Upside too Limited -- Selling Precision Drilling (PDS)

This afternoon I sold my shares in Precision Drilling (PDS), largely because of the changing dynamic for this company and its fellow income trusts following the Canadian government's decision to change the taxation status for trust distributions.

It wasn't long ago that I bought these shares -- a very poorly timed buy in mid-October, just a little while before the tax change was surprisingly announced -- and I hate to give up on the shares at this early stage.

But after spending some more time going over the company and my portfolio, and reconsidering how the tax changes would impact me in the future, my assessment has changed -- PDS may well still be a profitable company, but the reduced dividend potential is enough to make me want to sell.

I counseled patience (at least for myself) after the tax change was announced, and I'm glad I didn't sell immediately -- the shares have recovered somewhat from their initial shellacking. But now that I've taken my time to look it over, it doesn't make sense to wait for the ax to fall in a few years. I'll take my 15% loss now and move on.

PDS came with a fair amount of risk -- it's primarily an oil and gas driller after all, so faces commodity price risks that are not dissimilar to those of my largest holding, SeaDrill (even though the two companies are very different). Additional risk came from their concentration in a particular geographic area (even though that area, Western Canada, is one of the prime hydrocarbon-producing regions in the world), and in their exposure to natural gas.

That risk was nicely accounted for by the fact that the company was quite cheap, and by the fact that their trust structure provided a very strong dividend to prop up the price during any shorter term business slowdown that might occur.

But now, with the potential for that dividend to shrink over the next four years by roughly 30%, with all else being equal we might expect the share price to eventually fall by a similar amount (trusts are income-oriented investments, and I'd expect them to trade more on their dividend than anything else).

So far it has fallen by about 15%. I don't know how long it will take the market to discount the remainder, or if it will happen at all -- it might be that the cheapness of the company is enough to keep folks holding on, believing that oil services revenues are likely to grow enough to make this a worthwhile hold. It is, after all, even cheaper now, and nothing has changed in their operations or outlook.

For me, though, this was an add-on to my core energy holdings, and the one that I am least operationally comfortable with. As long as I have solid well-managed exposure to natural gas through my holdings in Chesapeake preferred shares, and heavy exposure to oil drilling in general through my investment in SeaDrill, which I think has a much higher return potential, my holdings in Precision Drilling became expendable as soon as the future dividend became questionable.

Full disclosure: My PDS shares were sold today at $24.97 (purchase price had been $28.90). I continue to hold shares in SeaDrill and Chesapeake Preferred (D series).

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The Unmitigated Gall of This Week (UBS, CHS, EXEL, PDS)

I expect very bad results from my portfolio companies to come along every once in a while. That's part of why I maintain a very broadly diversified portfolio, and why I focus on a very long time horizon for most of my holdings.

But this week has been abysmal for the short term prospects of several of my investments.

As I wrote yesterday, Precision Drilling (PDS) -- my most recent purchase -- got caught up in the new Canadian tax proposals for trusts, bringing an immediate haircut of 15% or so. Still thinking about the long term prospects on that one, and whether it's worth holding on for what I think will be a good business, and for four more years of low-tax, high-yield dividends before the new law goes into effect.

Earlier in the week, UBS (UBS) disappointed -- their trading results were weak and brought down the earnings for this most recent quarter, and it is starting to look like their investments in expansion are going to put the kibosh on the full exercise of their buyback and on any significant increases in the dividend in the near term. Although the same trading problems impacted most of the major foreign banks and that kind of thing is certainly to be expected from time to time, I may need to look for an alternative investment in this space -- UBS has shown some nice gains over the past year, but the future is looking a little murkier for me in this name.

Then today, both Chico's and Exelixis get pantsed ...

Chico's (CHS) is wearing a bit on my patience -- I fully expect even a company with a history of excellent merchandising to make some marketing or merchandising mistakes on occasion, and with a company as excellent as I've thought Chico's is, I'd consider most of these mistakes to be buying opportunities. But the tought times have really piled up for this retailer -- same store sales growth disappointed through the Spring, and again at the end of the Summer and for the last several months the same store sales have declined, which is unheard of for this company prior to this year. That's led to reduced third quarter guidance today from the company, and another decline by more than 8% in the share price.

Call me crazy, but I'm planning to hold through at least the next earnings call and see exactly what management is doing to fix their problems in same store sales growth. The fact that they are still successfully opening stores, as evidenced by their overall sales growth of about 10%, is encouraging, and I continue to believe that there is ample room for significant expansion for at least their Soma and White House/Black Market concepts (and I really wish they would buy out Lucy, the activewear company that has venture backing from Chico's, Maveron and others, before it gets too expensive).

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Just as an aside, Maveron has got to be the most interesting venture firm out there -- using Howard Shultz's money, among others, they've backed not only Lucy, but the Motley Fool, Potbelly Sandwich Works, iFloor, Drugstore.com, and Eos airlines. I don't know what their record is, but they definitely are funding some fun companies.

And back to the bad news, today also brought about a 15% decline in Exelixis (EXEL), one of my larger speculative biotech holdings. EXEL doesn't have any drugs in production yet, and an investment in this company is a bet that their excellent scientific reputation and well-stocked pipeline of cancer drugs is going to bring at least one significant drug to the market.

