WASHINGTON, December 19, 2012 – In one of our recent Morning Market Maven posts, we discussed the complications surrounding the recent initial public offering (IPO) of Solar City (SCTY) stock. But there was other action afoot last week with regard to new or moderately used stock offerings. Three other offerings popped up on our trading radar, all secondaries* rather than IPOs. Two—Williams Companies (WMB) and Access Midstream Partners LP (ACMP)—were in the energy area and sport generous yields. WMB currently returns a shade over 4%, while ACMP boasts a current yield of approximately 5.4%.
The third secondary, Legacy (LGCY) actually marketed its secondary last month. But it merits a separate discussion, which we’ll eventually get to below.
MLPs and REITs: The same only different
Unlike normal, everyday stocks like Johnson and Johnson (JNJ), REITs (Real Estate Investment Trusts) and MLPs (Master Limited Partnerships)** trade like stocks but differ from them in terms of how you can make money in them and how they typically trade on the market
PE ratios don’t usually matter, as a REIT’s underlying net asset value (NAV) is usually the major determinant of the stock’s price. That’s different from regular stocks, which are generally determined to be value buys (often but not always) if their individual price-earnings ratios (PEs) are significantly lower than the average PE of their industry groups. For this reason, while PEs are not entirely irrelevant for REITs, you can often collect a swell dividend even if the stock is having a horribly negative quarter—or vice-versa.
As for those dividends: REITs, at least currently, boast good, to great, to massive dividends, today ranging from low yields around 4% to much higher ones of 15% and higher. Hence, their current popularity. Part of the reason for these high dividends is that in exchange for its REIT status under IRS rules, REITs must pay out at least 90% of their earnings to shareholders in the form of dividends. In theory, at least, a high tech company could earn as much or more per annum than a REIT. But typically, such a company would retain all its earnings for reinvestment in future projects and wouldn’t pay a dividend at all. REITs absolutely have to offer a big payout with regard to their earnings.
So if REITs have typically high yields, at least currently, and if you can’t evaluate them in terms of PE ratios, how do you determine which ones might be worth investing in? That’s relatively simple. Three things are important: current and projected net asset value (NAV); cash flow; and, of course, that dividend—and the likelihood that it will continue at a high level.
NAV is simply the current value of the properties the REIT is currently holding. If the stock sells for less than NAV, all things considered, it might be a good deal. Right at NAV, still an okay deal. Above NAV? Well, if it’s only a bit above, okay. If it’s a great deal above its NAV, though, you might find a better deal elsewhere.
Cash flow largely determines how much of a dividend the REIT can or will pay, and this is important. A REIT might even log a substantial loss in a given quarter without disrupting its dividend, due to the deployment of leverage or other typical real estate complications. It’s only if you start getting back to back losses that start damaging cash flow that you might start getting reductions in quarterly dividends. So if you see this or see this coming, it’s probably time to exit. Or not get in.
Which ultimately gets to the dividend. If you have enough evidence that the dividend you found attractive will continue or increase, at least for a few quarters, well, it’s okay to stay around, generally.
MLPs—our topic for the day—largely resemble REITs, except for three things: they generally state target dividend rates, which management is incentivized to achieve, rather than being subject to the REITs’ 90% rule; a portion of MLPs’ dividends may be and often are tax free to the investor under current IRS rules and limitations; and finally, MLP properties are generally producing oil and gas wells or oil and gas pipelines for whose use the MLP charges a “toll,” which creates income. Like REITs, though, an MLP’s NAV reflects the current real or implied value of its underlying properties.
Williams and Access
The Williams and Access deals occurred oddly (to us) in tandem, the proceeds of both apparently being used—we’re grossly oversimplifying here—to move the ownership of various assets around and give Williams a greater interest in properties of Access Midstream’s controlling partner, of which more anon. You need a phalanx of lawyers to explain how some of this stuff works. But in his capacity of an educated and experienced layman, the Maven thinks he’s more or less figured this out.
Access Midstream is the relatively recent (June 2012) renaming of the MLP formerly known as Chesapeake Midstream Partners (CHKM), which itself was a spinoff from Chesapeake Energy Corp. (CHK), the oil and once-primarily-gas company run solely—until fairly recently—by buccaneering entrepreneur Aubrey McClendon who in recent years ran roughshod over his company’s compliant, crony-dominated board of directors (BOD). And CHK is that controlling partner of ACMP we mentioned in the previous paragraph, working with ACMP to gradually sell off a portfolio of its own producing properties. This isn’t an uncommon arrangement. But when CHK is involved in anything these days, red flags go up in the HQs of many investment firms. Just because.
CHK was a market high-flyer until the acquisitive Aubrey nearly wiped the company out with debt. He was one of the early believers in the richness of energy deposits, aside from coal, in the upper Appalachian area, and he attempted to buy out pretty much the entirety of available drillable land in the Marcellus and Utica shale formations, rewarding himself monetarily in the process, again with the acquiescence of his board. Not illegal, but also, perhaps, not in the best interests of CHK’s stockholders.
