Targa Resources Needs an Activist

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Writing a blog from the vantage point of your own firm is fantastically liberating compared with analyzing markets at a well-known behemoth, where any criticism risks offending a corporate client. Thus it was that in April 2014 I could write ADT and the Ham Sandwich Test, as we invoked Warren Buffett’s advice to only invest in companies with a sufficiently strong business model that they could be run by a ham sandwich. In other words, management can surprise you with their ineptitude. ADT continues to disappoint.

Sometimes the failings of management are rather more subtle. The “Peter Principle” holds that managers rise to the level of their incompetence, to the detriment of shareholders. Success in one position leads to promotion further up the corporate ladder until the demands of the role exceed the manager’s abilities, at which point he stops moving up. Too often, Boards of Directors stumble in their oversight and allows the management to engage in self-interested behavior This is what has happened at Targa Resources Corp (TRGP) which is the General Partner (GP) of Targa Resources Partners (NGLS). NGLS is an energy infrastructure business structured as a Master Limited Partnership (MLP). They run pipelines for Gathering and Processing (G&P) crude oil and natural gas, and provide additional “downstream” services such as fractionation, storage, distribution and marketing.

The business has been ably run by its GP, led by Joe Bob Perkins. Distributions since 2008 have grown annually at 8.5%. Even in 2015, with distributions on the Alerian Index down 6% compared with last year (see Measuring Dividend Growth is Complicated), NGLS has managed 6.2% growth. TRGP’s 2015 distributions are up 26.5% compared with 2014. That’s why you own the MLP GP rather than the MLP itself, because they grow faster and it’s where the people that actually run MLPs put their own money (see Follow the MLP Money).

However, TRGP’s operating excellence has not been matched by its strategic insight. Management has run the business well and at the same time destroyed substantial wealth for their investors, via a Board rubberstamping management’s self-serving recommendations. We need Joe Bob Perkins and his team to focus on operations and let someone more capable lead the company. July 2014 was the point at which the strategic inadequacy of TRGP’s leadership began to weigh on their strong operating ability. That was when the market’s growing recognition of their value  was highlighted with Energy Transfer Equity (ETE)’s attempt to acquire them. CEO Kelcy Warren is someone who clearly understands the value of the MLP GP (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). Although it’s breathtaking to consider today, with TRGP languishing at $41,in July 2014 negotiations broke down with TRGP trading as high as $160. In other words, Perkins and his Board were unwilling to sell their 42.4M outstanding shares of TRGP, citing undervaluation at that price.

TRGP remained bullish on the outlook for gathering and processing, because in October 2014 they announced the acquisition of Atlas Pipeline Partners (APL) by NGLS, with TRGP acquiring APL’s GP and related assets at Atlas Energy, LP. They paid with $610M of cash (financed with debt) and 10.4M shares of TRGP stock, (then worth $1.1B trading at an adjusted close of $104 on the day of the announcement, even though by that point it had shed a third of its value since the aborted discussions with ETE). Although they weren’t willing to sell at $160 in July 2014 to a primarily long haul pipeline company, three months later they were willing to trade their stock while taking on leverage (previously there was almost no leverage at TRGP) for a business with significantly more commodity exposure (APL’s G&P business is closer to the well-head with significantly less fixed fee contracts). In addition, they conceded $78M in GP/IDR givebacks at TRGP while paying $190M in change of control and transaction fees as part of the Atlas transaction.

Chart for Nov 29 2015 Blog

In 2015 TRGP and NGLS stock fell along with the rest of the MLP sector, although their operating performance remained fine. Then on November 3rd, management stunned investors by announcing that TRGP would acquire NGLS by issuing new shares to current NGLS owners. TRGP was at $58 the day before the announcement, and since then has sunk below $40 to complete a colossal destruction of value. Just prior to the announcement, TRGP was yielding 6.95% and NGLS 10.8%. The high yield on NGLS reflected a higher cost of equity, threatening to impede its ability to fund its growth by issuing new equity at a competitive cost. The logic behind the merger was to improve the distribution coverage by giving NGLS unitholders lower-yielding TRGP stock, and to improve the growth outlook by eliminating the payments to TRGP that take place under Incentive Distribution Rights as with most MLP GPs.

