Breach of trust

Income trust distribution cuts normally don’t come as a shock these days. The weak economy combined with the impending new tax has made it impossible for most trusts to maintain the high payouts that investors enjoyed prior to Jim Flaherty’s announcement on Oct. 31, 2006 that the sector would effectively be killed.

In most cases, the news of a payment reduction is greeted with a collective shrug, not because investors don’t care but because they have been conditioned to expect it. However, there have been a few exceptions where investors were left fuming by the actions of management.

One was the case of BFI Canada (TSX: BFC) which last August announced a 73 per cent distribution cut as part of its plan to convert to a corporation. BMO’s Gavin Graham, a contributing editor to my Income Investor newsletter, described it at the time as “a shock” adding that “even professional money managers didn’t see that coming.” BFI management took a lot of flak but the cut (and the conversion) went through anyway. As a corporation, BFI was recently trading at $11.45, less than half its 52-week high, and yielded only 4.4 per cent.

The next stunner was the announcement by Advantage Energy Income Fund (TSX: AVV.UN) in March that it was discontinuing distributions entirely as part of its corporate conversion program. The trust had been gradually cutting its payments since 2005 but the complete elimination of distributions left many investors outraged. The shares recently were priced at $4.04, less than one-third of their 52-week high of $13.75.

Now we can add Yellow Pages Income Fund (TSX: YLO.UN, OTC: YLWPF) to the list of trusts that have blindsided investors with an unexpected distribution cut. In some ways, this particular breach of trust is worse than the others because YPG management had repeatedly given assurances that the distribution was safe, at least until the implementation of the new tax in 2011.

But just a few months after once again assuring investors that the distribution would be maintained through 2010, the management of Yellow Pages Income Fund announced a 32 per cent cut in its payments, beginning in June. The new rate will be 6.67c per unit monthly (80c a year) down from $1.17 annually.

The announcement has to be seen as a serious blow to management’s credibility. No one forced them to make a “no-cut” commitment. They simply could have said they would endeavour to maintain the payments as long as business conditions allowed, thus providing some wiggle room. Now they have to live with the broken promise and the reasonable suspicions people will have about future statements from the organization.

Naturally, senior management attempted to justify the move by citing the recession and the need to maintain the financial integrity of the company. “Difficult times call for difficult but important decisions,” said CEO Marc Tellier, adding that these are “challenging economic times” and that there is no way of knowing how long these conditions will last. “These measures are in the best long-term interests of all of our stakeholders,” he said.

As was the case with BFI Canada and Advantage Energy, the announcement of the cut was combined with a confirmation that Yellow Pages will convert to a corporation in the first quarter of 2011. When that happens, the dividend target will be in the range of 60 per cent to 70 per cent of cash earnings per share. “The articulation of a preliminary dividend policy at this time is intended to provide clarity to investors as we look to the transition period from an income trust to a corporation,” said Mr. Tellier. “We believe this expected level of payout should provide sufficient financial flexibility to YPG as we convert while we aim to grow returns to shareholders.”

That’s very nice, but is it credible? Only a few months ago, Mr. Tellier and his team were saying there would be no distribution cut. Once-bitten, twice-shy investors can be forgiven for wondering if this latest promise is just more pie in the sky. The market price of Yellow Pages shares, which recently traded in Toronto at $6.12, implies that people are suspicious about the future of the company. Even with the distribution cut, the shares are yielding about 13 per cent which suggests the market is pricing in another drop in the payout down the road.

Following the announcement, Dominion Bond Rating Service (DBRS) downgraded its rating on the shares by one notch to STA-2 (high). In a press release, DBRS said the downgrade ” reflects the reduced distribution stemming from the downturn in the economy and its objective to strengthen its financial flexibility.”

The rating agency also took a swipe at Yellow Pages management, saying: “The reduced distribution had not been anticipated by DBRS as management believed that it could grow its distributable cash organically (and leave its distribution flat at $1.17 per unit) allowing it to target a 70 per cent payout at the end of 2010.”

The agency said that while it is “comfortable” with the new rating, there could be problems in the future. “DBRS notes that the conversion into a corporation along with its additional financial flexibility could lead YPG to pursue additional acquisitions,” the press release stated. “DBRS cautions that a strategy which moves the company away from its core directory operations could pressure the business risk profile and hence its corporate credit ratings. This pressure could be compounded if its online conversion of its existing businesses does not allow it to maintain its customers, revenue and EBITDA margin profile.”

Surprisingly, the country’s other major rating agency, Standard & Poor’s Canada has not changed its rating on the shares, which is currently STA-2 (stable). Nor had S&P made any comment on the distribution cut at the time of writing. In fact, the last research report from S&P on Yellow Pages was published more than a year ago. We have to wonder what they’re doing over there.

Almost unnoticed in the furor created by the announcement was the simultaneous release of the trust’s first-quarter results. They showed consolidated net earnings of $131.6 million compared with $127 million for the same period in 2008. Income from operations was $185.7 million, up from $171.4 million last year, while cash flow from operating activities reached $197.4 million from $145.3 million in 2008. Distributable cash of $180.4 million (35c per unit) was relatively unchanged from the previous year. Distributions were 29c per unit. Basic net earnings were 26c a unit, up from 24c a year ago.

With those numbers, we truly have to wonder about the urgency to cut the distributions now. YPG management has a lot to answer for

This article originally appeared in The Income Investor, a bi-monthly newsletter that provides timely advice on income-producing securities. Try it for three months for only $18 plus tax. Click here for details.

Photo © Kevin Yiu