The matter of trusts
The market for new offerings of common shares may have dried up, but investors have never been hungrier for new income-trust units. Issuers love them, too: 91% of the IPOs this year on the TSX were income trusts. Are these equities that resemble bonds the way of the future, or just another investment fad?
Wayne Lilley
National Post
Tuesday, October 01, 2002
NO CONTEST: Through most of 2002, the performance of income funds has been the only bright spot in a dismal equity market. The question is: how long can it last?: North American Market Performance: Relative return: BMO Nesbit Burns Income Trust Index: +6.5%, S&P/TSX Index: -13.4%, Dow Jones: -11.9%, S&P/500: -18.1%, NASDAQ: -29.1%: (See print copy for complete chart/graph.)
David Cynamon's KIK Corp., a maker of household bleach, turned itself into an income trust and raised $260 million
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David Cynamon, CEO of KIK Corp., thought he had a pretty good turnaround story to tell when he went shopping for capital in the late 1990s. Despite sales of $US21 million when he took over in 1995, KIK, a Concord, Ont., manufacturer of private-label household bleach, had been close to bankruptcy, Cynamon says. Within three years, he'd borrowed enough to consolidate the fragmented North American bleach industry, augmented his product line with cleaning products, and added retail giants such as Wal-Mart Stores, Inc. and Loblaw Companies to his customer list. By the late 1990s, he'd boosted KIK's revenues to more than $100 million and turned a modest profit.
Even so, Cynamon recalls, it was tough to impress potential investors focussed on the triple-digit wins that technology companies were posting between 1996 and 2000. "I had to walk into meetings after they'd listened to a great software or biotech story and give them a pitch on the merits of bleach and household cleaners," he says. "It would have been easier to talk about something they didn't understand, like a microchip or a cure for cancer. But they all understood cleaning products. And they saw things like bleach as boring."
Truth be known, it still is, despite being a staple in more homes than computers are. But it's a measure of changing times that investors these days care less what KIK makes and more that it has real revenues and earnings. Last July, Cynamon had no trouble selling 49% of KIK
through an oversubscribed public offering. "At the time we did the deal I think it was the third-biggest IPO in Canada this year," says Cynamon. "With the over-allotment, it was a $260-million deal. When the tech bubble burst, anything not tech suddenly became beautiful. I had one investment banker tell me that he wouldn't invest in a company unless he could take its product home and have his wife understand it."
Another big reason for KIK's IPO success was its structure: it was done as an income trust, a concept that distributes most of the cash generated from operations to shareholders. While weak stock markets and economic uncertainty have dampened the reception for new issues of common shares, there is suddenly an almost endless parade of income-trust IPOs. Trusts accounted for 62% of the Toronto Stock Exchange's IPOs in 2001 and 87% of those in the 12 months ended last August. As a result, the trust sector now accounts for slightly less than a third of all new equity issues (including secondary offerings), says Ken Mangret, a managing director of BMO Nesbitt Burns Inc., one of the leading underwriters of the vehicles.
Income trusts (often called income funds) have been around for years, first as real estate investment trusts (REITs) and later as royalty income funds in the energy and resource sectors. Operating companies only latched on to the concept a few years ago. But Wayne Adlam, head of trusts for CIBC World Markets, estimates the trust sector's total market capitalization at $40 billion -- about 4% of the TSX's market capitalization -- and growing. This month, Standard & Poors and the Toronto Stock Exchange will introduce new indexes devoted to REITs and energy trusts as well as one that is a composite of all trusts.
Instead of selling shares to the public -- more or less a non-starter in the current market environment -- companies like KIK sell them to an income trust that holds rights to all or most of the operating company's free cash flow. The trust, in turn, sells units to investors to whom it then distributes all or most of its monthly or quarterly cash flow on a per-unit basis. The distribution yield, which typically ranges from 8% to 12% based on the price of the unit, appeals to investors frustrated by the measly income from bonds and GICs. There's even capital gain potential should the units go up in value (see chart, p.75).
