of capitalism” Microsoft’s initial dividend ≠ good news

How Conversions were justified

Corporation $EBITDA 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Assumed P/E 10XEquity Value 550Enterprise Value 650Multiple of EBITDA 6.5X

*Assume $100 Debt at 4%

Income Trust $ EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Assumed Yield 10%Equity Value 850Enterprise Value 950Multiple of EBITDA 9.5X

Valuation Premium = 55%

SOURCE: PWC (PriceWaterhouseCoopers)

Growth Assumption

Corporation assumed to have P/E= 10X Corporate growth rate must be zero for

corporation to be comparable to trust Zero growth rare since earnings normally

retained for reinvestment P/E = 10 implies P = 10Estatic

If Corporate E growing, then P > 10Estatic

Therefore P/Estatic > 10 Say P/E = 12 if Earnings are growing

Assumptions questioned

1) Differences in growth assumptions2) Distributable Cash vs. Cash Distributed3) Zero corporate dividend distribution 4) Differences in Personal level taxes:

– tax on capital gains realized on corporate shares is 22% (≈ tax on dividends paid)

– tax on interest income on Trust units =44% All of these 4 factors impact valuation

Comparative Valuation – based on correcting assumptions (1) and (2) Corporation $___ EBITDA 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Dividend paid 0Assumed P/E 12XEquity Value 660Enterprise Value 760Multiple of EBITDA 7.6X

*Assume $100 Debt at 4%

Income Trust $___EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Cash Distributed 75**Assumed Yield 10%Equity Value 750Enterprise Value 850Multiple of EBITDA 8.5X

**Average distribution = 88%Valuation Premium = 12%

Comparative Valuation – based on correcting assumptions (3) and (4) Corporation $ EBITDA 100Interest Expense* 4Depreciation 10Corporate Tax 31Net Income 55Dividend paid 55After-tax Div Received 43Assumed Yield 10%Equity Value 430Enterprise Value 530Multiple of EBITDA 5.3X

*Assume $100 Debt at 4%

Income Trust $EBITDA 100Interest Expense* 4Sustaining Capex 10Capital & Other Taxes 1Distributable Cash 85Cash Distributed 85Cash Received 48Assumed Yield 10%Equity Value 480Enterprise Value 580Multiple of EBITDA 5.8X

Valuation Premium = 9%

Accounting Issues Yield, like Income, can be manipulated 70% of ITs distribute some Return of Capital Distributable Income (DI) =GAAP Net Income

+ Non-Cash Expense – Normalized CAPEX DI and CAPEX not GAAP measures,

therefore Trusts have significant discretion Can always borrow to payout DIV or DIST E.g., free rent tenant inducement considered

income and distributed (with borrowed $) Not quite Cash box accounting

Free Rent Tenant Inducement

YR Cash Rent Rec’d Distributed1 0 92 9 93 12 94 12 95 12 9

Total 45 45

Where to hold Income Trusts Interest income (t ≈ 44%) tax-disfavoured compared

to dividends or cap gains (t ≈ 22%) Better to hold tax-disfavoured income (e.g., Income

Trusts) inside RRSPs and equities outside RRSPs Equities are tax-favoured anyway Losses inside RRSP cannot be offset against gains

outside RRSPs, and may be wasted Diversification applies to entire Portfolio, and not

just Registered Portfolio Trusts may constitute a separate asset class

Portfolio Diversification

P = Portfolio; R = Registered Portfolio NR = Non-registered Portfolio

R

NR

P

Trusts more correlated to equities than bonds

S&P / TSX Composite Index

3- to 5-year Canada Bonds

10-year Canada Bonds

S&P / TSX Composite Index

1.00 0.13 0.17

3- to 5-year Canada Bonds

0.13 1.00 0.82

10-year Canada Bonds

0.17 0.82 1.00

S&P / TSX Income Trust

Index

0.50 0.42 0.31

IT = Separate Asset Class (5-yr correlations)T-bill Equity All

Bond CorpBond

GovBond

High yield

IT

T-bills 1.00

Equities -0.3 1.00

All bonds 0.25 -0.09 1.00

Corp Bond 0.24 0.04 0.97 1.00

Gov Bond 0.28 -0.11 0.98 0.92 1.00

High Yield -0.09 0.22 0.10 0.22 0.05 1.00

Inc Trusts 0.10 0.37 0.15 0.19 0.11 -0.05 1.0

Distributions vs. Dividends Cyclical or non-stable Income Trusts may be

forced to reduce distributions, while corporations will likely continue paying dividends out of retained earnings (e.g.,CIBC)

Distributions more likely to fluctuate than DIV Retention of distribution is penalized with

taxes - therefore does not necessarily serve as signal of quality or ‘excuse’ for expansion

Reduced dividends may be justified as serving expansion or growth objectives

Few high dividend-paying stocks

Only 7 Cdn stocks have dividend yield > 4% (= 1-year T-bill yield on March 25, 2006)– Manitoba Telecom, Rothmans, Russel Metals,

Emera, BCE, TransAlta and Quebecor World Only 16 of the 500 S&P companies had

dividend yield > 4.68% in February 2006 (= 1-year US Treasuries)– Only 10 of 16 stocks were judged to be

sustainable in their dividends by Merrill Lynch

Dividend Policy

Dividend yields fall when stock price ↑ High dividend yield not necessary good

– May reflect higher risk or sluggish growth– higher dividend often at expense of growth

Microsoft’s initial dividend was not considered good news by the market

Cdn banks known for raising dividends

Red Flags for Distribution Cuts* Pre-tax yield ≥ 12%

– High yield indicative of high risk Payout ratio ≥ 90%

– May not be sustainable with volatility Debt : EBITDA > 2

– Insufficient slack if cost of debt goes up “Since 1999, one in five business trusts have cut their

distributions. In 2005 alone, ten business trusts cut their distributions, and the average return six months later was -46%.”

*McLean & Partners Wealth Management Ltd

Trusts overstate payout ability

Sustaining CAPEX (≈ average of 22% of cash generated from operations) was not subtracted in reporting the amount of distributable cash by 57% of trusts examined by S&P in January 2006

“slack & ambiguous way in which trusts report distributable cash” – S&P Jan /06

“lack of accounting rigour in trust sector” –Independent analyst Harry Levant

“free use of cash” can include debt – Al Rosen “Pyramid schemes” via return of capital – Al Rosen

Sustainability of Distributions

Dominion Bond Rating Service (DBRS) website at www.dbrs.com offers stability ratings for most income funds on a scale of STA-1 to STA-5

Standards & Poors website at www2.standardsandpoors.com (click on Canada) also offers stability ratings from SR-1 (most stable) to SR-7 (least)

Return on / of Capital

Aggregate yield confusing 6% of trusts had return of capital < $0.01 Not rocket science but need to get hands dirty Distributable Income not a GAAP measure Corporations also distribute return of capital Despite CIBC’s $2.4 b ENRON write-off in

2005, it continued paying a dividend from its capital (retained earnings)

Yield major determinant of Price Unlike pension funds, retail investors (often

seniors) not averse to higher cash flows, even if it is return of capital

Trusts aimed at retail investors, while shares aimed at cynical / sophisticated inv.

Trusts similar to Housing: cash flows (house consumption) likely remain the same even if yield repriced

Everyone likes relative performance evaluation – hence inclusion of Trusts in S&P/TSX Composite Index

Questions / Comments?