Investors in TRGP regarded the elimination of the economic and other associated rights of the GP negatively. TRGP always has the option to temporarily waive its claim to IDRs if it supports NGLS (as it did in the Atlas transaction), so why concede them permanently? Consequently, TRGP’s stock sank. But it was no better for NGLS unitholders. The pricing of 0.62 shares of TRGP for each unit of NGLS was expected to represent an 18% premium to the prior day’s close, but as TRGP investors reacted poorly to the loss of their GP rights the takeover premium quickly evaporated. On top of this, the transaction is taxable to NGLS unitholders.

Rather than lowering its cost of capital, TRGP management has managed to increase it. TRGP’s yield has jumped from 6.25% to 8.75%. Once again, the investment bankers advising an MLP have wrought mayhem (see Investment Bankers Are Not Helping MLPs). TRGP’s management has completed their 180 degree U-turn, from rejecting ETE’s overtures in 2014 when their stock was at $160 to now issuing a substantial number of new shares with the price 75% lower.

It represents strategic incompetence of Biblical proportions.

Given the reaction of TRGP and NGLS, everybody is poorer. Leon Cooperman dryly asked whether their advisors had expected such a market reaction on the conference call to discuss the transaction. It still has to be approved by both sets of shareholders. Given the series of mis-steps by this leadership team and the destruction of value they have perpetrated, it’s not clear why anyone would vote to approve. Joe Bob Perkins and his strategy team have clearly risen to the level of their incompetence. They should stick to running the day-to-day business and stay away from strategy because they are so bad at it. TRGP is desperately in need of new leadership, of interest from activist shareholders who will demand a more thoughtful approach. We plan to vote against the proposed transaction, and we believe all TRGP and NGLS investors would benefit from voting No.

We continue to hold TRGP as we believe the assets which have G&P exposure to the best basins and enviable downstream NGL logistics have strategic value to many midstream peers, and are worth substantially more in others’ hands.  We encourage the Board to consider their fiduciary duty to shareholders and act in their best interests by pursuing a sale of the company.

We are also invested in ETE.

 

Measuring Dividend Growth is Complicated

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You’d think this would be a pretty simple issue. It’s certainly an important one. Equity investors derive their returns from dividends, dividend growth and capital gains. A simple estimate of long term returns on an equity security is to add the current dividend yield to expected dividend growth to arrive at the expected annual return. If the dividend yield remains constant then the security’s price will rise at the dividend growth rate, hence adding them together makes sense. It’s a shorthand, necessarily imprecise estimate; the dividend yield can fluctuate and the growth estimate can be wrong. Currently, the S&P 500 yields around 2% and dividend growth has averaged 5% for the past 50 years, so a 7% long term return estimate for U.S. public equities is defensible on this basis. Different assumptions will produce a different result.

But the devil is in the details, as you will see. Since much of what we do is in energy infrastructure, we look pretty closely at the Alerian Index as the benchmark for Master Limited Partnerships (MLPs). Growth in distributions (what MLPs call the dividends they pay) is a key component of total returns in this sector, so what have distributions done in 2015?

There’s more than one answer. You can derive a monthly dividend rate on the Alerian Index (AMZ) by multiplying its month end yield by its price. Using this methodology, adding up the last 12 months’ dividends and comparing with the prior 12 months gives a drop of -4.0%. If you estimate the last two months’ of 2015 to be at the same rate as October, you arrive at a full year 2015 figure of -6.0% versus 2014. Another estimate uses just the October 2015 payout rate compared with the prior October, and on this basis they’re down -9.5%. None of these figures are wrong, they’re just different measurements.

The chart shows distribution growth using the one year change in the monthly rate going back to 2007. Prior to the collapse in oil, growth was running at around 5% so the 15% deterioration in the AMZ growth rate is similar to the drop that occurred in 2008. This roughly matches the performance of the index, which by September 2015 had fallen 40.1% from its August 2014 high, roughly the same as its 41.1% drop from June 2007 to December 2008.

Alerian Monthly Distribution Growth Chat for Nov 22 2015 Blog

Veteran MLP investors may recall that AMZ enjoyed positive distribution growth through the financial crisis and be puzzled by the chart showing it was negative. In fact, full year 2009 distributions were 0.5% higher than full year 2008. The year-on-year change in the monthly distribution rate was -2.5% in July 2009. Incidentally, Alerian reports that 2009 growth was +3%. They measure this by taking trailing growth multiplied by the year-end weights of those securities in the AMZ. This doesn’t necessarily reflect the actual experience of investors in AMZ in 2009. Methodology counts for a lot.