As appealing as income trusts have proved to yield mavens, they're rapidly becoming even more so to small-to-medium-sized companies like KIK. For companies that have gone about their business in virtual anonymity, building sales on fundamentals and growing profitable organically, the income-trust structure has been like discovering a closet full of party dresses. While some former private companies enduring the IPO-prospectus spotlight admit to some disclosure anxiety, the income-trust structure has given even the most prosaic of them the chance to strut their stuff on a more public stage.
Technically, Menu Foods Inc. didn't need to transform itself into an income trust. The Mississauga, Ont.-based private-label pet-food manufacturer had financed its growth from retained earnings and wasn't hard-pressed for cash. But some of its original owners, now in their 70s, requested a "liquidity event" to unlock their capital. "We looked at possibilities such as finding a financial partner, going public, dividending money out or taking on debt to satisfy them," says Menu CFO Mark Wiens.
Menu eventually reduced its options to a conventional IPO or finding a partner with fresh capital. But Wiens had reservations about both: common shares issued in an IPO wouldn't fetch as much as Menu felt it was worth inasmuch as the company's pet-food products, although growing in sales and profits, were about as exciting as, well, bleach. "And our concern with a strategic partner was that it would have its own culture and would want to change things," says Wiens.
Reorganization as an income trust, on the other hand, accomplished all of Menu's goals, Wiens says. In the transaction completed last May, it sold 50.5% of its assets to an income trust and raised $129 million, enough to execute the older shareholders' exit strategy. Existing management retained the other 49.5% of Menu, which maintained stability. In most cases, management also invested capital from the IPO back into Menu's trust units at $10 each. CEO Robert Bras, who died in September, was Menu's biggest unitholder. "He didn't know where else he could invest his money as well," says Wiens. "But basically, the people that wanted to stay in stayed in and others got cashed out."
Income trusts have considerable appeal as an alternative to debt for smaller companies. Swiss Water Decaffeinated Coffee Co. Inc., a Burnaby, B.C.-based processor of coffee beans for customers such as Loblaws, Starbucks and the Tim Hortons chain, had sales of only $21 million in 2001. But its private-equity investors, who financed the purchase of the company from Kraft Foods Canada Inc. in 2000, wanted to cash out. Even if it had been able to sell common shares through a conventional IPO, says CFO Jeff Belford, Swiss Water would be merely a small-cap player destined to be ignored by institutional investors.
Selling 100% of the company through an income trust IPO last July, however, raised $55 million. And while institutions might not be excited about the decaf coffee business, they liked Swiss Water's distribution target of $1.20 for each $10 unit. In September, funds managed by Dynamic Mutual Funds Ltd. bought 11.7% of Swiss Water's income-fund units to become its biggest single investor.
Belford admits that the income-trust structure has altered management's operating approach slightly, a view shared by executives of nearly all companies that have reorganized as income trusts. But most are also quick to note that the change adds a dollop of discipline, yet another appeal for investors weary of excesses such as management-driven acquisitions that subsequently crater into sinkholes for shareholders' money. "In the past there was no punishment for management if ideas didn't work out," Belford says. "But if management of an income trust is thinking about a $20-million acquisition, it has to generate earnings immediately to contribute to the income fund."
Trusts similarly eliminate the likelihood of Enron- and WorldCom-like accounting debacles, according to Kevin Karr, spokesman for the FP Newspapers Income Fund, whose $65.7-million IPO last May funded the purchase of the Winnipeg Free Press and Brandon Sun. "A lot of the [U.S. accounting] problems were rooted in deliberate misclassification of assets," says Karr. "But income-trust companies are forced to pay monthly in cash, so no amount of reclassification is going to provide the cash they need to make their distributions."
Income trusts also obviate the issue of management stock options. KIK's David Cynamon says they won't be missed by investors who have seen options skew management decisions toward boosting stock prices rather than earnings. He doesn't miss them as an incentive for management either, and believes that trusts are more effective since they usually offer performance incentives based on earnings in excess of those required to meet their distributions. "You don't have to worry about what the market is doing to your stock price," says Cynamon. "If you're doing well, you're going to get paid every month on your units. It's a different mindset, and I think it's a good one."
