Markets indeed move quicker than most anticipate, and I can say the same for the common shares of Davis + Henderson (TSX: DH) as I have unloaded them today for a mild profit. Readers may recall my entry into the former income trust units, and partial sale in October of last year.

I have no concerns with the underlying business – although I have concerns with the speed of their acquisitions – it assumes that management can execute on proper integration. The balance sheet of DH is less than stellar, with about negative $224 million in tangible equity, but their debt levels (about $200 million in low cost debt) is manageable in relation to their cash flows (due for about $100 million after CapEx in the 2010 year). They will be giving off about $100 million in distributions to income trust holders in 2010, however. In 2011 the situation will change somewhat as they reduce distributions by 35% and will also incur an income tax (which will cut their cash flows by about 27-28%).

Most people will look at the headline yield number (roughly 5.8%), but the company should be evaluated on cash flow generation rather than the dividends they give out. On a free cash flow basis, they should be generating about $75 million after the trust conversion or about $1.39/share. Given their share price, this works out to a P/E of roughly 15, or a 6.7% combined yield. It is a healthy valuation considering the various businesses they are involved with.

The capital will likely be better invested in other options throughout the year but presently the pickings are slim on the Canadian side. I suspect 2011 will involve a lot of waiting.

It wouldn’t surprise me to see DH go up to $23/share if they show they have executed well on their acquisitions, but I’m happy to get out now – my initial valuations were also somewhat fuzzy since I don’t have a full comprehension of their industry. Most of the gains from the price they traded at after they did their corporate conversion plan have been realized with the existing stock price. No point in getting greedy right now.

I am now slowly unwinding my trade in Davis + Henderson Income Fund (TSX: DHF.UN). If the units go higher by approximately 5%, I will be exiting the entire position compared to the partial sale of my position as of this writing.

While I do not have concerns about the stability of their distributions (especially as they will be reduced 35% or to $1.20/share after they convert to a corporation), I do have concerns about the ability of management to grow the company’s free cash flow from existing levels. They have been pursuing a strategy of growing revenues and income through acquisition, which is generally a risky method compared to growing organically. So far, it has worked for them. The question is whether it will continue to doing so – which is never a given.

This company is not unique at all in the income trust sector to being bidded up. All sorts of income-bearing securities are becoming very expensive.

Although DHF will pay 5.85% a year (at 20.50 per share) in eligible dividends in 2011 when they convert to a corporation, I do not think this cash stream is worth paying the current price for given other investment opportunities – none of which give yields.

What I find interesting is it is likely retail investors that will be focusing on the 5.85% yield instead of looking at the underlying business and asking what they are purchasing. I am not complaining – I am taking this opportunity to take some more of my portfolio off the table and holding yet even more cash for future deployment.

The net gain is approximately 25% above cost basis; not factoring in the few distributions that occurred between the purchase price and the disposition, not bad considering that the upside is more limited than the downside.

Income trusts are starting to announce conversions to corporations and the effects on their unit/share prices are quite telling. For profitable companies, they will have to announce distribution/dividend cuts to compensate for the effect of the upcoming tax on trust distributions.

Davis and Henderson is a business services company, doing about $482M in revenues for 2009. They are primarily an acquirer and consolidator of smaller companies and they have been fairly good at streamlining synergies with these acquisitions. Their balance sheet is messy (negative $235M in tangible equity, little cash and about $200M in revolving term loans as debt) but they generate hefty cash flows. They also distribute, just like most profitable trusts, the vast majority of their free cash flow. However, they pass my ‘trust test’ which is that they generate more in net income than they distribute in cash.

They announced that they will be converting to a corporation and with it their distributions will be going from $1.84/unit to $1.20/share in 2011 because of the tax impact. This is a 35% reduction in distributions and they rationalized the 64 cent cut by saying that had they been a corporation in 2009, they would have had to pay $0.60 to $0.66 in taxes. Their communications person must be a good spin doctor since they didn’t mention that the projected tax would effectively have to be paid on a larger income amount than $1.84/share – after backing out the intangible amortizations, the company generates about $2.27/unit in cash and a 28% corporate tax take is appropriate. In addition, the corporate tax rate will be dramatically decreasing in Canada in 2010, 2011 and 2012. In 2011 it will be 16.5% federal, and roughly 11% provincial, while in 2012 it will be 15% federal and roughly 10% provincial in the major jurisdictions (BC, Alberta, Ontario).

The point is that the distribution cut is going to be more than covered by the company’s cash flows, and they can use the surplus to pay down debt and reduce leverage on their balance sheet.

I know how a lot of retail investors think, and whenever they see a dividend cut, they will panic and sell. So that, they did:

Trading instinct is a difficult thing to describe, but since I’ve been stalking Davis and Henderson for quite some time now, I knew this would be a good time to pounce. When examining their release and annual report, I estimated investors will take down the stock between 5-15% for the day, so I layered an order to buy shares continuously between 6-12% and got enough of a fill to get a 3% position in the company – I was prepared to take 6%, so this was better than nothing. The low for the day was 8.8% below the previous day’s trading price. As you can see, institutional investors and myself likely cashed in on the retail panic.

People that are not in the upper tax bracket can receive Canadian dividend income virtually tax-free. Starting in 2011, I will be getting about 7.6% “tax-free”, and this should be a sustainable yield on my investment given the financial state of the company and the relatively boring businesses they are involved in. The largest risk to this company (other than the slowdown in the business services they are involved in that will exhibit a natural decline, such as cheque-printing and processing) is rollover risk of their $200M term loans. They can equitize the debt with about 19% dilution to existing holders and the history of the company suggests that their relationship with the banks are stable and it is unlikely we will see an attack on their equity by hedge fund artists that want to bet on a recapitalization.

With Rogers Sugar being my other major equity holding, they are due to announce what they plan on doing with their corporate structure. As it is likely they will be contemplating the same thing, investors would be wise to look at trusts that are planning conversions and seeing if they can realize short term trading opportunities. I know that in 2011 the structure of my registered accounts will be looking different since I want to move dividend-bearing securities outside the RRSP because dividend income will be virtually tax-free.