BC Lower Mainland Real Estate liquidity drying up

Skimming the Greater Vancouver Real Estate, and the Fraser Valley Real Estate statistics packages, it is not surprising in the least to see volumes decline in the July month-to-month comparisons.

The reason is very simple – the introduction of the HST and the threat of higher interest rates. While HST has an impact on new homes sold, the threat of higher interest rates also pushed demand forward. Even though short term interest rates have a smaller impact on the longer-term fixed rates than most people think, it is likely that most financially unsophisticated people would think that rates (at least in the short run) are going up, so they must “lock” their purchases in today.

Usually the opposite thinking works better – the best time to buy real estate are when interest rates are high – since real estate is a credit-driven market, one would surmise that once credit becomes more expensive, real estate demand would drop and subsequently prices would have to lower in order for transactions to proceed.

If the 50% reduction in sales reported is sustained for the following year, you are bound to see price reductions as people that need liquidity in the short-term will be forced to reduce their asking prices. The people that are not urgently seeking liquidity are more likely to sit on their high asking prices and not have a transaction occur.

In terms of sheer valuation (costs vs. income potential/rent savings), Vancouver real estate is by far and away an expensive option. I’ve already explained some other intangible components to the valuation, but one major pillar of real estate has been its “safety” perception by the local populace. Once the “real estate is safe and/or never loses value” mantra disappears, you remove one of the intangible components of demand in the market.

I do not foresee a collapse in the market like we saw in certain USA markets, but a protracted period of time where the price level does not move and/or a slow downturn in prices is likely in the cards.

Rogers Sugar announces 3rd quarter results

Rogers Sugar Income Fund announced their quarterly results yesterday. The operational performance is not relevant to this post, but rather the announcement of how they will be treating their distributions after 2010 is over:

Management of Lantic and the Board of Trustees of the Fund continue to work on a plan to convert from the current income trust structure to a more conventional corporate structure. This conversion is expected to be effective as of January 1, 2011, in order to allow the current Unitholders of the Fund to maximize the benefits of the current income trust structure. The current intention is to pay quarterly dividends of approximately $0.085 per share, in order to maintain cash dividends to shareholders of the converted structure at levels that would provide an after-tax distribution equivalent to that currently enjoyed by our taxable Canadian Unitholders. The amount of dividends paid following the conversion will be at the discretion of our Board, and will be evaluated quarterly and may be revised subject to business circumstances and expected capital requirements depending on, among other things, earnings and other conditions existing from time to time.

Currently the distribution rate is $0.46/unit of interest income. At yesterday’s closing price of $4.91/unit, this translates into a 9.37% yield. A $0.085/quarter dividend translates into $0.34/year, or a 6.92% dividend rate. This is also a 26% haircut from the current payout rate. This is relatively comparable to other businesses that are publicly traded and give out dividends representing most of the free cash flow of the corporation.

The following table is a before-and-after concerning a unitholder’s after-tax distributions in British Columbia, assuming the units are held in a non-registered account, using 2010 rates (which is a critical assumption of this model, 2011 marginal rates will be slightly different due to changes in the dividend tax credit):

After-Tax Income:
Income Range Marginal Rates $0.46 $0.34
Low High Income Dividends Income Dividend Difference:
$ – $ 35,859 20.06% -12.59% $ 0.368 $0.383 (0.0151)
$ 35,859 $ 40,970 22.70% -8.79% $ 0.356 $0.370 (0.0143)
$ 40,970 $ 71,719 29.70% 1.29% $ 0.323 $0.336 (0.0122)
$ 71,719 $ 81,941 32.50% 5.32% $ 0.311 $0.322 (0.0114)
$ 81,941 $ 82,342 36.50% 11.08% $ 0.292 $0.302 (0.0102)
$ 82,342 $ 99,987 38.29% 13.66% $ 0.284 $0.294 (0.0097)
$ 99,987 $ 127,021 40.70% 17.13% $ 0.273 $0.282 (0.0090)
> $127021 43.70% 21.45% $ 0.259 $0.267 (0.0081)

As we can see, the after-tax dividend post-2011 is slightly higher than the pre-tax income distribution for all income brackets.

Also, as I have written before, anybody holding income trust units (other than REITs) in their RRSPs and TFSAs should be moving them into their non-registered accounts at the beginning of 2011.

