Income Trusts

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Income Trusts. Amin Mawani Schulich School of Business York University amawani@ssb.yorku.ca. Taxes matter in timing of death!. Estate tax rates have varied across the past century - PowerPoint PPT Presentation

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  • Income TrustsAmin MawaniSchulich School of BusinessYork Universityamawani@ssb.yorku.ca

  • Taxes matter in timing of death!Estate tax rates have varied across the past centuryDying 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 taxLow tax

    Low taxHigh 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 2003A 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 CompanyIncome TrustBusinessNotes (High interest rate)Equity

  • Explosive Growth1995: first income trust was Labrador Iron Ore for $200 million driven by Norcens need to monetize small stake in Iron Ore Corp Feb 2006: 235 Income Trusts with market capitalization of $186 billionRepresents > 10% of total Canadian equity market

  • Explosive Growth - Numbers

  • Explosive Growth Market Value $

  • Anticipated new conversionsGeneral Electrics insurance assetsBCE Incs telephone land line holdingsexpected market cap > $4 billionBut telecoms need to make strategic investmentsAGF Management LtdCI Financial Inc (stock 6.5% on news)we pay out all our earnings anyway, either through share buy-backs or dividends: weve 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 TrustsReal Estate Investment Trusts (REITs)income-producing real estateOil & Gas Trustsincome stream from Oil &Gas propertiesPower & Pipeline TrustsIncome from public utilitiesBusiness TrustsIncome from mfg, service or industrial

  • Ideal Income TrustsPredictable yield Stable cash income (margins) arising fromNon-cyclical, contractual revenues, protection from competitive pressures, inflation protectedLow sustaining Cap. Expenditure (CAPEX)Defensive CAPEX to maintain existing CFHigh Income (and Capital) Tax-paying100% Canadian content to reduce currency risk & to reduce complexity of repatriating foreign income into tax-exempt Trust

  • Business TrustsBiggest # of new trusts & also highest riskCyclical, 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 causeE.g., Sleep Country, Aeroplan

  • Statistics: Trusts vs. CorporationsTRUSTS CORPORATIONS Mean Median Mean MedianDebt : 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 TrustsRisk of a distribution cutLess income going forwardValue of investment fallsPHN 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 businesssince greater emphasis on distributing cash than on reinvesting in equipmentRisk of new tax legislation Alberta suffering tax loss from Ontario unit-holders

  • Risks facing Income Trusts Royalty trusts face risk of accelerated depletion of assetsREITs susceptible to downturn in real estate market in part due to rising interest ratesHigher 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 capitalOffer limited organic growth potentialMany dont have the strength & stability to maintain distributions in bad times

  • Blackmont Capital on Business TrustsEven modest increases in interest rates may reduce trust unit values by 5-10%1 in 4 business trusts < $10 IPO pricePrediction: 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 TrustsMonetized spin-offs from larger corps led by management were up by 8% in 2005Trusts 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 covenantsRetained 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 ratesReal estate considered sound hedge against inflation

  • Income Trusts curtail Agency CostsAgency costs: loss to shareholders or unitholders due to abuse of discretion by management hired to run the firmInsufficient effortSelf dealing (perks and theft)Entrenchment strategies (e.g., poison pills)Extravagant investments (NPV < 0)Some agency costs reduced by TrustsIf distributions , agency costs may reappear

  • Two Options(+) Shareholders get the option of keeping managements 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 & BondsIncome Trusts, Stocks and Bonds all span a wide spectrum of risk and returnLike Bonds & Equities, Income Trusts should be judged on risk versus returnNone in high-tech fields, and generally do not make risky capital expendituresTax motivation for conversion from corp to income trust largely diminished

  • Income Trusts are likeBONDSPeriodic payments (but not contractually fixed)Yield increases with riskMarket value sensitive to changes in interest rates (due to higher yields)STOCKSDistributions not contractually guaranteed and can fluctuate Returns and Price depend on underlying business profitsUnitholders have residual claim on earnings

  • Income Trust IPOsIPOs consist of small companies that would not see light of day because they are boringNow market likes them because they are boringTrusts are crowding out corporate IPOsHigh Tech IPOs not getting much attentionTrusts equity for commissions, IPO liability

  • New Issues in ProgressTotal Issues in Progress in Aug/05: $860mm5% Underwriter Fees in Progress $40+ mmPlus large fees for accountants & lawyersPlus no competition from US underwritersProvinces (especially Alberta) still thinking about taxing Income TrustsTrusts domiciled in Alberta pay large distributions to unitholders in Ontario

  • Yield major determinant of pricingTrust 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 YieldDistribution yield = key performance metricRisk premium for REITs in 1998: 350 bpsUnit Price Dist / (10-yr GOC yield + 350bps)H&R REIT issued @ $11.75 in May 1998Annualized distribution: $1.04410-Yr GOC yield =5.4%; +350 bps = 8.9% Therefore, Price = $1.044 / 0.089 = $11.73

  • Shrinking Risk Premium & YieldsH&R REIT on Feb 25/05 = $19.10Annual 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 premiumIPOs promise 100% payout ratio (of distributable cash flow) to maximize proceeds

  • Adjusted Funds From OperationsReturn 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 GAAPDIPU = $0.88; AFFO = $0.66; Therefore Return of Capital = $0.22

  • Price/Earnings vs. Price/Free EBITDAPrice / Earnings Ratio for StocksPrice / Free EBITDA for Trust UnitsFree EBITDA measure of cash flow= Earnings Before Interest, Taxes, Depreciation & Amortization less anticipated Annual Capital ExpendituresCompare your Income Fund with other similar Income FundsHigher valuation than shares reduces the cost of capital, & thereby competitiveness

  • Dividend Valuation ModelsPerceived as flattening of growthMyron Gordons Growth