#$dpm

Image Source: Brian Cantoni

Valuentum has been highlighting the inherent risks associated with the master limited partnership (MLP) structure for some time now, but we are not alone in acknowledging the limited sustainability of such structures. Internal simplification transactions may only become more common moving forward as management teams seek to optimize the structure of their entities. Readers should continue to cast a skeptical eye on this business model.

By Kris Rosemann and Brian Nelson, CFA

Quite possibly, Valuentum made the “call of the century” when it outlined its warning on MLPs in June 2015, embedded in its Kinder Morgan (KMI) “call,” and more explicitly in September 2015, “Why the MLP Business Model May Be a Goner.” There was a rebuttal to our take “MLPs for the Long Run,” that tried to poke holes in our independent, authentic thesis. At the time, we were very surprised, but we appreciate varying opinions on the matter, as that’s what makes a market. When debate and discussion happen, investors win!

Let’s fast-forward to today. The firm that had issued a rebuttal to our opinion in 2015 noted that, “in fact, more MLPs cut distributions (21) in 2015 than in any other year in the sector’s history (March 2016).” Further that same firm noted in a subsequent October 2017 piece that “companies in the Alerian MLP Index have reduced distributions 56 times, including 45 explicit cuts and 11 stealth cuts over the last 3 years.” The very crux of our thesis in mid-2015 had been that MLPs were being “incorrectly” valued on the basis of a distribution yield. Here’s what the firm that had rebutted our thesis in 2015 is now saying, from that same 2017 piece:

Investors in the U.S. midstream energy sector should be aware of the number and level of dividend cuts announced by MLPs and understand that distribution yield may not be as effective a valuation metric as it once was (source).

Certainly, it has been a wild ride for investors in MLPs during the past few years, and we think our “warning” on the space in mid-2015 saved throngs of investors from multiple income disappointments. There have been dozens of instances of companies “cutting” their distributions in the Alerian MLP index since our call in mid-2015, and I don’t think we could have done a better job getting out there, helping investors get ahead of what we thought was to come. Our assessment that MLPs were being “valued” incorrectly on a structural basis, a collapsing crude oil price environment at the time, and tightening credit market conditions with deteriorating credit quality in the customer base were but three of many colliding criteria that led to our major concerns.  

Today, we maintain our view that the sustainability of the MLP structure (AMLP) may be in jeopardy over the long haul, as in our view, the primary reason why we think the MLP model had existed in the first place--to capture a “yield valuation” mispricing in the market to raise funds--has effectively gone away. It had been our contention that prior to the collapse of the MLP space in mid-2015, MLPs acted as a vehicle to take advantage of favorable capital-funding conditions, where MLPs would sport prices and issue equity on the basis of market “yield valuation” approaches. The issuer could float (create) an MLP and the market would end up pricing MLP units on the basis of their “yield,” instead of on organically generated free cash flows, which include growth capital spending. Since most MLP distributions approximate an MLP’s measure of distributable cash flow, the energy complex effectively had been using the MLP business model to raise external capital within the corporate umbrella at a lofty price on the basis of the market’s “yield valuation,” instead of on the basis of internally-generated free cash flow.

A systematic mispricing had occurred in an environment of ultra-low interest rates during 2015, and when the energy complex faced a massive threat given the collapse in crude oil prices, many owners of midstream MLPs realized that midstream equities were not immune to the troubles of their customers, as even fixed and seemingly iron-clad contracts could be broken during the chapter 11 process. Even some of the stronger oil and gas producers, for example, were facing tough times, and even while many midstream MLPs had a small percentage of direct exposure to energy prices, through their customers, the exposure was quite large. Unless the market goes back to valuing MLPs on the basis of “yield,” we doubt the MLP business model will catch much favor again, and we continue to expect it will not last over the long haul.

For starters, many MLPs do not generate sufficiently positive free cash flow, as measured by cash flow from operations less all capital expenditures (both maintenance and growth) in any given year, but most continue to pay lofty and growing distributions to unitholders, with “safety” represented by the industry-specific coverage measures using distributable cash flow, which ignores the growth capital spending that helps to drive net income, the core component of distributable cash flow. When it comes to the concept of distributable cash flow, there remains an imbalance, see: “MLP Speak: A Critique of Distributable Cash Flow.” We think the market may have wised up on how to “value” MLPs, and we continue to see instances where MLPs are being consolidated or folded up.

In July 2016, for example, Plains All American (PAA) represented one of many instances, as the limited partner issued new common units in exchange for the incentive distribution rights of its general partner, “Plains All American to Undergo Simplification Transaction.” The simplification also resulted in a reset of the distribution, which was necessary for the limited partner to arrive at more optimal levels for its cost of capital and distribution coverage moving forward.

