The Commodity Investor Q&A
With Matt Badiali
November 26, 2008
Q: Canadian royalty trusts pay solid dividends, now some in the 20% range, yet the share prices continue to decline. I believe the tax change has already been baked into these low prices. Am I missing something here? – M.T.
A: A couple years ago, the Canadian prime minister declared an end to the royalty trust structure. Like REITs here in the U.S., royalty trusts avoid corporate tax by paying out most of their earnings in dividends. New taxes are going to take a bite out of their yields... but I agree that's likely "baked in" by now.
Something much bigger and much worse is about to hit royalty trust shareholders...
Since June, Canadian Oil Sands, Penn West Energy, and Enerplus Resources – three of the biggest royalty trusts – have fallen an average 54%. Now the three yield an eye-popping 19.5%.
I don't think that's a bargain, I think it's a warning.
This year, we saw oil spike to $145 per barrel. The biggest three royalty trusts made an average $56 in profit on every barrel of oil they produced. But today, oil sells for only $54 a barrel.
In other words, earnings are headed down. And since dividends ebb and flow with earnings, dividends are about to tank, too. But wait, there's more...
The second pitfall waiting for potential scavengers is debt. Because royalty trusts pay out their earnings to shareholders, they have to borrow to grow. And nearly all the big royalty trusts made acquisitions at or near the top of the market.
Penn West, for example, owes $176 million per year in interest payments. That nut isn't too bad when you clear $2 billion... But the company isn't terribly efficient at producing oil. It only made $29.50 per barrel last year during the good times.
Three other royalty trusts to watch out for are Harvest Energy, Advantage Energy, and Paramount Energy. These three all have enticing yields above 20%. But they also have interest payments that require almost 15% of last year's earnings. When earnings fall in half... or even worse... that's going to get painful.
Update: Earlier this month, a reader asked, "Is there any hope at all for base metals?"
As part of my answer, I told you about a troubled base-metals miner, Lundin Mining:
In 2007, Lundin's revenues were $1.15 billion. I expect that to fall to $260 million this year. It'll be enough to pay for interest, taxes, and keeping the lights on... but little else.
Right now, the company's market value is around $550 million. That's just over twice my sales estimate – too expensive. I think we need to see another two or three quarters worth of poor results before the market throws in the towel on base metal miners.
Last week, HudBay Minerals, another base-metals mining company, agreed to buy Lundin Mining in a friendly takeover. The all-stock deal valued Lundin at $630 million when the companies announced it. But HudBay's shares plummeted from $5.50 to below $3 after the news.
Now Lundin shareholders will pocket only $430 million, about $1.38 per share. That's down from the stock's peak of $14.40 last year. And it's a 23% discount to Lundin's average share price in October (assuming HudBay's shares don't fall any farther).
Two weeks ago, I told you Lundin would earn about $260 million this year. The HudBay deal values Lundin at about 1.7 times earnings. So don't pay more than 1.7 times earnings if you must go scavenging among base-metals miners.
But that sport looks a lot like picking up nickels on a train track. There are easier and safer investments out there right now.
Good investing,
Matt Badiali
P.S. If you'd like to submit a question to the Commodity Investor Q&A, e-mail me here. Please keep in mind... I can't give personalized investment advice.
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