Corporate Canada's new panacea

Consider what played out in Corporate Canada in a few short hours on Thursday.

7:08 a.m. EDT -- CanWest Global Communications Corp. spun the country's largest newspaper chain into a $2.2-billion income trust, a move that promises to reduce debt to manageable levels for the first time in living memory.

9:42 a.m. -- CI Fund Management Inc. kicked off a trust conversion that promises to eliminate a $170-million annual tax bill, prompting a rally in every mutual fund managers' stock.

12:03 p.m. -- The CEO mused that Transat A.T. Inc. might loop its way into a trust, and a travel stock burdened by soaring fuel costs suddenly took wing.

Believe it or not, there are more days like this coming. The market is littered with companies that can either convert, or spin out divisions, and realize the same one-day double-digit rallies and long-term premium valuations that have played out among many of the 212 trusts on the Toronto Stock Exchange.

Chris Rankin, diversified trust analyst at Canaccord Capital Inc., says: "I do think this thing gets much larger."

Morphing into a trust is the market's magic elixir -- a tonic for everything from growth stocks that ain't growing through to moribund telecom giants, scandal-plagued banks, family-owned firms with succession issues and cash-strapped governments.

Once likened to a corporate lobotomy because they were seen as shackling the CEO's ability to wheel and deal, trusts now enjoy the blessing of executives across the country, along with broad acceptance among institutional investors and boards.

CI chief executive officer Bill Holland spent months wrestling with conversion, and emerged at the end of the process to say: "As a CEO, the question isn't why are we becoming an income trust, it's why not?"

Carving a sleepy sardine canning plant out of the George Weston empire created a Maritime growth story at Connors Bros. Income Fund. The hottest deal makers in Montreal work at Yellow Pages Income Fund, formerly a BCE backwater. The envy of Bay Street are the founders of GMP Capital Corp., the first brokerage house to morph into a trust, as the employees' million-dollar paycheques are only exceeded by their multimillion-dollar personal holdings.

"In Canada, we've got businesses in every industry that have matured to the point where a trust fits their profile, and represents a far more efficient capital structure," said Jeff Singer, a Stikeman Elliott lawyer focused on the sector. "CEOs would be remiss if they don't consider trust conversion with their boards."

So how do you spot the next conversion candidate? It's actually easy. First, look for companies paying tax and churning out a reasonable amount of cash. Anything over $50-million of all-important EBITDA -- that's earnings before interest, taxes, depreciation and amortization -- is enough to start a conversation with the lawyers and bankers.

Mr. Singer says: "Conversion is not as complicated as people think, and the transaction costs aren't material to most companies,"

The ideal candidate is an unloved, publicly traded company, fetching less than 18 times its earnings. At a price-to-earnings ratio above this level, trust valuations don't offer much of a premium to those of common stock. So there's no juice to be squeezed out of converting.

For example, TSX Group Inc. would make a fabulous trust, but since it already changes hands at a lofty 23 times forecast earnings, there's no pop from conversion. On the other hand, companies such as GMP Capital and Penn West Petroleum had P/E multiples in the low teens, and rallied 30 per cent plus on the prospect of becoming trusts.

How wonky does Corporate Canada look when you start slapping trust valuations on companies that convert, or those with subsidiaries that were previously taken for granted? The sun can go down on a company changing hands at six times EBITDA, and rise on a trust that commands 11 times EBITDA.

Look at Cinram International Inc. The DVD maker traded at $19 in March when analysts noticed that hard-charging hedge funds had bought in and were pushing for conversion. The stock is now at $28, with the board reviewing the prospect, and expected to hit $35 if Cinram makes the leap.

Or consider ACE Aviation Holdings Inc., which has given birth to a hugely successful trust in Aeroplan Income Fund. Two more chunks of Air Canada are likely to be spun out, regional airline Jazz and the company's aircraft maintenance unit. On its own, Jazz will be worth an estimated $700-million. Analysts project an $800-million trust is coming when the servicing division makes its debut. That means the two trusts, still embedded in the company, are expected to eventually garner a larger market capitalization than the parent airline.

Want to get truly outrageous? Telus Corp. is a $45 stock now. CIBC World Markets analyst Dvai Ghose pegs the value of Western Canada's dominant telecom play at $60 in the unlikely event that it converts.

Cannacord's Mr. Rankin says that, while the banks themselves can't become trusts, there's nothing to stop Canadian Imperial Bank of Commerce, or any other of the big banks, from spinning out one of its divisions.

Before we get too giddy, let's look at what trust conversion is not.

First off, slapping the words "income fund" behind the corporate moniker is not a cure-all. The trust structure sees a company hand most of the cash it generates over to investors, usually without paying corporate tax. That can't turn around a cyclical downturn -- SFK Pulp Fund is suffering with the rest of the newsprint industry. And, it certainly doesn't put an end to inept management and other corporate shenanigans -- witness the accounting scandal that rocked Atlas Cold Storage.

Trusts that stop handing out cash get whacked the same way common stocks get hammered when profits fall or dividends dry up. But for a business in good health, trusts suit the times. They impose discipline on management. And they feed cash to investors at a time when low interest rates mean traditional sources of income, such as bonds, offer thin gruel.

"Consider this trend from the point of view of a retail investor who had to live through the nightmare of the tech bear market," says Stephen Pincus, a Goodmans lawyer doing the CI and GMP deals. "You've now got a security designed to provide income that also offers potential upside from capital gains, without the gambling that comes with common stock that can only give you capital gains."

Trusts are also not government-friendly. With 23 firms on the road to conversion this year -- from truckers to DVD makers to oil well drillers -- the tax-dodging trend has Ottawa's full attention. The Finance Department launched a review Thursday of a market phenomenon with roughly $170-billion in capitalization, a total that's up tenfold in the past five years.

"Trusts have many beneficial roles for the Canadian economy and for our tax base," Mr. Pincus says. "It's appropriate for the federal government to take a look, but I hope that study ends with the conclusion that there's a net benefit from the structure."

Ottawa estimates that it already forgoes $300-million in tax revenue, with this figure poised to skyrocket if the likes of BCE and Telus start to embrace the trend.

It's remotely possible that Finance Minister Ralph Goodale will put an end to the trust party. But the more likely outcome of the process begun this week is a fine-tuning of the tax regime. Analyst Wui-Seng Kon at Wellington West Capital Markets said yesterday in a report: "We could see a compromise to narrow the tax gap. It is possible to see a small rate of tax being introduced [on trusts]while corporate taxes are reduced and/or the dividend tax credit is increased."

If trusts have a bright future, the current record of three conversions in a single morning is a standard that's likely to fall.