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Business trusts no laughing matter

Money managers who ridiculed mattress makers and sardine canners back in the late nineties are now rushing to buy in


Hardened money managers hooted with laughter back in 1997 when mattress maker Simmons Canada Inc. was flipped into an income trust.

The same crowd giggled when the grocers at George Weston Holdings Ltd. lined the shelves with a trust based on sardine canner Connors Bros. Ltd. But the professional investors had grown deadly serious by last year when a wet pet-food supplier, ice maker, cheque printer and no-name bleach plant all hit the trust market.

Business trusts have come from nowhere in the past six years to become major players in the Canadian market. The eclectic group has followed a trail blazed by real estate and energy companies, which popularized trusts in the late 1990s.

While some business trusts have hit the rocks, investors who stifled their giggles and bought into the sector's potential were rewarded by their faith. Scotia Capital's trust index, which ropes in 111 of these creatures, is up 23.9 per cent in the past three years, against a Toronto Stock Exchange benchmark that's down 11.1 per cent.

There are now $10-billion worth of operating companies, most in consumer products and industrial sectors, trading as trusts on the TSX. Behind this crowd is a long line of businesses -- phone directories, an egg producer -- all prepping and preening, ready to go public. There's widespread expectations that the $50-billion sector will double in size in the next two years, with business trusts making up the bulk of the new companies.

For investors, all these funky new creations promise both opportunity and peril.

"This is an emerging asset class. Trusts are going to bump and grind as they grow up, like any emerging asset class. But trusts are here to stay," said Ben Cheng, who holds more than $1-billion worth of trusts at CI Mutual Funds.

The perfect business trust makes a virtue of boredom. Think of it this way: If companies were people, the best candidates for trusts would be on life support, their every vital sign a flat line -- revenue, capital spending, cash flow.

Ideal candidates for a trust don't need to make big investments in their operation -- that rules out the likes of tech or mining companies. Good trusts also enjoy a barrier to new competitors. A monopoly of sorts can be based on dominance of their sector, brand recognition, regulatory protection or long-term contracts with clients. In such a company, there's a predictable amount of cash that can be sent out each month to investors.

Flat-line cash distributions, while dull, are enough to satisfy most trust owners. What's put sizzle in the sector is some executives' ability to boost their business within the trust structure, increasing distributions and by doing so, lifting the price of units.

Our Canadian idol in the sector is Energy Savings Income Fund. The natural gas and electricity retailer pulled off a stunning 13 increases in distributions in just 24 months. Veteran institutional investors see freshly minted pet food maker Menu Foods Income Fund and the kings of no-name bleach at KCP Income Fund holding the same sort of growth potential.

"Some trusts are going to appreciate over time, as they build their business and provide capital gains," Mr. Cheng said. Winners may come from unlikely sectors. Mr. Cheng said they have their detractors and challenges, but "trucking firms or restaurants, while riskier trusts, might fit that bill."

Trusts have been a salvation for companies that converted to the structure and saw their market capitalization take off, as former vices such as limited growth potential or regulatory constrictions suddenly became virtues. Mattress maker SCI Income Trust was the first to pull off this transformation. It's been followed by a varied cast that includes Big Rock Brewery Income Trust and Clearwater Seafoods Income Fund.

"There's been a lot of companies that, for whatever reason, got no respect," said Ira Gluskin, founder of Gluskin Sheff & Associates Inc., which has $200-million invested in trusts. "No matter what management did, the stock traded at a discount to net asset value, or a low price to earnings ratio. These make great trusts, with regular 10-per-cent yields that pay investors to be patient."

Larger corporations such as BCE Inc. and Abitibi-Consolidated Inc. have been able to use trusts as a way to raise money by spinning off low-growth, cash-generating subsidiaries. Such moves created two of the largest trusts on the TSX. Abitibi put $414-million in its coffers when it turned a paper mill into SFK Pulp Fund, while BCE made $324-million by selling stakes in Northern Quebec and Ontario phone networks to Bell Nordiq Income Trust.

However, the risks in the sector are very real.

Several business trusts stumbled coming out of the gate. Investors have lost money on an overly optimistic peat moss maker, a warehouse manager that featured Air Canada as a major tenant and a Halifax dock operator that lost two of its five biggest clients.

You could call the business trusts an accidental result of the 1990s merger game. The first of these businesses were born out of failed takeovers.

It all started in 1997, when oil company Norcen Energy Resources Ltd. hired Scotia Capital Inc. to sell a small stake in Iron Ore Co. of Canada. The package included a royalty on all the raw material for steel that Iron Ore Co. produced at its Quebec mines.

