The possibility that Finance Minister Ralph Goodale will take a knife to income trusts shouldn't be the only concern on the minds of investors in the sector. The number of trusts that have either suspended or cut their distributions continues to rise, and now stands at a reported 21. Last week, the Markham, Ont.-based Connors Bros. Income Fund–North America's largest branded seafood company–warned it might be the next in line.
Owning a company that stops its cash payouts can deal a crippling blow to your portfolio. Just ask owners of Clearwater Seafoods Income Fund (TSX:CLR.UN), based in Bedford, N.S. Last month, the company announced that it wouldn't pay another cent to its investors for the rest of the year. (It had distributed a total 63¢ per unit over the first nine months of 2005.) Management blamed its ailing cash position on currency fluctuations, lower scallop fishing quotas and “unexpected repair costs” to its vessels. The day after the announcement, Clearwater units dropped 35% to around $3.50, not far from their current value of $3.75.
Sure, hindsight is 20/20, but Clearwater's operating business, Clearwater Seafoods LP, already seemed to show symptoms of a deteriorating cash condition. Its rolling 12-month net income as a percentage of cash distributions fell to 77% in Q2 2005, from 87% in Q1 2005. What's more, its rolling 12-month payout ratio (cash distributions paid divided by distributable cash) jumped to 118% in Q2 2005 from 105% in Q1 2005. In fact, the payout ratio for the second quarter alone was a whopping 1,490%.
Looking back, Clearwater's distribution halt seems like it was inevitable. But can we look into the future of other trusts? Are there actually symptoms of a sickly rather than healthy cash-generating business?
Well, Standard & Poor's (stabilityratings.com) and Dominion Bond Rating Service (dbrs.com) rate the cash generation stability of income trusts. Both use a scale of 1 to 7, from most to least stable. The problem is the two companies publish ratings on less than half the income trusts on the market. And trusts themselves approach the credit agencies to get a public rating, so businesses that believe they may get a poor score have an incentive not to get one.
So what do you do when you're trying to diagnose the cash-generating health of an income trust without a handy S&P or DBRS rating? Here's what the experts say.
Ronald Charbon, director of structured finance ratings at Standard & Poor's, suggests comparing distributions declared over the past 12 months with three figures over the same period: cash flow from operating activities, funds from operations and cash available for distribution. Trusts typically report distributions paid and distributable cash in their quarterly financial reports and monthly press releases on distributions. Cash flow from operating activities and funds from operations are lines on a trust's quarterly and annual cash flow statement. (If a company excludes funds from operations from its reported figures, calculate it by subtracting changes in non-cash working capital items–a figure on the cash flow statement–from cash flow from operating activities.) “If distributions paid is higher than cash flow from operating activities, funds from operations and non-cash working items,” explains Charbon, “that would definitely be a flag.” That signal, he adds, could suggest a business unable to churn out enough cash to pay its distributions. In such cases, investors should look deeper to diagnose the problem.
Barbara Komjathy, associate director of corporate ratings at Standard & Poor's, says that approach isn't appropriate for income trusts that have recently boosted distributions by a significant amount. Historical figures, she explains, will not reflect futures ones. As well, she says, “most of the time, the potential things that could go wrong are often identified in the initial prospectus, which is publicly available on SEDAR” (sedar.com). Matthew Kolodzie, a senior vice-president at DBRS, who warns that while that document can be a tough read, “there's usually 10 pages that are really good.”
Joel Sutherland, an analyst at National Bank Financial, says common sense can help spot an unstable cash distribution condition. He suggests looking at trends in a trust's sector, such as changes in the price a business charges for its product or service. As an example, he says, “if we were to see a drop in oil prices to under US$40 a barrel, that would affect the cash flow of some of the energy trusts.”
Kolodzie recommends paying attention to an income trust's debt levels. To do that, he explains, keep an eye on trends in the debt-to-capital ratio. “If you see a jump of more than 10% to 15% over a quarter or a one-year period,” Kolodzie adds, “you should find out why.” Sutherland points out that “as soon as you see debt increase to finance distributions, that's a red flag.”
Of course, looking for symptoms of a trust with an unhealthy cash-generating business alone won't let you avoid all trusts that will suspend or cuts distributions. Still, if you do your homework, you might be able to avoid that seasick feeling Clearwater unitholders know all too well.