DEALS & DEAL MAKERS

Is Wall Street's Latest Kosher?

By DENNIS K. BERMAN
Staff Reporter of THE WALL STREET JOURNAL
April 7, 2004; Page C1

They were once Wall Street's great unwashed: humdrum businesses such as pickle merchants, hot-dog vendors and tiny telephone companies that haven't grown for years and whose prospects for expansion remain grim.

Now they are some of the hottest properties on the Street, which is using a novel, Canadian-born finance vehicle to roll out initial public offerings in low-growth, high-cash-flow businesses.

The finance vehicles go by different names, but they are generically called "income trusts" in Canada and as Income Deposit Securities, or IDS, in the U.S. All work on essentially the same concept. They typically stitch together a share of company equity with a company's junk-rated bonds, making them saleable in one "unit," much like a real-estate investment trust.

Instead of trading on a company's growth prospects, IDS units are valued on the consistency of their cash flows. Those cash flows are nearly all paid to shareholders in the form of quarterly dividends and bond interest payments. Banks expect that IDS issuers will pay annual yields of 8% to 11%, which they are hoping will attract investors still hungry for dividends in the wake of last year's dividend-tax rollbacks.

Canadian Imperial Bank of Commerce's CIBC World Markets, Lehman Brothers Holdings Inc., Goldman Sachs Group Inc. and Credit Suisse Group Inc.'s Credit Suisse First Boston are among those in a scramble to get an estimated $12 billion in new IDS issues to market this year. More than two dozen such issues are in the pipeline, say people familiar with the matter. These people add that local phone providers Alaska Communications Systems Group Inc. and Valor Telecommunications, along with Norwegian phone directory-business Findexa AS are soon expected to register their own IDS shares.

The IDS route, meanwhile, is essentially a way to put riskier junk bonds into small investors' hands. "You're basically doing a public leveraged buyout," says one private-equity investor. While the returns on IDS units are attractive, they are still riskier than the dividends offered by a traditional utility or real-estate firm, for instance. What's more, the Internal Revenue Service has yet to give its full blessing over how income trusts treat corporate taxes. And like any debt-heavy offering, a jump in interest rates could roil the income-trust market before it gets well off the ground.

Nonetheless, the income trusts are "getting traction because they are a yield product and that talks to baby boomers going to retire," says Jeffrey Rosen, a partner at Debevoise & Plimpton, which has helped to structure IDS deals.

The Volume Services deal, for instance, sold about 40% of its shares to individual, or "retail," buyers, with the rest soaked up by institutional investors, people familiar with the deal say. "These are understandable, Main Street industries. And that resonates with investors," says Earl Rotman, the CIBC vice chairman leading the bank's U.S. IDS effort.

Some investors like to describe the income-trust structure as "tax-efficient." IDS units are often tax-efficient, but not any more so than any other highly leveraged company. What is appealing to some investors is that IDS issuers often have large noncash expenses, such as depreciation, amortization or pre-existing tax losses. Those noncash expenses increase the amount of cash available for distribution as dividends.

The task for investors will be figuring out the stability of a company's cash flows. Companies with low capital expenditures are naturally ripe for the IDS model. A Goldman Sachs presentation notes that check printing, music and film publishing and oil-pipeline businesses make good IDS candidates. Goldman is marketing the income trusts as Yield-Oriented Units, or YOUs.

In Canada, 91% of all IPOs last year were done as income trusts, according to CIBC. "It's remarkably obvious what has worked and hasn't worked," Mr. Rotman says. What hasn't worked, says Mr. Rotman, are "businesses based on one or two customers, and businesses too susceptible to commodity-pricing risks."

A test of the U.S. market will come with the IPO of B&G Foods Holdings Corp., which registered to sell income-trust shares valued at $565 million late last month. The maker of pickles, Ortega Mexican foods and a host of smaller food brands, had revenue of $328 million last year, up 12% from a year earlier. Last year's earnings before interest, taxes, depreciation and amortization rose solidly, to $67.2 million, up from a 2002 Ebitda of $56.4 million.

But as the filing itself says, the company is dependent on its 10 largest customers for roughly 37% of its net sales, with Wal-Mart Stores Inc. commanding 6% of sales. The filing notes that, as the grocery business consolidates, "our retail customers may demand lower pricing" and offer their own private-label food brands.

What's more, the tax worries still hang over all these offerings, including B&G. The IRS is expected to want more comfort that the equity and debt being offered are truly separate equity and debt -- and not one simply disguised as the other for purposes of lower taxes.

So far, most major accounting firms have issued "should pass" letters to clients, which generally means that IDS issuers have about a 70% to 80% chance of passing the IRS's muster. This falls short of what is called a "will pass" letter, which generally offers about 90% assurance that the IRS will approve the tax treatment.

As B&G's registration notes: "The IRS may challenge our position and such challenge may be successful."

Write to Dennis K. Berman at dennis.berman@wsj.com1
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