Tuesday, 22 February 2011

Carfinco – More For You – Less For The Tax Man – More To The Story

Carfinco Income Fund (TSX:CFN.UN)
Units issued: 24.5 million
Units fully diluted: 24.6 million
Current monthly distribution: $0.02
Q1/2010 special distribution: $0.04
Q2/2010 special distribution: $0.10
Q3/2010 special distribution: $0.10
Q4/2010 special distribution: $0.31



Recent volatility in Carfinco’s trading price has certainly caught the attention of a number of investors simply based on calls to our office and postings on the chat boards. Since Christmas, the price twice dropped from the $7.50 range to around $6 before beginning a recovery as it is at the time of this writing.

We’ve seen this type of situation before with Carfinco as evidenced in the trading chart since July of last year. We do know that investors are awaiting some direction from management on what the future looks like in context of the tremendous $0.785 total of regular and special distributions that we enjoyed in 2010.

If one stepped into the market in January of last year for around $2 per unit, the cash and special distributions would have provided a 35% to 40% return, let alone a potential gain of 200+% on the value of the units.
Logic dictates that it will be very difficult for management to duplicate that combined performance in 2011. However, for those people who invested for yield and a high rate of return, is Carfinco any less attractive today or perhaps even more attractive than in 2010?
At this point we will stop referring to Carfinco as an Income Fund as for all intent and purpose, including from a tax perspective, it is a corporation.

What is an acceptable rate of return is of course a question answerable only by the individual. What everyone should be considering when buying yield is, what’s in my pocket after the tax man removes his hand?

The regular and special distributions investors received in 2010 will be taxed as income. Whatever Carfinco now sends investors are dividends, irrelevant of the fact it has not yet converted to a corporation.

“Distributions received from a trust are subject to the new “SIFT” (specified investment flow-through trust) rules, which makes any distributions received, treated as dividends for tax purposes. Whether the distributions come from a trust, or a trust converted to a corporation, the distributions received will be treated as dividends.”

A key point is that you will keep more in your pocket under the tax treatment of dividends versus distributions.

To illustrate the point that less can be more, we refer to a section taken from a circular as an energy Trust was preparing for conversion in 2010. The below numbers are not related to Carfinco in any way.

The Trust, based on its operational outlook, expects to be able to maintain its current monthly distribution of $0.06 per Trust unit for 2010 ($0.72 per unit annualized).

Currently the Trust anticipates that subsequent to the corporate conversion a monthly dividend in the amount of $0.045 per share ($0.54 per share annualized) will be paid to shareholders. Provided the conversion to a corporation is approved, dividends paid in 2011 will be taxed as dividends rather than regular income, as they are today. Certain investors may be entitled to dividend tax credits which would enhance after-tax yield and significantly reduce the after-tax impact of the reduction in distributions. The anticipated dividend rate would therefore provide an effective 3% after tax increase.
As such, the per share dividend is 25% less than the per unit distribution but after tax one is still ahead of the game with dividends. Of course, your personal tax situation has a bearing on the final net numbers. As a rule of thumb, you should be about 40% better off after tax with dividends versus distributions as they were calculated as income.

Under the trust or Fund model, Carfinco was paying out its earnings to its investors, which did impact or restrict rates of growth. As a corporation, we anticipate management will retain a percentage of earnings to strengthen the balance sheet thus allowing for greater leverage. It’s been often stated in the past that maintaining a 20% annual growth rate in the loan portfolio was the objective.

In part, this was dictated by Carfinco’s banking syndicate that would only allow so much leverage as the earnings were being paid out and not being retained. Now, there is flexibility to retain a percentage of earnings, enhance book value and enjoy additional loan leverage.

We can’t answer nor will we second guess what management and the board will decide is the right balance between what percentage of earnings will be retained and what shareholders will receive in dividends.

There is a new element in the Carfinco story as a result of valuation methods for corporations versus just the yield aspect of distributions.

We note in the January 2011 update from Industrial Alliance analyst Fred Westra that he gives Carfinco an $8.50 price based on 14x projected earnings of $0.61 per share. Discussions about Carfinco and its earnings power will now take on much more weight than in the past when investors and the investment community are valuing the “corporation”.

In the same report, Mr. Westra comments on the news that Carfinco hired U.S. based FBR Capital to knock on the doors of companies that might be interested in buying Carfinco.

This year should be interesting for investors and the company. Investors are waiting for management’s goals and objectives and a sense of what the dividend picture will look like going forward. We recently spoke with management and met with two Toronto based directors and it’s fair to say that this topic is very much on their plate. That being said, we expect it will be a couple of months before there is public discussion on this important item.

Should a company show interest in possibly taking over Carfinco, we’d expect the discussion about earnings, dividends and goals to be delayed in the public arena.

However, should a deal occur, that certainly answers the question for people who are looking for a healthy and immediate capital gain from current trading levels.

For those with a longer-term perspective, will today’s price provide you with an attractive after tax rate of return and the realistic potential of increasing earnings and a higher stock price into the future?