Investors might want to keep some of their royalty trusts even though the federal government will begin taxing them like corporations on Jan. 1, 2011. Indeed, you might even consider making some new investments.
A number of analysts view many of the royalty trusts as takeover candidates. They also see a several of them converting to corporations paying high yields and generating greater rates of growth.
Potential for takeovers
Harry Levant, a seasoned income-trust analyst who offers advice at IncomeTrustResearch.com, says “one side effect of the new trust tax is to make royalty trusts buyout targets.”
“True, they face a higher tax burden but the news has been discounted,” he explains. “Meanwhile, many of them have valuable reserves that make them likely takeover candidates at current, or even higher, prices.”
“The year-end financial reports are a crossroads,” says Mr. Levant “That's when the trusts report their reserves based on year-end inventory counts. The market will then have up-to-date estimates of reserves and a better idea of the value of the trusts.”
Conversions to high-yield corporations
Paul Bloom, president of Toronto-based Bloom Investment Counsel, also thinks the uncertainty generated by the tax has resulted in trusts becoming undervalued. The veteran manager of income-trust portfolios has just launched a closed-end fund, Canadian High Income Equity Fund CIQ.UN-T , to take advantage of buying opportunities.
His fund began trading Feb. 18 under the ticker symbol CIQ.UN. A news release explains one reason for creating the fund: “Certain income trusts may outperform in the coming period … as they become takeover targets due to attractive valuations.”
Another reason: a number of trusts are expected to outperform after their conversion to corporations. Many of the conversions to date have, in fact, established dividends at levels comparable to trust distributions. As conversions multiply, Mr. Bloom believes a new market for high-income common equities will emerge in 2011 and beyond.
The Case of Crescent Point Energy
Mid-cap oil producer Crescent Point Energy Corp. CPG-T is an example of a royalty trust reborn as a high-yield corporation. When it converted in July, it was able to keep paying the same monthly distribution thanks to its low payout ratio and growth orientation. At current prices, the dividend yields about 7 per cent.
By becoming a corporation, Crescent also enjoys better growth prospects. It is no longer constrained by the government-imposed limitation on trusts' growth. As a result, it enjoys better access to capital markets.
The high-yield corporations emerging from the trust sector are of interest to Bruce Campbell, a portfolio manager at Oakville, Ont.-based Campbell & Lee Investment Management Inc. He prefers plays like Crescent because they have yields comparable to trusts yet the risk of a distribution cut is relatively small compared to existing trusts.
“It's not cheap,” admits Mr. Campbell. But he thinks Crescent deserves a premium due to its significant growth prospects: “With acquisitions and interests in the Bakken and other fields, Crescent has 8 to 10 years of drilling prospects. Management may not increase the dividend much but the share price could double in the years ahead,” he adds.
Other winners (and losers)
Not all royalty trusts will avoid significant cuts to their distributions, warns John Stephenson, a portfolio manager with First Asset Investment Management Inc. Danger signals include: high payout ratios, overleveraged balance sheets, minimal hedging programs and small tax pools. Business models are an important consideration, too.
Three trusts he believes could avoid cuts are: Canadian Oil Sands Trust COS.UN-T , which already cut its distribution and is conservatively managed; Arc Energy Trust AET.UN-T, which has a low payout ratio and is evolving into an oil play; and Vermilion Energy Trust VET.UN-T, which has a low payout ratio and about two-thirds of its operations are already taxed in other countries.
