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Feasting on beer, pizza and points

The appetite for new offerings is likely to remain red hot, MICHAEL RYVAL writes

Special to The Globe and Mail

With more than 200 income trusts listed on the Toronto Stock Exchange, more than double the number three years ago, you would think that the appetite for these securities would have abated.

But the flow of new issues has continued, as businesses as diverse as CanWel Building Materials Ltd., Cargojet Holdings Ltd., Pizza Pizza Ltd., Lakeport Brewing Corp., Aeroplan and E. D. Smith & Sons Ltd. have gone to market.

To the end of May, companies raised about $7.3-billion, including initial public offerings and secondary issues. That compares to $15.1-billion for all of 2004. "It's about the same pace as last year," observes Gordon Tait, royalty and income trust analyst with BMO Nesbitt Burns Inc., in Calgary.

While Mr. Tait notes the offerings seem to be plentiful, they are also smaller. "There are a lot of deals that are under $150-million." Less common are deals such the Aeroplan Income Fund, a spinoff from ACE Aviation Holdings Inc. It raised $287.5-million, and was over-subscribed long before the IPO's closing date of today.

What drives companies to take this route? Becoming an income trust gives them cachet in a still-hot market, plus the means to grow.

"This puts you on the map," says Ajay Virmani, president of Cargojet Holdings Ltd., a Mississauga, Ont., cargo service provider that raised $59.5-million early this month. Cargojet Income Fund began trading at $10 on June 9. As of Friday, it traded at $10.52 and yielded 10.7 per cent.

"Now we have the currency to make more acquisitions, which we plan to do," adds Mr. Virmani, who helped found the company in 2001.

Tom Donaldson, president and CEO of CanWel Building Materials Ltd. expresses a similar objective. In early May, the Vancouver-based building materials distributor, with 18 centres across Canada, converted its common shares to CanWel Building Materials Income Fund and raised $125-million. Its units began trading on May 18 at $8.70. Units traded on Friday at $8.37 and yielded 11.7 per cent.

"From a capital markets perspective, we wanted to increase liquidity in our shares," Mr. Donaldson says. "But as a growth-oriented organization, we believe the conversion would facilitate our growth plans. It gives us a currency that will help achieve our strategic goals."

He notes that building products stocks trade at a price-earnings multiple of about seven times earnings, while income trusts multiples can go as high as 10 times. A higher multiple gives the firm more leverage in making acquisitions.

Last December, CanWel acquired Vancouver-based hardware and building materials distributor Sodisco-Howden Group Inc. "That's an example of our strategy," Mr. Donaldson says. "We intend to grow not just organically, but through acquisitions and focus on our customer base." With sales of $1.1-billion, CanWel is one of the largest players in an industry that is ripe for consolidation.

The income trust mechanism forces managers to be disciplined about maximizing cash flow and executing its growth strategy, Mr. Donaldson adds. "As you acquire new businesses, you have to ensure that they have a positive impact."

He deflects criticism that some companies may not be suited for the income trust structure. "What are the characteristics of a successful income trust?" he asks. "They are: strong steady cash flow; low annualized capital expenses, and being in a steady sector of the economy. CanWel passes all three tests with flying colours."

Mr. Virmani also defends his decision to go the income trust route, saying he believes Cargojet's business model is more suited for an income trust than common equity.

"We have long-term customer contracts, which means more consistency of cash flow," he says. "Our product is not a 'want' or a 'maybe.' It's a necessity. People use us when they really need us."

Cargojet contracts its overnight services to major carriers, such as UPS, DHL and Midland Courier, and international airlines, such as Cathay Pacific and Korean Airlines.

The firm earned $10-million on revenues of $106-million for the year ended March 31. It has a fleet of 11 Boeing 727s that delivers more than 226,800 kilograms of cargo each night to 13 major centres across Canada.

It also benefits from the fact that foreign-owned carriers are not allowed to fly between Canadian destinations. "Our model is very cost efficient. These customers can grow at a variable cost rather than putting out their own airplanes."

Cargojet is not in direct competition with similar domestic firms, such as Kelowna Freightcraft Ltd. who work for Purolator, Mr. Virmani says. "Our biggest competitive challenge is that we provide 98-per-cent-plus on-time performance to our customers, on a cost-efficient basis, so they can compete effectively with single customer networks such as Purolator."

Mr. Virmani, who asserts that until his firm came along few have succeeded in the overnight cargo business, expects revenues to grow at a healthy pace. "We can easily grow 25 per cent without adding a lot of cost. It will all fall to the bottom-line."

How will this wave of new income trusts fare? It's too early to say, Mr. Tait suggests.

"It takes several quarters of operations to know if the company can meet its targets," he says, adding that it takes some time to determine if they have been priced properly. "Like common equity, some do better than expected, and some do worse. It's no different in the income trust market."

He points to successful IPOs, such as Liquor Stores Income Fund, whose units have risen to $19.15 as of Friday from its IPO price of $12 last October. Armtec Infrastructure Income Fund has risen to $14.75 from $10 last August.

But some have disappointed, too. For instance, Hot House Growers Income Fund went public in December, 2003, at $10 but encountered problems and suspended distributions last fall. The B.C.-based tomato and cucumber producer's units traded on Friday at $6.63.

Indeed, mindful of some of the risks, mutual fund managers are being highly selective. "We're only investing in some," says Oscar Belaiche, vice-president at Toronto-based Goodman & Co. Investment Counsel, and manager of the $2.1-billion Dynamic Focus + Diversified Income Trust Fund.

He has bought E. D. Smith Income Fund, whose IPO raised $110-million for the Winona, Ont.-based jam and ketchup maker E. D. Smith & Sons Ltd. Its units have climbed from $10 on June 3 to $11.73 on Friday, with a yield of 8.8 per cent.

"When we do our due diligence, we look for five criteria: sustainability of income, a dominant industry player, management with a significant equity stake, an ability to reduce the payout ratio over time and a reasonable valuation," Mr. Belaiche says. "I'm not saying the other new issues are bad. But some of them are not suitable for the income trust structure."

Leslie Lundquist, manager of the $980-million Bissett Income Fund and vice-president at Calgary-based Bissett Investment Management, is equally critical.

Scanning the latest flock of IPOs, Ms. Lundquist says: "Many of them are opportunistic. They are not all businesses that have the characteristics that would make a company attractive as an income trust."

Echoing Mr. Belaiche, she adds that many new names don't have large stable operations, stable cash flows or a dominant industry position. "Some are good companies; but some are less good.

"They are using the current strength in the market to strike while the iron is hot -- get a public issue and get top dollar for their assets," she says, suggesting that lower-quality issues are being promoted by private equity groups. "Some are selling at higher prices that they may never see again."

© 2007 The Globe and Mail. All rights reserved.

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