Friday, November 7, 2008

potato wedges - income trust yields & valuations

After enjoying and featuring "..Kraft Dinner.." by the colourful blogger, Potato, over at Blessed By The Potato, we thought we'd sign him to a temporary guest column series contract with the moneygardener for an undisclosed sum... This post series promises to be unlike any other consumer reporting/ offbeat commentary you've ever read. John Stossel eat your heart out.... This series will be a change of pace, and we're calling it potato wedges. Enjoy...

potato wedges
Income Trust Yields & Valuations

The market has been a little insane lately. The market can stay irrational longer than you can stay solvent, as the saying goes, and one is often instructed not to catch a falling knife. Nonetheless, I couldn't help but plow the money I got from Q9 being taken over right back into the market, specifically into some high-quality income trusts that I think are just ridiculously under-valued at the moment. Quarterly results have just been released, and while I recognize that they are lagging reports (for the period ended Sept 30, though the markets and economy didn't really go totally batshit loco until October), they seem to underline just how non-catastrophic some sectors are.

Yellow Pages income fund (YLO.UN) had very strong results: they are well on track to keep up the modest ~4% revenue growth needed to maintain their distributions after a conversion to a corporate structure. They had impressive improvements in their margin, so net income was up even more, 19%, helped also by the growth of their online business. If a temporary bump in the road comes along, the distribution is less than 80% of their cashflow, so there is a safety factor there. I know that the coming recession hasn't really hit them yet, but at the same time, keeping up your ad in the Yellow Pages is pretty much necessity for any small business. Advertising spending may get chopped next year, but the part of it that goes to YLO will surely be the last to go. MG likes and owns them as well, and just had a post on averaging down. Right now YLO is down so much it's yielding about 15%.

H&R Reit (HR.UN) is a real estate investment trust that has commercial real estate (office space, industrial buildings, and retail space) that it leases out. It has a preference for long-term leases with large, stable companies. To go with that, it has long-term fixed mortgages, so the credit crunch shouldn't really affect them much. Nonetheless, it's down to below the value of the real estate it owns (though the balance sheet values of real estate holdings must be discounted in this market) and is also yielding about 15%. They haven't released their quarterly results yet, but I would be incredibly surprised if it was anything other than "steady as she goes". Their payout is a little higher at 90%, but they don't need to build up the tax cushion other trusts do (REITs are, AFAIK, immune to Harper's tax).

Why did I bold the 15% yields? It's because they are, to my senses, screaming for attention. The gains for the market as a whole will likely average about 10% per year over the next decade or two, a prediction by John Bogle that Canadian Capitalist recently commented on. I personally expect equity nominal returns to be somewhere in that range as well, possibly a little lower on a 20-year timeframe (unless inflation is high). So when these stable companies are offering a 5% premium to that (or put another way, a third higher), which can be continued (hopefully) indefinitely, and moreover, predictably -- the payout comes every month, despite what the market may do (and that ~10% prediction is going to feature lots of ups and downs along the way) -- I sit up and take notice. To top it off, once Yellow Pages converts, that regular, lucrative distribution will become a dividend, which will have the added benefit of being favourably taxed.

I think these trust valuations have gotten so low, and the yields so high, that it just can't be ignored any more. There could be more bad news ahead. Given the trends, there probably will be. But I think 10 years from now I am not going to regret buying something that's this stable and yielding 15%.

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Potato said...

I suppose in the interests of full disclosure, I should mention that I own both YLO.UN and HR.UN.

Patrick said...

Do you have an opinion on PZA.UN? It has also been flirting with a 15% yield lately.

gmst said...

I am trying to figure out how .UN work but maybe you can help me. Is the 34% tax applied pre distribution or can you shield from it in a RRSP?

Anonymous said...

Given the fact you are a dividend growth investor, investing in stocks with a low payout ratio, how did you make the transformation to invest in trusts 9 and sleep at night ) with their 80-90% payout.

MG (moneygardener) said...

Lyndon, I have no rule to invest in stocks only with low pay out ratios. I have not made a transformation at all. My portfolio consists 14% of income trusts both of which have pay out ratios less than 80% of earnings. My sleep is unaffected. I don't see these companie as trust, I see them as businesses that I want to hold for many years to come. Soon they will not be trusts anymore and will be paying tax efficient dividends.

Potato said...

GMST: Presently, trust distributions are taxed in the hands of the investor, and that in a complicated way (sometimes as normal income, sometimes as interest, sometimes as return of capital). You can shield the distributions within an RRSP.

In 2011, the trusts will have to start paying tax on the distributions. The tax will be before the distributions are made, so you won't be able to shelter that with an RRSP. Most trusts have announced an intention to convert to dividend-paying corporations rather than pay the new income trust tax. Real estate investment trusts will be allowed to continue under the current structure.

If you'd like to read more, I have a post on income trusts on my blog, at Be forewarned that that post is very political.

MG (moneygardener) said...

My only opinion on Pizza Pizza is that their Pizza tastes like cardboard. Other than that I've never looked at the trust.

Potato said...

Patrick, I hadn't looked at PZA.UN until you mentioned it.

First off, I just wanted to say that the yield is only part of the story. Also important is how sustainable it is, how sound the underlying business is, etc.

