My friend Lamont in Yonkers recently became a subscriber to the column. I asked him for his general impressions and he said, “I basically read it to see if I’ve been mentioned.” Well, the rest of the column will be Lamont-free, so buddy, you can bail right now. But if you do, you’ll be missing part two of a three part series devoted to income trusts. In part one I talked about some of the trust basics, such as payout ratios, yield, and taxation issues. In this edition I’ll write about the different types of trusts and mention where I’m investing. Know that today’s edition is super-sized and available at the same low price you’ve come to know and love. Let’s go…

Many commentators speak of income trusts as if all trusts are created equal. This is obviously wrong. Some trusts have quality management, while others do not. Some have a solid balance sheet, while others do not. Some operate in sectors that are appropriate for the income trust structure, while others do not. As a matter of fact, there are many different categories of trusts, each with different metrics, risks, and rewards. Let’s have a look at business trusts, oil and gas royalty trusts, utility trusts, and real estate investment trusts.

Business trusts
This class offers 50 trusts engaged in a colourful assortment of businesses, including restaurants (A&W), mattress stores (Sleep Country), home sellers (Royal Lepage), sardine canners (Connors Brothers), water heater companies (Consumers Waterheaters), and bleach manufacturers (KCP Income Fund). The most appropriate candidates for trusts are very mature (i.e., slow growing), profitable businesses with significant market share in their respective sectors. For example, Davis + Henderson (DHF.UN) dominate the cheque business and Superior Plus (SPF.UN) controls the propane industry. Both have been very successful.

Ideally, a business trust won’t be dependant on any one customer or facility. Investors in Halterm (HAL.UN) learned this lesson the hard way. The trust operates a container handling facility that serves the Port of Halifax. In 2002, three of their customers accounted for 76% of revenue. So when two of these customers left, the cash flow situation was hit very, very hard. The trust was forced to suspend distributions altogether and the units crashed on the TSX. A few months later, Versacold Income Fund (ICE.UN) had a roof collapse at one of their cold storage warehouses. They have 22 facilities and 1700 customers, so the damage to the trust was minimized. Diversification is one heck of an insurance policy.

My largest holding in this category is waste collection and landfill operator BFI Canada Income Fund (BFC.UN). You know those blue garbage bins in alleys and behind pizza parlours? You know those blue garbage trucks? That’s probably BFI. Can you imagine the company saying “we have to lower distributions because people aren’t making enough trash?” Me neither. The landfill operations keep me paying attention, as governments are involved and this adds an element of uncertainty. The company just increased their distributions to $1.28 for a yield of slightly less than 9% and a fairly conservative payout ratio of 77%. On the downside, very little of the distributions are tax-deferred. The units have had quite a run, so I may have to trim the holding. Overall, the reality of making money off garbage is absolutely thrilling…and capitalism at its finest.

My second largest holding is in the Yellow Pages Income Fund (YLO.UN). They put out, well, the yellow pages and have doctors, lawyers, and other professionals as their main clients. I recently participated in the initial public offering, about which I’ll have more to say in another column. For now, I’m lukewarm on the holding.

With all these businesses converting to the trust structure, what’s next for the sector? More of the same. In fact, Alliance-Atlantis (AAC.B) is thinking about spinning off their movie distribution unit. And why not? The unit’s revenues have been flat for several years and are projected to remain the same for several more. A traditional IPO wouldn’t command very much interest on the street, but a trust offering would be considerably more popular. That means more money for the company and they need it to address some nasty debt problems. Similarly, Priszm (yup, that’s the correct spelling) is thinking about converting their Canadian franchises of Taco Bell, Pizza Hut, and KFC. It would be fun to get monthly cheques based on burritos, personal pan pies, and Big Crunch sandwiches. I’m looking forward to reading the prospectus.

Oil and gas royalty trusts
In this sector, a focus is placed on mature properties that are already producing oil or gas. On the plus side, this means virtually no exploration risk. On the downside, production results in the gradual depletion of the reserves, so the trust has to find a way to replace production. If they don’t, the trust will get smaller and smaller and could theoretically cease to exist. However, Canadian royalty trusts are actively managed, so this is not an issue. This last point was always missed when analysts and advisors were dismissing the sector a few years ago. They never bothered to read any annual reports, figuring all you had to do was own Nortel or JDS and the good times would keep on rolling. I’m on the edge of a rant here, so let me take a minute to compose myself….I’m not ready yet….OK, now I’m ready.

