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Income Trusts

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

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Income Trusts

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  1. Income Trusts Amin Mawani Schulich School of Business York University amawani@ssb.yorku.ca

  2. 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.

  3. Dying to Save Taxes High tax Low tax Low tax High tax

  4. 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

  5. A Simple Income Trust UNITHOLDERS ↓ ↓ Income Trust Notes (High interest rate) Equity Operating Company Business

  6. 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

  7. Explosive Growth - Numbers

  8. Explosive Growth – Market Value $

  9. 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

  10. 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

  11. 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

  12. 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

  13. Statistics: Trusts vs. Corporations TRUSTS CORPORATIONS Mean Median Mean Median Debt : Assets 0.26 0.20 0.19 0.15 EBIT : Interest 5.6x 6.8x 5.6x 6.9x EBIT : Sales 0.18 0.14 0.12 0.10 Volatility of CF 0.59 0.47 0.65 0.58 Sales 228m 140m 479m 132m Book Value 219m 110m 414m 71m SOURCE: Klassen & McDonald; Klassen & Mescall (2005) U. of Waterloo

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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 Trusts are like

  24. 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…

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. Price/Earningsvs.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

  31. 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

  32. Corporation $ EBITDA 100 Interest Expense* 4 Depreciation 10 Corporate Tax 31 Net Income 55 Assumed P/E 10X Equity Value 550 Enterprise Value 650 Multiple of EBITDA 6.5X *Assume $100 Debt at 4% Income Trust $ EBITDA 100 Interest Expense* 4 Sustaining Capex 10 Capital & Other Taxes 1 Distributable Cash 85 Assumed Yield 10% Equity Value 850 Enterprise Value 950 Multiple of EBITDA 9.5X Valuation Premium = 55% SOURCE: PWC (PriceWaterhouseCoopers) How Conversions were justified

  33. 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

  34. Assumptions questioned 1) Differences in growth assumptions 2) Distributable Cash vs. Cash Distributed 3) 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

  35. Corporation $___ EBITDA 100 Interest Expense* 4 Depreciation 10 Corporate Tax 31 Net Income 55 Dividend paid 0 Assumed P/E 12X Equity Value 660 Enterprise Value 760 Multiple of EBITDA 7.6X *Assume $100 Debt at 4% Income Trust $___ EBITDA 100 Interest Expense* 4 Sustaining Capex 10 Capital & Other Taxes 1 Distributable Cash 85 Cash Distributed 75** Assumed Yield 10% Equity Value 750 Enterprise Value 850 Multiple of EBITDA 8.5X **Average distribution = 88% Valuation Premium = 12% Comparative Valuation – based on correcting assumptions (1) and (2)

  36. Corporation $ EBITDA 100 Interest Expense* 4 Depreciation 10 Corporate Tax 31 Net Income 55 Dividend paid 55 After-tax Div Received 43 Assumed Yield 10% Equity Value 430 Enterprise Value 530 Multiple of EBITDA 5.3X *Assume $100 Debt at 4% Income Trust $ EBITDA 100 Interest Expense* 4 Sustaining Capex 10 Capital & Other Taxes 1 Distributable Cash 85 Cash Distributed 85 Cash Received 48 Assumed Yield 10% Equity Value 480 Enterprise Value 580 Multiple of EBITDA 5.8X Valuation Premium = 9% Comparative Valuation – based on correcting assumptions (3) and (4)

  37. 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

  38. Free Rent Tenant Inducement YRCash Rent Rec’dDistributed 1 0 9 2 9 9 3 12 9 4 12 9 5 129 Total 45 45

  39. 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

  40. Portfolio Diversification • P = Portfolio; R = Registered Portfolio • NR = Non-registered Portfolio

  41. Trusts more correlated to equities than bonds

  42. IT = Separate Asset Class (5-yr correlations)

  43. 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

  44. 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

  45. 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

  46. 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

  47. 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

  48. 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)

  49. 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)

  50. 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

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