Tuesday, November 14, 2006

Precision Drilling Trust--Spudding Dry Holes for Investors?


"I am looking to diversify my portfolio and am looking at oil/energy stocks. I read your nice review on
Precision Drilling Trust and decided to buy the stock. Unfortunately, this was the day before the plunge happened after Flaherty's comments. I bought at $28 and got out at $25 during the panic. But the only reason why I sold was because of the overall sell-off - I was trying to be disciplined about selling when the loss got past 8-10% (an IBD strategy). Now the stock is down to $23 and I am considering getting back in, especially given the "watered down" context of Flaherty's comments. I like the dividend and I think the stock has hit a bottom - one accentuated by politics. The dividend realized is actually 15% less than the proclaimed yield, however, as the Canadian govt. takes a 15% cut as a foreign tax - my own experience from holding Canadian Imperial Bank shares. So, do you still support the stock and do you feel that this is a nice opportunity to get back in?”

Ed. Note: We expect the dividend payout ratio (about 92.0%) to be cut substantially, for (i) the current dividend payout is built-on the existing premise of a corporate [expense deduction] pass-through to unit trust holders and (ii) the Company will need to reconcile its dividend distributions and expected capital spending expenditures with the final income trust tax bill.

The Common Stock of Precision Drilling Trust (PDS--$22.42), Canada's largest oilfield services company, has plunged about 27.8% since November 1, when Jim Flaherty, Canadian Finance Minister, stunned investors on Bay Street to Wall Street with news that the Canadian government was planning to tax dividends on income trusts.

Royalty (income) trust have become increasingly popular in our Neighbor to the North, for the trust structure avoids the double taxation that came from combining corporate income tax with shareholders' dividend tax. By passing through the earnings—in the form of both cash dividends and a pro-rata share of return-of-capital, the trust structure reduced—or eliminated—its income tax liability, thereby increasing the amount of cash available for distribution to unitholders and for future capital expenditures.

Anticipating that increasing cash distributions to unitholders would provide an attractive rate of return without impairing Precision’s ability to finance maintenance and expansion capital expenditures, the Company (on November 7, 2005) converted to a trust structure through a plan of reorganization.The Trust, through its wholly-owned subsidiaries, now operates the Company’s contract drilling services to the Canadian oil and natural gas industry.

When Canadian telecom giants
Bell Canada Enterprises (BCE-$23.99) and Telus Corp. (TU-$47.98) announced plans to convert to income trusts, the Tory-led government feared a domino effect would occur in other sectors of the economy (allegedly among financial institutions and other energy concerns). According to Flaherty, “$70 billion of new trust conversions had been announced so far this year — and (this) converting was solely to avoid paying corporate taxes.”

Flaherty imposed this punitive tax on income trusts to “stem the growing number of companies” that were converting to trusts—and broke a central election promise. The Tories promised in their platform book to preserve income trusts by not imposing any new taxes on them (after accusing the Liberals of attacking retirement savings). Acknowledging the broken election platform, the Tories still countered that income-trust acceleration would have meant the loss of billions in the tax base provided by corporations. “Increasingly, individuals and families in Canada would shoulder the burden,” Mr. Flaherty said.

It is estimated that foreigners only hold about 20 percent of all (Canadian) income trust units. This means that Canadians—with many being retirees dependent on the distributions from these trusts to meet monthly expenses—(despite proposed tax relief) will eventually feel the impact of less income (in addition to the loss in savings/assets from the drop in market value of all the affected trusts).

The Tory-led government will be under pressure, too, from Canadian oil & gas executives, as foreign investors look away to more attractive markets.

American investors ought to note that the Conservatives have—at best—a tenuous hold on power. In the 2006 Canadian federal election, held on January 23, 2006, the Conservative Party of Canada won a plurality of seats in Parliament: 40.3% of seats, or 124 out of 308—but mathematically, the numbers resulted in a minority government led by the Conservative Party with
Stephen Harper (becoming the 22nd Prime Minister of Canada).

On September 25, 2006, the Conservative government announced that within the fiscal year, there would be a $13.2 billion-dollar surplus (that will be used to pay down the country's debt). This statement supports a modification of the income-trust tax proposal.

Even if Harper’s Tories stand together, tax reform will still require support of either the New Democratic (NDP) or Bloc Québécois parties for passage of the Trust Tax. [Ed. note. Taxes are the only politics that the Conservatives have in common with the New Democratic party (with 29 members in the House), for the NDP’s ideology is more to the left—and liberal—to that of the Tories. The Bloc Québécois party has 50 seats in the House of Commons.]

Although the new tax (estimated to be 34 percent) is not slated to take full effect until 2011, we must assume the core advantage of being an income trust has been mortally wounded.

Absent final clarification by the Harper-led gang on Parliament Hill in Ottawa, uncertainty will continue to shadow all income trusts, including our Precision Drilling holding, for all affected companies need to know what tax reform bill it is that they need to adjust to (reconcile dividend distributions with capital spending needs)?

Granted, we just said last week that
cheap can get cheaper, but with the price of Precision Drilling Trust off about 41 percent from its April 2006 high (of $38.30 per share), the contraire in us loves the uncertainty, and we bought more shares of the Common Stock (which has a book value of $8.46 per share and little in long-term debt, only 14.1% of equity).

Long Positions in'10Q_Detective' sorted by Bought in Ascending order
PrecisionDrilling Trust (PDS)
SymbolPositionBoughtOpen PriceValueCostNet%Change

Editor David J Phillips is long shares of Precision Drilling Trust but has no financial interest in any other company mentioned in this posting. The 10Q Detective has a full disclosure policy.

1 comment:

Javaman said...

Thanks for the follow-up, David. I appreciate the info. I'm back on the bus now.