Iron Ore Co.'s natural buyers were a number of U.S. steel mills that already held large stakes in the Montreal-based company. But Scotia Capital's financiers felt the steel companies weren't paying the premium justified by the future stream of cash promised by Iron Ore Co.

The financial engineers came up with the concept of packaging Iron Ore Co. shares and debt into a trust, which would be sold to retail investors. Down the road, the royalty payments would be used to cover the interest payments on the debt, which took the form of notes. The result was Labrador Iron Ore Royalty, a trust that money managers such as Mr. Cheng said: "Sets the standard on how these companies should be structured."

In the wake of this successful deal, at a price superior to that which strategic buyers were willing to pay, coal companies Luscar Coal Ltd. and Manalta Coal Ltd. were sold as trusts.

Investment bank CIBC World Markets Inc. got into the game by creating SCI, and the business trust market began in earnest. Initial public offering activity slowed in 1999 and 2000, as investors devoted their attention to the tech market. But when the bubble burst and interest rates fell in 2001, the stage was set for the business trust boom.

What's the future hold for business trusts?

Well, here's the bad news. Performance isn't likely to match the 20-per-cent plus returns off the past three years. The fundamentals of the sector are geared to 5- to 10-per-cent yields, with a bit of spice added if units rise in value. And there will be blowups, as some trusts fail.

"When interest rates rise, many trusts aren't going to perform as well," Mr. Cheng said. "But you're talking about more moderate performance, rather than dismal results."

Even if performance cools off, demand for trusts can only rise, based on demographics and the maturity of many Canadian businesses.

"Look at Canada's demographic profile. In 10 years, half the population will be over 50. They need investments that can replace wages, and either create or enhance their retirement income," said Oscar Belaiche, portfolio manager at Goodman & Co. He predicts trusts, now 5 per cent of the TSX's market capitalization, could eventually become 10 to 15 per cent of the market, which translates into $300-billion worth of companies.

"Right now, there's more investor demand for trusts than there is product available. Don't worry, we're hard at work," said John Budresky, managing director of Scotia Capital.

"There's so many reliable, high-quality Canadian companies, the kind you'd never read about in the papers, that would make fabulous trusts," said Leslie Lundquist, who holds $600-million of trusts in Bissett Income Fund. She closed her fund to new investors last year, concerned she couldn't find enough quality plays, but said: "If those companies start coming to market, I'd like nothing better than to reopen my fund and start buying."
It's all business

                                    Market cap,  Revenue,

By market capitalization            $million as  $million

Headquarters  Business             of May 30,'03  2002      Yield,%

Superior Plus

Calgary       Propane distribution       1,170   $640.9      10.0%

Fording Cdn Coal

Calgary       Coal                       1,100    882.2      13.0

TimberWest Forest

Vancouver     Forestry                     880    464.0       9.4


Aylmer, Ont   Telephone, cable internet    667      N/A      10.6

Atlas Cold Storage

Toronto       Storage facilities           654    295.7       8.3

Davis + Henderson

Toronto       Cheque printing              545    232.0       9.5

Consumers Waterheater

Toronto       Waterheater rentals          459    6.6(1)      9.0

Labrador Iron Ore

Toronto       Iron ore                     456     43.8       6.5

Bell Nordiq

Montreal      Local phone network          410    303.3       7.1

Westshore Terminals

Vancouver     Coal terminal                388     44.7      14.9

North West Co.

Winnipeg      Retail                       375  750.0(2)      6.7


Montreal      Transportation               378    445.0      14.7


Toronto       Zinc smelter                 365  401.0(3)     10.2

Rogers Sugar

Vancouver     Sugar                        365   35.1(4)     11.6


Calgary       Energy services              337    118.0       8.9

SFK Pulp

Montreal      Pulp and paper               336   87.4(5)     15.0

BFI Canada

Toronto       Waste removal                331  108.5(6)      9.6


Concord, Ont  Bleach                       325   68.9(7)      8.8

Gateway Casinos

Burnaby       Casinos                      295    7.5(8)     10.8

Clearwater Seafoods

Bedford, N.S  Seafood processor            280    320.0       9.9

Note: 1. Oct. 28 to Dec. 31 '02; 2. Year ended Jan. 25, '03; 3. Year ended March 31 '03; 4. Year ended Sept. 30 '02; 5. Five months ended Dec. 31 '02; 6. April 25 to Dec. 31 '02; 7. Aug. 23 to Dec. 31 '02; 8. Nov. 28 to Dec. 31 '02

© 2007 The Globe and Mail. All rights reserved.

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