The Energy Transfer family (ETE/ETP) announced a simplification transaction in late 2016, too, that resulted in an implicit distribution cut and consolidation of its ownership structure, but its IDRs were maintained. At the time we said, “We view this simplification transaction as a short term alleviation of what will eventually turn out to be long-term pressures.” Energy Transfer management appears to agree with our opinion that additional measures will need to be taken to secure the long-term health of its businesses as it has noted multiple times in recent presentations to investors that it “Will evaluate optimal structure for the family, but do not expect any internal restructuring transaction to occur before late 2019.”

In early 2017, Williams Cos (WMB) underwent a simplification that resulted in the general partner (Williams Cos) waiving its IDRs in limited partner Williams Partners (WPZ) and exchanging its general partner economic interest for new issued common units of the limited partner as it sought to lower it cost of equity capital, “MLPs: Williams’ Double Equity Raise.” However, the issuance of new equity from Williams Partners resulted in the need for a reduction in its quarterly distribution. Even with the elimination of IDRs, many MLPs find it necessary to reset their distributions to achieve the stated goals of the simplifications.

More recently, shareholders in beleaguered master limited partnership StoneMor (STON) have begun to push for the entity to reconsider its structure as an MLP and convert into a C Corp. The movement officially began with Axar Capital Management, which owns a 17.5% stake in StoneMor. According to a recent SEC filing dated March 9, (The Reporting Persons refers to Axar) “The Reporting Persons believe that the recent reductions of corporate tax rates effective for 2018 make the conversion of the Issuer into a C corporation more attractive than under prior tax rates. The Reporting Persons also believe that a conversion of the Issuer into a Subchapter C corporation, together with addressing the Issuer's incentive distribution rights, would result in a more liquid market for the Issuer's equity securities, improving the Issuer's opportunities for capital raising, senior management recruitment and other strategic transactions.”

While this may only be the latest example of the MLP business model fading away, it is yet another data point on the continuance of the “investor-led” push against the hazards of the MLP business model, further explained in July 2016, “Distributing Truth on MLPs.” Regardless, we expect the typical MLP structure to come under increasing levels of scrutiny, particularly as ongoing income disappointments for retail investors continue to pile up. We maintain our view that the long-term sustainability of many distribution growth trajectories within the space should be met with increasing levels of skepticism, and we are reiterating our opinion that the MLP business model may not survive over the long haul as "yield-valuation" pricing effectively goes away.

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Kris Rosemann and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. Valuentum is not a money manager, broker, or financial advisor. Valuentum is a publisher of financial information. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

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Let’s talk about a controversial metric that is used in master limited partnership (MLP) reporting. Just how useful is it, and should it be allowed?

To subscribe to Valuentum’s investment research services, please read more about it here.

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--> Handout 1: Pitfalls of Distribution Yield Analysis (pdf)

--> Handout 2: Linking P/DCF to Enterprise Free Cash Flow Valuation (pdf)

By Brian Nelson, CFA

It’s been a few years since the fallout in the prices of most master limited partnerships (AMLP), but to me, it still feels like yesterday. We continue to have many concerns about the longevity of the business models of MLPs, and we maintain our view that the operating structure will be challenged over the long haul.

New equity and debt funding (issuance) continues to, in part, fuel the distributions of most MLPs, and we think it is fair to call most MLP distributions financially engineered. As in almost all MLP cases, traditional free cash flow, as measured by cash flow from operations less all capital expenditures, is less than cash distributions paid, and most MLPs “use” the financing section of the cash flow statement to make up for the shortfall--in essence, issuing new equity or new debt. Hence, most distributions are, in part, financially engineered.

The poster child we often use to explain this unique circumstance is Energy Transfer Equity (ETE). Looking at its GAAP financial statements for the six months ended June 30, 2015, for example, the entity generated $1.1 billion in cash flow from operations, but distributed north of $1.6 billion in cash to noncontrolling interests and partners. Meanwhile, capital spending during the half-year was $4.2 billion.

Traditional free cash flow generation was -$3.1 billion (negative $3.1 billion) during that 6-month period, and after accounting for the $1.6 billion shelled out as cash distributions, the cash burn came to -$4.7 billion (negative $4.7 billion). The shortfall was financed by issuing net new debt of $4.1 billion ($15.4 billion in proceeds from borrowings less $11.3 billion in repayments of long-term debt), as well as another $1.8 billion in subsidiary equity offerings.

