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.

Federal Budget 2010 – brief thoughts

The budgetary cycle this year from both the federal and provincial government can best be described as “nothing changing, we are staying the course”.

The federal government, in particular, managed to crunch 424 pages of relatively little of political substance in their budget document. A lot of the documentation (as always) discusses the fiscal outlook which is interesting from a macroeconomic standpoint. In terms of government operations, the summary table, as follows, is what one really needs to look at:

Once you remove the effects of the stimulus package, spending continues to increase at a slow rate. This rate is actually a faster rate of spending when you compare it to the equivalent in the 2009 budget (the tables are different sizes in the documents so you will have to click on this image to see the numbers more clearly):

It is obvious that the non-action is highly political – if the government decided to slash and burn spending and government programs, the opposition would likely topple the government and force an election about “providing government programs to Canadians”. In a minority government, the status quo is the safest political approach, to the detriment of the rest of the country. It is only until a clear majority of the public and/or the Liberal opposition starts calling for real spending cuts (compared to the Mickey Mouse “we made tough choices” line given by the Finance Minister) will it be likely that we will see less largess in the present government.

Some commentators have noted that the government is heavily depending on revenue increases to balance the budget in 5 years (which is such a far-off time horizon that nobody will be kept accountable for this plan) – I think the revenue ramp is actually reasonable, not aggressive but not conservative either. It really depends on whether companies will start to hire people, but considering the government sees the big picture with respect to investment capital and corporate tax rates (which, federally, will be dropping from 18% to 16.5% in 2011 and 16.5% to 15% in 2012), this, combined with a reasonable stability in commodity markets, should help the country get back on track economically.

The last note is that interest rates will have a large effect on the bottom line – however, the government has assumed an accounted for a 3-month T-bill rate of 0.7% for 2010 and 2.4% in 2011, both reasonable projections.

“Wait and see” seems to be the message for this budget. It has been the least exciting budget so far in this government’s administration, but this is probably a good decision given the political constraints in the House of Commons. I am not happy with the huge expense ledger, however.

First Uranium gets whiplashed

I have written earlier about First Uranium’s woes – they had an environmental assessment permit that was critical to their business venture pulled.

Today they announced that they have it back.

This is what I was referring to the political instability risk concerning investing in companies that have major operations overseas – judging how burdensome the local government is very difficult unless if you are living there and have a “feel” for them.

First Uranium equity today jumped by 39% and closed the day at $1.81/share. This gives them a market capitalization of $300 million. Before this fiasco began, their equity was valued at about $2.50/share. I suspect their equity is under-valued, but I am not interested in the equity – I am interested in the debt. The equity still has other risks (dealing with governance, management compensation, composition of the near-majority shareholder, etc.) that I am not interested in taking. In addition, there still is the operational risk of actually being able to get the gold refining project up assuming anybody wants to finance the operation. The operation will likely be financed with some combination of equity and debt. Future dilution is something equity holders will face, but this is already baked into the relatively low share price.

The debentures are trading at bid/ask 68/71. Now with their business prospects significantly enhanced (providing that they can raise $100 million of capital that would be require to get the project going), I believe there is a material chance that these debentures ($150M par value) will be paid off at par in 2.3 years to maturity. I am guessing that once the project gets established and the revenues come in as projected (which will be substantial) that sometime in 2011 or early 2012, the cost of capital for the company will be considerably lower and I will get paid off at par. At 69.5 cents, the debt has a 23% annualized combined yield-capital gain for an acceptable risk.

Physics always trumps marketing

One reason why Robert Rapier is such a powerful writer (and a wonderful one to read) is that he rarely strays into dogma and talking points (and the times he does so, he usually signals it); his articles are quite analytical and verifiable. In his latest post, he rips into Range Fuels and Cello Energy, and also states that venture capitalist Vinod Khosla had no idea what he was investing in.

