OUR 29TH YEAR
David West on how economic and industry fundamentals help RONA to nail it. Page 4. David Louis on the Twixters’ return. Page 6. Malcolm Gilroy rebalances. Page 8.
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F L A S H
A D V I C E
♦ Boston Pizza Royalties Income Fund: Page 2. ♦ Cineplex Galaxy Income Trust, Bell Nordiq Income Fund, Livingston International Income Fund, Trinidad Energy Services Income Trust: Page 3. ♦ RONA Inc.: Hold/Buy, Page 4. ♦ iShares Lehman TIPS Bond Fund: Buy, Page 8.
Volume 29, Issue No. 11
June 2005/First Report ♦ Single Copy: $10.00
THE MONEYLETTER
®
STRATEGIES FOR SUCCESSFUL INVESTING
SMALL-CAP INVESTOR
None expected to be part of S&P/TSX 60 Index
SMALL-CAP
TRUSTS
David Graham
OVER THE PAST FIVE YEARS THE income trust sector has skyrocketed from less than $20 billion in market capitalization to more than $130 billion. The number of income trusts listed on the TSX has grown to 193 from about 50. What investors may not realize is
David Graham is vice president of Canadian equities at TAL Global Asset Management and manager of the Renaissance Canadian Small Cap Fund. This article is provided for informational purposes only and does not constitute investment advice. TALCom@talinv.com
that most of these income trusts would be classified as small caps. At the time of writing, only 33 income trusts have market capitalization of more than $1 billion, the TAL threshold for small cap, and only 12 more than $2 billion. Standard & Poor’s (S&P) has just released the timeline and details for how it will implement the addition of income trusts to the S&P/TSX Composite Index, the benchmark indicator of activity for Canadian equity markets. By March 2006, the TSX will rebalance the S&P/TSX Composite with income trusts at 100%
weight. This will become the new benchmark index and the one quoted in daily financial reports. Income trusts are expected to comprise between 9% and 10% of the new index. But none will be incorporated into the S&P/TSX 60, the index for the largest capitalization stocks. Of the 65 income trusts that are likely to be added to the index, six are expected to be in the S&P/TSX MidCap Index and 59 in the S&P/TSX SmallCap Index. Income trusts would in fact represent between 40% and 42% of the weight in the small-cap index. The Renaissance Canadian Small Cap Fund uses the more established BMO Nesbitt Burns Small Cap Index (NBSCI) as a benchmark. BMO plans to phase in a new index coincident with the S&P/TSX and has indicated that 109 income trusts would qualify for inclusion. These would represent a 32% weight of the 400 total names included on the NBSCI. More income trusts are eligible for inclusion in the NBSCI than the S&P/TSX index because the
Continued on Page Two
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David Graham, from Page One
NBSCI policy requires each trust to be traded on the TSX for only two months. The S&P/TSX index requirement is generally one year. For those investors following benchmarks, there could be significant implications. When the NBSCI incorporates income trusts into its index, the largest impact for the NBSCI will be on the financial services sector, which could move to 15.7% from 10.8% of the small cap index, once real estate investment trusts (REITs) are included. Utilities will increase to 4.7% from less than 1%, and energy to about 19.9% from 17%. The two largest declines will be in materials, going to 20% from 27.6%, and in information technology, dropping to 5.8% from 8.8%. It is interesting to note that the yield on the NBSCI will increase to 2.3% from 0.9% once these changes take place. What does all this mean for investors? It certainly means that any small-cap investment decision should take income trusts into consideration. Over time, income trusts might also reduce the volatility of the small-cap market compared with the largecap and make the overall smallcap category more appealing. Small-cap stocks have generally been thought of as risk-oriented investments. The companies they represent are generally the developers of new products or market niches that may or may not succeed. Small caps typically spend all of their cash flow, and more, on growth, and investors buy these stocks expecting higher returns for the risk. This was not an area investors usually looked
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to for yield. Now the S&P/TSX index will offer a selection of high-yielding small-cap income trust alternatives. Like any other small-cap companies, some income trusts will experience good and bad times as their business fundamentals fluctuate. However, those that have sound fundamentals may provide good returns to investors, with less volatility. At TAL, we have followed income trusts since the 1990s, and have held income trusts in the Canadian value mutual funds that we advise (such as the Renaissance Canadian Core Value Fund), the Renaissance Income Trust Funds and the Renaissance Canadian Small Cap Fund. While I favor income trusts that can increase the distributions per unit, the emphasis is on the sustainability of each trust’s cash flow and its payout. I prefer modest growth to taking more risk and then being disappointed. I also consider the capital spending needs of each trust, particularly in the energy sector, and look at the distribution as a percentage of the cash flow after required spending.
valuations they might have under different scenarios.
