September 8, 2010
Written By Dr. Stephen Leeb
From The Complete Investor: “Beginning in 2011, Canadian income trusts will no longer have the tax advantages that allow them to pass most of their income on to unit holders tax-free. Though this change was announced in October 2006, many of the trusts are just now announcing their plans to cope with the rule change. For income investors who have avoided the group because of uncertainty, now is a great time to take a second look at income trusts, especially those that intend to maintan their high dividends after converting to corporations. (Plus, some trusts that now have limits on non-Canadian ownership will become easier for U.S. investors to buy.) The Complete Investor recommends an income trust with growth potential below, and we’ve featured four more trusts on page 8. (The Complete Investor has outperformed the market for the last five years, with an average 3.6% return across all portfolios, according to The Hulbert Financial Digest.)
“One ripple effect of the Deepwater Horizon disaster and the subsequent moratorium on deep water drilling is likely to be a heightened interest in Canada’s oil sands. Already one of every six barrels of oil consumed in the U.S. comes from the oil sands. If a slowdown occurs in oil production from the Gulf of Mexico—which now accounts for around one-third of U.S. oil production—the oil sands almost certainly would take up some of the slack. In short, the oil sands are a resource whose value will be growing, and so should the value of investments leveraged to them. … Of course, the most direct and leveraged play is Canadian Oil Sands Trust (COS- UN.TO 25.59 Toronto – yield 7.82%). This is a good time to review the company in light of its forthcoming change from a trust to a regular corporation, radically altering its structure. We’ve discussed these before, but they’re worth looking at again.
“In a few months, starting in January 2011, under legislation Canada’s government enacted in the spring of 2009, all existing Canadian trusts will convert to corporations. One consequence is that they will begin paying taxes at the same rate as any other corporation. This is old news that has been reflected in Canadian Oil Sands’ share price. But we don’t want it to come as a shock to any TCI subscribers counting on dividend increases from the company.
“As with any change, the upcoming conversion brings uncertainties, and one of the biggest is the dividend’s size. Management has clearly been considering paying a smaller dividend post-conversion. The company, however, has been preparing for the new tax structure and is likely to end 2010 with higher net debt, which is favorable for tax purposes. Because of the new corporate structure, cash from operating activities will be reduced by about 25%, but in anticipation of the transition, the company has accumulated about $2 billion in tax pools that could help it save on some taxes. These savings could last around a year.
“This would mean, everything else being equal, that in the year following conversion, dividends will likely be higher than in the years that come later. The tax asset, in effect, will constitute a tax- deductible loss, meaning the company will pay little or no tax at all the first year. But in part because these accumulated tax savings won’t last, we expect the dividend to be variable. Management, in fact, has stated that, post-conversion, it will have a ‘variable dividend strategy’, with a bias toward a lower payout in anticipation of spending on major projects. This indicates the dividend will be less than the current 50 cents per share per quarter. And dividends are likely to fluctuate, reflecting such factors as changes in crude oil prices, economic conditions, the operating performance of the Syncrude oil sands project, and the company’s operating and investing obligations. To sum up, unless cash from operating activities increases significantly, dividends will decline. We still like the company, though. Why?
“One reason is that while Canadian Oil Sands can’t control oil prices—to which it is leveraged—it can, and plans to, increase production. The latest results confirm its ability to grow. In the most recent quarter, profits rose fivefold: the company earned $237 million in Canadian dollars, or 49 Canadian cents per unit, compared to $46 million (10 Canadian cents per unit) in 2009’s second quarter. Analysts had been expecting profits of 38 cents per unit. Production averaged 118,569 barrels a day in the quarter, up 55% from the like 2009 period. And while the company reported some operating problems with an upgrader at the Syncrude project, this caused it to lower its production target for the year by less than 5%, to 110 million barrels. In all, we view Canadian Oil Sands as an energy investment with low exploration risk, and we expect it will continue to pay a decent dividend even after its conversion to a corporation.”
Stephen Leeb, The Complete Investor