In summary, I will point out that the two primary sources of cellulosic production being counted on by the EPA for 2010 were Range Fuels and Cello Energy. Both are Vinod Khosla ventures, and neither has come remotely close to delivering despite lots of funding and taxpayer assistance. I don’t think these are isolated cases. I think they are a symptom of things to come. We have gotten a lot of overpromises, because face it, that has worked to secure funding. But what this leads to are completely unrealistic expectations regarding our energy policy, and numerous bad decisions regarding where tax dollars should be spent.

Finally, I want to make one thing crystal clear. I am not criticizing failure here. That is normal and expected. Failure is a part of what it takes to learn and move forward. What I am criticizing is the nature of the failure; that it was primarily because inexperienced people were making claims they shouldn’t have made, and taxpayers are going to get stuck with the bills. Personally, I have a problem with my tax dollars being squandered away by smooth-talking salesmen.

The underlying science (mainly the first law of thermodynamics – not even process engineering is required to understand the issue) will show that it is very difficult, if not impossible, to get a net energy return on the production of alcohol-based (methanol/ethanol) fuel. Essentially, such fuels require energy inputs far greater than their desired output, so why not just use the input directly in whatever application you require the energy for?

There are some applications where energy conversion will be desirable anyway, despite a net energy loss – for example, the conversion of a diffuse source of energy (corn) into a concentrated source (ethanol), but if you are using a source of energy with even higher energy concentration and equal portability (natural gas), what is the point?

The government and a lot of people in the US Environmental Protection Agency (EPA) got sold a bill of goods, and they took the bait, hook, line and sinker.

Here in Canada, provincial governments are enacting legislation to blend in ethanol into fuels, which is a grave mistake. Also, the emphasis of hydrogen as a fuel to eventually replace gasoline is misguided; my thoughts are that hydrogen’s potential lies with energy storage rather than replacing conventional fuels.

Politicians get sold a bunch of fancy marketing and great promises in the hope that taxpayers’ dollars will get allocated toward whatever special interest of the day is being pitched at them (in this case, “less reliance on oil” is the message, although in the case of ethanol-blended gasoline “clean fuels to prevent global warming” is the message). The politicians and staff do not have the scientific capability of properly analyzing the proposals, and they get slick marketing pitches to sell them. Next thing you know, millions of dollars of taxpayers money are wasted with inefficient proposals and the end-consumer will pay for it when governments inevitably have to raise taxes to recover their losses on the project.

In the end, physics trumps marketing, but not after a lot of money is wasted once people scale up operations are realize they have no chance of delivering what they promised.

Psychology of ETF investing

Nelson writes the following:

It seems to me that the financial advisory industry as a whole spends a great deal of time creating instruments and building an investor culture that tries to act as if investing (or trading) can be simplified to a set of easy-to-follow rules and, hey, we’re professionals, so leave your money with us. I think it’s made even easier for them to convince people because the majority of people want to be convinced. They’re not that interested in thinking about how to invest their money — not really — so they do their best to wipe their hands of it, with all the consequences that entails.

This is absolutely correct. The psychology of “easy investing” has not changed since the dawn of cheap trading on the internet – the initial “brain-dead” way to invest was always going with a “trusted professional” (financial adviser, stockbroker, etc.) to make your decisions for you, since they clearly knew more than you did. Then for those that got jaded with the performance of such “trusted professionals” and eventually want to do-it-yourself, you have a whole host of products that essentially boil down to “stock pick” type newsletters (e.g. publications like the Motley Fool and TheStreet.Com, which are really fronts for subscriptions to newsletters). All of these don’t really involve any type of thinking – monkey see, monkey-do – if Cramer’s buying Amazon, might as well buy Amazon, eh?

Big banks, especially in Canada, will have you sit down in a branch with a “financial adviser” (who is really a salesperson for the funds the bank sells) and get you to fill in a simple questionnaire, which asks many questions to put you in one of three risk categories. If you were high risk (likely a “young” investor), you were suggested to invest 70% in equity funds, and 30% in bond funds. If you were medium risk, you are suggested to invest 40% in equity funds, 30% in “balanced” funds, and 30% in bond funds. If you are close to retirement and low risk, the suggestion will be 10% equity, 40% balanced, and 50% money-market funds. More “modern” suggested asset mixes may include 10-15% for “commodities”. Simple formulas to make investing easier.

