MLPs Report Encouraging Prospects

It’s earnings season, and last week Enterprise Products Partners (EPD) reported another solid quarter. An appealing feature of EPD is the absence of a General Partner (GP). So unlike many other MLPs, EPD LP unitholders do not suffer a haircut to Distributable Cash Flow (DCF) from GP Incentive Distribution Rights (IDRs) before the cash makes its way to the LPs for their distribution. This allows the growth of DCF from EPD’s portfolio of assets to flow right through to EPD unitholders, thereby giving it a lower cost of capital than would be the case if there was a GP. Insiders also own 35% of the units, a significant alignment of interests.

EPD’s full year results came in modestly better than expected and their distribution growth from 2013 was +5.8%. They also have unusually high DCF coverage of 1.4X which allows them to fund part of their planned growth through this excess of DCF over declared distributions. EPD is positioning itself to support the U.S. shift to role of refined products exporter, and its planned growth capex is on the same trajectory as it was last Summer when oil was above $100 bbl.

Kinder Morgan (KMI) held their Analyst Day on Wednesday and provided further detail on the business following their earnings release the prior week. As they pointed out numerous times during the day of presentations, 85% of their 2015 cashflows are fee-based and a further 9% are hedged, leaving only 6% subject to commodity price swings.

NuStar (NS) was also interesting, in that their reported earnings showed distribution coverage of 1.1, at last sufficient to cover payouts to unitholders. It’s not that long ago that  their distribution was at risk, but they have exited the asphalt business, greatly reduced their commodity sensitivity and focused on the storage business. Analysts on the earnings call were even asking about the timing of a distribution increase. NS has a publicly traded GP called NuStar GP Holdings (NSH). Its current distribution generates a yield of 5.8%, very high for a GP. NSH receives up to 23% of the DCF of NS and it is currently at that level. As the business returns to growth NSH’s IDRs, 13.1% LP interest and smaller outstanding number of unit compared with NS should translate into roughly twice the distribution growth rate as that experienced by the other LP unitholders in NS. It’s why we prefer the GPs.

We are invested in EPD, KMI and NSH.

Energy Transfer Shows the Power of the General Partner

This morning Energy Transfer Partners (ETP) agreed to merge with Regency Energy Partners (RGP). Terms included an equity swap whereby RGP holders will receive 0.4066 ETP units and $0.32 in cash for each RGP unit they hold. ETP is also assming RGP’s debt. Energy Transfer Equity (ETE), ETP’s General Partner,  already owns the GP and Incentive Distribution Rights (IDRs) for RGP. However, the IDR’s were only at the 25% split level with respect to RGP, meaning that ETE was receiving 25% of RGP’s Distributable Cash Flow (DCF), whereas ETE is at the 50% splits on its share of ETP’s DCF. Simply put, prior to the merger ETE was getting more of each dollar generated by ETP than it was from RGP. Following the merger, RGP’s DCF will in effect be subject to the same 50% split at ETP’s. ETE has agreed to forego $320 million of IDR distributions over the next five years as a sweetener. It is nonetheless a nice deal for ETE and the relative performance of the stock prices reflects this. ETE is currently up over 4% reflecting its improved cashflow outlook, while ETP is down more than 5%, perhaps in part because of the issuance of additional units. RGP is up because the terms of the transaction represented a premium to RGP’s Friday close. RGP’s projected 2015 distribution yield was 8.9% prior to the transaction compared with 6.6% for ETP, so even allowing for the modest premium the transaction is still accretive to ETP. Importantly though, ETE investors most notably including CEO Kelcy Warren did not have to provide any capital to make this transaction happen; it’s been funded by ETP, as directed by ETE, its GP. The subsequent entity will also have a stronger balance sheet with a lower cost of debt, making future acquisitons easier to execute.

It highlights the advantages of investing in the General Partners of MLPs. They have all the control, and can execute M&A transactions that improve their economics with little or no obligation to provide additional capital. We are invested in ETE, as is Kelcy Warren who owns almost 80 million units of ETE worth around $4.5 billion. He figured this out long ago.

Kinder Morgan Finds Value in a New Pipeline Network

Master Limited Partnerships (MLPs) have been falling along with the rest of the Energy sector since oil began its plunge last Summer. Following its peak in August, the Alerian MLP Index is down 15.1%. So far it’s down 1.6% in January, typically a strong month as retail investors implement asset reallocations settled on over the Christmas holidays. However, there are some signs of stabilization as the Index was -8.9% for the month by January 13th so has rebounded since then.

