I recently did some research into Canadian royalty trusts regarding the sustainability of their high yields after Jan.1, 2011 (when they are scheduled to be taxed like corporations). After I handed in my report, one of the sources called in. But since the reporthad already been submitted (with a firm deadline), his comments couldnt be included. So instead Ill pass them on in this post.
The source was Sam La Bell, vice president at Toronto-based Veritas Investment Research Corp. which is Canadas largest independent investment research firm. The boutique has nearly as many sells as buys on its coverage list, as I recall. There are some good forensic accountants on staff and they really dig deep into company statements and operations to come up with unbiased and insightful perspectives. Veritas covers over a dozen royalty trusts.
Most of them sport high yields. Will they crumble when the trusts start paying about 30% more in taxes under the new tax regime?
Mr. La Bell said nearly all the royalty trusts had accumulated large enough tax pools to avoid taxation for another 2 to 3 years. He also believed the trusts would convert to corporations before Jan. 1, 2011 because doing the conversion afterward would have adverse tax consequences for trust investors.
Longer term, he is concerned about the trusts ability to switch to new business models. Their previous strategy was to buy mature properties from producers at high prices and score profits off their tax advantage. By issuing new units to investors, they were able to keep replenishing their depleting portfolios.
Now that they will be losing their tax advantage, they cant follow this business model. They will have to find modelsbased on generating growth, yet theyll face more of a challengeacquiring reserves and developing holes without the tax advantage. The junior oil-and-gas firms should be better at acheiving growth –especially since they dont have legacy assets like the trusts do.
In fact, once the tax pools wind down, La Bell wouldnt be surprised if yields begin to drop. Cash flow will have to be diverted away from payouts to generating growth. Capital expenditures will be a significant claim too.
He doesnt see too many of the royalty trusts being taken over for their reserves. First, there is the question of valuations. Second, they dont have focused asset plays. In other words, their holdings are spread around and not concentrated in any of the more desirable drilling areas.
The only buy on Veritas list of royalty trusts is Baytex Energy Trust.