Has anything really changed since then? Not really. During the three months ended March 31, 2017, for example, traditional free cash flow at Energy Transfer Equity was still decidedly negative, and net cash provided by operating activities ($893 million) fell short of distributions to noncontrolling interests ($752 million) and partners ($251 million), or ~$1 billion. Interestingly, again, the shortfall is made up from ~$800 million in net new borrowings and even more new funds from units issued for cash. New debt and new equity used to pay existing shareholders? That’s how some see it.

The problem for the common investor is that he or she is being provided a different metric for MLPs than what is in the GAAP financial statements, and it is often lightyears apart in substance. Looking at the press release accompanying second-quarter 2015 earnings, for example, Energy Transfer Equity raised its quarterly cash distribution by 39% on a year-over-year basis that July 2015, as the company noted that its distribution coverage ratio was 1.2 times during the period (1.2 times!), despite burning through an estimated ~$4.7 billion. There’s just something terribly wrong about the measure “distributable cash flow” as a useful metric to investors.

Not only does “distributable cash flow” not reflect the economic reality of cash moving in and out of the business on an net operating basis, but the measure itself houses an imbalance that simply lacks consistency. The reconciliation of net income to adjusted EBITDA and distributable cash flow for most MLPs (see example here) begins with net income but yet, it doesn’t include the growth capital spending that is used to propel the very net income included in the “distributable cash flow” calculation in future periods. In many ways, MLPs are getting a free pass on growth capital (as if it were not unitholder money), especially if investors are “valuing” MLPs on the basis of distributable cash flow, or yield. Here’s some background from Energy Transfer Equity:

“Distributable Cash Flow and Distributable Cash Flow, as adjusted, are also important non-GAAP financial measures for our limited partners since these indicate to investors whether the Partnership’s investments are generating cash flows at a level that can sustain or support an increase in quarterly cash distribution levels. Financial measures such as Distributable Cash Flow and Distributable Cash Flow, as adjusted, are quantitative standards used by the investment community with respect to publicly traded partnerships because the value of a partnership unit is in part measured by its yield (which in turn is based on the amount of cash distributions a partnership can pay to a unitholder). The GAAP measure most directly comparable to Distributable Cash Flow, and Distributable Cash Flow, as adjusted, is net income for ETE on a stand-alone basis (the “Parent Company”).”

The large problem with “valuing” a partnership unit on the basis of yield (see here for more) is that when looking at the GAAP accounting, it becomes clear that an MLP's distributions do not reflect the economic reality of the business. In the calculation, “distributable cash flow” ignores growth capital spending, which itself is used to propel future net income, which is a core component of distributable cash flow, per reconciliation. Not only that, but because traditional measures of free cash flow, as measured by cash flow from operations less all capital spending, fall short of distributions paid, and are often negative, for most MLPs, distributable cash flow becomes a near-meaningless metric. Most MLPs are funding traditional free cash flow shortfalls with new equity and debt issuance, and it is clear as day on the GAAP cash flow statement.

But why am I bringing this up again? Well, the reason for this piece is not because I am having a bit of nostalgia, but rather because of an article published July 5, “SEC Tells Companies to Be Careful How They Talk About Free Cash Flow.” First and foremost, we applaud the SEC’s move to caution companies on how they present free cash flow, and we’re hoping that we may eventually see a systematic measure of free cash flow as a mandatory release for all companies--hopefully one as simple and straightforward as cash flow from operations less all gross capital spending (companies sometimes like to use net capital spending). The transparency and consistency that this one move would make across the financial markets would be phenomenal, and we hope one day we will see this.

That said, in the SEC’s May 2016 guidelines for free cash flow, it reads (Question 102.07) in response to a question that defines free cash flow as cash flow from operations…less capital expenditures: “Companies should also avoid inappropriate or potentially misleading inferences about its usefulness. For example, "free cash flow" should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure.” The guidelines make a lot of sense to us.

However, when we think about such guidelines for free cash flow, a punitive metric that deducts for allcapital spending, it becomes questionable whether distributable cash flow, because it does not deduct for growth capital spending, is a useful measure at all. After all, the general partner determines a discretionary reserve with respect to distributions, distribution coverage ratios vary quarter-to-quarter and are not fixed at 1, more than 20 MLPs have opted to cut their distributions since we warned about their business models in mid-2015, and many have chosen to pursue business-model simplification initiatives, rolling up subsidiaries and adjusting their payouts along the way. Yet, distributable cash flow continues to set MLP distribution policy, enabling “yield,” which then may drive equity “valuations,” something that we believe contributed to the bubble in early 2015 (see here on how traditional enterprise valuation can be used to value MLPs).

