The First Run-of-the-Mill Income Trust Shown the Door

Over the weekend, a friend of mine told me about her experience with income trusts of late. When the first blow was delivered around Halloween, she thought her portfolio, which was heavily laden with income trusts, would look like an airplane crash. But, apart from the initial blow, her broker seemed to have had erred on the side of caution. Apparently, he skipped the trusts with high- income/high-yield ratios and instead focused on the ones with sound core businesses and a portion of earnings being diverted back into the trust’s assets.

If only the same principle applied to all Canadian income trusts — and the portfolios of Canadians holding them! After the Conservatives dropped the ax about taxing income trust distributions, the industry went through the usual motions — first outrage, then denial. The next step would have an acceptance of the changed reality. In other words, not all existing income trusts would be able to survive over the four years’ time when the new rules kick in for real. And with a good reason!

Not even three months later, the first, among what is sure to be a long list of trusts, is looking for a way out. The trust’s name is True Energy, and it has decided that now’s the time “to take it all back” and become a regular company again. The only problem with “reinventions” of this kind is that you can’t create value out of mediocre, regardless of what kind of label you put on it.

For example, in 2005, True Energy’s underlying operations produced about 8,700 barrels of oil per day. That number rose by about 50% in 2006, when the trust pumped out approximately 13,000 barrels per day. So far, so good, right?

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However, since the trust diluted its unit ownership to the power of ‘n’ (meaning beyond the realm of economic viability) to finance growth, trust unitholders were left much, much worse off. To aggravate the situation further, things turned from bad to ugly as energy prices took a nosedive last year, taking with them the market price of True Energy’s units. In 2006, units of True Energy lost, on average, 64% of their market value.

Aside from the trust’s truly dismal market performance, there are even scarier things in the making. At the peak of Canada’s love affair with income trusts, investors were willing to pay $1.50 for every $1.00 of a trust’s underlying asset, be it energy reserves, real estate, what have you. This ratio is what effectively financed the mergers and acquisitions in the sector.

However, as at the end of last week, this ratio for True Energy (gosh, I just love the irony in its name!) has declined to $0.90 for every $1.00 in reserves. This means that the trust’s management had to do something. And all they could come up with was to turn True Energy back into a corporation. The only problem is that this reinvention is more likely for management’s sake than for the sake of the trust’s investors. In this case, retro-conversion will only prolong the inevitable.

What should income trust investors do? I already mentioned a nice, long talk with your broker. This time, make sure you also have your broker check out net-asset-value versus reserves ratio for you. Quality income trusts, and, yes, there are quite a few of them out there, will keep these multiples at favorable levels. You should put others out of their misery, and your portfolios will echo “True Energy, True Energy, True Energy…”

And don’t feel bad if you have to cut your losses. If nothing else positive came from the new income trust tax bill, at least it created an impossible environment for lousy trusts to survive.