"You could be embedding a kind of sluggishness in the economy."
-- Federal Finance Minister Ralph Goodale on income trusts, Sept. 21, 2005.
Listen to the Finance Minister these days, and it seems income trusts are a grave threat to the country. A clear and present danger to Canada's productivity, Ralph Goodale frets. Corrupters of the business soul, and tax dodgers to boot.
From the steps of the House of Commons, Mr. Goodale vowed last month to take a long, hard look at the exploding $160-billion sector, which has attracted legions of income-starved investors. New government levies seem imminent and inevitable, for the Finance Minister seems sincerely convinced that Corporate Canada will wake up one morning moribund, locked into a structure that Mr. Goodale said "offers little flexibility for reinvestment in future growth and development."
If Canada is embedding sluggishness in a space that's already home to 224 companies, with more joining every day, well, that's a heck of a scandal. So let's roam the land, and find out just what's happening inside the trusts. If ne'er-do-well chief executive officers are handing out cash without a care for our future prosperity, it's time to expose these bums.
Let's start the search in Blacks Harbour, N.B., at the sardine cannery that gave birth to Connors Bros. Income Fund. One of the early business trusts, this 83-year-old company was a backwater in the George Weston Ltd. conglomerate until it was spun out in 2001.
At first glance, there's a visible lack of ambition here. The employee parking lot is full of aging Fords and Chevrolets. One of the trust's major shareholders, Ira Gluskin at money manager Gluskin Sheff + Associates, says he's come to love this modest approach from successful executives. "These guys all drive North American-made cars. If a Mercedes-Benz showed up in the parking lot, I'd sell."
What kind of executive doesn't aspire to a Benz or BMW? Well, in the case of Connors Bros., it's hard-driving types who have netted three major rivals in as many years, and increased the market capitalization of their company fourfold, to $663-million.
In a Canadian business community that struggles with international expansion, Connors Bros. has moved steadily up the global food chain. New Brunswick's dominant player in sardines has morphed into North America's market leader in tuna, chopped clams, canned chili and chicken in a foil pouch. The CEO chowing down deals is Chris Lischewski, who joined Connors Bros. in 2004 when it bought his San Diego-based tuna processor.
"We're fish canners. We're not glamorous," says Mr. Lischewski, who opted to work at a trust after running divisions of food giants ConAgra Inc. and H.J. Heinz Co. "We would never, ever command this kind of multiple on the New York Stock Exchange. But as a trust, we do justify a superior valuation, and we use that to grow the business."
Here's how the sardines stack up. Connors Bros. units typically change hands for up to 10 times the company's earnings before interest, taxes, depreciation and amortization, or EBITDA. Conventional rivals in what Mr. Lischewski calls the "canned protein" space trade at six or seven times EBITDA. With his units commanding a premium to competitors' common stock, Mr. Lischewski has great currency to pay for acquisitions.
Mr. Lischewski also finds he's got more than enough cash to build a cross-border company. Connors Bros. forks over 76 cents of every dollar in cash it generates to investors. The rest of the money goes back into the business. Canneries remain state of the art. Advertising campaigns build brands such as Brunswick sardines and Clover Leaf and Bumble Bee tuna.
When it comes to taxes, Mr. Lischewski points out that while tax-efficient at the corporate level, his company sends steadily growing waves of cash back to Canadian investors, most of whom then pay income tax. The first year the trust was public, it handed out $18-million. Now annual distributions run to $77-million.
Kicking the conversation from his operations to his management philosophy, Mr. Lischewski says the discipline of having to justify all capital spending helps his team make better decisions. Connors Bros. has gone to the market twice to sell units in order to raise money for acquisitions. He also sees the transparent structure, where it's easy to follow the money, as a boon to investors.
"When I went to business school, I was taught that the best way to value a company was to look at it's ability to generate cash," says the CEO with an MBA from the University of Southern California. "We're all about generating cash. It's a lot easier for investors to measure this company, this structure, than it is to understand the valuation on Google, which I just don't get."
