Shelter for energy trusts

Guardian Capital's Michele Robitaille says deferrals will lessen the impact of the new tax regime in 2011.

Sonita Horvitch 28 April, 2010 | 6:00PM
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 Michele Robitaille, senior portfolio manager at Toronto-based Guardian Capital LP, says that some Canadian oil and gas royalty trusts are fully valued after their strong run-up from their March 2009 lows, so there is a need to be selective.

But she underscores that "the long-term prospects of quality energy trusts are excellent." She says they have accumulated large land positions and have the in-house technical expertise and cash flow to exploit these assets.

Robitaille adds that, in the context of the trust universe, energy trusts have a distinct advantage over other sectors in transitioning to the new tax regime that takes effect in 2011. "Many of these trusts/companies will be able to shelter tax until 2103-2014, based on current commodity prices and spending plans."

The reason, Robitaille says, is that these trusts have "some of the best tax pools in the trust universe." She expects that many oil and gas royalty trusts will be "conservative in their distribution levels." This will enable them to build the financial muscle necessary to make "opportunistic acquisitions" in key resource plays in Canada such as the Montney gas formation in British Columbia and the Bakken oil field in Saskatchewan.

A sub-advisor for the BMO Guardian family of funds that is now part of BMO Investments Inc., Guardian Capital is a pioneer in managing mutual funds that focus on income trusts. Robitaille, who is a key member of Guardian's equity-income team responsible for income trusts, points out that only real estate investment trusts (REITs) will be left relatively unaffected by the new tax regime.

But she considers that REIT valuations are currently at "the higher end of their historic range," following the sector's rally off the March 2009 lows. For that reason, she has been trimming her REIT holdings. "Capital appreciation for the group could be limited (in the) short term, but the current average yield remains attractive."

Michele Robitaille

The BMO Guardian family of funds has revised the mandate of one of its former income-trust funds and lowered the monthly payout rate. BMO Guardian Monthly High Income has been renamedBMO Guardian Growth & Income. The goal of this $495-million mandate is to achieve a balance between growth and income.

By contrast,BMO Guardian Monthly High Income II (assets $705 million) kept its name and distribution rate and has essentially the same equity-income mandate. However, given the changes in the trust sector, the fund's investible universe has broadened to the "top 75%" of equities in the S&P/TSX Composite Index in terms of their yields.

The fund, with about 35 names, currently has a substantial weighting in energy of around 38%. The next highest weighting is 30% in financials, though these holdings are mostly real-estate related since REITs are classified as being in the financial sector.

In selecting stocks and trusts, Robitaille and her colleagues look for sustainable free cash flow, effective capital-allocation strategies and reasonable valuations. Given the ability of "quality oil and gas royalty trusts to generate strong free cash flow," Robitaille says they will "continue to play a prominent role in the monthly high-income fund."

A long-time holding that Robitaille considers offers better relative value than some of its peers is Canadian Oil Sands Trust COS.UN, which has a market capitalization of about $15 billion. "We continue to like its long-life reserves, high-quality, proven resource base, low capital costs and leverage to oil prices." This trust's operational performance has improved under Exxon Mobil/Imperial management, she says.

Canadian Oil Sands has a 36.7% interest in Syncrude. Its annual distribution is currently $1.40 per unit. The payout ratio on 2010 cash-flow estimates before development expenditure is 50%, "leaving room for the distribution to increase -- particularly now that Conoco's Syncrude stake has been spoken for."

An energy trust that is "a clear leader in adding production and reserves on a per-unit basis" is Bonavista Energy Trust BNP.UN, which has a market capitalization of about $4 billion. "It has a premier management team, a high-quality asset base, a strong balance sheet, and good tax pools," Robitaille says.

Bonavista has a history of making high-quality acquisitions. For example, it bought a package of natural gas assets from EnCana Corp. ECA in central Alberta for $694 million in 2009. "Bonavista will benefit from using new drilling technology to boost well productivity from these assets," Robitaille adds.

Bonavista trades at a premium to net asset value of 125% versus the 145% premium for the group, says Robitaille. It has an annual distribution of $1.92 and a payout ratio based on estimated 2010 cash flow (before development capital expenditure) of 49%.

Another top holding in the fund is Vermilion Energy Trust VET.UN, which has a market cap of around $3 billion. "Vermilion has a strong management team with a history of value creation both in Canada and internationally," Robitaille says. The trust owns properties in Western Canada, Australia and Europe.

Vermilion has a "strong stable of growth opportunities," including its Corrib field in Ireland and its play at Drayton Valley in Alberta. Its annual distribution is $2.28 per unit and its payout ratio, based on 2010 estimates, is 53%.

Trust or index 1Y 3Y 5Y 10Y
Bonavista Energy Trust 38.1 0.0 0.2 3.7
Canadian Oil Sands Trust 16.9 7.5 16.4 22.4
Vermilion Energy Trust 34.4 7.3 14.9 21.7
S&P/TSX Capped Energy Trust 49.1 6.8 9.6 n/a
For periods ended April 26
Source: Morningstar

Turning to REITs, Robitaille says H&R REIT HR.UN offers good relative value in a sector that has had a strong run. H&R has a "high-quality diversified portfolio" with about 46% in offices, 34% in industrial properties and 20% in retail.

About 70% of its holdings are in Canada, with the remainder in the United States. Robitaille says the trust was "put in the penalty box" because it had difficulty in financing the construction of its major Calgary office tower, The Bow, during the financial meltdown. "This issue has largely been addressed, though investors remain cautious." H&R trades at a "reasonable valuation" of one times net asset value per unit "versus the REIT universe trading at an average 10% premium to NAV."

Robitaille sold her holding in a business trust, Consumers' Waterheater Income Fund CWI.UN, which owns and leases 1.3 million residential water heaters, primarily to customers in Ontario. "The operating fundamentals of this trust have deteriorated significantly over the past 12-18 months and we see no clear signs of improvement." The trust has a deteriorating balance sheet, she says, and it cut its distribution by 50% effective September 2009.

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Sonita Horvitch

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