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New model helps income trust investors minimize the risk of a distribution cut

by Wayne Cheveldayoff, 2006-09-21

For investors in business income trusts, the risk of a cut in cash distributions can be substantially reduced if one pays attention to four key financial indicators, says a recent report by Dundee Securities Corporation.

Investors have every reason to worry about distribution cuts. As the report by analyst Byron Berry explains, distribution cuts have occurred nine times in 2006 alone with a typical cut being 57 per cent and the unit price dropping 26 per cent. Four trusts have suspended distributions entirely.

The business income trust universe has expanded sharply, with over 160 business trusts now listed on the TSX. (This excludes trusts in oil and gas, pipelines, and real estate).

Many investors have been purchasing business trusts for stable cash distributions and low unit-price volatility. However, even one cut in a portfolio can have a significant impact.

Berry estimates that in a broadly diversified portfolio of 25 business trusts (averaging a 10-per-cent yield and projecting a 4-per-cent capital gain over one year), a cut by two of the trusts in that one-year period (assuming the typical cut and drop in unit price already noted) could end up reducing portfolio performance from an expected 14 per cent to 11.44 per cent – a significant cut in expected return.

Through doing a statistical analysis of the trusts, Berry found significant differences between those business trusts that cut distributions and those that did not. He developed a model to rank the trusts into three categories based on the risk of a distribution cut in the upcoming quarter.

If investors stay with only the top-ranked trusts, they “should reduce the risk of a distribution cut by about 60 per cent,” Berry maintains.

His analysis showed four key financial indicators of risk: (1) a higher cash flow margin (after subtracting capital expenditures) means a lower risk of distribution cut; (2) more physical assets mean a lower risk because they provide collateral against which the trust can borrow; (3) a higher cash yield indicates higher risk; and (4) a higher ratio of debt to EBITDA (earnings before interest, taxes, depreciation and amortization) indicates a higher risk.

One of Berry’s findings is that the payout ratio – the ratio of distributions paid to cash available for distributions – “has no relationship with the likelihood of cuts,” either in absolute form or in terms of change in payout ratio.

This is surprising because portfolio managers and other analysts have maintained that trusts with a low payout ratio are safer than those with a high payout ratio.

Berry emphasizes that the model’s distribution-cut score for each trust is not a stock-picking tool. There is a chance that the scores may be misleading, such as in the case of turnaround situations, and higher potential risk must be balanced by higher potential reward.

Connors Brothers Income Fund, for example, has a score that places it in the highest-risk category but Berry still rates the trust’s units as “Market Perform” because “fundamentally we believe the fund can continue to grow earnings without further cutting its distribution rate.”

Rating only those trusts with a year of published financials, the model identified 61 business trusts in the lowest-risk category, a group that should have less than 40 per cent the cut rate of the entire list. The average current cash yield in this group is 8.2 per cent.

Those in the moderate-risk category of income funds include Sun Gro Horticulture, Priszm Canadian, Great Lakes Carbon, Tree Island Wire, Cargojet, Brick Group, Movie Distribution, Data Group, Chemtrade Logistics, Gienow Window and Doors, Norcast and Somerset Entertainment. The average current yield in this moderate-risk group is 13.4 per cent.

Among those in the highest-risk category that hadn’t already eliminated distributions this year are KCP, Superior Plus, Osprey Media, Coast Wholesale Appliances, Custom Direct, Connors Brothers, FP Newspapers, Versacold, Terravest, Richards Packaging, Granby Industries, E.D. Smith, Art in Motion, Hardwoods Distribution, ACS Media Canada, and Canwel Building Materials. The average current yield in this group is 14.7 per cent.

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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©2006 Wayne Cheveldayoff