PZA.UN is yielding about 12.5% today. They get royalties from Pizza Pizza restaurant sales, but are set up so that they avoid most of the risks involved with selling pizzas (food input costs, etc). They also have next to no debt. Pizza Pizza is a franchise and a brand that I like: there's a Robert J. Sawyer book where "Food Food" is the dominant delivery restaurant in Toronto's future, and I can totally see that.

However, their payout ratio is very high, ~90%, and their growth is not on track to get them to the magic <70% number for 2011 when they have to start paying tax. So there looks to be a distribution cut in their future. I'd estimate that their sustainable distribution is probably something more like $0.82/unit, which is still a decent 11% yield at these prices.

There are trusts out there with yields that look downright crazy, but there are often real fears about distribution cuts there. IMHO, the fears around YLO verge on paranoia, so I think that the premium it offers over something like PZA is compelling. If however you think there's more risk in publishing dead tree directories than in pizza sales, then PZA may be the way to go.

Anonymous said...

Thank you for your comments, I dont mean to be inflammatory, from the LITTLE I know ( added emphasis ), one should only invest in a stock with a payout ratio of 60% or less, to give one some downside protection.Witness all these distribution cuts. I suspect your reasoning is
1. Recurrent revenues-yellow pages ads and electricity transmission, which I agree with, however I believe a corp has to retain a certain amt of earnings to fund growth.
I wonder, did you look at CML Health care-recurrent lab tests ? and Davis/Henderson-Cheque writing ?
I appreciate your input/education

Potato said...

Lyndon: good questions. I know you asked MG, but I'll jump in anyway.

The payout ratio is an important thing to look at, but it means different things to different companies. First off is the safety of the dividend or distribution: you of course want a small safety factor to smooth out the bumps in the road so that there isn't an unnecessary cut. But a cut in the distribution in and of itself isn't necessarily a terrible thing, as long as you know it's coming and can price it in. You also want to be sure that the company isn't cannibalizing itself or its future for the sake of maintaining a distribution.

You also want to be sure that the distribution is appropriate: start-ups or companies that are expanding rapidly or are taking on more debt shouldn't be paying out dividends. If a company can get more return by keeping money in the company than an investor can get outside of it, then they should hold on to the money.

But there are diminishing returns to growth for a company. At some point a business is going to reach the limits of its core competency, and it makes more sense to give cash back to investors than to reinvest it just for the sake of reinvesting it.

For many companies, your rule of thumb of retaining >40% of their earnings for growth and reinvestment is probably appropriate. But for some companies, they can spin out essentially all of their cash flow because they are at the end of their growth cycle. It's these companies that were ideally suited to becoming trusts. Yellow Pages already delivers a print directory to virtually every home and business in the country, what more is spending on growth going to do for them? Likewise, some downside protection and stability is important, but it does cost investors something. IMHO, a 10-20% cushion is probably enough for most cases across most years. Occassionally, the fecal matter hits the ceiling aerator and that's not sufficient. In those cases you're left sucking the cut, and hoping that the underlying business isn't hurt in the process.

Above, I poo-pooed Pizza Pizza Income Fund for its high payout ratio, saying that a cut in the distribution would likely come once the trust tax kicked in. So that's important to look at and consider when you're valuing this thing. But at the same time, as likely as a distribution cut will be 2 years down the road, it makes no sense for PZA to retain those earnings between now and then just for the sake of a lower payout ratio. They wouldn't do anything with the money because there is nowhere for their business to go as a royalty trust.

Anonymous said...

Thank you potatoe ( I luv that name ) for that excellent and detailed response, that helps sort things out for me. Is there a reference site to evaluate trusts ( what about the DBRS rating-S1/S2 /) etc, you mentioned a 20% cushion, sounds reasonable, however I wonder what the payout ratio will be when they convert to corps. Presumably the same logic will apply-ie end of growth cycle etc.
Secondly how do you really know a cut in distributions is coming, I am thinking of for example the Bank of America where MG like all of us was hoping/praying for this not to happen but I DID, it seems to my simple mind that one has absolutely no control of these things and the best you can do is limit your exposure to any one security.
I appreciate your input.

T. said...

no one giving any love to HR.UN? too boring for everyone?

Anonymous said...

I love HR.un, but that yield is an indicator of really bad news...this earning release coming shortly is going to be very interesting.

Potato said...

Well, H&R is down nearly 30% from when I wrote this. Their quarterly results came out last night, and there was a bit of a shock in there. There was one tenant who went bankrupt, and they took a writedown on those properties, but the big news was that they haven't secured financing for their billion dollar ongoing construction projects (the Bow in Calgary and Bell's building in Mississauga).

That wasn't so cool. Now, call me an eternal optimist, but I don't think it's quite as bad as the market seems to be making it. Yes, credit markets are tight, and it's going to be tough to get a billion dollars in financing. That's compounded by the urgency: they're going to need about 400 million in the next year, and only have about 200 million in free cash and open (short term) credit lines.

So the first thing out of analysts' mouths is "distribution cut!" And that's one possibility to fund these projects. However, it wasn't one of the possibilities raised by management in the MD&A. I think most likely they will simply borrow the money, but it will be at terms that are less favourable than they would have liked -- though probably not so unfavourable that it puts the distribution at risk.