Hold Arctic Glacier

Thursday afternoon, Canadian Edge Associate Editor David Dittman and I held a conference call with Arctic Glacier Income Fund (TSX: AG.UN, OTC: AGUNF) CEO Keith McMahon. Our conclusions from the discussion are threefold.

One, litigation risk will hang over the company until the US Dept of Justice (DOJ) investigation runs its course. Two, a great deal of litigation risk is priced into Arctic units already, and even a potential worst case doesn’t appear to be life threatening in any way.

Three, while the litigation-related drop in Arctic shares will slow its pace of acquisitions in 2008, the underlying business is extremely sound. Moreover, Mr. McMahon again affirmed the trust’s intention to remain an income trust after 2011, as well as to maintain at least the current dividend.

Let’s take these one at a time. Arctic currently faces two basic potential legal risks: the outcome of the DOJ investigation—still very much in progress—and a series of lawsuits filed by much smaller ice retailers and retail customers in the US that will likely form the basis of a class-action suit.

The most important fact about the DOJ investigation is Arctic still hasn’t been sent a “target letter.” That means it’s not yet officially a target of the DOJ’s efforts and is still basically a witness. It’s been subpoenaed by the DOJ for information and is cooperating, sending the first batches of requested data in recent days.

The effort to comply with the investigation is both time-consuming and costly. But McMahon—himself formerly Arctic’s chief financial officer—states there’s been no material impact on cash flow or liquidity from credit lines or the distribution.

There’s still the possibility the DOJ will send a target letter and Arctic will have to defend itself. If so, there still wouldn’t be an immediate financial impact, nor would any be inevitable. There would, however, almost surely be more downside in the shares.

Although Mr. Dittman does hold a juris doctor, we don’t consider ourselves qualified to forecast the outcome of the DOJ investigation. For his part, McMahon couldn’t comment on many aspects of the case, including why it began in the first place. However, there are some factors worth noting.

First, Arctic has at least one competitor in every market in which it operates. Second, its business model depends on scale and, therefore, geographic concentration but only to the extent that the company is able to control costs and enhance its service package. One way is by having multiple ice-making facilities in the same general area, which enables it to ensure supplies to customers when demand surges or if a particular factory shuts down. Scale also allows the company to control costs, a critical variable considering ice’s relatively low value per cargo weight.

McMahon admits prices have sometimes risen at companies Arctic has acquired. But he insists they’ve been related purely to service enhancements. That makes sense, considering the clients Arctic pursues, which include the likes of Albertsons and Wal-Mart. And differentiating in service quality is the only realistic way to compete for that kind of business.

Again, DOJ investigation risk is impossible to handicap at this point. But more important is how much Arctic units are already pricing in. And at less than 1.5 times book value, 1.3 times growing annual sales and a yield of well more than 12 percent, it’s obvious much already is.

Also, all five Bay Street analysts covering Arctic have set a target price well above current levels. That includes the trio who rate the units a “hold,” while the two “buy” recommendations have targets 30 percent or more above current prices.

Regarding the class-action suits, there are a number of attorneys out trolling the waters for ice retailers and consumers to join in the suit. Several firms have set up Web sites specifically for that purpose.

That’s certainly not unusual for a case of this nature. And if the DOJ does find Arctic to have some liability, the suits will almost certainly go forward as a combined class-action suit.

Significantly, however, none of Arctic’s major customers to date have seen fit to either join in or file their own suits. Rather, virtually all of the potential plaintiffs currently identified are very small entities, at least one with annual sales of less than $1,000.

One of the reasons most class-action suits are settled before trial is that losses to businesses generally involve treble damages. But again, unless and until a major customer joins in, the worst case here isn’t such a major event. Moreover, on the national level, most of the litigation in this ice industry case has been filed against Arctic’s competitors in Florida and East Texas, areas the trust doesn’t serve.

Again, we’re not comfortable handicapping the odds of a class-action suit, and any holder of Arctic should recognize the risks that do exist. But at this point, McMahon doesn’t expect either the DOJ investigation or the class-action suits to derail Arctic’s growth. And, at least at this point, that’s a positive.

The Real Question

The real question is, with these legal risks in mind, does it still make sense to hold Arctic Glacier in a portfolio? And the answer boils down to: Is this still a good business that will grow and pay us high distributions, even if the legal situation goes against it?

Happily, the two major factors that attracted us to Arctic in the first place are still very much intact. That’s the resiliency and simplicity of its business and growth model, and its built-in ability to skate through trust taxation in 2011.

Regarding the business, McMahon couldn’t comment on the specifics of first quarter 2008, for which Arctic will release earnings in mid-May. He did state categorically, however, that there would be “no surprises.” That’s a colossal plus in an environment like this one, particularly given the fact that 80 percent or so of Arctic’s business is carried on in the now dramatically slowed down US.