Given that an oil and gas trust distributes so much of its cash, it will have to come to market periodically to raise equity, with funds being used for acquiring other producing properties. Another option is the issuing of debt. With so many royalty trusts competing for assets, it can be a challenge to find properties available at reasonable prices. Paying a lot for properties will just add to the cost of production and cut into the amount of money that flows into your pocket. Not good.

One metric that can be helpful in evaluating the quality of the reserves is the Reserve Life Index (RLI). It provides an idea of how long the reserves would last given the current rate of production. Generally, a longer reserve life indicates higher quality assets. Among the higher RLI’s you’ll find Enerplus (ERF.UN) at 13 years and ARC (AET.UN) at 12 years. The average RLI stands at 10.4 years.

Another important consideration is production profile. How much is oil and how much is natural gas? Shiningbank (SHN.UN) and Primewest (PWF.UN) are among those favouring gas; Ultima (UET.UN) and Viking (VKR.UN) are among those weighted towards oil; ARC and Pengrowth (PGF.UN) represent those with a fairly even balance between oil and gas. Exactly which profile excites you as an investor will depend on which commodity you prefer.

My only holding in this sector is ARC. As mentioned in an earlier column, they have a very conservative payout ratio, a balanced production profile, a long reserve life, low debt levels and production costs, and seem to be able to make high quality acquisitions at low prices. Distributions are $0.15 a month, for a current yield of 13%.

When investing in this sector, remember that distributions and unit prices are highly sensitive to the price of the underlying commodity. This creates volatility and also accounts for the relatively high yields. As I’ve mentioned before, I believe energy prices are at historically unsustainable levels. That means we’re in for some cuts. Also in an earlier column I mentioned paring back my energy exposure. In retrospect, I jumped the gun in making this call.

Who knew the price of oil would stay so high, as the Iraqi’s seem to be very successful at destroying their pipelines? I wonder how they’d react to the idea of investors / infidels sitting in the Canadian ‘burbs making money off their antics? It more than makes up for the 82.9 gas I saw the other morning. Hope for peace but always have a few bucks on chaos.

Utility trusts
This category includes the power and pipeline trusts. Sounds boring, eh? Well, the cash flows and distributions are relatively stable and predictable. However, there are a number of key elements to consider. Some power producers rely on a small number of generating facilities. For example, Northland Power (NPI.UN) operates two facilities, but relies heavily on only one of the two. What happens to cash flow if there is a prolonged disruption at the main facility?

It also helps if the trust has a large corporate sponsor. For example, Transalta Power (TPW.UN) has the backing of Transalta, TransCanada Power (TPL.UN) has TransCanada, and Enbridge Income Fund (ENF.UN) has…you get the idea. Here’s how it usually works: The corporate sponsor spins out the utility trust and pockets the cash from the initial public offering. They maintain an interest in the newly created trust, although that interest is typically subordinated to that of the unitholders. This means the corporate sponsor receives distributions only after the unitholders have received their distributions. In other words, we get paid first. A sponsor can enhance the financial stability of the trust and provide support with acquisitions. A utility trust doesn’t need a sponsor in order to be successful. It’s just one thing to consider when figuring out the risk of the investment.

In terms of power trusts, I’m curious about how the power is generated. Hydro is cheap to produce but relies on strong water flow and sometimes Mother Nature won’t oblige. Algonquin Power (APF.UN) has experienced significant problems in this area. To minimize risk, hydro trusts are well-advised to operate facilities across several different watersheds. Gas-fired turbines are reliable, but relatively expensive to run. Ideally the trust will have a long term gas supply deal that provides some protection from short term volatility in prices. Alternative fuels such as biomass and wind power are promising, although I recently eliminated my holding in Clean Power (CLE.UN) because it kept missing its generation targets.

I also look for power trusts that have long-term power purchase agreements with their customers. Anything beyond 15-20 years is gravy. For the pipeline trusts, a take-or-pay arrangement is preferred, meaning the customers pay whether they use the pipeline or not.