The odds dipped a little bit today, as EXEL announced a very dramatic safety concern with XL999, one of their drugs in Phase II clinical studies, and from the initial announcement it's not at all far-fetched to assume that this drug will be dropped (nor is it a guarantee, since they are still continuing the study with existing participants even as they pause new enrollments).

They basically found that close to a third of newly enrolled patients in this study had "serious cardiovascular adverse events", and that about 10% of all enrolled patients had similar "events". That sounds awful to me, though I'm not a doctor and I suppose it's possible that the drug may still have some future.

But although this is certainly negative news, it's far from catastrophic for the company -- XL999 was among the more advanced EXEL drugs, one of four in early Phase II studies (there's one in Phase III, though it carries pretty limited financial expectations), so this cuts the chances that one of those drugs will make it through -- but the company also aims to file IND applications to enter the clinic with three new drugs each year, and they have three Phase I drugs and one IND lined up just behind the lead group already.

So if you bought EXEL because you thought XL999 would be a blockbuster, which is unlikely given that none of these cancer drugs have really progressed far enough to wow investors with their efficacy, you are very disappointed today.

If, on the other hand, you bought EXEL because the pipeline is strong and deep, this isn't much of a reason to sell even if the 10-15% haircut is fair -- after all, you'd have had to predict that at least half of their Phase II drugs were unlikely to gain approval.

If you do the math, there is a certain logic to today's decline -- they have eight drugs in the clinic, so -- all else being equal -- one failed drug could conceivably make it fair to downgrade the value of the pipeline by 12.5%, roughly where we are today. Given that it might take 15 years to develop a drug, and that somewhere between 10-20% of all drugs that make it as far as Phase I eventually get approved, you could really get carried away with valuing these companies based solely on probability ... but EXEL, with their strong history in target identification and drug discovery, and their deep pipeline, remains in my portfolio and I hope they'll have better results with some of their other Phase II drugs.

So ... one cruddy week on the back of a women's retailer, an oil and natural gas driller, a biotech company, and a megacap international bank -- if anyone had predicted for me that all of these would get pounded at about the same time, and for different reasons, I'd have thought it very unlikely. Shows what I know.

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Free ride ends for Canadian Trusts (PDS)

Well, it turns out that my purchase of Precision Drilling Trust (PDS) a couple weeks back was very poorly timed. Today, in a hugely surprising move from the conservative Canadian government, Canadian Income Trusts lost their tax advantages over regular corporations.

Previously, trusts operated roughly like US REITs -- they didn't pay corporate income taxes, and instead distributed most of their earnings to investors in the form of dividends.

Now, however, in the face of a massive wave of trust conversions that shows no signs of a letup, the government that issued campaign promises to leave trusts alone is going back on their word. They will begin taxing distributions from new trusts next year at a rate analagous to the corporate income tax rate, and existing trusts (including PDS) will begin to pay that tax in 2011 (though they plan to cut the rate slightly by then).

So what does this mean? Well, apparently it means that trusts are now worth about 10-12% less than they were yesterday -- that's been the drop across the board. And with pretty good reason, since these trusts might be significantly hobbled by the fact that they have to pay taxes on their distributions AND still pay out most of their free cash flow in distributions, in addition to investors paying income taxes on those distributions. Trusts are certainly losing their advantages over corporations, which is exactly the point (it appears that the government really panicked when Telus and BCE, two of the largest corporations in Canada, announced planned trust conversions).

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And it looks like this tax will be paid at the corporate level, so it won't be any different for US investors than for Canadians -- we'll still pay tax on the actual dividends received, but the dividends would be expected to be roughly 30% smaller to account for provincial and federal tax.

If this was in effect for Precision Drilling today, and we estimated the maximum corporate tax rate of about 34% on trust distributions, that would theoretically reduce the existing yield to about 8.5% (from close to 13% on today's price drop).

It's possible that by the time we get to 2011 that impact could be either drastically reduced by much higher distributions if the business performs well, or the company could react to the tax by minimizing their distributions to avoid tax, further cutting into dividends. It's certainly possible that the trusts will spend the next few years coming up with financial work-arounds that help to minimize the tax impact-- it's way to early to know what will happen.

So what should I do? 8.5% was the low end of what I thought we might see as a dividend if business hit a downtrend with lower oil prices and higher rig counts in Western Canada -- so now I guess my worst case scenario is going to have to fall significantly further.

But while this had an immediate stock market bite, it's also true that the tax implications are four years out -- the distributions will remain untaxed until the 2011 tax year, and there's also plenty of time for Ottowa to change its mind before then (this move is opposed by at least 2/3 of Canadians in the polls I've seen this morning) -- or, perhaps, for trusts to convert back into corporations.

The fact that the tax change is several years out makes me want to take a few days to think about this, read the new rules carefully, and see how the market feels about the shares once the shock wears off -- but this is certainly going to make income trusts dramatically less popular in Canada, and that means I need to seriously reconsider holding these shares.