Pressure from pension funds, investors, and finally even from his indolent board finally converged. Together, along with some mutterings from the Feds, they clipped Aubrey’s wings a bit with regard to his unrestrained penchant for deals that seemed strangely good mainly for his own portfolio. In addition, largely as a result of over-speculation, the company’s is now burdened with unsustainable debt and has been forced to sell, spin off, or otherwise get rid of, bit by bit, many of its valuable assets in order to restore its wobbly balance sheet which is currently very much a work in progress.
Had natural gas prices firmed or risen and allowed a decent profit to CHK, Aubrey’s bets might very well have paid off for everyone and we might not be writing this. Instead, we’d be praising Aubrey’s unprecedented foresight and genius. But new gas and oil discoveries nationwide have become so unexpectedly huge that they’ve served to keep prices depressed, making it more difficult if not currently impossible for CHK to book profits on output from its highly-leveraged properties.
Which leads us back to the current machinations of those two secondaries we have under discussion.
First of all, looking back, we suspect ACMP’s new name was rolled out at least in part to distance CHK’s spinoff MLP from the unpleasant market odor given off by its parent. Meanwhile, Williams, a veteran energy giant whose stock has been extraordinarily volatile of late, was willing to step in and help out with some of CHK’s restructuring, directly or indirectly, the better to get a hand in on some of those assets as well.
After all, sooner or later, someone will make the big money on these massive shale energy deposits. As best we can ascertain, last week’s virtually paired secondary offerings by ACMP and WMB appear to be part of the ongoing maneuvers that are at least indirectly part of CHK’s debt-clearing maneuvers.
Intermission: Energy stocks seem to be really wobbly at the moment. So much new energy has been discovered in the U.S. over the last two years that it’s essentially putting the moronic “peak oil” theory to rest, at least until the eco-fanatics can regroup. Oil bears are predicting a drop in oil prices from the current $85+ per barrel to as low as $50 bbl, although we’re skeptical of that number.
In any event, we think that any kind of economic recovery will only boost the fortunes of ACMP and WMB, which appear to be run by intelligent managers, and whose stocks boast better-than-average and likely secure yields. (Plus, those yields are likely to rise smartly if we ever get even a wisp of economic recovery.)
As a result, after careful consideration, we decided to participate modestly in these secondaries as well as another unrelated secondary, Atlas Pipeline Partners (APL, current yield 7.53%). As of this writing, WMB is slightly above the offer and ACMP and APL slightly below. This reflects the generally unreliable performance out the gate that we’ve seen recently in secondaries of MLPs which will likely be adversely affected by “fiscal cliff” selling and fear-mongering through at least the end of this month.
That said, MLPs may be an interesting place to park funds in 2013, which, like 2012, is likely to be another Wild West kind of year in the markets. Assuming an investor has established that a given MLP will have roughly stable earnings over the next four quarters, he can also assume that the MLP’s generally high dividend will remain stable or increase over the same time period. Thus, if the stock price remains within a reasonable range, its substantial dividend could make the necessity of capital gains a secondary concern—no pun intended. As we indicated earlier, MLP yields (dividends) have been ranging from the neighborhood of 5% to 9%, 12% and sometimes higher. That’s tempting, even if the Feds decide to help themselves to more of that yield.
Furthermore, a portion of each MLP’s dividend is generally considered a return of capital and is thus not taxable even under the worst negative fiscal cliff scenario we can see. Furthermore, if you’re like the Prudent Man, and place most of your MLP stocks in rollover traditional IRA accounts, the dividends may be effectively tax free at all until you withdraw money from the account.
Caveat: There are per account limits on this tax break with regard to the amount of dividends you can book tax free, even in an IRA. Since so much may change over the next 60 days, caution is your best bet here. It would also be a great idea to consult with your accountant or tax attorney once some of the fiscal cliff smoke has cleared. It’s the Prudent Man’s mission to offer ideas—not recommendations. He’s not a tax attorney and doesn’t play one on TV.
REITs and MLPs in the fiscal cliff environment
The current environment is one of the most confusing time periods we’ve endured since the Prudent Man reached adulthood several decades ago. Make double sure you’re confident in your goals and choices by consulting at least one if not two trusted experts in these fields before you commit to these or any investment concept. And know that Congress could still upset your plans, because—seriously—they don’t really care.
If you like the concept of deploying MLPs in your portfolio and understand the peculiar risks involved, you’ll immediately understand that even if your 10% ends up getting taxed 40%, you’ll still have more money in your pocket than you would if you parked your money in a money market fund yielding 0.01%. Obviously, a lot of this fiscal cliff paranoia is overdone when it comes to high-yielders, but this month at least, that hasn’t seemed to matter.
Yet there still are risks to these seemingly conservative investments. Dividends, like those of REITs, are largely pegged to cash flow rather than earnings, so PE ratios don’t necessarily give you the info you need to evaluate dividend stability. Cash flow is a better measure.