My largest holding in the group is the Calpine Power Income Fund (CF.UN). They have an interest in 3 gas-fired generating assets, have a large corporate sponsor with a subordinated interest, and have signed long-term agreements for fuel supply and power sales. Here’s something the trust doesn’t have: long term debt. I picked up the units when they were trading well-below the initial public offering price. At the time, there were concerns about the financial stability of their sponsor (overblown, I believe). Well, the Ontario Teachers Pension folks were bullish and snapped up a significant number of units. The unit price has since recovered. The trust plans to increase their distributions at a rate of 1% per year and thankfully, these distributions are expected to be nearly 100% tax-deferred through at least 2005 (current yield just under 9%). The plants are operating above forecast and the fund recently declared a modest bonus distribution. The sponsor has a network of over 70 plants and it seems reasonable that some of these assets may be sold to the trust. This would enhance the diversity of the trust and improve the balance sheet of the sponsor.

One of my other holdings in the area is Transalta Power (TPW.UN). It has an interest in 5 generation plants (3 gas-fired in Ontario, one gas and one coal-fired in Alberta). Fuel supply and power sales are under long-term contracts and the distributions will be largely tax-deferred through 2004. The trust recently assumed an interest in a large coal-fired plant in Alberta and did so without compromising the balance sheet. A few weeks ago, they made a significant change to the management structure that should provide more cash for unitholders. The committed corporate sponsor doesn’t hurt either.

Another holding is Inter Pipeline Fund (IPL.UN). The fund owns and operates four oil pipeline systems in Western Canada and recently increased their holding in Alberta’s Cold Lake Pipeline. The Cold Lake system is hooked up to the oil sands, providing the trust with some interesting growth possibilities. Adding to stability is the use of take-or-pay shipping commitments. The trust has traded at a discount relative to peers in large part because of some uncertainty surrounding management. The problems have since been resolved, but much of the discount remains (although the units have performed very well of late). Distributions are $0.18 a quarter for a current yield of over 10%. Pembina (PIF.UN) is another solid name in the sector, but it’s had a very solid run.

Utility units are highly sensitive to shifts in interest rates, generally moving down with a rising interest rate environment. I don’t see Canadian rates moving up in the near-term, so I’m quite comfortable with my relative overweight of the sector. However, I don’t expect to be adding to my holdings anytime soon. Some commentators have suggested power stocks as a great place to be because there should be some infrastructure spending in response to the big blackout. This plan really depends on government, so I assume nothing is going to happen. Along the way we’ll be teased, yanked, and pulled…reminds me of what I saw in Vegas.

Real estate investment trusts (REITs)
This is just about the only way to play the Canadian real estate sector. Some REITs focus on hotels, shopping malls, office space, industrial parks, retirement homes, or apartment buildings. Overall, they are less sensitive to interest rate fluctuations than the utility trusts. This makes sense because a strong economy is good for malls, office buildings, and industrial parks. A modest change in rates is unlikely to have much of an effect on REITs. Now if rates rise significantly, that’s another story. Again, I don’t see that happening for a while.

The key metric in this sector is occupancy. You want the malls to be fully leased, the office towers packed, and the hotels bursting at the seams. To reduce risk, it helps if the REIT has properties across a number of different geographical regions. The decline in many hotel REITs earlier this year taught us how dangerous it can be when a major chunk of cash flow comes from a single market (i.e., Toronto).

My largest holding in the group is Riocan (REI.UN). In a recent column, I wrote about Riocan’s involvement in 164 retail properties. I still love the investment, but I must confess to a recent paring of the holding. Nothing serious, just trimming the hedges. They deliver on their promises (the most recent quarter was solid) and play well with others. In fact, they just announced another joint venture, this time with some powerful pension folks. The plan is to invest in underperforming malls and use Riocan’s expertise to swing a turnaround. This could be fun to watch and I’m content with the position. You should know that I may have developed an emotional attachment to these units and the paring left me empty and cold.

The best is seeing a BFI garbage bin on a Riocan property. I see that and I’m set for the day. No wait…a guy in a BFI truck on a Riocan property, looking through the Yellow Pages. I better end this issue before I have an accident. In the next edition, I’ll write about the issues facing the trust market and mention additional ways to play the sector. Plus, I’ll offer some places to look on the Internet if you’re shopping for trusts. By that point, you’ll start begging to be let off this ride.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. He loves his new 6.25 horsepower, 3-in-1 mower. The grass is always greener atmail@marketguy.ca