Description
Sound Energy Trust has been left for dead in the wake of the Canadian government's attack on income trusts, and a very large distribution cut....but now represents a very compelling value imho. SND offers roughly a 16.2% yield (which is taxable at a very favorable 15% rate for U.S. citizens) as well as potential for significant capital gains on top of that yield, as the market corrects the company's extreme undervaluation.
Background
On October 31, 2006 the current Canadian government announced that it would seek to pass legislation essentially causing income trusts to lose their current tax-exempt status and be taxed like any other corporation, starting in 2011. The result was an immediate, massive sell-off by the energy trust sector, from which the sector has not recovered. The average energy trust is down 19.57% since Halloween..and the true impact of the proposed tax has been even worse than this raw number would suggest, as other energy stocks have been very strong over the same time frame (the XLE is up 16% in that span, for instance).
In the months following the "Halloween Massacre", more than half of the energy trusts determined that, given their much-reduced unit prices and somewhat soft commodity prices, it was prudent to cut distributions such that they were able to pay distributions and capex completely from cash flow, rather than by issuing additional devalued units.
SND was one of the energy trusts which decided that lowering their payout was appropriate. So, in mid February, the company announced that they were slashing their monthly distribution by 45%, from .10 per month all the way to .055 per month. The market was clearly disappointed, as this cut was larger than most others in the sector and larger than most sector observers expected from SND. SND sold off hard following the news and has yet to recover.
However, SND is still yielding a very impressive 16.2% (which compares very favorably to the sector average of 12.5%) and that yield should now be extremely sustainable (meaning that SND shouldn't have to cut its payout again, or raise money to make its payout)
It might take awhile for the market to completely "forgive" SND management for the large distribution cut (particularly in light of the fact that SND had also made a surprisingly large cut once before, in mid 2005). But SND shouldn't have to cut its distribution again and the company's recent guidance was extraordinarily good vs. its current unit price. Any concerns about SND's management are much more than priced in at current levels imho.
SND is dramatically undervalued relative to peers
Assuming AECO ngas prices at 7.80 and WTI crude at 63.63 (I believe that this baseline strip, which represents the actual average AECO and WTI prices in Q1 2007, is a reasonable estimate for 2007 commodity prices.... particularly considering that the 12 month strip is currently 8.47 AECO and 67.01, respectively), SND would have a 2.37 price/cash flow ratio in 2007 based on the company's guidance. Very impressively, no canroy other than TUI and THY (both of which are widely considered to be sector basket cases, due to perpetual large guidance misses) is projected to be below a 3.5 price/cash flow and the projected sector price/cash flow average of about 5.33 is roughly 2.2 times SND's price/cash flow.
Similarly, SND's projected 2007 pay-out-ratio ("POR") of around 40% (again, these projections are assuming the $7.80 AECO, $63.03 WTI price deck given above) and all-in POR (capex plus distributions/cash flow) of about 72% are both incredibly low for a trust yielding 16.2%.
SND's NAV, as calculated by the company using a seemingly reasonable price deck and 10% discount rate, is 5.05, meaning that SND is currently trading at roughly a 20% discount to NAV. I believe that this is one of the largest discounts to NAV in the sector.
It's also important to note that SND has very extensive tax pools, sufficient to "shield" its net income such that the company will likely pay no taxes for 3-4 years once the Trust Tax presumably goes into effect in 2011. This is a very big deal, as it essentially means that the Trust Tax (assuming it is passed as proposed which, while not certain, is the assumption I'm making for purposes of this write-up) will not affect SND's cash flows at all for 3-4 years after enactment. Few energy trusts have tax pools anywhere near as impactful.
Despite all of this, SND is down an astonishing 39.3% since Halloween versus a sector average of 19.57% (and the only two trusts down more are undisputed basket cases THY and TUI, neither of which is in the same league as SND). That underperformance will likely be corrected over time imho, given their stellar guidance, and the fact that they are one of the trusts best suited to operate within the new tax regime thanks to their tax pools, which should negate the Trust Tax's impact for 3-4 years.
Strong Q1 report ahead
I estimate that SND'S Q1 2007 report, which is due out on May 14, will show an improvement in cash flow per unit of a whopping 27.5% in Q1 2007 compared to Q4 2006. That's especially impressive considering that many trusts will show lower sequential cash flow per unit.
I expect the market to be very impressed with this improvement, and think that SND will move up significantly after releasing the Q1 report.
I project SND's Q1 POR at around 43.1%, which is extremely low for a trust yielding 16.2%.
These projections assume that SND's Q1 production was close to guidance.. But I don't see a lot of risk there, as SND just confirmed in a presentation at the end of April that current production is around 10,100...which is just a touch below guidance of 10,206 (not enough of a shortfall to make an appreciable difference in their metrics).
SND's IR has said that the trust is likely to pick up additional analyst coverage sometime after reporting Q1. If so, this could be a real boon to SND as they are woefully overlooked by the analyst community (only one analyst covers the company, making SND the energy trust with the most minimal analyst following) and any additional analyst coverage should serve to help get SND's very compelling value story across to investors.
Catalyst
1) Market recognition of SND's extreme undervaluation
2) Very strong Q1 report, followed by possible additional analyst coverage.