Morneau Sobeco Income Trust announces corporate conversion

Morneau Sobeco specializes in outsourcing HR services. They have an annualized distribution of $0.94/unit, but they recently announced a corporate conversion which will take effect in 2011:

“Today, we are announcing our plans to convert to a corporation at the end of 2010,” said Bill Morneau, Executive Chairman of the Fund. “We intend to maintain our current distribution level for 2010 and provide an effective 10.6% after-tax increase in 2011 for unitholders taxable at the highest marginal rate.”

The conversion is being undertaken in response to the legislative changes enacted by the federal government that will apply a tax at the income trust level on unitholder distributions commencing January 1, 2011. The current monthly distribution level of $0.07871 per unit (or $0.94 per unit annualized) is expected to remain unchanged for the balance of 2010. Starting in January 2011, the monthly dividend level is expected to be $0.065 per share (or $0.78 per share annualized) with a sustainable payout ratio of 65% to 80% of cash flow. This dividend policy will facilitate the repayment of debt, while providing investors with an attractive yield. Going forward, the Fund’s intention is to continue to reward its investors with dividends in line with business performance. A special meeting of unitholders will be held in the second half of 2010 to obtain unitholder approval of the conversion.

A 94 cent to 78 cent reduction in distribution is a 17% decrease in distributions, and is somewhat less than what would otherwise be expected on an after-tax basis. It is not surprising that trust units are not trading too far down – about 3% at the time of this writing.

My valuation exercise on the company indicated they are trading at their fair value range, so I have not even bothered to place any orders for the units. The units are trading at $10.19 a pop, which is a 9.22% yield on their current distribution, or 7.65% in 2011. Given the risk involved, this is appropriate.

Toyota Motors Company – Will not touch

Anybody having common shares of Toyota Motors may think they are purchasing to be a “contrarian” with all of the allegations flying around with respect to their accelerator pedal and perceived safety issues of cars. Looking at a 5-year stock chart, one might think they are catching the lows (currently $77/share)…

… but what really is the upside to an investor? I recall during the ramp-up in oil prices and the downfall of GM and Chrysler (2007-2008) that analysts were jumping all over themselves to compliment Toyota and implying the company is destined to greatness.

Auto manufacturing, at least at the low end consumer market, is a very competitive business and margins are very tight. When companies like Toyota have to end up recalling millions of vehicles because of a politically-motivated examination of perceived safety flaws of their vehicles (I am of the opinion that it is far more likely that for most part the company did not design a ‘flawed’ vehicle), it will affect their market capitalization far more than the recent 15% haircut their stock has taken. They are more likely to head down than up.

I have written this without doing a shred of financial analysis on the company – Toyota stock is being psychologically valued at this time by the marketplace, not financially.

Music to a bondholder’s ears

I own some long term debt in Sprint. Recently, the following was quoted from their CFO:

NEW YORK (AP) — Shares of Sprint Nextel Corp. rose Monday after Chief Financial Officer Bob Brust told investors the telecommunications company plans to pay down its debt and continue to strengthen its balance sheet.

“(In) the next 30 months, we have about $5.2 billion of debt coming due. Right now we plan to pay that as due, not refinance,” said Brust at the Raymond James Institutional Investors Conference, according to a transcript.

The only other better news that could come out of his mouth was that they would be raising capital through the equity markets to pay down more debt, but I will settle with this. Sprint has negative net income, but they have strong positive cash flows, and I think their debt is still (slightly) undervalued. It is my second largest portfolio component.

The only issue I have with their debt is not their ability to pay it off – it is the more macroeconomic perspective of rising interest rates and a US government that is seemingly destined to inflate its way out of its fiscal situation.

Davis and Henderson purchase – Corporate conversions from income trusts

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.