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Major hit for tomato income trust unitholders could be opportunity for other investors

by Wayne Cheveldayoff, 2004-09-23

When the Hot House Growers Income Fund suspended cash distributions recently because of plunging tomato prices, its unitholders took a major hit as the unit price dropped from $11.75 to $7. The situation has its lessons for income trust investors but it also could be an opportunity, albeit a risky one, for those willing to bet on a tomato-price recovery and the fundís diversified growth strategy.
The fundís suspension announcement August 30 was completely unexpected. Normally savvy analysts and fund managers were taken by surprise, especially since the fundís August 13 news release and conference call on second-quarter results had not given them any hint of what was coming.
Everyone had expected the annual $1.275 per unit in cash distributions, producing a yield of 10.8 per cent, to continue. There certainly did not appear to be any advance knowledge in the hands of public investors since the unit price continued to trend upward right up to the announcement.
In fact, one prominent fund manager earlier in the summer had made the Vancouver-based fund, which trades on the TSX under the symbol VEG.UN, one of his top picks for future growth in distributions because of the fundís current 27-acre expansion project, which will increase its greenhouse growing area to 150 acres when it is completed next April. (I had been swayed by this recommendation and had bought a small number of units for one of my childrenís portfolios.)
So, what happened? As the fundís management explains it, tomato prices took a dip in July and this was expected to be minor and short-lived, as others had been.
Instead, due to a great growing season all over North America and Mexico, along with increased production by growers to take advantage of last yearís higher prices, an excess supply of tomatoes overwhelmed the market and prices dropped sharply and for a longer period of time than expected. The fund sells most of its tomatoes through an agency and therefore experiences some delay in receiving pricing information.
Tomatoes account for 82 per cent of the fundís production, with sweet bell peppers making up the remaining 18 per cent. Of production, 29 per cent is beef-steak tomatoes, 30 per cent large tomatoes on the vine, 16 per cent campari tomatoes and 7 per cent specialty tomatoes.
For the period July 1 to August 15, average prices for campari tomatoes were down 39 per cent from the same period in 2003. The decline was even greater, at 54 per cent, for large tomatoes on the vine.
With so much of the fundís production concentrated in tomatoes, and especially those tomatoes whose prices had been pummeled, cash flow was badly hurt and management decided to suspend distributions. The fact that its arrangements with the banks require the fund to maintain a certain level of financial liquidity also played a role in managementís decision to conserve whatever cash was coming in rather than continuing to pay it out to unitholders.
Given what has happened, it is tempting to be pessimistic about the fundís prospects and cut and run, especially since the timing of the resumption of distributions is completely uncertain. History would certainly be on the side of those dumping the fundís units Ė bad news for a company or fund is usually followed by more bad news.
But leaving the fund units behind when they are trading at $7 may also be missing a decent chance to get back some or all of the losses.
The optimistic case Ė treating the fund more like a small-cap stock Ė rests on not only some potential recovery in tomato prices but also on the fundís major expansion and diversification into other crops.
The fund estimates that due ot the expansion, its tomato crop will account for a reduced 67 per cent of total production in 2005, down from 82 per cent. Sweet bell peppers will account for 19 per cent and cucumbers, a new crop, will account for 14 per cent.
The cash flow from the higher, diversified production should add to the distributable cash eventually available to unitholders, making up for some of what was lost from falling tomato prices.
If, in addition to the expansion being properly completed, tomato prices recover some ground, there could be enough cash being generated overall to resume distributions at some level and perhaps eventually again at the previous level.
One other special feature of this fund is the subordination provision for the 25 per cent of fund units owned by the original owners who retained an interest when the fund went public in December 2003 at $10 per unit.
The previous owners have not been paid any distributions yet and they now wonít be paid any until public unitholders, accounting for 75 per cent of the units, are caught up. Furthermore, this subordination provision lasts until public unitholders have received a minimum five times the initial annual distribution of $1.275 per unit.
This amounts to a strong incentive for the original owners, which include present management, to recover lost ground and make the fund a success.
But while considering the outlook, the lessons shouldnít be forgotten. One is that when a fund is so concentrated in one product, the risk to investors is substantially higher. Another is that when the cash yield is high, the risk is also usually high (although it is not always the reason since some funds carry a high yield because they are just too small for large institutional fund managers to buy into). Yet another is that good growth prospects have to be balanced with other considerations, such as whether there is a substantial cash cushion in the event business sours.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

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©2004 Wayne Cheveldayoff