Although diminished retained earnings, a result of distributing most of the free cash to unitholders, might appear to hamper growth by acquisition, that hasn't proved the case. Wayne Adlam notes that companies with a good distribution record have had no trouble. "What tends to happen is they issue new units for cash because we can sell them so easily and they can use the cash," says Adlam. "But they can also issue units to acquired companies that then sell them into the market."
A positive, Ken Manget adds, is there isn't the same dilutive effect when additional trust units are issued as there is in the case of common shares. Trust unitholders still receive the same monthly or quarterly payout. In fact, a good acquisition, such as a new oil-producing company by an existing income trust with limited oil reserves, may even extend the timeline over which a royalty income trust will continue distributions.
Not surprisingly, the more income trusts sprout up, the more businesses follow suit. When A&W, a 585-outlet, Vancouver-based hamburger chain, raised $83 million last February through the A&W Revenue Royalties Income Fund, it opened a floodgate. The Keg restaurant chain raised more than $80 million through the Keg Restaurant Royalties Income Fund in May. Prime Restaurants, operator of a chain of multi-branded, casual-dining outlets, followed in July with the Prime Restaurants Royalty Income Fund IPO that raised $61 million.
The light also went on at Boston Pizza, a 158-outlet, Vancouver-based fast-food chain that wanted to pay out its founders without alienating franchisees. Mike Cordoba, president and COO of Boston Pizza, says the royalty income fund it created last summer worked superbly. Its IPO , which raised $77 million, promises unitholders 4% of Boston Pizza's franchise revenue. In addition to welcoming the money, mainly allocated to paying down debt as well as paying off the founders, Cordoba says Boston Pizza felt the higher profile resulting from the IPO road show boosted its brand awareness. "A lot of people in Eastern Canada had no idea we'd been in business for 40 years," says Cordoba. "We even had serious queries from a couple of attendees about the possibility of becoming Boston Pizza franchisees." A franchise, he notes, costs $1.2 million.
Naturally, investment bankers are delighted with income trusts. Hawking them has made up for -- and perhaps exceeded, though nobody keeps track -- the fees lost as a result of flagging common-equity issuance or faltering merger and acquisition deals. Even a smallish trust deal like Swiss Water Decaffeinated Coffee's generated fees of more than $3 million for its underwriting syndicate. KIK Corp.'s creation of the KCP Income Fund earned almost $13 million for its team of underwriters, led by CIBC World Markets. SFK Pulp Fund, which Abitibi Consolidated spun out into an income trust with a $415-million income-trust IPO in July, generated $23 million for its underwriting syndicate.
There's a virtuous-circle aspect to income trusts: the more that come to market, the more comfortable and receptive investors become. "They're a lot easier to sell now that we can show so many examples," acknowledges CIBC World Markets' Adlam. Furthermore, the wealth is spread around, since most trust issues are sold by syndicates involving several investment bankers. "In common share issues," says Adlam, "about 20% might go retail and the rest institutional. But about a quarter to a third of income funds are now sold to the retail market, so you have to rely more on retail forces than you do in a common share offering."
Bankers concede that income trusts have a way to go in attracting institutional money. Money managers still think first of bonds, which offer security of initial capital, when considering the yield objectives of their portfolios. Common shares are expected to produce the capital gains. But that could change as more corporate issues hit the market. As the trust sector's market cap increases, managers of billion-dollar pots of cash, who couldn't previously make a meaningful impact on their portfolios by investing in trusts, will be able to consider them, Adlam predicts. "There's more liquidity now," says Adlam. "It's an asset class now, whereas before it was more of a niche."
There's little to suggest that the growth of income trusts will cool soon, but like most investment trends, it will at some point. An economic recovery that helped share prices would entice some investors away. Similarly, interest-rate hikes would make yields from bonds and GICs more competitive with those from trusts -- with the added benefit of a guaranteed return of capital.