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Back to Buying (PDS)

Well, after a few weeks in hibernation ... I'm back! And I did very little to my portfolio during my time away from this site -- I made one purchase a couple days ago, which I'll talk about in a minute, but generally just let things slide. Google brought some great earnings to the table yesterday, which everyone heard, and I've been generally impressed with the continued strength across my portfolio companies here, early in earnings season, but I didn't see any prices that made me stand up and take notice or add to any of my positions.

What I did do, just a couple days ago, was buy a small opening position in Precision Drilling Trust (PDS). The catalyst for this was the writeup by the excellent 10QDetective, but I wouldn't have bought this quickly if I hadn't already been looking at this sector. I didn't know that PDS existed, but once I found out about it and did my research, I was sold.

I have mentioned a few times that I have a great fondness for some oil services and energy companies -- I only own a few, including SeaDrill (SDRL.OL) and Chesapeake (Preferred D), but I still believe that energy is in a long term bull market as long as economic growth, particularly in the developing world, continues to outpace alternative energy development.

And I've been thinking for awhile about diversifying my holdings in this area a little more. Two options that were on the table were a return to some Canadian Royalty Trusts I owned shares of years ago, including Enerplus Resources (ERF). I took great profits from those holdings when I sold at the end of 2004, but also missed an even stronger run in 2005 and early 2006 ... and the fact that the recent 25% haircut in oil prices caused these shares to dip made me think it might be a buying opportunity.

But I think it's probably not the right time to pick up these royalty trusts -- while the income is great, they rely on purchasing new fields and new resources and they'll be paying pretty solid prices for those going forward if they want to replenish their reserves and keep the monthly distributions high. They have the same problems with reserve replenishment as the oil majors, even though some of these trusts have a good number of years of reserves at current rates of depletion, and they're no longer the "undiscovered" gem that they were just a few years ago, so valuations are still pretty high.

And I thought about some more of the drilling names as well -- Nabors (NBR) in particular caught my fancy, as I've noted a few times, and it is so ever-loving cheap that I still find it hard to resist ...

... but then I read David Phillips' excellent analysis of PDS and it looked like an excellent mix of the dividend yield and energy services exposure I'd been looking for.

I won't go into much detail here, because that work has been done by Mr. Phillips so recently ... but PDS became an income trust (a lot like the REIT conversion process in the US) less than a year ago, and has slowly raised the monthly income distribution since then but still distributes a nice, low percentage of their free cash flow compared to many US REITs, and with very low debt levels.

They are a broadly diversified oil services company, not unlike a Shlumberger or Nabors or Halliburton, and they provide drilling and a broad array of oilfield services. PDS is one of the largest diversified operators in Canada, which is quietly one of the world's great petroleum powers (and certainly the biggest one to have very limited political risk for the US).

So this nets me a company with a great cash distribution policy in a good business that shows no signs of what I would consider to be serious decline (not unlike Rayonier, one of my favorite core holdings), but one without the reserves replacement risk or the hair-trigger relation to oil prices of the royalty trusts.

Canadian income trusts come in several flavors, for those who don't know, and they have grown exponentially over the past few years as the tax advantages they convey have migrated out of the oil patch and into nearly every Canadian boardroom. Royalty trusts are open-ended trusts that pay a royalty on the commodities they mine or drill, but Business income trusts, like PDS, are operating businesses that pay a high percentage of their income out as dividends to unit holders.

You can buy trusts that are tied to everything from ice to restaurant chains to the yellow pages, and Canadian Bell phone company BCE and Telus are converting to trusts this year -- so there is some risk that this bubble of trust conversion will cause a regulatory or tax backlash (though I'd guess that's not terribly likely as long as Canada's budget surplus continues to climb on high energy prices).

I really just like the idea of buying an excellent land drilling company with a focus on high dividends but a relatively low payout ratio that allows for expansion, and with a valuation comparable to Nabors and lower than most any other major company in the sector.

A couple other nice things to recommend PDS, and which helped in my decisionmaking: They are considered a corporation for US tax purposes, so their dividends qualify for the 15% tax rate (some trusts are Partnerships, which give me tax headaches); They may well have a big end-of-year distribution since they're required to pay out a large percentage of their distributable income; and unlike many other income trusts, they have pretty ambitious growth plans, including re-expansion to the US market (often conversion to a trust hobbles a business, preventing them from investing in growth -- that appears not to be the case, at leaste not yet, for PDS).

We'll see how it works -- as we learn more about the company after they've finished their first year as a trust I may be interested in building on this position a little further (unless, of course, natural gas really does return to $3 as some pundits appear to believe ... then all bets are off).

Distribution cuts are probably pretty likely in the next year or so if natural gas prices remain depressed and Precision's more desperate small competitors slash prices to keep equipment out of mothballs, but even a lowered distribution would probably keep the yield at 8-10% (it's nearer 12% at the moment), and my guess is that over the next several years prices are more likely to go up than down ... and that PDS' position as a dominant service provider in Canada's busiest energy patch will enable them to keep prices fairly firm.

Plenty of risk, but an intriguing company. Thanks to the 10QDetective for calling it to my attention at what seems to be an opportune time. I bought shares of PDS at $28.90.

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