Second of all, like REITs, and as we’ve just pointed out above, MLPs do occasionally offer secondaries, often as many as two or three times per year. These frequently, though not always, cause the issuing MLPs to tank right after the offer. That’s understandable because most investors realize that issuing more shares dilutes earnings. But again, in MLPs, this may be shortsighted, as much of the money raised by the new shares of responsible and proven MLPs usually goes toward the purchase of new assets that are immediately accretive to cash flow. I.e., the dilution is effectively taken out of the stock in fairly short order, so the sell-a-thons are often foolish short-term reactions.
The dilemma of LGCY
Our recent investment in a secondary of Legacy (LGCY), which we mentioned briefly above, illustrates how you can still get stung by post-secondary issue selloffs in MLPs when these selloffs get out of hand. The Prudent Man is currently suffering through a massive selling episode in Legacy Reserves LP (LGCY), another MLP with which he has been frequently and successfully involved in the past. Like our previously discussed MLPs, this company also makes money and pays impressive dividends, so the Prudent Man was interested in getting on board a secondary offering of the stock last month and did so.
Interestingly, the stock price slid way more just prior to the offer than such stocks normally do on the day of the offering’s pricing. When the pricing did occur, the stock was priced down more than that day’s plunge, which again is typical, again part of that delusionary dilution fear factor as well. Problem is, the stock continued to plunge sickeningly since then. It’s currently down about 10% from its price the day the offer was officially announced.
Selling has been steady and above normal, but no news to explain it has crossed the tape. So we now have a bit of a dilemma. The selling has gotten so bad that the stock is hitting, and threatening to break through, its one- and two-year lows.
It would be nice to know what’s going on. Is there something fundamental that’s gone wrong with this company that we’re not being told about? Or have some big sellers just concluded that it’s time to dump a big batch of a high-dividend stock like LGCY lest the fiscal cliff gobble up some of that yield in 2013? Or, more optimistically, are some sellers just taking capital gains before such gains likely turn into “ordinary income” in 2013?
Our first move was to average down a bit by buying more LGCY at a much lower price than the secondary. This worked for about a day. The stock is now lower yet again.
Thus, we confront a typical MLP conundrum with LGCY. Have we just about hit bottom, given those one- and two-year lows? So should we hold? Or is there something more seriously wrong with LGCY underneath the hood?
The stock doesn’t go ex-dividend again until late January, and an announced cut in the dividend could be a big tell. But we’re not likely to get such a call until next year when it will be less helpful.
So we’re stuck in a waiting game right now and are a bit confused. We violated our own internal discipline by not selling the stock when it was down over 5% (you should have similar limits you’re comfortable with, too.) So what to do, what to do?
We think LGCY has probably bottomed here, but we need more confirmation. Not willing to bet the ranch, we lightened up on our position for a loss late last week. The stock this week is beginning to show at least tentative signs of firming. If it hasn’t, and if it starts to plunge, we’re likely to bail. No point in sticking with a loser. Hoping a stock goes up—aka, an addiction to the drug Hopium—without any evidence that it will is always a bad strategy. If LGCY decisively breaks its two-year lows, we’ll make an exit and vow to behave more rationally the next time. Even if we leave now, that doesn’t preclude our return in the future. In this market, timing is what you have to get right. If your timing is wrong, which ours occasionally is, then the best strategy is a retreat, not a defeat.
Bottom line on MLPs: they’re great investment vehicles for our current turbulent times if you know what you’re doing. But always expect secondaries and attendant volatility to mess with your game. It’s the price you pay for those uncommonly swell dividends.
*Note on Secondaries: For those unfamiliar with the term, are simply newly issued and (generally) additional shares of existing companies. The bad news about these offerings is that the new shares add to the total shares outstanding and can dilute the yield in many instances. The good news is that sometimes—particularly in REITs and MLPs,*** the proceeds of such stock are used to purchase new rental or producing assets that are immediately accretive to earnings—i.e., they add to profitability.
**REIT and MLP Sidebar: For those not familiar with these investments, Real Estate Investment Trusts (REITs) essentially are companies that invest in commercial or retail real estate that have elected to be taxed as REITs under the IRS code. For the individual investor, what this means is that each REIT is required under this election, to distribute (pay out) to its investors at least 90% of its annual income, usually in the form of dividends. The good news here is that a well managed REIT operating in a reasonable economic climate can and often does offer outsized dividends to its investors. The bad news is that investors generally don’t get much say in how these companies are run.
Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
Any positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.
Illustrations, charts, commentary, and analysis are only the author’s view of current or historical market activity and don’t constitute a recommendation to buy or sell any security or contract. Views, indications, and analysis aren’t necessarily predictive of any future market or government action. Rather they indicate the author’s opinion as to a range of possibilities that may occur going forward.
References to other reporters, analysts, pundits, or commentators are illustrative only and do not necessarily represent an endorsement of such individuals’ points of view. If specific investment vehicles are mentioned in any article under this column heading, the author will always fully disclose any active or contemplated investments in said vehicles.
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