Okay NDP. Listen up: “Debt is the pariah in the new economic order”

There was a good article in Saturday’s Globe by industry player (read: not a lame reporter) Tom Bradley entitled “Debt is the pariah in the new economic order”. This is a reality that all Canadians, especially policy makers need to understand.

Interest on debt, like distributions on income trusts is paid from pre tax cash flows. Both are then taxed in the hands of investors. So far, so good. The differences between debt and income trusts are however twofold. First distributions on income trusts paid to foreign investors is taxed at the rate of a 15% withholding tax. Courtesy of Jim Flaherty (the true progenitor of tax leakage), interest paid to foreigners is now taxed at a rate of ZERO. Flaherty reduced the withholding tax on interest from 15% to ZERO in the 2007 budget. This causes tax leakage, without a doubt. The other main distinction, that is making itself known these days, what with the pending bankruptcy of Nortel and Canwest today issuing warnings on its debt covenants, is that debt has interest and principle obligations that are mandatory repayment obligations. The failure to make timely interest and principle payments, means that a company is insolvent. When was the last time you heard of an income trust going insolvent?

An income trust will (virtually) never go insolvent as there is no obligatory payment of distributions to unitholders and there is no fixed maturity repayment. Distributions are paid to investors in accordance with the “ability to pay”. There is never any mismatch in the ability to pay with an income trust. If Nortel and/or Canwest were income trusts, they wouldn’t be filing for bankruptcy or be in default of their debt covenants. This is a virtue that is lost on many, including the NDP. Apart from this important virtue, the attributes of an income trust, versus a common share, are such that the marketplace is wiling to place a higher value on a business structured as a trust versus a corporation. This is simple matter of supply and demand, and has nothing to do with any tax benefit conferred on trusts at the expense of Ottawa, since Ottawa collects as much from a business as a trust as it collects from the same business as a corporation, and often more.

The corollary of this higher value that is placed on these companies formed as income trusts, is that they have a lower cost of capital and are much better able to compete in the global economy, where cost of capital is a major determinant of competitiveness. We do want Canadian enterprise to be competitive don’t we? Those who lobbied for the death of income trusts were actually lobbying for a preservation of the status quo, and sought to deny the emergence of the greater cost of capital competitiveness of Canadian businesses.

If the NDP thinks that there is a tax benefit conferred on trusts at the expense of Ottawa, then they need to prove it. 18 pages of blacked out documents is all Flaherty has offered as his empty "proof". Is that the NDP’s standard of proof? I certainly hope not, if they wished to be viewed as a credible junior opposition party.

Meanwhile, BCE provides a good case example of the new paradigm of debt being the pariah of the new economic order. Denied by Harper ans Flaherty to maximize shareholder value (and tax collection to Ottawa), BCE resorted to a LBO, that would have seen Ottawa lose $800 million a year in taxes (vis a vis an income trust) and see the company burdened with a capital structure that was 90% debt (or was it 105%?). That looming debt load was what prompted BCE to fire 2500 people and increase service costs to its customers. Is that what the NDP stand for? Meanwhile the BCE deal was completely stillborn in this new economic order that is before presently us. BCE was deemed to be insolvent before it even left the womb of the cowboy capitalists who conceived it.

Wake up NDP. Somebody has to own these companies. Preferable don’t you think that these companies be owned by Canadians (rather than foreigners) under a capital structure that ensures their ongoing survival and competitiveness? A model that also just happens to maximize the collection of tax revenue by Ottawa. Yes Virginia. I am speaking about income trusts.

Debt is the pariah in the new economic order

TOM BRADLEY
Globe and Mail
January 10, 2009

When trying to explain what's going on in the stock market, we often draw comparisons to the housing market. It helps to put the mysteries of Wall Street into terms that people are more familiar with, namely real estate.

For the purposes of this column, the analogy is useful in discussing how a new economic order is developing in the corporate world.

For purposes of the comparison, the house is equivalent to the company's operating assets - its facilities, staff, products, customers and brand. In the case of the house and business, the assets have a capital structure laid over top. The homeowner likely has a mortgage on the house. A business may have some long-term liabilities against its assets, such as bank debt, bonds and/or preferred shares.

If the value of the assets drop from $500,000 to $400,000, not everyone is affected equally. Mature homeowners with no debt are down 20 per cent. That's serious money, but not nearly as bad as a younger family with a $300,000 mortgage. Their equity has declined 50 per cent.

Leverage and a 20-per-cent drop in asset value makes for a wide range of outcomes, which shape future options and actions. A family with a small mortgage and a need for more space can use the weak environment to upsize. They're smiling all the way. At the other end of the spectrum, the new owner who put zero down has been wiped out and is looking for rental accommodation.

In business, the severity and duration of the credit crisis has made a company's capital structure a key differentiator. The economic order is changing based on whether you're "levered" or "liquid." Companies with a clean balance sheet, no near-term debt maturities and some cash around haven't had to do anything new or different to move up the industry ladder. They've just held their place while their once formidable but debt-laden competitors have slipped into survival mode.

Think of it as revenge of the guy who drives a seven-year-old Honda Accord and has no mortgage, or the executive that finished second on his last three deals. Over the past five years, a period when anything that moved could get a loan, these under-levered "losers" lagged behind, but they're looking pretty good now.

The impact of the credit crisis has been nothing short of remarkable. One of the most extreme and tragic examples of this is Teck Cominco. The company is well run, owns high-quality assets and is diversified across different commodities. And it has always had a strong balance sheet, until recently when it did a heavily leveraged deal at the top of the market (Fording Coal). With the rapid decline of commodity prices, Teck has gone from being one of the world's leading mining companies to fighting for its life, all in a matter of months.

Teck, and other firms like it (levered), will be forced to sell assets at distressed prices and/or dilute existing shareholders, just as the banks have done. And they need the credit markets to open again so they can refinance their debt. Other cyclicals like Barrick, Potash Corp. and Magna International (liquid) also want the credit markets to reopen, but their motives are different. They want access to credit so they can expand their capacity, purchase distressed assets or do deals that are accretive to profits.

The hypersensitivity to financial strength has caught many investors off guard. Buying stocks when they're beaten up is a value investor's bread and butter, but it hasn't worked so far. Stocks with any balance sheet or liquidity issues have started out cheap, got cheaper, hit a point where there was no downside, became a screaming buy, and then ... and then ... became too risky to hold because of the threat of bankruptcy. The reward/risk measure gets better and better until it flips over.

Leverage and the credit crisis have dealt some companies a serious blow. But I'm not as discouraged as most people. Companies will recover and many will come out of the downturn in a stronger position than they went in.

In the meantime, there is a new greeting etiquette developing among business and investment people that reflects the importance today of a sound capital structure. A typical exchange on the Street goes something like this.

"Hey Jake, how are you doing?"

"Levered. How about you Fred?"

"Liquid. Hang in there buddy."