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Bogs on My Radar Screen

George C. Fisher

There has been a lot of chatter on the Internet about Canadian Income Trust Units. As high yielding common stocks are becoming harder to find, and bond yields offer virtually no real rates of return, investors have been scanning the horizon for different ideas. One potential investment avenue coming up on many investors’ radar screens are income trusts. The income trust market was hot in 2003, and the action is anticipated to continue in 2004.

Simply, an income trust is a corporate structure that favors tax-advantaged distributions to unit holders. A reasonable expectation for income distribution could be around 90 percent of distributable free cash flow, or operating cash flow less capital expenditures. “Normal” corporations pay a dividend representing a much smaller percentage of free cash flow, but investors anticipate management will grow their business through retention and re-investment of non-essential cash flow. The key to income trusts is steady, sustainable cash flow; the best candidates for an income trust should have a proven track record and also offer an opportunity for cash flow growth.

Income trusts come in varied flavors. There are Resources trusts including oil and timber, Utility trusts including power generation and natural gas distribution, and Business trusts, including various economic sectors. Examples of business income trusts include such miscellaneous businesses as check printing, home cleaning products, shipping terminals, telecommunication services and wholesale food distribution. My esoteric favorites are the Swiss Water Decaffeinated Coffee Trust that roasts, of all things, decaffeinated coffee, and the Hot House Growers Income Trust, the largest growers of greenhouse tomatoes and sweet bell peppers.

During a discussion recently with Mr. Robert Gibb, a regular contributor to CMS, he referred me to a website that lists all types of Canadian income trusts.

http://www.investcom.com/incometrust/incometrust.htm

In my research, I uncovered an interesting business income trust that drew my interest. This company is the largest Canadian producer in their industry, has only 17 competitors in Canada and no competitors in the US. The closest competitors are located in Finland, Ireland and Russia. Even though it has no domestic production, the US market represents 98% of total North American consumption. Canada currently holds 25 percent of all known worldwide reserves and generates10 percent of the world’s production. The North American market is characterized by a small number of long-term participants, stable pricing, a diversified client base and an increasing demand for its products. The company is small and operates in a relatively small niche market. Company revenues through the first nine months of 2003 totaled $146 million, up 6 percent over 2002, including an average 9% adverse currency adjustment. 80 percent of year-to-date revenue was generated from clients in the US.

The product is sphagnum peat moss and the company is Sun Gro Horticulture Income Trust ($8.39 GRO_UN:TSX). For US readers, the stock is traded on the US Pink Sheets using the symbol SGHRF or SGHRF.PK. Sun Gro harvests, packages and markets peat moss and pre-mixed plant growing media.

What drew my initial attention is the barrier to entry for new competitors. It is unlikely that any new deposits will be suddenly discovered along the outskirts of Pittsburg since the peatlands were formed in the Ice Age and created by the decomposition of specific organic material. In addition, I know peat moss first hand as I am an avid gardener, and agree with the experts that good, old Canadian sphagnum is far superior to its alternatives.

Sun Gro has an interesting history. Founded during the Great Depression in 1929, the company currently owns or has leasehold rights on 52,000 acres of peatlands. Over the years, the company has changed hands several times and, in 1995, was acquired by a US private equity firm. In 1997, a new management team was installed, led by a Weyerhauser-trained CEO. The new management team proceeded to reorganize the business model by instituting a decentralized profit center approach, a greater focus on professional and industrial customer opportunities, and a broadening of their private label position in the consumer retail market. In addition to increasing the number of profession and industrial clients, the company is focusing on moving the client up the product scale and becoming a larger player in the more profitable horticultural pre-mixed growing media business. Sun Gro operates 14 facilities, six Canadian peat and mixing plants and eight US mixing plants. While the overall peat moss market is not growing at the same stellar pace as the cell phone market, historically it has experienced steady expansion. The added focus on incremental sales to the professional and private label markets should create above industry growth for Sun Gro.

All is not rosy, however, in the peat bogs. In the first 9 months of 2003, Sun Gro’s monthly distributions to unit holders totaled $18.2 million, or $.83 per unit. Distributable free cash flow was $14.5 million, or $0.66 per unit. For the full year 2003, Sun Gro distributed $1.01 per unit. Investors should realize the future of distributions exceeding income generation relies on borrowings or asset sales. In the case of Sun Gro, they have been borrowing the distribution shortfall, using their revolving line of credit. As the business is generally seasonal and stronger in the first half of the year, making up this shortfall in the 4th qtr seems unlikely. The Board of Directors has acknowledged this is an unsustainable situation.

In 2004, I am looking for a cut in the annual distribution to somewhere around $0.80. This assumes distributable cash flow increases slightly and 90 percent is returned to investors. At an $0.80 annual income return, the current stock price would generate a yield of 9.5%, still generous within the range of competitive income investments. From a company viewpoint, I like Sun Gro’s positioning in the market and their redirected sales focus. I expect management will provide greater than industry-average sales growth, and this will fuel a more stable and eventually growing distribution in the future.

As with all investments, it is important that you conduct your own research and due diligence to determine if a specific investment fits your portfolio risk levels. Income Trusts are a different corporate structure with different corporate goals, and it is important investors are familiar with these differences. I like Sun Gro’s prospects so much, I recently bought 315 shares and enrolled in my broker sponsored synthetic dividend re-investment program. Over time, the power of reinvesting a high and growing dividend will produce a tidy position in this unique market leader. Author’s note March 2004 – I discovered later that the US Pink Sheet designation negates the ability to synthetically reinvest monthly dividends through my broker. In addition, my broker does not offer trades on foreign exchanges without opening a multi-currency account. As Sun Gro, or other non-US exchange traded foreign companies, is not meant to be a large enough holding to warrant a separate account, I decided to take another approach. I increased my holdings from 315 shares to 482 shares. This will throw off around USD $25 a month after foreign tax withholding and exchange rates that will be added to my money market account. When the cash grows to a sufficient amount, or is added to by systematic profit-taking, I plan on buying more Sun Gro over time.

George Fisher, author of The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002) and All About DRIPs and DSPs (McGraw Hill, 2001), Sagamore Beach, MA [email protected]

Copyright North Shore Associates 2004