A quick tour of the financial records at top-performing trusts shows CEO after CEO who first puts money back into the business, to ensure continued prosperity, before cutting a cheque to unitholders. Trusts that run into trouble sport so-called payout ratios of more than 100 per cent. That's a measure of the cash they hand out compared with the cash they generate, and only borrowing to pay investors can keep payouts this high.
One of the strongest oil patch players is Peyto Energy Trust, which targets a 50-per-cent payout ratio. RioCan has one of the lowest payouts among real estate investment trusts, and is a top market performer. The pick of the pack in business trusts is natural gas marketer Energy Savings Income Fund, which keeps payouts in the 65-per-cent range.
CEO Rebecca MacDonald opted to take Energy Savings public as a trust in 2001 in part because investors just weren't interested in a conventional, common stock IPO. Now, as her $1.7-billion debt-free company expands from Ontario to Quebec and into the U.S. Midwest, she says: "We couldn't have settled on a better structure."
"The U.S. is our growth market for the next 10 years," Ms. MacDonald said in a recent investor presentation, adding that the trust will make its first foray into New York this fall, the largest potential market it's ever tackled.
A walk down Bay Street finds there's a consensus view on why many trusts were initially viewed as stagnant, but are now growing like weeds. "Trusts tend to go public promising to pay out almost all the cash they generate. But as they mature, and management gets more seasoned, the better executive teams lower the payout ratios to invest in the business, while still raising their monthly cash distributions," says Simon Romano, a Stikeman Elliott lawyer who has written a book on trusts.
From the corner office, let's journey into the world of academia for further thoughts on whether these new-fangled financings are a good way to allocate precious Canadian capital.
"Income trusts haven't been around long enough to generate meaningful data on issues such as productivity and reinvestment," says Laurence Booth, a finance professor at the University of Toronto's Rotman School of Management. "However, the basic idea of a trust is to pay out as much of the cash as you can spare, and that stops management from thinking that any accumulated cash is theirs, and wasting it."
Keeping CEOs from making dumb decisions has won fans among Canada's biggest money managers. "In the majority of cases, you would have been better off as a shareholder if the companies had paid out extra money to you, rather than reinvested it. Most management teams are not good at capital allocation," says Brian Gibson, senior vice-president of the $88-billion Ontario Teachers Pension Plan. "Look at BCE [Inc.]. Instead of buying all those businesses they then had to write off, it would have been better just to pay out the money."
"Quite the opposite of undermining the competitiveness of the economy, [trusts] actually improve things. Capital ends up getting invested in things that make sense," says Mr. Gibson, whose fund holds $2.2-billion of trusts and earned $900-million from the sector last year, or enough to pay pensions to 25,000 retired teachers, who are all taxed on their income.
But what of the laggards? The young trust sector has already seen implosions. Are the companies that crashed harbingers of what's to come if a concept that depends on cash generation is found wanting in tough times?
Let's start by looking at the biggest failure to date, Heating Oil Partners Income Fund, currently under creditor protection. The trust got hammered by soaring oil prices, which it couldn't pass on quickly to clients. SFK Pulp Fund, owner of a Quebec mill, saw its unit fall in price after it chopped distributions in step with a declining pulp and paper market, which should surprise no one. Another spectacular collapse came at Atlas Cold Storage Income Trust, where there was outright accounting fraud. Unfortunately, Ottawa can't legislate against volatile commodity markets or lousy managers.
Knock on the door of Lennoxville, Que.-based Advanced Fibre Technologies Income Fund, and you're greeted by one of the few management teams that experts say became undone when it put a damper on reinvestment. The company went public two years ago when it had market leadership in a narrow field. It supplies high-end parts such as steel screens to the mills that turn trees into paper.
The 350 employees at Advanced Fibre compete with far larger players, such as Finland's Metso Corp., which serves both forestry and mining companies and employs 22,000, and Germany's Voith AG, active in pulp, paper and power sectors and home to 24,000 workers.
