With all the noise around income trusts these days, you'd think the sky is falling on one of Canada's favourite investments.
Headlines blare that trusts are on Ottawa's hit list, as Finance Minister Ralph Goodale muses that it's time he slaps on taxes. A sector that could do no wrong is suddenly reeling, losing $18-billion of market capitalization last month.
While the prospect of taxes certainly does change the way that investors value trusts, the sky isn't exactly falling. In fact, a sector that's only a decade old is starting to sort itself out. In a field that's now crowded with 227 public companies, a select few trusts are starting to emerge as all-star performers.
To understand what it takes to be a standout trust, consider the fundamental tension that exists in all these companies.
The CEO of a trust is asked to pay out as much cash as possible to investors, in the form of distributions. The bigger the distributions, the higher the price of units. And everyone wants higher prices, as the majority of executives get units as part of their compensation.
However, every business needs to reinvest some of the cash it generates, in order to stay competitive. Capital spending for the long term comes at the expense of higher distributions, which fit the market's short-term focus.
At all-star trusts, managers have struck that fine balance between boosting payouts and pouring money back into the business to make it grow. These are the trusts that investors want to own, no matter what kind of noise is coming out of Ottawa.
Finding the superior performers means poking around in some strange corners of the business world. Like 18-wheel rigs. Or garbage dumps. Or bleach. Or door-to-door sales. The best trusts tend to be dominant players in obscure sectors. Glamorous, they're not. But wow, do they crank out cash.
For example, take a look at TransForce Income Fund. The trucking company converted from traditional common stock play to a trust in 2002 -- a journey that now faces roadblocks from the federal government.
When it switched engines, Transforce carried market capitalization of $540-million. Three years later, it is worth $923-million.
"Transforce is doing it all," says Scotia Capital trust analyst Navdeep Malik. "It's done 40 acquisitions in the past few years to become a dominant player in trucking, yet it's also boosted distributions five times."
Then there's BFI Canada, the folks who run garbage dumps. Just a few years back, this was a company with no domestic management team: It was a division of a larger U.S. player. Toronto-based private equity fund Edgestone Capital bought the operation, built an executive team, then launched it as a trust.
Last year, BFI Canada hauled in a $1.1-billion merger with a Texas-based garbage company. Despite spending for expansion, BFI was still able to hand out more cash.
Entrepreneur David Cynamon watched father-in-law Gerry Pencer build a successful no-name soda pop company, Cott Corp., with a traditional common stock structure. But when it came time to strike out on his own, Mr. Cynamon created KCP Income Income Fund as a trust that contained the dominant North American bleach maker. Not exactly sexy, to be sure, but making consumer products is mature, cash-spinning business that's well-suited to the trust structure.
After stumbling coming out of the gate -- distributions were cut briefly just after KCP's initial public offering -- Mr. Cynamon has mastered the balancing act. With units trading above the $10 IPO price, he's using the cash generated from selling bleach to buy a shelf full of new products, becoming dominant in deodorant, shaving cream and aerosol-packaged products.
The CEO who's done the best balancing act on trusts is Rebecca MacDonald, founder and chairman of Energy Savings Income. The company's sales force knocks on doors to sell homeowners on natural gas. From a base in Ontario, Ms. MacDonald's moved into Quebec, Manitoba and the United States, while raising distributions 20 times in five years.
Trusts that expand, while thrilling investors with larger distributions, are affectionately called "cash cows" by Barbara Gray, who covers the sector for investment dealers Blackmont Capital. She hands this exalted title to companies that:
Kick off growth in distributions that average 2.5 per cent a year or more.
Pay out less than 90 per cent of the cash they generate to unitholders, with the rest of the money invested back in the business.
Enjoy strong competitive positions in their sectors, with high barriers to entry for new competitors and the ability to set prices with customers.
Boast stable cash flows, right through a business cycle.
Keep debt levels at 0.5 times earnings before interest, taxes, depreciation and amortization, or less.
Who are the next generation of cash cows, the up-and-coming all stars among trusts?
Analyst Aleem Isreal, who covers the trusts for Sprott Securities, recently crunched the number of trusts that have gone public in the past year. He says candidates for distribution hikes before the end of this year include the Liquor Stores Income Fund, which runs a chain of booze stores in Alberta and has done successful acquisitions, bargain-bin retailer XS Cargo Income Fund, oil field services firm CCS Income Trust and real estate consultant Altus Group Income Fund.
© The Globe and Mail
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