The drop in distributions in 2015 has been driven by exploration and production names, many of whom have cut or eliminated their distributions. Upstream businesses are highly sensitive to oil and gas prices. Midstream MLPs have done rather better. The GPs of midstream MLPs have done better still. For example, in our Separately Managed Account strategy, actual cash distributions and dividends for 2015 are coming in at 15.7% higher than 2014. Part of this is driven by reinvestment of dividends, so reversing this feature to get to apples and apples results in 12% growth, 18% better than the equivalent for AMZ. The table below shows selected holdings of ours. We don’t expect growth at the same rate, but it illustrates the difference in operating performance of GPs compared with the AMZ.

Name Trailing 12 Month Distribution Growth
Energy Transfer Equity (ETE) 37%
EnLinc Midstream (ENLC) 11%
Kinder Morgan (KMI) 16%
Plains GP Holdings (PAGP) 21%
Targa Resources Corp (TRGP) 24%
Williams Companies (WMB) 14%

 

Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Nothing herein is or should be construed as investment, legal or tax advice, arecommendation of any kind, a solicitation of clients, or an offer to sell or a solicitation of an offer to invest in a fund or funds. An investment in a Fund may be offered only pursuant to the Fund’s prospectus.

 

 

Retail Therapy

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Retail stocks have recently taken a pounding. Nordstrom (JWN) fell 15% on Friday following weak earnings. Macy’s (M) fell 14% a couple of days earlier following their earnings. All of a sudden retail is a tough business. Consumers aren’t buying quite as readily as they were. We’re not invested in the retail sector, so as I watched these stocks collapse I must confess to experiencing the kind of grim satisfaction that one feels when others experience a discomfort with which we’re already uncomfortably familiar. A friend reminded me it’s Schadenfreude. It’s not just energy infrastructure names that can cause sharp, sudden financial pain to their investors. Yeah!! Finally, it’s somebody else’s turn for a price shock! Readers who are invested in retail stocks will hopefully forgive this temporary insensitivity to their plight.

Although the S&P500 is flat for the year, there’s evidence to show that individual, retail investors have had a substantially worse time of it. Master Limited Partnerships (MLPs) are predominantly held by individuals whereas U.S. public equities are largely held by institutions. The 29% drop in the Alerian Index this year is substantially worse than the S&P500 and has been disproportionately endured by individuals.

Closed end funds is another area where individual investors dominate, because there’s insufficient liquidity to attract many institutions. The sector appeals because of the yields but also because of the opportunity to invest in funds at a discount to their net asset value. Many large funds are trading at double-digit percent discounts, reflecting the diminished appetite of new money to invest and close the gap. CEF Connect lists Pimco Dynamic Credit Income (PCI), DoubleLine Income Solutions (DSL) and Cohen and Steers Infrastructure (UTF), all fairly sizeable funds with a market cap of $1.6-2.6BN, with discounts of 13-17%. MLP funds in this sector usually trade at a premium, since investors value the 1099 for tax reporting (since direct holdings of MLPs generate K-1s) but even these funds are at a discount to NAV. Kayne Anderson (KYN), one of the largest such MLP funds at $2.2BN in market cap, is down 43% this year. Because they use leverage, like many of their peers, they will have undergone forced selling of positions in order to remain within their borrowing limits, causing a permanent loss of capital and illustrating some of the non-economic selling in the sector. KYN has a 10 year annual return of 5.25%, versus 9.4% for the Alerian Index. Leveraged exposure isn’t that smart.

Activist hedge fund managers are some of the smartest guys around. It’s interesting to watch their moves and copying them can be compelling. They’re often on TV and the stocks they own garner outsized media attention. You don’t have to try that hard either. For those unwilling to hunt through SEC filings there is a convenient mutual fund called the 13D Activist (DDDIX) which invests in stocks targeted by activists. It’s down 9.1 for the year. It owns Valeant (VRX), which has ruined the year for a few Masters of the Universe as well as retail investors.

So it seems as if individual investors are having a pretty tough year that is not reflected simply by looking at the S&P500. Asset classes that are most favored by individuals have had a tough year, and as we head towards the Holidays it’s a time for dumping what’s not working. Tax-loss selling or simply cutting loose investments that have not worked is depressing certain security prices by a surprising amount. It’s likely causing some of the liquidation we’re seeing  that often appears to be borne out of resignation rather than an assessment of new information.