We’re in earnings season, a time during which those firms with solid fundamentals and limited direct commodity price exposure can differentiate themselves by reporting their results and providing guidance. Kinder Morgan (KMI), although no longer technically an MLP since their reorganization last year, still derives over half their cashflows from natural gas pipelines and is solidly in the midstream sector. During the conference call following their earnings they went through the coverage of their $2 distribution and although there are many moving parts the distribution coverage looks comfortable even with crude oil substantially lower (into the $20s per bbl) and natural gas down to $1 per MCF. Their direct exposure to crude oil and natural gas prices is limited. They reaffirmed 10% distribution growth through 2020. The stock yields 4.7% on its 2015 dividend.

KMI also made their first investment in the Bakken Shale in North Dakota by acquiring Hiland Partners LP, a privately owned MLP with pipeline assets in a still under-served area, from Continental CEO Harold Hamm. The $3 billion price tag will help fund Hamm’s expensive divorce.

KMI expects to invest an additional $800M in these new assets, expanding their capacity to transport crude oil from North Dakota. At a time when many are worrying about production cutbacks by U.S. shale producers this decision to make a new capital commitment highlights an interesting advantage pipelines retain over other form of crude oil transportation such as rail or truck. Only around half the 1.2 million bpd of output from North Dakota moves by pipeline, so increasing the Double H Pipeline (for example) from 80,000 bpd to 108,000 by next year will help. Pipelines operate at as little as 25% of the cost of rail and truck. While the latter two can offer greater flexibility, once a pipeline is in place its substantial cost advantage makes it a formidable competitor, and the long term commitments required of shippers provide far greater certainty about future cashflows. Some have suggested that E&P firms will press their MLP partners for price cuts on transportation, but they’re more likely to start by cutting use of more expensive rail and trucking assets. Pipelines are also far safer, with proportionately fewer injuries or spills.

The impact of production cutbacks is more likely to be felt by the higher cost transportation networks such as rail and truck. The area of the Bakken served by Hiland’s network has, according to the North Dakota Department of Mineral Resources, an IRR of 10% even with oil as low as $38 bbl. It’s one of the more profitable areas, and likely to keep producing output at current price levels. The Hiland acquisition is expected to be accretive to KMI by 2017. The company isn’t immune to reassessing its backlog of projects though, and although the figure only fell slightly (from $17.9BN to $17.6BN), $785MM of planned capex was shelved, mostly in its CO2 division where they have more direct exposure to the price of oil. So there clearly are some reductions in planned investment because of the drop in oil. These figures offer a measure of their likely magnitude, at least for a bellwether midstream operator.

In other news, Markwest Energy (MWE) increased its dividend by 4.7% YOY. It currently yields 6.2% based on its expected 2015 distribution. MWE owns its General Partner too, so unlike many MLPs there is no drag on distributions to investors from Incentive Distribution Rights. Consequently, all the growth directly benefits MWE investors.

We own both KMI and MWE in our portfolios.

Health Care Versus Energy Within the S&P500

The chart below shows the performance of different sectors of the equity market so far this year. Of course, there are always sectors that are outperforming, so nothing much new there. However, if in general as an investor you don’t commit much to health care and you are overweight energy, recent months have likely given you reason to examine comparative performance rather more closely, as we have. If in addition you’ve had a couple of small positions in smaller energy names, you’ve also experienced first hand the relative underperformance of small cap stocks versus the market. Suffice it to say that the results of owning a handful of large health care stocks and being short a smattering of small energy stocks would have been about as perfect a position to hold over the last three months.

"EnergyThe chart tells the story, but to put numbers on it, while the S&P500 is +14% this year, Healthcare (defined as XLV, the sector ETF) has returned almost double at +27% while Energy is -19%. A good portion of the Health Care/Energy relative performance has occurred just in the past three months (28%). Interestingly, the daily returns of MLPs have been most highly correlated with Energy (64%), even though MLPs have outperformed Energy by a whopping 19.5%. In fact, at +11% for the year the performance of MLPs is not far short of the S&P500.  What’s happened is that bigger than typical daily falls in Energy spill over to MLPs even though midstream energy infrastructure (what most MLPs are engaged in) has a very different risk profile from Exploration and Production. So on days when XLE fell 1%, the correlation with MLPs was higher than normal, at 76%. MLPs react to sudden moves, but on the days when Energy is not down 1% or more (84% of the time this year) they react to their own economics.