The bottom line: If traditional free cash flow should not be viewed as a measure representing “the residual cash flow available for discretionary expenditures,” including dividend policy (which is discretionary), some may reason that distributable cash flow should probably not be used either to set MLP distribution policy, itself discretionary to a large degree. It is our view that only when debt and equity funding becomes more prohibitive in the face of rising interest rates or tumbling energy resource prices will we see (again) just how much MLPs depend on the healthy functioning of the capital markets to fund their distributions--and how little "distributable cash flow" reflects the underlying “value” of the MLP business model.

Oil & Gas - Major: BP, COP, CVX, PTR, RDS, TOT, XOM

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, OKS, PAA, SE, SEP, WES

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Image Sources: Simon Cunningham, Images Money, Trading View. No alteration has been performed on the pictures.

The financial engineering of the MLP business model is shocking.

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By Brian Nelson, CFA

(A version of this article appeared on www.valuentum.com August 2015.)

Many dismiss economic factors when it comes to analyzing equities, and that may be fair, but in no time in history have interest rates been more important to the future prices of most US equities, in our view. The relationship between risk-free assets such as the 10-year Treasury bill and equity income-growth vehicles, namely high-dividend payers, may be the lynchpin to the sustainability of this bull market. If high-yielding equities begin to crack, they may take the remainder of US equities with them. Some of these lofty dividend yields aren’t what we call organically-derived ones, meaning they aren’t paid out as a portion of earnings or traditional free cash flow (cash flow from operations less all capital spending).

What we’re trying to say is that the fall-out from the Financial Crisis has not been avoided but only delayed, and we’re growing more and more concerned that the real repercussions are drawing nigh. If you recall, many retirees were punished significantly during the 2008-2009 period. Some opted to reduce exposure to equities, perhaps entirely, absorbing the corresponding capital losses to their treasured savings. To make up for the shortfall and the derailment of their retirement plans, today, retirees and near-retirees are now reaching for unsustainable distribution yields to make up for the reduced capital bases, and Wall Street is doing all that it can to offer as many options as it can. Where there is a financial need, it seems as though Wall Street can financially-engineer it.

And they have.

Many of the share prices of high-dividend-yielders that retirees and near-retirees have come to count on for critical income needs are, in our view, propped up by artificial valuation paradigms surrounding their financially-engineered dividends, which are supported by ongoing debt and equity issuance. Financially-engineered dividends are ones that are supported by the financing section of the cash flow statement, meaning that the operating section of the cash flow statement isn’t large enough to offset both the cash drain of the investing section and dividends from the financing section. In today’s market, share prices of these entities are receiving substantial “yield support” on what we would describe as artificial dividends, instead of being valued on the basis of their underlying operations.

If asked, Wall Street may contend that their share prices may hold as long as the threat of rising interest rates remains subdued. What can go wrong? A lot, in our opinion.

Once the relationship between yields on risk-free (Treasury) assets and yields on risky assets (dividend-paying stocks) crosses, we posit that the artificial “yield support” on companies with financially-engineered dividends will inevitably fade, and their prices will converge to more reasonable valuations that are based on actual core operating enterprise free cash flow. What we think Wall Street wasn’t expecting was that the impact of collapsing energy resource pricing on the health of financially-engineered payouts in the energy sector may be an equivalent catalyst as rising interest rates themselves.

How we interpret the financial engineering that’s proliferating across the MLP space may surprise you. Let’s try this example, using Kinder Morgan's (KMI) financials from 2015. We know that Kinder Morgan is not an MLP and the financials used are stale, but neither matter in illustrating the point we're making (we're using Kinder Morgan in this example because it is among the most well known entities, the original poster child for the MLP business model). Said differently, the following example is purely hypothetical and for educational purposes only, but let’s explain, for example, how Apple (AAPL) can effectively financially engineer a completely new “Kinder Morgan”, or create ~$75 billion in incremental equity value or more, using less than 5% of Apple’s current balance sheet, or arguably with nothing at all.

Have I got your attention now?

First, let’s cover some financials. Kinder Morgan, the largest energy infrastructure company in North America, is on pace to generate ~$4.5 billion in “distributable cash flow” in 2015. Traditional free cash flow, however, will be substantially less than "distributable cash flow" during the year given growth capital investments that are necessary to drive future increases in net income, a component of future "distributable cash flow." Let’s assume that Kinder Morgan’s “distributable cash flow” will advance at a ~10% clip over the next few years, in line with management’s expectation for the pace of dividend growth over the same time frame. Kinder Morgan’s enterprise value is currently ~$120 billion, consisting of about $75 billion in equity and $45 billion in debt.