Unfortunately, such cookie-cutter solutions will never provide superior returns. In fact, they will dramatically underperform. The reason is because of the fallacy that asset mix determines 90% of portfolio performance and neglecting to look at valuations.

Once an investor starts to realize that there is no informational benefit to newsletter-type subscriptions, or mutual funds, they will eventually shift to another form of control – exchange-traded funds, which essentially are mutual funds that are easier to buy and sell by virtue of being exchange-traded and not having to deal with an annoying bank middle-man. Once you give up and realize you can’t beat the market (the literature that suggests this starts to be compelling when you suffer losses), you will invest in the S&P 500 index fund, which apparently has slipped the actual index by 0.19% (which is actually not that bad, but slippage should be less than 5 basis points for such a large fund).

Even investing in different ETFs you have to do your homework and cannot apply a “cookie cutter” solution. There is no better example than with commodity-based ETFs.

Commodity-based ETFs that invest in underlying commodities with futures are very bad products. They experience huge trading losses when they have to rollover front-month contracts – the biggest culprit so far has been UNG, the United States Natural Gas ETF. Traders have absolutely ripped UNG’s investors to shreds, and rightfully so – investing in futures is not the same as investing in the commodity itself.

Commodity-based ETFs that invest in the underlying commodity (not futures) are legitimate long-term investment products – the best example is the Gold Trust (GLD), which invests in the physical metal. Your cost of investment is 0.4% per year instead of taking delivery of a gold bar and storing it in your own safety deposit box.

Note that I am making no opinion on the future pricing of natural gas or gold – I am just using these ETFs as an example. If I wanted to bet on a higher price of gold over the long run, I could consider the Gold Trust ETF. If I wanted to bet on a higher price of natural gas over the long run, I would not use the UNG ETF.

I have no issues with investing in ETFs – they provide much cheaper coverage than most mutual funds do, although there are some ETFs out there that are clearly geared towards traders/gamblers than actual investors. People that invest in most ETFs would likely be much better off looking at the top ten holdings and just investing proportionally in the common shares of such companies and will be able to save significant amounts of money from management expense ratios.

Just as an example, if you think energy will be a hot product in the future and choose to invest in XEG.TO (a Canadian energy sector fund), we see the following as the top 10 holdings:

17.74% SUNCOR ENERGY INC
14.02% CANADIAN NATURAL RESOURCES
9.31% ENCANA CORP
7.36% CENOVUS ENERGY INC
6.72% TALISMAN ENERGY INC
5.09% CANADIAN OIL SANDS TRUST
4.45% NEXEN INC
3.63% IMPERIAL OIL LTD
3.05% PENN WEST ENERGY TRUST
2.82% CRESCENT POINT ENERGY CORP

The MER of the fund is 0.55%, so if you invested $10,000 in XEG, you are paying roughly $55/year for management of the fund. This $55 is reduced from the dividend payments you would otherwise receive had you been invested in the common shares (which is a tax-inefficient way of paying for management expenses since such dividends are tax-preferred eligible dividends – a better way would be to bill ETF holders directly and they can take a full deduction for this expense from income). If you can scale into the 10 positions for less than $55 (which is easily done at a properly selected brokerage firm) then with a little mouse-clicking, you can save money on your long-term investments. Since 74% of the fund is invested in its top 10 holdings, the tracking error is trivial since the top 10 securities (74% of investments) are likely to be highly correlated investments to the other 26% in a sector fund.

The conclusions are fairly clear – for most passive index funds out there, it is better to just invest in individual components unless if you are dealing with small amounts of money, or small amounts of time.

True out-performance is difficult to achieve – it requires research, work, and sharp decision-making. It is very unlikely that Joe Investor out there will be able to outperform without going into microscopic details of individual securities. This requires skills such as being able to read financial statements, and knowledge of the sector. Not many people will want to do this – and thus, they will dump their RRSP money in some index fund since it is an easy decision to make and will likely underperform since others will be doing the same thing.