My retired bond trader friend was well known for making money from bearish bets on bonds by selling first and buying later, although he always maintained that he was comfortable making money in either direction. He did this more regularly than most and enjoyed substantial professional success. However, while enduring a particularly tough period of shorting the market only to be forced to cover at a loss, he was lamenting to his wife how difficult it was to make money. Her breezy advice was to do what she did when she was fed up; go out and buy something. Of course, buy first and then sell was the answer.

Retail therapy is what’s needed by today’s retail investors, and the retail industry could certainly use it.

 

Investment Bankers Are Not Helping MLPs

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Several MLPs released earnings last week. Results were mixed. November is seasonally a weak month (see Why MLPs Make a Great Christmas Present), and many investors are weary of the sector after its second ever worst year. So reports below expectations resulted in steep drops, while good earnings caused modest ones.

Plains All America (PAA), which is in the crosshairs of the drop in U.S. crude oil production as the largest crude oil pipeline operator, met 3Q15 expectations but lowered 4Q15 guidance and didn’t provide any for 2016 which drew a sharply negative reaction. Their current distribution of $2.80 yields just under 10%. There’s no plausible risk of it being cut and flat 2016 growth should be followed by a resumption of growth in 2017. Plains GP Holdings, PAA’s GP, yields 7.2% having just increased its distribution 21% year on year. At $12.82 PAGP is down almost 60% from its August 2014 high of $31.55. What’s probably not well understood is that PAGP has only $559MM of debt. The $10.2BN of long term debt they show on their consolidated balance sheet is mostly $9.7BN at the PAA level. With $617MM of distributions coming to PAGP from PAA, and a public float of only $2.8BN (65% is already owned by management and entities with board representation), PAGP could easily take itself private through an LBO. They’d simply switch public equity holders for debt, increasing their upside exposure by 50% by using what the company would have paid in dividends to service the debt. This would not be a good outcome for public unitholders since the price is so low, but would represent an opportunistic roundtrip for the insiders who only took PAGP public two years ago at almost twice today’s price.

NuStar (NS) lowered 2016 guidance due to reduced volumes out of the Eagle Ford in Texas, and its price fell sharply as a result. Crude oil pipelines represent a quarter of NS’s EBITDA and gasoline & distillate pipelines comprise 30% while Storage of refined products and crude oil represents just under half (they have a small marketing business). The Storage business did well; the silver lining of excess crude production is increased demand for places to put it. They are at capacity and are raising prices on renewals. Neither NS nor its GP, Nustar GP Holdings (NSH) are growing their distributions at present, although we believe that will eventually happen. Meanwhile, NS and NSH yield 9.6% and 8.9% respectively. Energy Transfer Equity’s (ETE) three MLPs (Sunoco, Sunoco Logistics and Energy Transfer Partners) all had good quarters but nonetheless sold off.

Enlink Midstream Partners (ENLK) modestly exceeded expectations but its price fell nonetheless. Its GP, Enlink Midstream, LLC, yields 5% and reaffirmed its guidance for 15% distribution growth in 2016. ENLC purchased ENLK units recently alleviating all equity capital requirements in the near term.

The biggest shock of the week though was the announcement by Targa Resources that its GP (TRGP) will buy in its MLP (NGLS). While operationally Targa is well run, its strategic mis-steps are breathtaking. In the Summer of 2014, negotiations to sell itself to Energy Transfer Equity (ETE) broke down when TRGP was trading at $150. At that time, management argued the stock was undervalued. Now, having lost fully two thirds of its value, they see fit to issue TRGP shares in order to buy in NGLS. The case in favor for NGLS investors is a lower cost of capital and modestly better distribution coverage (although they’ll be receiving a lower distribution from TRGP than they were from NGLS). As with the Kinder Morgan transaction, the NGLS assets move to TRGP with a stepped up cost basis, eliminating TRGP’s tax obligation for many years but at the expense of being a taxable transaction now for NGLS unitholders. The 18% premium that TRGP is paying for NGLS is intended to compensate but in our view is needlessly generous. Most significantly for us, TRGP is foregoing the GP/MLP structure, which sacrifices valuable flexibility and is one of their most attractive features. The GP is also a prized acquisition target. The market reaction was swift, and by day’s end investors in both securities were worse off than if the transaction hadn’t been announced. We think management may be acting defensively to pre-empt a bid for TRGP in the same way that Williams Companies (WMB) sought to buy its MLP, Williams Partners (WPZ) before eventually agreeing to sell itself to ETE.