Apple holds over $200 billion in cash, cash equivalents and marketable securities on its balance sheet, as of June 27, 2015. For illustration purposes, let’s have Apple create a corporation called iNewCorp, in which it sets up a partnership agreement by which Apple contributes ~$4.5 billion, more or less, in cash to iNewCorp per annum in exchange for 100% ownership of iNewCorp.

The agreement stipulates no minimum distributable-cash-flow to dividends-paid ratio, meaning that dividends can exceed Apple's cash contributions at any time, which equivalently happens periodically across the master-limited-partnership arena when dividends exceed distributable cash flow in certain periods. From a baseline of ~$4.5 billion, let’s also assume that iNewCorp plans to increase dividends to its future shareholders by 10% each year through 2020 and by a more-reasonable growth rate after that.

The initial ~$4.5 billion “start-up” obligation could easily be covered by Apple, an entity with $200 billion on the books and one that has generated ~$68 billion in cash flow from operations during the nine months ending June 27. Apple can cover the initial ~$4.5 billion obligation 40+ times over with cash on the balance sheet and 15+ times over with nine-months-worth of cash from operations.

Let’s now assume that Apple guarantees iNewCorp’s growing dividend stream and any and all of iNewCorp’s debts, thereby giving iNewCorp an investment-grade credit rating. With such an investment-grade rating, iNewCorp then borrows ~$45 billion against the future cash flow stream that is implicitly backed by Apple.

If you think this is good thus far, it gets better.

iNewCorp then uses this $45 billion in newly-raised debt to backstop its very own future dividend payments to its very own future shareholders. With the newly-raised debt alone, iNewCorp would then be able to cover growing dividends to its future shareholders for ~5-10 years depending on the growth rate, without any future Apple cash contributions.

Apple now IPO’s iNewCorp.

iNewCorp can now raise equity on the open market such that, with its newly-raised debt, the corporate is now able to fund its entire growing dividend stream via external capital-raising efforts, maybe on a 50%/50% equity/debt split if it wants to. Said differently, iNewCorp can fund its entire future and growing dividend stream purely from financing activities.

Under this scenario, to sustain iNewCorp's dividend, Apple itself would not have to pay any more ongoing cash to iNewCorp after the initial ~$4.5 billion outlay. Since there is no minimum distributable-cash-flow to dividends-paid mandate within this particular partnership agreement, Apple would only have to stand as a backdrop and guarantee the newly-created entity’s future dividends and debt load. The external financing markets are sustaining the dividend.

What Apple has done in this example is financially engineer the future dividend stream and capital structure of a new “Kinder Morgan,” which we have called iNewCorp, and it has done so with effectively no capital at all. Apple is just standing behind iNewCorp reinforcing its investment-grade borrowing capacity, which supports the dividend that supports the equity price, which provides incremental equity capital that can also be used to support iNewCorp's dividend, and so on.

On the basis of the then (but now hypothetical) enterprise value of the actual Kinder Morgan, iNewCorp should theoretically fetch an enterprise value of at least $120 billion, which would be all equity in iNewCorp’s case, until borrowings are distributed to iNewCorp’s shareholders as dividends. If dividends should happen to be paid directly from newly-issued equity, then there’s no reason to believe iNewCorp’s equity wouldn’t hold a ~$120 billion equity price, all else equal (at least in this market).

There's more that meets the eye, however.

Kinder Morgan then (but now hypothetically) traded at a price to distributable cash flow ratio of ~16.5 times (a ~6% distribution yield), and some may argue the enterprise value and equity market capitalization of iNewCorp should theoretically be higher than Kinder Morgan's. After all, Kinder Morgan requires growth capital to fuel future net income and dividend growth and has exposure to commodity price shifts and other operating risks, while iNewCorp does not. Apple's newly-created corporation is pure and growing cash.

It's our contention that iNewCorp should be the one to fetch a ~16.5 times P/DCF multiple (~6% distribution yield), while Kinder Morgan's P/DCF should be substantially lower given commodity and operating risks as well as the massive growth capital that is required to drive future net income expansion. In the example of iNewCorp, valuing different equities with varying growth capital outlays and commodity/operating risks on a standardized P/DCF ratio is fraught with risks. It's widely known, for example, that relative valuation techniques are exposed to the hazards of systematic overvaluation.  