So what does one conclude? The surprise of the past 2-3 years has been that ACA (The Affordable Care Act, or “Obamacare”) has been very good for the health care sector. I doubt many architects of that legislation expected to create such wealth for health care providers. However, the major news story of 2014 is clearly Oil. Small energy sector servicers have been extremely weak, while the economics for many energy infrastructure businesses have remained sound notwithstanding big drops in some of their customers’ stock prices. Friday was such a day. with the Energy sector -6.3% and MLPs -5.3%. There are substantial crosscurrents beneath the simply headline result of the S&P500.

 

Another Activist Exposes a Weak Board with a Lousy CEO

It’s an odd phenomenon that, although capitalism as a philosophy is built around the meritocracy of free markets, in the area of corporate governance the power of profit maximization has often failed to dump ineffective boards of directors and/or management in favor of more competent people.

Boards are usually made up of invited friends, and sometimes their supervision of senior management resembles that of golf partners where it’s good manners to ignore others’ poor shots while offering congratulations on the good ones. The pressure to avoid rocking the boat is felt by everyone.

Hence the Economist this weekend noted an innovative solution to the issue of weak, sometimes unqualified board members. Why not outsource the function to companies whose business it is to provide such services? This currently happens with audit and legal work. Board members are hardly engaged full-time by any one corporation. Why not develop specialists who are truly independent and full-time?

It struck me as quite a clever suggestion. It ought not to be necessary, but the many failings we see week after week highlight that capitalism is often coming up woefully short in this important area of corporate governance, or how the very stewards of capital are managed and evaluated. Even Warren Buffett punted when a few months ago he was asked about the egregious compensation plan recommended by Coke’s (KO) management.

Although Berkshire (BRK) is KO’s biggest shareholder and Buffett about as vocal on investor rights as anybody, the great man meekly abstained rather than vote against a plan he freely admitted was needlessly generous.  “If you keep belching at the dinner table, you’ll be eating in the kitchen,” was his typically folksy and non-combative explanation. He understands as well as anybody the duty of board members to be only occasionally critical and then in the nicest possible way.

Other examples include ADT, which as I’ve written before is busy demonstrating the ham sandwich test (invest in a company that could be run by a ham sandwich, because one day it will), as shown by their buyback of Corvex’s position in ADT stock last year at $44 just before disappointing earnings took its price eventually below $30. Activists are often a force for good as they seek to expose management failings, but Keith Meister’s Corvex is a negative since he’ll readily throw other investors under the bus for a quick profit. We own ADT in spite of its leadership since we think anybody could run it as badly as current management and many could do better. It’s an option on executive suite change.

Currently the role of using capital to improve management is taken by activists such as Carl Icahn. He just provided a stark reminder of how shareholders often need activists to correct some of their self-seeking behavior. Family Dollar (FDO) just the other day agreed to sell itself to Dollar Tree (DLTR), an unlikely partnership since they operate different business models and would continue to do so afterwards.

FDO CEO Howard Levine noted that no discussions had taken place with the more obvious and bigger merger partner Dollar General (DG), to whose steadily improving operating metrics FDO eternally aspired but never reached. DG’s CEO Rick Dreiling flatly contradicted this by noting that DG had expressed interest in a combination multiple times in recent years. Carl Icahn backed this up, recounting a dinner with Levine at which the subject of a combination with DG was discussed. With DG, Howard Levine will lose his job to the superior operator, whereas with DLTR he’d keep it. As Icahn memorably noted, Levine thinks that because his father founded the company the son owns it. But he doesn’t. FDO’s stock has consistently underperformed DG’s in recent years as has its business. As close competitors it’s been helpful for investors as well as the companies themselves to compare their relative operating performance which has invariably favored the larger, better run DG (we are currently invested in DG, and were until very recently invested in FDO).

DLTR was a better merger partner for a CEO putting his own job ahead of his fiduciary obligation to his shareholders, and the FDO board passively acquiesced. Levine even agreed to a $300 million break-up fee in the DLTR transaction, a final slap in the face to those stockholders who thought he had their interests at heart.

