FSU Editorial: "Time to Buy Canadian Income Trusts Again?" by Deepcaster 11/17/2006

TIME TO BUY CANADIAN INCOME TRUST AGAIN?
Yes, Almost, Provided It Is Done Very Selectively
by Deepcaster
Deepcaster.com
November 11, 2006

Virtually every informed person in the investing world surely knows by now that Canadian Finance Minister, Jim Flaherty, made a Halloween week announcement that would severely disadvantage new conversions to Canadian Income Trusts and phase out favorable taxation on existing ones by 2011.

That very week, Deepcaster recommended to its subscribers that they sell the only Canadian Income Trust in our portfolio. This was appropriate, since the price of that Trust's shares has dropped significantly since then.

But Deepcaster believes that now is the time to begin considering buying these Trusts again, provided certain criteria are met. Indeed, Deepcaster is seriously considering recommending two of these Trusts (with yields of about 13% and 15%) to subscribers very soon.

But let us first review what specifically caused the Canadian Income Trust share prices to swoon so dramatically.

Finance Minister Flaherty's announcement was that Canada intended to eliminate tax benefits by 2011. It is generally agreed that if this decision is implemented, it would result in Canadians paying in excess of 30% in taxes and Americans likely having over 40% withheld from any payments from these Trusts.

Since the relatively high yield of these Trusts would thus suffer a 30% plus reduction for Canadian and a 40% plus reduction for Americans, the exodus from Trust shares, and resulting drop in share prices, has been stunning.

Now consider the reasons to seriously consider buying shares in selected Canadian Income Trusts again.

Consider that no Bill has yet been passed!
Moreover, Flaherty stated that existing income trusts would continue to operate under the old rules and that the plan was to not phase out their tax benefits until 2011. That means that existing Trusts would presumably be left with their tax benefits until 2011, although no Bill has yet been passed.
There has been a firestorm of criticism from Canadians and from abroad. Massive letter writing campaigns are being undertaken to turn this decision around. Thus it is reasonable to expect that even if this decision is implemented, it will be implemented in a much less draconian fashion. Should any public indication be given that a less draconian tax treatment is forthcoming, the share prices of these Trusts would most assuredly turn on a dime and head up.
We reiterate that for existing Trusts the taxation rate is not planned to change for four years even if a Bill is passed. In principle, therefore, one could have four more years of the high and tax advantaged yields remaining (all other things being equal), even if such a Bill is passed.
Those Canadian Income Trusts which not only have high yield but also represent excellent businesses are worthy of special attention now because one now has an opportunity to acquire shares in an excellent business with a strong and sustainable cash flow at a much reduced share price.

Key Criteria for Choosing Canadian Income Trusts

First, one should look with disfavor at the small oil and gas producer trusts which investors bought mainly for income and which have depleting assets to support their distributions and yield. These are subject to the vagaries of oil and gas prices but and thus are not well positioned to offer a reliable cash flow. Moreover, crude oil prices are still in a downtrend, as Deepcaster has forecast, and will likely remain in one until crude is well under $50 per barrel. Oil and gas producers Trust shares should suffer a "sympathetic" fall with crude prices.
As well, one should avoid Trusts which have a significant chance of a dividend cut, for whatever reason. There are two reasons for this: one does not like one's dividends (and thus yield) to get cut and, equally important, a dividend cut usually means that the share price takes another hit.
Thus one should try to identify Trusts which have been: a) reliably increasing dividends and b) one whose cash flows and dividend levels are sustainable over time, and not necessarily those that have a high current yield, though some may have all the aforementioned characteristics.
Finally, the "sound business criterion" is the most important. A Trust which is merely a repository for oil and gas production, has a depleting asset and thus should not get a close look at this time (and until crude is closer to having bottomed). But, for example, a Trust such as a Power Trust that has a stable cash flow almost regardless of the economic environment is one to be very seriously considered.
As well, it is important also to evaluate strength of cash flow. For this evaluation, we need to look at two factors: a) First, adequate and sustainable recurring operating cash flow (also known as Distributable Cash Flow - - "DCF") which is the cash flow less what is needed for maintenance of the entity (and which does not include any one-time benefits or charges). Second, one needs to look at the payout ratio. One wants Trusts which have a payout ratio significantly less than 100%. This is a no-brainer because a company that pays out more than it takes in is not going to be in business for very long or (alternatively) its share price will take a substantial hit.
Finally, one should take a look at debt to cash flow to determine how leveraged the company is. Do not purchase shares in overleveraged Trusts.

Conclusion:

Thus, if a Canadian Income Trust meets all the aforementioned criteria and has bottomed out technically and, if the prospects for the industry which is its focus, are good, then it could be a buy. That is, it would be a buy and hold for up to four years, if the proposed legislation passes.

Thus Deepcaster is evaluating several Trusts including two which have yields of 13% and 15% plus, respectively. These now appear to be making a nice bottom after the initial shock of the Flaherty Halloween announcement. Indeed, when it appears that either of these "juicy yield Trusts" is bottoming, we expect to issue a buy. We expect that Deepcaster readers will not mind buying these payouts at a really cheap price. We expect to make such a recommendation in the next very few weeks.

Deepcaster

CONTACT INFORMATION
DeepCaster LLC
www.deepcaster.com
USA
Email | Website

DEEPCASTER FORTRESS ASSETS LETTER
Wealth Preservation, Wealth Enhancement, & Financial and Geopolitical Intelligence
Gravitas, Pietas, Virtus

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.