TRUSTS TO OUTPERFORM
In my view, income trust valuations have been stretched for several months as investors looked for investments that have included a yield. However, I believe income trusts should continue to outperform normal equities, particularly because it appears interest rates might flatten and perhaps even decline slightly as the economy slows. Trusts may not do well in an environment where interest rates rise dramatically and/or commodity prices fall, but neither would a number of other equities. TAL holds several small- or mid-cap income trusts in our income trust and small-cap portfolios. Here are five: ♦ BOSTON PIZZA ROYALTIES INCOME FUND (TSX: BPF.UN; recent $17). Boston Pizza restaurants typically have 5,500 square feet, with both a casual dining area and a sports bar. This income trust owns certain trademarks used by its franchisees across Canada, and has licensed the use of these trademarks in exchange for a royalty of 4% of the revenues from each restaurant. This top-line royalty structure may remove some of the volatility that might be associated with an income trust that is dependent on bottom-line earnings or cash flow. The income trust benefits not only from the same-store sales growth of its existing restaurants (6.8% in the fourth quarter of 2004, year over year) but also from new openings (25 planned for 2005) as it expands across Canada. It has grown from 135 restaurants in 2000 to about 195
ORGANIC GROWTH
A business model with solid organic growth is important. Many income trusts grow by acquisition, and then finance the acquired assets with an equity issue. Some of these income trusts are being valued as growth investments. However, investors may not always be there to buy the equity issues that fund that growth. It is therefore important to assess the underlying business models, the safety of the distribution, and the
The MoneyLetter/June 2005/First Report
today. Revenues in 2005 may, however, be dampened by the absence of NHL playoffs. The trust trades at about 13 times 2006 consensus cash-flow estimates of $1.24 per unit (after deducting capital spending needs), and yields 7.3% using the indicated $1.16 annual distribution. ♦ CINEPLEX GALAXY INCOME TRUST (TSX: CGX.UN; recent $14.66). Cineplex operates 86 theatres (64 Cineplex/22 Galaxy) with 775 screens in 6 provinces across Canada. Cineplex has about a 31% share of the movie box office revenue in Canada. The risk with box office revenue is that it is dependent on both the economy and on the appeal of new releases (first-quarter 2005 revenues were in fact down 4.5%). The recent new Star Wars release and the forthcoming Harry Potter release augur well for this income trust. Management has also been focused on increasing the concession and ancillary revenues at its theatres (now 33% of revenue/patron). The trust yields 8%, using $1.15 distribution, at about 10 times 2006 cash flow. ♦ LIVINGSTON INTERNATIONAL INCOME FUND (TSX: LIV.UN; recent $21). Livingston provides a full line of customs brokerage and trade-related services for any company shipping products across the border. Revenues can fluctuate with trade flows, but we generally see cross-border trade increasing. As customs clearance also becomes more complex, we expect an increasing need for Livingston’s expertise. Many companies are outsourcing to acquire that expertise. Livingston has 70 offices in Canada and about a 15% market share. It has a relaReproduction in whole or in part prohibited
tively high valuation (price/cash flow of just over 13 times 2006 estimates), and its yield is more modest at 6.7%. But we view it as one of the more stable income trust operations, and recent acquisitions should be accretive to future cash flow. Livingston has almost no net debt, giving its distribution a cushion if necessary. ♦ B ELL NORDIQ INCOME FUND (TSX: BNQ.UN; recent $17.28). The trust was formed in 2002 to purchase a 36% interest in each of Telebec and NorthernTel from BCE Inc. These two telephone companies operate in northern Quebec and Ontario, offering all the core telecommunication services, including local, long distance, wireless, Internet, data, and cable. In its territory, we believe Bell Nordiq has 100% of the local market, 90% of the long distance market in Quebec and 60% in Ontario, about 70% of the wireless share and 80% of cable. Although this income trust faces many of the same trends and threats the major telcos do, such as declining long-distance revenues and VoIP competition, we believe its state-of-the-art network and its smaller market will protect it from intense competition. The income trust provides steady cash flow of about $1.25 per unit, implying a 13 to 14 price/cash flow multiple. Its current distribution of $1.07 yields 6.3%, the 86% payout allows some room for distribution increases, and its $40 million cash reserve provides a distribution cushion on the downside. We expect, however, to see continued organic growth, plus the possible sale of other territories from BCE to the trust. ♦ T RINIDAD ENERGY SERVICES INCOME TRUST (TSX:
TDG.UN; recent $11.63). Trinidad was formed in 1996 and converted to an income trust in 2002. The company specializes in oil and gas drilling and well servicing, and is now Canada’s thirdlargest drilling contractor, with about 7% share. Its fleet has grown to 52 rigs at the end of 2004 from eight drill rigs in 2000, and six more rigs are currently under construction. Drilling can be a volatile business, reflecting commodity prices, but Trinidad has tried to address the risk by focusing on low-cost diversified operations, long-term contracts with customers, and a low distribution payout. It has an exchangeable share structure whereby management foregoes its share of distributions, allowing more cash flow for capital spending. Distributions of $0.64 in 2004 were only 61% of available cash flow. The trust recently increased its distribution to $0.90 to yield 7.7%. It currently trades at 10 times expected cash flow. Some of these new income trusts may disappoint as their fundamentals deteriorate, but I expect many will provide solid, sustainable distributions. The 30% to 40% weight in the small-cap indexes may reduce the volatility of these indexes relative to the TSX Composite, and create a whole new appreciation of small caps as investment choices.▼
The information contained herein is accurate at the time of publishing. Individual circumstances and current events are critical to sound planning; anyone wishing to act on this article should consult with his or her advisors. TAL Global Asset Management Inc. (TAL Global) is a subsidiary of Canadian Imperial Bank of Commerce (CIBC). The views expressed in this article are the personal views of the author and should not be taken as the views of TAL Global or CIBC. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Read the prospectus before investing. Mutual funds are not guaranteed; past performances may not be repeated.
The MoneyLetter/June 2005/First Report
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