Investors though should be far more assertive. If well-run boards with good corporate governance were more highly valued, they’d arrive more quickly. The more a poorly run company’s stock is shunned the quicker activists or competitors can buy a stake and fix it. The best solution to poor corporate governance is to invest with competent management and avoid the poorly run, at least until they’re cheap enough to draw in an activist. FDO had at least met this test in the last couple of years. Even institutional investors don’t have to own every publicly listed large cap company. Until investors become even more discriminating in their allocation of capital, activists will continue to correct perhaps the biggest weakness in contemporary capitalism – the management of the executive suite.

The Trading Risk Confronting Some MLPs

Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.

IBM, The Stock That Gets No Respect

IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a short recommendation.

It’s true IBM has been a poor performer against the S&P500 over the past year. However, it has less volatility than the market with a trailing Beta of 0.66 so all other things being equal you would expect it to lag somewhat when prices are rising. And it’s true that revenue growth for years has been non-existent, hovering frustratingly around the $100BN annual level. However, earnings have grown nicely over the past ten years aided by improving margins and a reduced share count. So although revenues are flat since 2004, over that time EPS has more than tripled from $4.93 to an estimated $17.90 consensus forecast. The sharecount has dropped from 1.7 billion to around 1 billion as they relentlessly return cash to shareholders through buybacks.

As for debt, it’s true that it’s risen although IBM is hardly a leveraged company. They’re expected to finish the year with $48BN of long term obligations less Cash of $17BN for $31 BN of net debt, supporting pre-tax operating income of $21BN. This hardly seems like reckless leverage. Meanwhile, they still look to be on track to hit their target of $20 in operating EPS next year. At $194 a share it just doesn’t seem ridiculously expensive.

As for innovation, in 2013 IBM inventors received 6,809 patents, the 21st consecutive year of being the most prolific recipient of such awards.

So IBM isn’t that exciting on a daily basis, but it does look like a fairly compelling place to invest some of your money if you’re not one of those people who requires daily gratification on your stock picks. Fred Hickey’s price objective on his short IBM was $150 in the abovementioned article. At the time of his interview it was trading at $182 but has since risen $12, over a third of Hickey’s sought after gain. Shorting isn’t easy, and don’t imagine we’re claiming victory because we still own IBM and anything can happen. But there must be better ways to make money than trying to short IBM. They just keep generating cash, $18.1 BN in Cash from Operations (less change in Financing receivables) over the past 12 months, or about $18 per share.

For excitement, watch Amazon (AMZN) as they continue to break records for the most inefficient converter of revenues into profits. In ten years sales have increased sevenfold while EPS has halved. In their most recent quarter over $19BN in revenues, up 23% year on year, generated a small operating loss. The best investment you can make in Amazon is to sign up for Amazon Prime. Being a customer is far more likely to be satisfying than being an owner.

 

 

 

 

The Shifting Regulatory Landscape for Bond Investors

In my new book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, I make the case that some big trends in the U.S. economy and Finance began shifting following the financial crisis of 2008, the consequences of which will include interest rates insufficient to compensate bond investors for inflation and taxes (hence the Crisis). The last few days have produced two news items of note which illustrate the altered economic and political landscape.

On Thursday, the Wall Street Journal reported that “Embattled J.P. Morgan” would be bulking up its oversight by spending an additional $4 billion and adding 5,000 employees to clean up risk and compliance problems. No doubt the company has been hit by a succession of issues from the huge loss in the office of the CIO to problems with mortgage underwriting standards and commodities trading. They’ve responded by deploying substantial amounts of money and people to resolve these problems and reduce the odds of new ones in the future.

I can imagine the stultifying impact these additional legions of compliance, regulatory and legal experts will have on many aspects of business. I worked at JPMorgan for 23 years and it’s a great company. I know from first hand experience that when additional layers of oversight are added whose job is to basically say “No” to any transaction or new line of business that carries a hint of the risks that have so bedeviled them in the past couple of years, it leads to a pretty frustrating environment. If you choose to make your career protecting a large bank from the sometimes questionable instincts of its revenue-generating employees, “Yes” is a word that carries career risk and limited upside. Many potential transactions and activities will now not occur, because they won’t pass muster with an increasingly vigorous compliance culture or because the weary revenue generators will steer clear of anything that is the least bit questionable. It will certainly make it a less fun place to work, and will hurt the top line while seeking to curb the Legal Expense line. It will make banking at JPMorgan more risk averse, less interesting and presumably more aligned with the public interest. If you hit a bank with enough $500 million fines, they do get the message.