After-Tax: After-Tax:
Income Range Marginal Rates $0.46 $0.34
Low High Income Dividends Income Dividend Difference:
$ – $ 35,859 20.06% -12.59% $ 0.368 $0.383 (0.0151)
$ 35,859 $ 40,970 22.70% -8.79% $ 0.356 $0.370 (0.0143)
$ 40,970 $ 71,719 29.70% 1.29% $ 0.323 $0.336 (0.0122)
$ 71,719 $ 81,941 32.50% 5.32% $ 0.311 $0.322 (0.0114)
$ 81,941 $ 82,342 36.50% 11.08% $ 0.292 $0.302 (0.0102)
$ 82,342 $ 99,987 38.29% 13.66% $ 0.284 $0.294 (0.0097)
$ 99,987 $ 127,021 40.70% 17.13% $ 0.273 $0.282 (0.0090)
> $127021 43.70% 21.45% $ 0.259 $0.267 (0.0081)

Dog days of Summer

August is the month that the market (including myself) takes a break.

Thus, any action you see in the marketplace should be taken with a grain of salt.

I am in the camp that the next macroeconomic foot to drop will be related to the onset of inflationary pressure, but in order to see this you need a very spontaneous change of mentality amongst market participants that cash is something to be throw into assets, as opposed to cherished because of high uncertainty in terms of US government policy. There has been a lot of money throw into the economy, but the money has not been sloshing around – it has been saved up in the balance sheets of financial corporations. When this money eventually gets released, it will be ugly.

However, the bond market, where you can lend your money to the US government at 2.91% for 10 years, seems to say otherwise.

It is very difficult to predict exactly when this phenomenon will occur, or whether I am just another kooky market analyst that has no idea what he is talking about. There is one element that I think everybody can agree with – the sheer amount of government debt will be crippling unless if there is some sort of monetary inflation, whether now or later. It is very unlikely that the government will be repaying this debt with equal-value or deflated-value (i.e. higher purchasing power) dollars.

In the meantime, I continue to wait patiently and observe where the currents are going. My current answer is that the money is swimming to income-oriented securities and since my portfolio has been loaded with these since early 2009, I will be waiting for appropriate exit opportunities. Even after all of the investment managers turn off the autopilot switch on their portfolios when they return home this September, I don’t think it will be the end of the universe for fixed-income securities. This is fortunate since some positions are at the upper range of my price bands and I don’t want to needlessly dispose them in calendar year 2010 exclusively for tax reasons. Although taxation is important, it should not dominate the decision to sell a security above fair value.

Canadian mobile service market heats up

Rogers has just fired their own broadside with the introduction of another virtual mobile service, Chatr, which feeds off of their own phone network (very similar to Fido, another Rogers-owned company).

It is very obvious with their pricing structure, and the cities that they are in that they are strictly trying to wipe out Wind Mobile and/or Mobilicity off the face of the planet. What’s hilarious is that Wind Mobile has no spectrum license in Quebec (other than the Ottawa-Gatineau area), and Rogers/Chatr’s service offerings are identical to the locations offered by Wind Mobile – Vancouver, Edmonton, Calgary, Toronto and Ottawa. On Montreal, they stated:

“We’re working out some translation issues in Montreal, but it will very soon be our sixth market,” Chatr’s senior vice-president Garrick Tiplady said in an interview.

Translation issues indeed! More like “There’s no rush since our competition isn’t there!”

You can be sure as Wind Mobile expands to other cities and/or expands their coverage in their existing cities, that Chatr will come up with “service enhancements” to incorporate those areas into their own “home network” as well.

Their pricing plan is, for the most part, identical to Wind Mobile’s structure, with the most notable exception that on Rogers/Chatr’s $35 plan, they charge 25 cents to recover your voicemail, and they charge for incoming text messages.

Since the coverage areas between Chatr and Wind is nearly identical, I have no idea who would sign up to them.

As I stated in a previous post, the new entrants to the Canadian wireless market are not going to be making any money. The only reason why Rogers is doing any of this is to bankrupt Wind Mobile and Mobilicity – Rogers/Chatr’s offering adds absolutely no value whatsoever to the Canadian mobile marketplace other than wasting consumer’s time as they have yet another offering to review.

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.