How a spin-off can give shareholders headaches
When companies set out to benefit shareholders they can do so in strange ways, says this analyst as he dissects one firm’s spin-off.
When companies reward their shareholders, it’s good.
But sometimes those rewards can be a mixed blessing. Especially when so-called spin-offs are involved.
We don’t mean the kind of mixed blessing that occurred when BCE Inc. (TSX-BCE) spun out shares in Nortel Networks to its shareholders.
For those who saw the shares turn from gold into straw, there was very little blessing in the mixture.
No, we’re talking about a more recent spin-off that is proving to be something of a head-scratcher for shareholders.
At least, it is for Mr. John Sartz. And if he, a seasoned investment executive, is scratching his head, what is the average shareholder to make of it all?
This is the case of Toromont Industries (TSX-TIH) and its decision to split itself up by spinning out gas compression firm Enerflex.
Mr. Sartz tells the full story in the latest edition of Investor's Digest of Canada, and it has more twists and turns than your average thriller.
Inducing headaches
Toromont has two businesses. It is one of Canada’s two big Caterpillar heavy equipment dealers (Finning International (TSX-FTT) is the other), holding the franchise for Manitoba, Ontario, Nunavut, Newfoundland and eastern Labrador.
It is also in the gas compression business. This is where Enerflex comes in. In fact, it has come in more than once, which is part of the confusion.
When Mr. Sartz first bought shares in Toromont in the mid 1980s, “the company, in conjunction with John Aldred, Enerflex’s founder and CEO, were the only shareholders of Enerflex.”
It was a private company providing compression services in the oil patch. It did so well that it eventually went public, and Toromont let go of its holding.
“So far, so good!” says the analyst. “The behavior thus far seems quite rational. Regrettably, more recent history becomes headache inducing.”
Now another company comes into the picture.
After much acrimony
A few years ago, Precision Drilling (TSX-PD) one of Canada’s top oil service firms, decided to get into the compression business.
But the company had overextended itself, relates Mr. Sartz, and it decided that compression didn’t fit within its “core competency.” So it sold the business to — Toromont.
This was a substantial addition to Toromont’s gas compression business. Yet Toromont wanted more. Here the history “gets a bit bizarre.”
A year ago, after rumours had been flying around for some time, Toromont made an unfriendly bid for Enerflex, which by now was an income trust, under the name Enerflex Systems Income Fund.
Despite the fact that it had once had a stake in Enerflex, Toromont was now in for a fight. “After much acrimony, and one shudders at the millions of dollars spent on legal fees and financial advisers, Toromont bumped the price a bit, and Enerflex became a wholly owned subsidiary of Toromont in the spring of 2010.”
After all that, you might think Enerflex was a keeper. Not quite.
The tax man benefits
“Fast forward to the present,” says Mr. Sartz. In November, Toromont announced that is was spinning off Enerflex to its shareholders. Existing shareholders will own Toromont, “hereinafter known as the core business, and will additionally be shareholders in Enerflex.”
The analyst has one pertinent question. “What causes my headache to materialize is when I try to fathom how on earth all this back and forth with Enerflex has served to improve my life as a shareholder of Toromont.”
When it comes down to dollars and cents, things don’t get any easier.
A year ago, clients of Mr. Sartz’s firm owned both Toromont and Enerflex Income Fund. When Toromont acquired Enerflex, “they received cash for part of their holdings, despite having opted to receive payment in Toromont shares.”
That meant capital gains taxes. What’s more, Toromont had become an outsized portion of client portfolios. Prudence dictated partial liquidation, and that meant more capital gains taxes.
The Enerflex spin-off will be a tax-free rollover. That’s good. The problem now is that both Toromont and Enerflex will be below the firm’s normal portfolio weight (and suffer the same fate in well-structured individual portfolios as well).
Thus Mr. Sartz and his colleagues will get rid of one or both or purchase more. They will choose the option that is the most tax efficient.
In the end, it is far from clear to Mr. Sartz that all of this has enriched his firm’s clients or himself as a shareholder of Toromont. “What is clear is the fact that the tax man has benefited, as have financial advisers and lawyers acting for both Enerflex and Toromont.”
And yet Mr. Sartz and his clients have been supporters of Toromont for over 25 years. The company has done a great job, he informs readers of Investor's Digest of Canada, and the shareholders have “fared extremely well.” It trades today at $31.07, and yields 2 per cent on its $0.64 dividend.
He just hopes it has all this “financial engineering” out of its system.
The lesson is clear. As an investor, feel free to watch the companies you hold like a hawk. Even the best of them can lead you through some head-scratching mazes.
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