The thing is, senior management will be well aware of the potential impact on revenues of rejecting all but the most anodyne transaction and will no doubt strive to maintain a profitable balance between the competing cultures of “No” and “Yes”. They will be very sensitive to the new trade-off. And yet, they’ve still chosen to go down this road. The bank that most successfully navigated the financial crisis of 2008 has assessed the ongoing regulatory  environment which must increasingly look as if they’re every government lawyer’s favorite target, and have adjusted their posture accordingly. The political mood has shifted against big banks and Big Finance after thirty years during which financial services grew its share of U.S. GDP. This is one manifestation of the altered landscape.

A second story of note is Larry Summers’ withdrawal of consideration for the position of next Fed chairman. Interestingly, it was the lukewarm support from Democrats on the Senate Finance Committee that led to the calculation that Republican votes would be needed even to get the President’s nominee to the full Senate for consideration. Summers is regarded by some as less enthusiastic about increased regulation than they might like, further reflecting the mood for a more tightly controlled banking sector. Listening to Senator Elizabeth Warren discuss the urgent need for ever more banking oversight may not  reflect a balanced view, but it does once again reflect the new reality Finance faces.

Financial markets have this morning provided their input – bond yields are down and stocks are up, reflecting the view that a Fed Chairman Yellen will continue Quantitative Easing and low interest rates for longer than would a Chairman Summers.

Whether or not this is good public policy isn’t really the point – others may debate that. However, what both stories highlight is that a shift towards more banking regulation and dovish monetary policy pushes back the time when bond investors might expect to earn a decent yield on their savings. The market expects a Yellen Fed to continue to promote the interests of borrowers at the expense of savers through very low rates. The JPMorgan story illustrates that what’s good for Finance is clearly less important in Washington than what’s good for everyone else. So bond investors should conduct their affairs accordingly. Current interest rates are unattractive, and it will likely be a long time before bonds are a good deal.

 

Bridgewater Reassesses Flight to Quality

If you stop to think about it there are several analogies for the Fed’s “tapering”, under which they gradually relax the support which has been underpinning the bond market. Maybe it’s the parent who creeps out of the young child’s bedroom at night believing they’re finally asleep, only to be halted by renewed cries from the little one. Maybe it’s Jenga, a game played with wooden blocks where players alternate turns of removing one without causing the structure to collapse. Or perhaps the magician who dramatically whips the tablecloth smartly off the table while leaving the place settings unmoved.

Whatever imagery does it for you, somewhere within the investment horizon of most people the Fed will make their move. Which is why a Bloomberg article on Bridgewater’s $80BN All Weather fund caught my attention earlier today. It seems that in recent weeks Ray Dalio substantially reduced their exposure to Fixed Income. Apparently not in reaction to the weak bond market of the second quarter, but instead as a result of many months of analysis which concluded bonds were no longer as attractive in a portfolio that’s expected to generate positive, uncorrelated returns most of the time.

The classic justification for holding bonds is the diversification they provide to a heavy weighting in equities. It’s worked more often than not, but we may just be heading into a period of time that will test conventional wisdom. To start with, yields on high grade and government bonds are unattractive on a buy and hold basis. It’ll be hard to finish ahead of taxes and inflation with yields of 2-3%. The idea that bonds will rally during times of equity market stress, thus mitigating the inevitable mark to market swings of a conventionally allocated portfolio only seems to justify bonds if you’d actually sell them when they’re bid up through a flight to quality. Few investors do, and the ownership of bonds for the temporary sugar high that turmoil may bring seems less interesting when the long term prospects are poor. Watch for creative explanations from financial advisors to defend clients’ bond holdings in the future.

But the other side of things is that stocks and bonds may at times be highly correlated on the downside. If the Fed’s attempts to at least slow the growth of its $3.5 trillion balance sheet awake the sleeping child, or perhaps even result in a smashed dinner set all over the floor, weaker stocks may be accompanied if not even caused by weaker bonds. The flight to quality may not work.

We believe the most likely outcome is one of very measured, non-threatening reductions in Quantitative Easing and a further very long interval until short term rates rise. This is what the Fed has told us to expect. But that’s just a forecast, and we could be wrong. However, if we do find ourselves in a substantially weaker equity market caused by the Fed’s lack of manual dexterity, we at least won’t have compounded the error by owning bonds as well.