For now, most income trusts seem content to market themselves as sound financial managers. In addition to meeting criteria such as steady growth and earnings that investment banks like to see in a client, for instance, Menu Foods had no huge capital expense demands on the horizon. "We spent $105 million over the last five years on capital expenditure and maintenance and now expect that it will generate even better earnings," says Menu's Mark Wiens. David Cynamon adds that KIK deliberately built a cushion into its capital expenditure requirements to prevent a surprise that might disrupt distributions.
Still, unlike bond interest, trust distributions aren't guaranteed. The income of oil or gas royalty trusts, for instance, is somewhat hostage to oil and gas prices, and distributions could be cut if prices fall. But then, that volatility, with its attendant higher risk, is also why energy-trust yields tend to be higher; income-seeking investors who desire more stability from an income trust can elect to buy units of power-generation trusts whose lower yields reflect the consistency of their income from contracts with utilities.
Although the history of trusts based on operating companies is short, they're not viewed as being as volatile as energy or commodity-based trusts, nor as stable as power-generation versions. Cash flow from businesses such as restaurants, air-freight storage or seafood is far from assured. It follows that neither is the distribution to unitholders of the income trusts that own such businesses.
Most observers, though, don't see dramatic distribution swings happening. "Typically, the companies that are coming to market are dominant in businesses that are integral to the economy," says BMO Nesbitt's Ken Manget. "It's hard to imagine the market for peat moss collapsing, for example. It's a boring, staid piece of the economy that will be there well into the foreseeable future."
KIK's Cynamon also sees the income-trust structure becoming an even stronger part of KIK's future. He's planning a secondary issue of units to raise expansion capital, for instance. And he's as confident of investor support for income trusts now as he was worried about raising money by any means for a bleach company in the tech-mad 1990s. "People would lift up our bleach bottles like they were from outer space," he says. "But since the tech bubble burst, we've become glamorous."
GREAT IDEA, UNCERTAIN EXECUTION Income trusts exist to distribute cash flow from assets or businesses. All investors have to do is figure out which ones will deliver the promised yield
No matter what their names, all income trusts work from a common premise: they exist to distribute cash flow -- money generated from underlying businesses or assets after operating expenses are deducted -- to their unitholders. The amount they distribute, usually expressed as a percentage of the current market price of their units, is their yield. As with a bond, the nominal yield on a trust unit goes up if the unit price goes down. Conversely, a rising unit price produces a lower yield. And as with a dividend-paying stock, the value of a trust unit is often driven by market supply and demand on the Toronto Stock Exchange.
The biggest factor affecting an income trust's unit price is the actual amount of cash flow it has available for distribution. Income trusts will state "target" distribution levels, but there's no guarantee they'll be able to meet them. Cash royalties from an oil production company owned by an energy trust, for instance, depend to a great extent on the fluctuating price of oil and on the size of the company's depleting reserves. An oil royalty trust with 10 years of reserves has to offer unitholders a higher yield than a trust with reserves estimated at 25 to 30 years. Power-generation trusts, on the other hand, can offer lower yields because their distribution is more stable; they own electricity-producing facilities that sell power to utilities through long-term supply contracts that generate relatively consistent cash flow. Similarly, real estate income trusts (REITs) pass on to unitholders the free cash flow from professionally managed portfolios of industrial, commercial or residential real estate.
With the explosion of income-trust IPOs in recent times, investors now have to judge the cash generation possibilities of a much wider range of operating companies. The current crop of income trusts is based on everything from manufactured goods and restaurant sales to natural resources like zinc, peat moss, fish and pulpwood. Investors also have to contend with the so-called "structured trusts," financial instruments that combine complex derivative strategies to generate cash flow for distribution now along with a promise to return your capital at a fixed date in the future. The inability to make their derivative strategies work satisfactorily has already forced some of these to cut their payouts or fold earlier than their prospec-tuses predicted.
The plethora of income trusts coming onto the market gives investors a broad choice. But it also increases the potential that some will not perform as expected. The competition to sell units and raise as much as possible selling units through an IPO, for example, may also lead some income trusts to promise higher yields than is prudent, given the earnings expectations of the business the trust owns. A close inspection of the prospectus should be as fundamental for buyers of trusts as it is for any other security.
© Copyright 2002 National Post Business Magazine
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