In this hypothetical example, with less than 5% of its balance sheet or with perhaps nothing at all, Apple has created in iNewCorp ~$120 billion in incremental equity value, or a ~20% boost to Apple’s entire market capitalization (Apple would have received the proceeds from the IPO of iNewCorp or retained an ownership stake). That's certainly a needle-mover for one of the largest companies in the world.

One may even say that Apple can easily cover an arrangement like this many times over. If you believe in the financial engineering above, then theoretically Apple can create trillions of equity capitalization repeating this over and over again. Apple’s balance sheet and cash flow generation are assets much like the pipelines in the ground are assets.

There is a very good reason, in our view, why dividends should be paid out of traditional free cash flow (cash from operations less all capital spending) or earnings, as anything else is textbook financial engineering. We’ll soon find out whose been “swimming naked” once the tide goes out of this energy cycle, which may be sooner than later (yes, it's now completely over). Wall Street wasn’t prepared for the collapse in energy resource pricing in 2015, and we doubt they will be when the next downdraft comes.

We’re sticking with companies that have organically-derived dividends, and we're not omitting varying growth capital outlays and operating risks from our analysis. From our perspective, the financial engineering is pretty alarming.

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, OKS, PAA, SE, SEP, WES

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Valuation and conviction by the market should change the opinion of any investor.

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“Valuentum called the collapse in Kinder Morgan’s shares from $40 per share to the low-teens, and now we have called the rebound to $20 from the low-teens. Our fair values, if estimated correctly, often act as magnets to the stock price. Though this action may not fit into the playbook of the “buy and hold” investor, the idea of “selling” overpriced stocks that are going down and “buying” overpriced stocks that are going up is a core part of our methodology.”

By Brian Nelson, CFA

I’m still getting emails about how wrong we were about our calls on Kinder Morgan (KMI). Will they ever stop?

We’re doing our best to relieve investors of the shackles of “buy and hold” thinking, which is separate, distinct and runs counter to investing with a focus on long-term fundamentals. The first means an investor holds a stock for a long time effectively regardless of events, while the other means the investor makes decisions on the basis of the long term but he or she may be active in the market in the near term. These two frameworks are not the same thing -- where “buy-and-hold” investors may be inactive for an extended period of time, the long-term-focused investor may “sell” high-conviction overpriced stock, valued on the basis of long-term fundamentals, and “buy” high-conviction underpriced stock, valued on the basis of long-term fundamentals – sometimes the same stock in just a 12-24 month period, for example.

As the price of shares changes relative to a forward estimate of its intrinsic value, one’s opinion of the investment opportunity should change. “Buy and hold” investors may be operating with a different set of rules, which may preclude them from embracing changes of opinion (or even recognizing them), but expanding horizons and being open to new ways of looking at things should be par for the course for any investor, either a “buy and hold” investor or one focused on long-term fundamentals, as we are. The stock market will always be a forward-looking, discounting mechanism of the trajectory of future enterprise free cash flows. In one case, for example, a focus on the long-term can drive shares of a company to lofty levels in the near term even if the company today is not generating profits, while a focus on the long-term can drive shares of a very profitable company to near-$0 today if the future outlook may spell material bankruptcy risk. A focus on the long-term is simply par for the course for any investment framework, and has nothing to do with your holding period – a long-term focus is a different concept than “buy and hold” investing.

To be fair, however, “buy and hold” thinking may not be the entire reason for the confusion regarding our calls on Kinder Morgan. Barron’s, the print edition, ran an article a few weeks ago supporting another research firm’s opinion that Kinder Morgan is still overpriced and should be a single-digit priced entity. That wasn’t us. Our fair value has been $20 for Kinder Morgan for some time, and shares have now converged to effectively that level since our more optimistic note was printed in Barron’s online, January 21. We apologize for the confusion but it is beyond our reach. Valuentum called the collapse in Kinder Morgan’s shares from $40 per share to the low-teens, and now we have called the rebound to $20 from the low-teens. Our fair values, if estimated correctly, often act as magnets to the stock price. Though “selling” and “buying back” over a short period of time may not fit into the playbook of the “buy and hold” investor or any long-term focused investor for that matter, the idea of “selling” overpriced stocks that are going down and “buying” overpriced stocks that are going up is a core part of our methodology. With Kinder Morgan, it just happened over a very short period of time.

