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The dirty little secret of income trusts: cash flow
Wednesday, May 14, 2008
It's been almost a year since the bean-counting authorities in this country tried to nudge income trusts into being a little more forthright about what they call distributable cash.
Did anyone listen? So far, it looks like the answer is: Not particularly. Trust investors should pay close attention to this matter, though. Lots of trusts will be converting to corporations in the next couple of years. A big change like that is the perfect opportunity for aggressive management to quietly reveal that the economics of a business aren't nearly as good as the distributions implied they were.
Last July, the Canadian Institute of Chartered Accountants published (CICA) a 50-page door stopper that tried to standardize the meaning of distributable cash flow, just as earnings are standardized under the rules.
In theory, distributable cash is what a trust or fund can hand its investors without hurting the cash flows of the business. In practice, if a company paid out all of its true distributable cash, its profits would grow at around the rate of inflation, but no more, because it would have no money to expand.
The CICA doesn't generally act unless it sees something alarming. You can assume that the freedom trusts enjoy when it comes to wooing investors with high distributions or low payout ratios was cause for concern. Given the dozens of companies that have cut or eliminated distributions for no reason other than they were set too high in the initial public offering, that's understandable. Hence last summer's guidelines.
The institute is busy checking up on just how eager companies were to embrace its advice. The answer is that about a third of trusts have. That ratio isn't based on financial statement analysis, either. It's based on how many have adopted the CICA's jargon, notably "standardized distributable income." The cynic will assume that the number of trusts that actually changed their accounting is a lot lower than a third. We'll see once the CICA finishes its checkup.
Meantime, though, investors can do their own work. The guideline, at least the version that was published, was really simple: Distributable cash is cash flow less cash spent on maintaining the assets.
The problem with this is pretty obvious. What if the company isn't investing enough to maintain its assets such that they can maintain the cash they churn out?
The original drafts of the paper tried to account for that possibility, but there was too much opposition from industry and not enough enthusiasm from investors.
So now the recommended calculation of distributable cash is basically cash flow less what the company spent on maintenance, rather than what it should have.
The two can be very different. What you should spend doesn't just mean keeping a building in the same state. It also means keeping it competitive with new buildings so that it can keep earning the same rents, which means you have to improve the building just to stay even.
It's no coincidence that I used real estate as an example, because I think that's where some of the most egregious examples of bogus distributable cash figures come from. I've seen trusts that define distributable income as cash flow, and analysts who condone it, which is stunning. Real estate is hyper-competitive. You not only have to maintain your buildings, you have to improve them so they can keep up with new, state-of-the-art stock that competes for your tenants.
Yet most REITs reinvest a lot less than they depreciate, and some barely reinvest at all. They're easy to spot: The balance sheet value of their properties falls. They'll tell you that's okay because the market value goes up. Rubbish.
To see why, think of your own house. It might have been bought for $10,000 50 years ago (excluding the land, which doesn't depreciate.) After 40 years, the standard depreciation for a building - its carrying value - is zero if you don't do anything to it.
But during that time, you will have upgraded your kitchen and bathroom twice, redone your roof a couple of times, replaced your furnace and water tank at least once, rebuilt your fence and made all sorts of other upgrades to keep it "competitive" with a new house, like added air conditioning or a second storey. Because of inflation, you'd have spent more on maintaining your house than you paid for it - a lot more. If you had a balance sheet, the value of your house would be higher than 50 years ago.
The same argument can be made of another industry that loves to cloud its economic condition: oil and gas. It's a little trickier there, because even though reserves per unit might fall (i.e., you haven't maintained you assets), higher commodity prices skate you onside. But be careful: Reserves have to be replaced and the cost of doing that rises in lockstep with the cost of oil and gas.
So don't count on the rule makers to keep corporations honest. Protect yourself. It starts by being highly skeptical of what they tell you.
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