Leon Cooperman, whose fund Omega is a significant investor in TRGP, noted the 8% drop in the stock price and dryly asked on the conference call, “did the advisors that worked through this transaction with you expect this type of market reaction?” Since investors in both TRGP and NGLS saw a substantial loss in value on the announcement, and since TRGP management has shown themselves to be strategically inept, one would think that shareholder approval of the deal is by no means certain and perhaps even a hostile bid will appear to relieve TRGP of its burdensome stewards. We would be supportive of such. TRGP needs new leadership.

The deal hurt valuations of other GPs as investors considered where else investment bankers might show up. The MLP GP is the most attractive place to be in the MLP structure, and TRGP’s apparent rejection of it has led to selling of other GPs and left investors puzzled. In recent weeks they’ve persuaded Kinder Morgan (KMI) to issue dilutive, poorly structured securities (see MLP Earnings Offer Scant Support for Bears and Rich Kinder Gets Outplayed) and now destroyed value for TRGP/NGLS. We’d all be better off if Wall Street bankers refrained from offering any more help, and let the industry just get on with its business.

We are invested in ENLC, ETE, KMI, NSH, PAGP, and TRGP.

 

 

MLP Earnings Offer Scant Support for Bears and Rich Kinder Gets Outplayed

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We’re in earnings season and several Master Limited Partnerships provided updates this week that were generally unsurprising and reflected the stability of their business models. On Monday, Energy Transfer Partners (ETP) announced an 8% year-on-year increase in their distribution. Their GP Energy Transfer Equity (ETE) increased its distribution 37% on a year ago. These securities yield 9.5% and 5.5% respectively. ETE expects to close on its acquisition of Williams Companies (WMB) during 1Q16 which will add Williams Partners (WPZ) to the family of its MLPs it already controls (along with ETP they also control Sunoco LP and Sunoco Logistics Partners, LP).

Enterprise Products Partners (EPD) announced earnings showing 5% growth in distributions with 1.3X coverage. Its price rallied but still yields 5.8% based on its forecast next twelve months’ distribution. WPZ reported a 21% year-on-year increase in 2015 EBITDA driven by good performance from several fee-based projects. WPZ rallied on the news although curiously its future controlling entity ETE did not, even though ETE will ultimately benefit from this performance through its ownership of WMB. On the earnings call Williams noted that low prices for natural gas had led to about 900 million cubic feet (MMCF) per day of “shut-ins” whereby the E&P company temporarily stops producing natural gas because of the low market price or lack of infrastructure to get it to market. To put it in perspective, the U.S. consumes around 77 BCF per day, so this is a little over 1% of consumption. It didn’t seem to hurt results and they expect some of that production to come back online in the near term.

Overall, results were steady and unspectacular, which is usually the case. Distributions were as expected, growth guidance was generally reaffirmed. As I often say, the business performance is far less exciting on a quarterly basis than one might conclude by observing movements in MLP unit prices.

Kinder Morgan (KMI) also issued a $1.6BN mandatory convertible security, and regrettably it looks as if they were ripped off by their bankers. When they began contemplating alternatives to issuing equity, their stock was trading in the low $30s and their reluctance to sell equity at this level was understandable. Instead, they’ve sold equity at possibly as low as $27.56 (the lowest possible price at which conversion can occur). This is where their shares wound up when the deal was priced, no doubt depressed by the underwriters shorting the stock to hedge the new convertible issue. The 9.75% coupon they’re paying on this security is higher than either KMI’s debt or equity even though it sits between those obligations in seniority on their balance sheet, and the only risk being taken by the investor is the possibility of being converted into common at $27.56 at a time when the market price is below that. While the rating agencies treat the issue as equity, those bearish on the security will argue it’s high-cost leverage and that management is signaling they’re worried that the stock is headed much lower than $27.56.  The bulls will see it as super expensive, dilutive equity.  It’s inconceivable that KMI expected this outcome; they would have been far better off continuing with their original plan of regular equity issuance. A rare lose-lose from Rich Kinder.

My new book, Wall Street Potholes, was just released and it’s aimed at retail investors. I may have to start working on another version written for capital markets clients outfoxed by their bankers.

Overall, there wasn’t much over the past week in fundamental news to provide much support to bears. The most negative issue might be the continued volatility and relatively high dividend yields.

We are invested in EPD, ETE, KMI and WMB

 

 

 

 

 

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