"Our sense is the company got focused on cash distributions at the expense of product development. When that happened the Europeans started to eat their lunch," said one mutual fund manager who bought the Advanced Fibre initial public offering, then sold the units at a loss. A $130-million company when it went public, Advanced Fibre is now worth $21-million.
For all Advanced Fibre has been though, Mr. Potvin says he continues to believe that it's good discipline to pay out extra cash, and go to the markets to sell new units in order to fund major expansion. "We would face all those business issues as a normal public company. Being a trust has its benefits, and drawbacks," he says.
But, Connors Bros.' Mr. Lischewski, says, "Trusts aren't right for everyone. Any company with a high need for capital spending, on anything from R&D [research and development] to marketing, wouldn't want to be one. But it sure suits us."
And even if a few trusts go splat, as some newly public companies always do, they are seen by some as a welcome addition to Canada's capital markets. "Trusts tend to be smaller companies, in the $100-million range, who would otherwise only have bank loans to finance expansion. And we all know how reluctant to lend the banks can be," Stikeman Elliott's Mr. Romano said. "The ability to go public as a trust opens a new avenue for growth at small- and mid-cap companies."
No journey through the economic impact of trusts would be complete without looking at just what investors do with the river of income they're suddenly receiving. There's now a $1-billion a month pouring out of the sector in cash distributions and an estimated one million individuals own trusts. Are these folks somehow wasting the bonanza they've been handed?
Our search moves to a farm near Stratford, Ont., where 80-year-old Bruce Beaumont is living off a portfolio that is 80-per-cent trusts, including RioCan and several energy plays. "Most people in government just don't understand the basics of running a business," Mr. Beaumont says. This from a fellow who started by milking his father's cows in 1941, and built one of the largest dairy operations in Southern Ontario by buying up 10 neighbours' farms over six decades. "I get my distributions, and I reinvest most of it into the companies that deserve support."
Big money managers also put trusts' cash distributions to work. Mr. Gluskin says: "Most investors put the [trust] income they receive right back into the market. A primary concern is preserving wealth for clients, which trusts do rather well."
Marc Tellier, who is CEO of the country's largest business trust at Yellow Pages Group, told a conference in Montreal this week that the government needs to have more faith in Canadians, noting: "If these investors are savvy enough to elect their public officials, surely these same investors are savvy enough to reinvest their earnings in growth and distributions."
When it comes to tax, Mr. Beaumont is baffled by the whole debate. Last year, he paid a six-figure income tax bill on the distributions from his seven-figure trust portfolio. Mr. Beaumont says: "The government seems fixated with burdening good companies with new taxes. It's like making the best hockey players carry weights around their necks when they play."
Income trust report card
A+ trusts balance capital spendings with boosting cash distributions. Get that balance wrong, and fail to make the grade.
TOP STUDENTS
Connors Bros. Income Fund
Class of '01
Teacher's comment: Moved from dominating sardine canning to tuna, chili & stewed beef.
Yesterday's close: $12.58, down 32¢
CBF.UN - TSX
Peyto Energy Trust
Class of '03
Teacher's comment: Conserving cash to drill new wells built reserves, and boosted units.
$27.16, down $1.44
PEY.UN - TSX
Energy Savings Income Trust
Class of '01
Teacher's comment: No debt, two acquisitions, 19 distribution hikes. No one does it better.
Yesterday's close: $17.90, down 45¢
SIF.UN - TSX
BACK OF THE CLASS
Advanced Fiber Tech. Income Fund
Class of '02
Teacher's comment: Larger rivals and an industry downturn spelled TROUBLE.
Yesterday's close: $1.45, down 6¢
AFT.UN - TSX
Heating Oil Partners Income Fund
Class of '02
Teacher's comment: Oil prices rose faster than what homeowners were charges, which proved fatal.
Yesterday's close: $0.005, unchanged
HIF.UN - TSX
General Donlee Income Fund
Class of '02
Teacher's comment: When airlines are major customers and they're all going bust, it hurts.
Yesterday's close: $4.19, down 16¢
GDI.UN - TSX
SOURCE: THOMSON DATASTREAM
This ends a four-part series. Read the package at globeandmail.com
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