Good Research vs Bad

In the torrent of equity research that has followed the Finance Minister’s announcement on Income Trusts, I’ve seen a range of analysis and wishful thinking about the new reality.

In the wishful thinking camp, the winner is undoubtedly the research analyst that predicted that the changes may not get through Parliament, and that all was not yet lost for the business trust consolidators (such as Newport Partners). I’m a personal fan of the analyst in question, but to hope that the NDP and BQ would stand up for Bay Street was nothing short of ludicrous.

In the “generate some news” category, this weekend’s all-is-not-lost piece in the Globe and Mail fits the bill. If your trust’s unit prices are down, don’t worry, as those smart private equity guys are sure to take these trusts private now. Two problems with that idea: good private equity shops don’t overpay for assets; and if they do (Yellow Pages), that’s merely because the exit mutliples will be that much higher. Without the trust market it’ll be hard to launch IPOs at superlative valuations. As such, the merchant banks will need to pay an attractive price (to them) on these going privates.

The Four Seasons’ proposal this am is a case in point, I suppose. If the idea of coverting the company to an income trust were still viable, then the bidding group would need to pay up to compete. In the absence of a conversion opportunity, the price they need to pay to get a fairness opinion from a the Board’s special committee just dropped (by 18% perhaps?).

The primary reason that private company EBITDA investment multiples have risen over the past 3 years is that the income trust market was there, ready and willing, to pay even more on the ultimate IPO. Sure, low bank rates and a market awash with investable $ didn’t hurt, but the market was awash with money as the pension fund LPs all saw the income trust market as a great arbitrage and piled into everyone’s most recent merchant banking fund.

In the good research department, Wellington West’s note this morning is a great example, calling for an 18% drop in valuations:

“Base-Case Impact on Valuation ~18%; Other Factors May Make It Better or Worse
• Valuation recalibration implies 18% base-case target price declines.
We estimate a 31.5% tax in 2011 on a “typical” trust – taxable portion at 81% of DCPU – would reduce the PV of future cash flows ~18%.
• M&A roll-up model compromised; non-taxable DPU lowers 2011 tax. Roll-up target prices lowered more than average w/ arbitrage multiple reduced; return of cap/dividends not taxable; non-CDN earnings exempt?
• Drillers to be affected by negative impact on Royalty Trust capex. Higher WACC for the royalty trusts is apt to hit capital programs negatively, likely result in downward pricing pressure in services sector.
• What stands out? Counting on private equity to provide a floor price ignores fact that exit
multiples have shrunk; but conversions to IPS may cap tax rate at 20%.

We reduce valuations across the WWCM business and energy trust universe with the announcement of trust taxation; we submit that down the road IPS conversions may provide a solution, significantly lower net tax effects. We estimate that the government’s Tax Fairness Plan will reduce trust valuations about 18% from pre-taxation levels. As such we recalibrate our trust price targets, noting that trusts using now compromised M&A roll-up strategies,
should see larger valuation cuts, while trust-like vehicles such as IPSs are likely unaffected by the new policy and thus should not experience devaluation. While it is still early in the game, we contend that trust conversions to the IPS structure may ultimately cap taxation at 20%, down from the currently proposed 31.5% rate. In addition to ~20% price target cuts for the Energy trusts owing to the new taxation, we also reduce estimates for select companies with direct susceptibility to lower pricing/activity rates in the short-term – we attribute this to further capital constraints placed on the Royalty Trusts with new taxation.”

MRM