Certainly the timeliness of our call on Kinder Morgan on the way down was unprecedented, and now our call on the way up has turned a great many heads as well. The price-fair value equation of the equity will always inform whether an idea is attractive or not (not its name or how you feel about management or any other qualitative factor), which is why we put an extensive discounted cash-flow valuation process (and margin of safety) as the first and foremost criteria within our stock-selection methodology. We then back that process with a relative valuation overlay, which itself is overlaid with an assessment of market information via share price direction. More information on the Valuentum Buying Index can be found at the following link, “Our Stock Selection Methodology, the Valuentum Buying Index.” At the very least, if there is anything one can do to become a better investor, it is to be open to new information and new ways of looking at things – and always ask why. The ‘why’ with us is quite simple – investors deserve better research, analysis, and processes, and we’re doing our best to provide the right lens through which to look at investing.    

As we have stated many a time before, while we believe the energy master limited partnership business model is in jeopardy over the long haul, the entities still have intrinsic value. We’ve published our intrinsic values of the group on several occasions to help investors, and while we don’t hold any energy MLP in the newsletter portfolios, we continue to monitor improvements in the composition of their investor bases and their stronger equity prices the past few weeks. We’re expecting a break out in the Alerian MLP (AMLP) very soon. If the market re-inflates the debt-infused stock bubble based on financially-engineered dividends used in obsolete dividend discount models, we have to be mindful of the possibility of that development. Rising energy resource pricing has also helped mitigate some pressure on credit quality, and so has speculation that the wheeling-and-dealing across the industry may finally slow, with indications that the Energy Transfer Equity (ETE)/Williams (WMB) deal may fall apart. Our fair value estimates for the energy MLP space can be found at the following link on our website:

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, PAA, SE, SEP, WES

On the basis of Kinder Morgan’s undervaluation and improving stock price momentum, the corporate is included in the Best Ideas Newsletter portfolio. We evaluate companies objectively on the relationship of their stock price to the present value of their future expected enterprise free cash flow streams and net balance sheet, which allows us to pick exit and entry points effectively as we use market information to offer added conviction to either side of the investment decision. We’re long-term investors and never take our eye off the long-term, but when shares are overpriced or underpriced on the basis of that long-term assessment, we think action is prudent at times. We’ve been bullish on Kinder Morgan’s shares for some time now, and we like the price-to-fair value convergence.

Interested in learning more about how to use valuation and market information to improve stock selection, consider subscribing to Valuentum here.

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Valuentum’s updated discounted cash-flow model on Kinder Morgan is available for download...  

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To access the downloadable Excel file, please click here (membership required): http://www.valuentum.com/articles/20160131  

If you are currently not a member of Valuentum, please subscribe to access this download and more.

Valuentum offers full coverage on more than 1,000+ stocks and dividends, including providing members fully-populated models, per request. 

A Glimpse of Valuentum’s valuation process: 

http://www.valuentum.com/categories/20110615

Please contact us at [email protected] if we can be of any assistance. Other valuation models available for download:  

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A version of this article was published on November 3, “MLPs Breaking Out But More Questions.”

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As we stated when we added exposure to the energy sector in the newsletter portfolios October 6, and separately in our piece dated November 3, we’d be fools not to acknowledge the possibility for a strong technical breakout in units of master limited partnerships. 

The group still has a long way to go to get back to “even,” but for the sake of retirees who are “DRIPping” into these equities, we sincerely hope some losses can be recuperated. Our experience tells us, however, that the road won’t be an easy one, but we are hoping chartists will be piling into units in the coming days. Again, we reiterate that fundamental investors may not be aware of this “technical” catalyst to come, but the breakout could be a big one, especially if energy resource pricing keeps bouncing. 

MLP investors have lost so much money in the group since late 2014 that the recent move higher looks rather insignificant, but don’t underestimate it – it is an important one!

The Valuentum process combines both value and technical/momentum indicators into a single rating – only when both considerations point in the same direction are we “bullish” or “bearish.” When the market is telling us information, we listen. We’re currently watching the technical breakout across the MLP space closely, and we do not include any MLPs in the newsletter portfolios.

The age-old distinction between the concept of price and value is very important. Price is what you pay for something and can be viewed on the stock ticker “tape,” while value is what you get, best expressed as the present value of future free cash flows generated by the operating assets of the business, absent financial-engineering and recirculation of capital from the equity and debt markets back into unitholder pockets. Price and value are almost never the same, but sometimes they do link up, if only in the case when that last cash flow is received by shareholders in the event of a buyout. Since the peak in 2014, investors that are “pricing” units and those “valuing” units have come to the same conclusion -- units of MLPs were far too expensive.