The first quarter is traditionally not an important one for Arctic, as demand for packaged ice runs thin in the colder months. Only 9 percent of annual revenue is earned during the three months ended March 31, and cash flow is typically negative. The same is true of fourth quarter earnings, though the trust did turn in very strong results, as noted in the March 10 flash alert.

“No surprises,” however, is a pretty good sign its packaged ice business is not noticeably slowing down for reasons to do with the US economy. That means the company is still on track for solid second and third quarters, when the hot weather comes and it earns the majority of its annual cash flow.

The drop in the US dollar over the past year had only a marginal impact on Arctic’s fourth quarter earnings. That’s partly because it hedged its US dollar cash flows and has continued to do so in 2008. More important is the fact that Arctic’s costs here are also priced in US dollars—from operating expenses to the debt used to finance its expansion here. Very little ice is exported from Canada to the US.

As a result, a falling US dollar depresses the Canadian dollar value of expenses as well as revenue, with the result that overall impact is muted. In fact, Arctic has been able to take advantage of the falling US dollar to make acquisitions more cheaply.

The upshot was last year’s strong results, even in the face of the most dramatic rise in the Canadian dollar in decades. The Canadian dollar backing off in the first quarter and roughly stabilizing bodes well for this year. And again, so does “no surprises.”

Business is already being affected by the DOJ investigation in one very tangible way. Basically, the resulting drop in the unit price in recent weeks has convinced management to avoid, for now, raising capital by issuing new units, at least until the DOJ investigation and related litigation are resolved.

That will almost certainly slow Arctic’s growth-by-acquisitions strategy, probably at least for the next quarter or two. The trust still intends to pursue a handful of “tuck in” acquisitions that it can finance with cash flow. But other than that, it will have to rely on increasing cost efficiencies at its current operations and winning new customers to boost cash flow. We’ll get an idea of how successful their efforts are when first quarter earnings are released.

As for the long term, McMahon intends to return to Arctic’s strategy of making strategic midsized acquisitions when the DOJ investigation is concluded. More important to us investors, however, is where he sees the trust beyond the investigation, and that means 2011 when trust taxation kicks in.

When Flaherty first laid his egg, Arctic was in the forefront of declaring it would suffer little, if any, impact from the new trust tax, first declared at 31.5 percent and now reduced to 28 percent. That remains McMahon’s position today.

As I’ve pointed out, Arctic’s substantial US income doesn’t fall under the trust tax. That leaves the roughly 20 percent generated in Canada, a percentage that’s likely to resume shrinking as the trust continues to expand into the US. Moreover, that 20 percent is protected by “tax allocations”—basically, return of capital accounting—that exempt the lion’s share of it from taxation.

The bottom line is a projection from McMahon that only 5 percent of the cash distribution, or 5 cents Canadian to 6 cents Canadian per unit annually, will potentially be affected by the 2011 tax. And even that will be offset by growth and the trust’s available profit cushion and liquidity.

His forecast is no impact on the current distribution. Moreover, he states, barring something better for shareholders coming down the pike, Arctic intends to remain a trust long after 2011.

Again, this is pretty much what the trust has maintained all along. But reaffirming it now is a very strong statement, given the legal challenges Arctic faces.

What to Do Now

As Canadian Edge readers know, I’m no fan of backing up the truck on any individual trust. There’s just too much temptation to get emotionally involved, which in turn makes it hard to respond to a situation changing as fast as this one is.

I moved Arctic from the Conservative Portfolio to the Aggressive Portfolio this month for tangible reasons. Mainly, no one can guarantee a positive outcome for Arctic in the DOJ case or the class-action lawsuits. The US dollar/Canadian dollar exchange rate has proven itself capable of being extremely volatile. And no company can predict every business development—positive or negative—between now and 2011.

What we can do, however, is weigh these risks versus the potential rewards and bet sensibly. And in this case, the prudent course is to continue to hold onto Arctic Glacier Income Fund.

For one thing, we’re diversified. Arctic is just one of 28 individual trusts and three closed-end mutual funds in the Canadian Edge Portfolio. And there are many holdings working very well right now. Shining particularly brightly now are the nine oil and gas producer and service trusts, which are up an average of more than 20 percent this year, not including their distributions.

I recommend diversity for a very good reason: I’m not omniscient. No one can predict every outcome. I can give you my best judgment based on what I know. But putting all your money into one trust or any other investment or sector is grandstanding and opens you up to unjustifiable risk.

That said, Arctic appears to be pricing in its reasonable legal risk. And if things shake out the way management expects, it’s going right back to its old highs—probably later this year—even as it continues paying its massive monthly distribution. Most important, its long-term fortunes as a business still look strong, and the dividend is quantifiably 2011 proof.

I’m going to keep watching Arctic’s situation closely, and management has pledged to keep me informed. But at this point, it’s staying in the Canadian Edge Aggressive Portfolio.