An investment vehicle that has taken Canada by storm over the past three years with the lure of stable, above-average returns is also becoming a potent weapon for shareholders to tighten the leash on spendthrift corporate managers.
Known as income trusts, these structures enable businesses to distribute a high portion, typically 70 to 80 per cent, of their pre-tax operating income to unit holders. While the business reduces - and often eliminates - its tax liability, unit holders are assured a steady monthly or quarterly income so long as the underlying business continues to generate a stable cash flow.
But with virtually no cash reserves on the balance sheet, any sizeable expansion or acquisition requires a fresh injection of equity or debt, giving investors and bankers an unusual degree of control over corporate decisions.
“The discipline is very important,” says Bob Bertram, head of investments at the Ontario Teachers Pension Plan, one of Canada's biggest institutional investors. “It prevents management from reinvesting cash flow in inappropriate fashions.”
About 150 income trusts are listed on the Toronto stock exchange, with a value of more than C$80bn (US$61bn), or 7 per cent of the total market.
Prominent companies that have converted to income trusts include Fording, a leading metallurgical coal exporter; Yellow Pages, which publishes directories; and Canadian Oil Sands, which owns 36 per cent of Syncrude, the world's biggest oilsands producer.
A chain of 49 liquor stores in Alberta and British Columbia said last week it planned to go public through an income-trust offering and on Monday Penn West, a Canadian oil explorer, said it was seeking an advanced tax ruling from Revenue Canada to see whether it could convert into an income trust.
Canadian banks have been trying to export the concept to the US in the form of “income deposit securities”, but only one company has so far completed a public offering.
In spite of rising interest rates, which narrow the yield spread between income trusts and bonds, the Toronto stock exchange's income trust total return index has gained 7.7 per cent so far this year, compared with a 2.5 per cent rise in the exchange's composite index. Income trusts yield, on average, five to six percentage points more than do 10-year Canadian government bonds.
The most suitable candidates for income trusts are well-established businesses, such as oil and gas producers and property projects, with a relatively stable cash flow that is not required for new capital investment.
But ballooning investor interest has attracted a variety of more volatile businesses, including hotel and restaurant chains, a newspaper group, a container terminal and a film distributor.
Setbacks have forced some of the newcomers to curtail or eliminate monthly payouts, underlining warnings that income trusts carry the same risks as equities. One trust, Atlas Cold Storage of Toronto, one of North America's biggest frozen storage operators, is embroiled in an accounting scandal and has stopped payments to unit holders.
With 150 trusts trading, “you're going to get surprises”, says Gordon Tait, an analyst at BMO Nesbitt Burns. “You're getting profiles that certainly don't look like what we thought trusts would look like.”
Still, some companies' performances have improved markedly since they converted to income trusts, says Sandy McIntyre, portfolio manager at Sentry Select Capital in Toronto.
Mr McIntyre cites Contrans, a big Ontario-based trucking company, which restructured as an income trust in July 2002. Contrans raised C$46m in its initial offering, and issued units worth another C$41m this year, giving it the resources for several acquisitions. Net income of C$13.7m in the first half of 2004 was 37 per cent higher than a year earlier.
“The discipline of a monthly distribution makes them focus on every possible expense in the business,” Mr McIntyre says. “It's made them a better company.”
Connors Bros, a seafood processor that went public in 2001 through an income trust, financed a big US acquisition this year, partly by raising C$262m in new units. By operating within the confines imposed by the trust structure, which include setting aside a fixed amount for maintenance expenses, “we had more or less earned a strong level of credibility in the marketplace”, says Bruno Del Bel, senior vice-president of finance at the company.
That credibility is reflected in the yield on Connors units - about 8 per cent - compared with the average for the income trust sector of 9 to 11 per cent. “That's your currency,” says Mr Del Bel.
Conversely, several analysts take the view that Molson, the troubled Canadian beer group, might have been forced to hold back on its US$765m acquisition of Kaiser, Brazil's third biggest brewer, two years ago had it been structured as an income trust. Molson, which unveiled a deal last month to merge with Adolph Coors of Denver, has struggled to improve Kaiser's performance.
“Structured as an income trust, companies just don't have the leeway to waste money the way they might in other circumstances,” says Leslie Lundquist, who manages an income trust fund for Bissett Investment Management in Calgary.
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