In his new book, Thieves of Bay Street, author Bruce Livesey describes income trusts as a clear case of “the Canadian financial industry marketing Ponzi scheme-like investments.” He minces few words in describing how banks marketed the trusts to retail clients and investment advisors using a “turbo-charged hype machine.”
Perhaps it’s no wonder investment bankers are trying to resurrect income trusts, as a follow-up to the more than $2 billion in underwriting fees raked in during the trust era. So why are some advisors keen to test the waters again after being badly burned the first time around?
To be fair, the new trusts are focused on the energy sector, and energy trusts have always been in their own class—somewhat removed from the business income trusts of days past.
Business trusts offered the worst of the worst to clients in their heyday. It was not unusual to witness underwriters cramming a cyclical construction company into the high-payout trust model at the height of a boom, only to see the company collapse when it could not meet its lofty cash promises through normal times.
What’s in the market?
The latest incarnation of trusts are known as FAITs (Foreign Asset Income Trusts), and more colloquially as Cross-Border Trusts. Eagle Energy and Parallel Energy are currently the only two examples of the new format. Two others attempted to go public last year, only to meet a lack of appetite from investors.
Eagle came to market in November 2010, and we’ve received queries from advisors ever since. It has a market cap of $220 million and holds a working interest in the Salt Flat Field in south-central Texas.
Most of the banks and major brokers participated in the underwriting at $10 per unit, and the price has risen roughly 15% since then. Eagle announced a subsequent equity offering on April 30.
Parallel has taken a different course since it went public in April 2011, with a stake in the West Panhandle Field in Northern Texas. Also debuting at $10 per unit, the price sank steadily until a subsequent offering was announced in April 2012 at $7.05 per unit. The new funding was to acquire the 41% interest in its Texas property that it did not already own.
Despite the troubles with Parallel over the past year, many of the underwriting firms have picked up more dedicated coverage of the cross-border trust sector, and are looking for it to grow.
In a January 2012 research report entitled “Cross Border Trusts,” National Bank Financial stated it expects the sector will “continue to expand and become more prevalent given the growing desire for steady income stream investment opportunities.”
As independent research providers, we feel some of the interest (and thus some of the loftier target prices) is being driven by the thirst for underwriting fees.
The purported benefits of the new trusts are similar to the old, which is to aim for stable (hedged) cash flows generated from longer life, mature oil-and-gas assets. The risks are typical to the industry, notably the need to replace assets at an attractive rate in order to stave off depleting resources.
Many of the key operating metrics are similar to those of small and mid-cap exploration and production companies, such as break-even WTI prices, netbacks, price-to-NAV, and balance-sheet strength.
As long as investors stay focused on the tried and true, they should not run into any of the problems associated with some of the former trusts, such as misleading distributable cash figures. As with any high yielding names, advisors should also pay close attention to distribution sustainability, and more specifically, cash payout ratios before and after dividend reinvestment impacts.
Click below to read more about Eagle Energy.
The Eagle advantage
We will focus on Eagle since it has the more attractive name. Starting with the caveat that Eagle is a small-cap stock, the company possesses some compelling metrics relative to peers.
Eagle has a strong balance sheet with no debt and an undrawn credit facility. The company has top-quartile netbacks, but also some of the highest cash costs among peers due to its 100% exposure to oil.
Eagle’s combined cash payout ratio (planned capex plus distributions) on 2012 expected cash flows is approximately 80%to 85%, falling to roughly 55% to 60% after adjusting for the DRIP (dividend reinvestment program).
Roughly 38% of 2012 expected production is hedged at just over $90/barrel, and the distribution seems sustainable even at $70 WTI. Eagle will need to add production either organically or through acquisitions this year or next, signalling its major weakness relative to peers, which is its current inadequate reserves.
The big question in everyone’s mind is whether there could be a change in tax policy that might ruin the party for high-yielding cross-border trusts.
The trusts avoid taxation under the SIFT rules by establishing themselves as mutual-fund trusts. They must meet certain criteria, the most notable being that the assets must be located outside of Canada, and they cannot hold any non-portfolio property (as defined by the Tax Act).
In order to qualify as tax-efficient in Canada, the new trusts must not operate within Canada. The trust cannot carry on business itself, but must instead hold an investment in an operating company (a corporation or partnership) that in turn owns the producing assets.
The operating company is still subject to U.S. tax, which is kept more tax-efficient through interest and resource credit reductions to taxable income.
The assumed advantage relative to the old trust structure is the Canadian government does not have an interest in changing the current regime in order to tax the new structure because there is no corporate tax leakage, as there was with the former trusts, which held mostly Canadian assets.
This does not preclude the U.S. authorities from changing the tax treatment in the future, but such a change would require addressing a multitude of other investment structures as well.
Given the current size of the sector (just $500 million in market cap), cross-border trusts will likely fly under the radar for some time. The sector would need to become significantly larger in order to draw the attention of the IRS.
Eagle and Parallel offer good cash-on-cash payouts of 9.1% and 12.5%, but there is significant choice for yield in the energy sector in Canada.
Many former energy trusts have kept their income-oriented structure, with S&P/TSX60 names like Crescent Point and ARC Resources yielding 6.6% and 6.2%, respectively.
Enerplus is another high-yielding S&P/TSX60 energy name, but we have had a SELL recommendation on the company for some time, and we were definitely not fans of its offering in mid-February at $23.45 per share. Enerplus currently yields 11.7%, putting it squarely in between Eagle and Parallel when it comes to measuring payout.
It is still early days for cross-border trusts, but that doesn’t mean advisors can’t learn from the past. While Eagle seems to have good potential, Parallel has only delivered disappointment.
Recalling the early former trusts, the best returns came first when the highest-quality assets and businesses were made available to investors. From there, the underwriters became greedy and hyperbole masked the weakening fundamentals.
That said, advisors will need to keep an eye on the price that cross-border trusts pay for assets and qualifying acquisitions moving forward.
On the plus side, U.S. assets are currently priced better than similar Canadian assets, but that will probably change with greater competition for available resources as more investment is placed in the sector.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada.