Superior Plus – why do they look cheap?

A company that has always stuck out like a sore thumb on my stock screens has been Superior Plus (TSE: SPB). It does this by virtue of its relatively high dividend yield ($1.62/share, $13.50/share = 12%). It converted from an income trust to a corporation and did not reduce its payout rate simply because it was able to engage in some financial engineering to give it a very, very significant tax shield ($800 million in pre-tax income = approximately $200M in tax) against future income taxes.

Putting a complicated tax story into simple terms, income trusts were able to engage in transactions with loss-bearing corporations to give themselves a shield against future income taxes, something corporations were unable to do because there are extensive CRA rules that explicitly define how you can and cannot do it. Superior Plus essentially bought out Ballard Power Systems, while the previous Ballard Power Systems formed a new corporation, transferred its assets to that corporation, and life went on as normal, except that they monetized $800 million in tax losses for approximately $50 million. The Canadian government was able to close this for future income trusts in the 2010 budget.

One reason why Superior Plus is able to maintain their high dividend rate is that they can avoid paying Canadian income taxes for the foreseeable future, assuming the CRA and/or tax courts will rule that such transactions were valid (i.e. they had some form of business substance opposed for just doing a transaction for tax reasons, which there are court precedents established). So their CFO gets high grades for pulling off that transaction, assuming it works!

The company itself is diversified into four segments – energy (propane, fixed-price energy contracts), specialty chemicals and construction products dealing with insulation, walls and ceilings. The businesses weighting, by gross profit as stated in the March 2010 quarterly financials, is roughly 60/20/20. The company traditionally has been profitable, with revenues around $2.2-$2.5 billion, and income around the $70M range in the last two full fiscal years. Cash generation has been significant, with about $200M generated in the last two years, and averaging about $100M in capital expenditures. Dividend payments are about $150M/year at the existing rate.

This is the area where an investor should stop and think – if your business is sending $250M out the door, but is only generating $200M in cash, how does that get bridged? Long term debt issuance. Indeed, debt from the end of 2007 to 2009 has gone up approximately $370M to pay for this and some acquisitions. About half their total debt load is in bank loans, and half of it is in debentures. Indeed, the market doesn’t seem to mind this – their debentures are all trading close to par value. Their balance sheet otherwise is unremarkable, with equity minus goodwill/intangibles at around negative $150M.

Unless if Superior Plus is able to either generate more cash, or reduce capital expenditures, their dividends currently are unsustainable and probably need to be chopped by about 25% or so for the health of the overall company. They would be smart to think about de-leveraging a little bit – they have about $240M of debentures due in December 2012 and one would consider that the after-tax cost of capital is higher when you have such a huge tax shield to work with.

This is likely the reason why Superior Plus is trading relatively “cheaply” – investors clearly have priced in the fact that their dividend distribution rate is too high given their cash flow and capital expenditure requirements. The company otherwise appears to be in good shape, but I won’t be investing in their equity at existing prices.

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