Apple to Income Trusts

By Roger S. Conrad and David Dittman

Many of you with young children or grandchildren will head out to your local orchard soon, as the leaves begin to change, for some foliage-watching, hayride-taking and apple-picking. (And yes, it’s a little soon to speak of fall rituals while still so deep in summer.)

You’re going to pick a few on the farm, pulling the nice-looking ones off the branch; some you’ll dump once you get home and have a chance to take a closer look.

An apple can’t change after the seed’s been planted. (This is where the analogy breaks down a bit.) A Macintosh can’t become a Golden Delicious; a Granny Smith can’t convert to a Pippin. But crop scientists can create hybrid apples–new types with new tastes and different uses.

You’ll choose based on your personal objectives and desires; when you get back to the house and go through your barrel, you’ll find satisfaction in many of your picks, but you’ll have to toss aside a few bad ones.

In Canadian Edge, we provide a ladder of sorts by reporting payout ratio data for each of the income trusts in our coverage universe. We also publish a Dividend Watch List on a monthly basis to give a little head’s up on those businesses that may be operating a little too close to the edge of comfort.

CE recommendations are built around sustainability, which means we look at distributions paid as a percentage of cash generated by operating activities, investment in ongoing business activity and leverage, among other items. In our monthly issues, in our correspondence with readers, in our conversations in person (with those we meet at investor conferences as well as those who drop by the office), we stress sustainability over sexy current yield numbers.

We do our best–and the record reveals that effort’s been pretty good so far–to pluck the bad apples.

It’s absolutely a good thing that the Canadian Institute of Chartered Accountants has finally issued guidelines to standardize the reporting of distributable cash. The new framework for Canada’s 70,000-plus chartered accountants is meant for “filling this gap in financial reporting that has put investors in income trusts at undue risk.”

Self-described independent investor advocate Diane Urquhart has criticized the new procedures as too little, too late to help investors who have lost billions of dollars on income trusts. But most of those lost billions can be chalked up to Minister Flaherty’s tax move, which Urquhart supported.
Kevin Hibbert, chief accountant at Standard and Poor’s Canada, told the Toronto Star that the new policy gives income trusts “much-needed direction in how to improve comparability, clarity and consistency in the reporting of distributable cash.”

Urquhart’s revisionism aside, you can’t dismiss the worst-case, worm-infested apples described here. But not all trusts were created in the back office of an investment bank on a long, crazy weekend.

Running to Stand Still

As Heather Scoffield reports in the Toronto Globe and Mail’s Report on Business, Minister Flaherty has convened a panel to discuss private equity’s impact on Canadian business. The panel will focus on questions about private equity’s impact on taxation, corporate accountability, investor choice, productivity and the Canadian national interest.

Sounds a lot like the bill of particulars levied against the income trust sector.

Private Equity Likes Theses Apples

Economist Daniel Gross has taken his act to Newsweek, in which he writes (rather wryly) this week on what makes a good private-equity target:

…a stock that has been beaten down recently, allowing the buyer to get the deal done on the cheap; an underlying business with healthy margins that generates lots of cash, which will be needed to service the debt incurred in a buyout; a valuable brand and a long operating history that serve as ballast; little or no existing debt so that the new owners can borrow heavily to pay themselves dividends or to pay down the debt raised to acquire the company. Finally, the company should be one that finds being a public company more of a liability than an asset and thus would benefit from escaping the frequently harsh glare of public ownership.

His conclusion? The Blackstone Group should take itself private.

The Roundup

Our Canadian partner MPL Communications, in the latest edition of its Money Reporter, published the following list of trusts that have disappeared through merger, acquisition or privatization since Halloween 2006. Not all of these are dogs, but on the whole, most were of low quality:

Amtelecom Income Fund
Arriscraft International Income Fund
Associated Brands Income Fund
Bell Nordiq Income Fund
Calpine Power Income Fund
Canada Cartage Diversified Income Fund
CanWest MediaWorks Income Fund
CCS Income Trust
Clean Power Income Fund
Custom Direct Income Fund
ED Smith Income Fund
Entertainment One Income Fund
Gateway Casinos Income Fund
Great Lakes Carbon Income Fund
Haltern Income Fund
High Arctic Energy Services Trust
KCP Income Fund
Lakeport Brewing Income Fund
Legacy Hotels REIT
Liquor Barn Income Fund
Movie Distribution Income Fund
Norcast Income Fund
Osprey Media Income Fund
Shiningbank Energy Income Fund
Sound Energy Trust
Specialty Foods Group Income Fund
Summit REIT
Sunrise Senior Living REIT
UE Waterheater Income Fund
Versacold Income Fund
Voxcom Income Fund

The bottom line: Trust investment capital is becoming ever-more concentrated in an increasingly higher-quality universe.

On the second quarter earnings front, one CE-covered trust, Priszm Income Fund, reported this week. The trickle will soon become a flood, and we’ll break the numbers down as they become available.

Business Trusts

Connors Bros Income Fund (CBF.UN, CBICF) expanded its recall of hot dog chili sauce made by its Castleberry Foods unit to include canned meat products on concerns they’re contaminated by a bacteria which causes botulism. The company said there were no reported illnesses linked to the products in Canada, and that the contamination was believed to be isolated to a US plant, which has been shut down.

The products affected make up about 4 percent of the company’s annual revenue, but Connors Bros hasn’t yet determined the financial impact of the recall. Castleberry operates two US Dept of Agriculture- and Food and Drug Administration-inspected food processing plants, Castleberry’s Food Co in Augusta, Ga., and Snow’s/Doxsee in Cape May, N.J., with national distribution. Connors Bros Income Fund is a hold.

Priszm Income Fund (QSR.UN, PSZMF), which runs 484 KFC, Taco Bell, Pizza Hut and Long John Silver’s outlets in seven Canadian provinces, reported a CD1.9 million loss as sales for the second quarter sagged 4.2 percent from the comparable period of 2006 to CD113.4 million. Distributable cash fell to CD5.2 million from CD10.1 million, but Priszm maintained its monthly distribution at 10.67 cents Canadian per unit for a payout ratio of 107 percent.

Priszm said performance for the quarter “was hampered by regulatory approvals on the advertising elements that resulted in a restricted message to the consumer” on its trans-fat-free initiative. Strict federal marketing rules limited how Priszm could promote its trans-fat-free products.

Same-store sales were down 5 percent from a year earlier, dragged down by a 6.2 percent decline at Ontario outlets open a year or more. Comparable-store sales in the rest of Canada were down 4.1 percent. The net loss amounted to 12 cents Canadian per unit, compared with net income of CD4.2 million, or 27 cents Canadian per unit in the year-earlier period, when sales were CD118.4 million.

The company plans to complete six or seven more multi-brand conversions, four of which will be in Quebec, by the end of 2007. Priszm will also relocate two of its restaurants and begin construction on three more this year. Priszm Income Fund is a hold.