We’ve been critical of the MLP business model since we launched coverage on units several years ago (and only more recently has our thesis come to light), but we want to disclose our fair value estimates and fair value ranges for MLPs under coverage to be as helpful and as transparent as possible. Please note, however, that we do not deduct for growth capital spending in the calculation of their intrinsic value (something we’ve long taken issue with in our MLP coverage universe). Importantly, there’s nothing inconsistent with our being concerned about the long-term health of the group, their measures of annualized GAAP leverage, their free cash flow shortfalls relative to distributions, and still note that such entities retain intrinsic value, all the same. This is an important concept that is often lost in the articles we write -- they’re not lost in our 16-page reports and 500-line valuation models that we provide to members, however.  

You’ll notice that, at least in the context of this most recent rally the past few days, our fair value estimates have for the most part, acted like magnets attracting the unit prices of MLPs, including that of Energy Transfer Partners. This is a tendency that we call price-to-fair value convergence. Stock prices can undershoot and overshoot intrinsic value all the time, and many, in our view, are now bouncing back from very oversold positions to our estimate of intrinsic worth. 

For those interested in diving deeper into our valuation work, we make available our valuation and dividend reports on our entire MLP coverage universe on our website. Please be sure to access our reports there! A table outlining our fair value estimates and the fair value ranges of our MLP coverage universe can be found below. Thank you very much for reading!

Share price information as of December 23, 2015.

By The Valuentum Team

“The bust may still be ahead of us.”

Interested in viewing Valuentum’s body of research on the energy sector and MLPs specifically? Please subscribe here. We cover over 1,000 stocks on over a hundred industry groups. Give the gift of Valuentum today.

Valuentum’s President Brian Nelson’s concerns regarding the master limited partnership business model became mainstream in June of this year. In his piece, “5 Reasons Why We Think Kinder Morgan’s Shares Will Collapse,” an article that itself may go down in history as one of the most timely pieces of stock research ever written--in light of Kinder Morgan’s (KMI) eventual share-price collapse--Mr. Nelson said of the MLP space at that time:

“Most, if not all, MLPs report distributable cash flow, which does not in the calculation consider growth capex, an important driver behind the generation of increased cash flow from operations in the future. When MLPs report distribution coverage ratios, this particular calculation also backs out growth capex from the equation, instead using only ‘sustaining capital expenditures.’

There are a number of contractual reasons why the data is presented in such a way, but from a valuation standpoint, we’ve always taken an issue with the MLP universe being implicitly valued on a future distributable cash flow stream that “covers” the distribution than on future free operating cash flow, which is a better measure of the free operating cash flow that a business generates.

The reason why free operating cash flow is more informative is quite straightforward. Distributable cash flow does not deduct the investment associated with driving future growth in an MLP’s cash flow from operations. Said differently, it’s like getting a free pass on all of the future growth spending that is required to drive incremental cash flow from operations, a severe imbalance in the valuation equation.

In valuing MLPs, we’ve circumvented the valuation imbalance by making the universal assumption that MLPs will continue to have access to the capital markets and that they will be able to issue equity and/or debt in such a way that is not value-destructive. Said differently, in our valuation models, we give MLPs credit for the future growth in cash flow from operations without deducting the growth capex that is required to drive it. We disclose this dynamic in every one of our 16-page reports within the MLP space.”

Though Valuentum has long warned about the significant risks related to the master limited partnership model, we recently reiterated our views that the risks to the downside for most MLPs were considerable, especially as their cost of capital is ratcheted higher and as credit quality deteriorates. In particular, Valuentum outlined the following dynamic in its early November piece, “Update: A 10% Cost of Capital for Midstream Equities Is Reality:”

“That the recent convertible preferred issue (which will turn into equity) was priced at $49, below the $50 face value, suggests the marginal cost of capital for Kinder Morgan (or the effective yield) is close to ~12% {[9.75% + (1/50)] = 11.75%}. We’re not sure how a near-12% cost of capital float was more appealing than the cost of equity capital today, but if it is, the very thought that the marginal costs of borrowing debt or floating pure equity are greater than 12% for midstream equities is near frightening.

…we think the implications on the master limited partnership arena are even more dire. As we had outlined in this chart here, we believe investors continue to “price” equity in the MLP space (AMLP) on the basis of a “mid- to- high-single-digit” yield-equivalent on their distributions, a function of the industry’s definition of “distributable cash flow,” which we have noted our objections to in the past. We think all midstream corporates should disclose non-GAAP free cash flow, as defined as cash flow from operations less all capital spending.

In the event, however, that MLP distributions are “valued” on a 10%+ discount rate, unit prices on MLP equities would tumble. There’s more downside risk to the prices of units across the MLP space, in our view, but we’ve been rather surprised by the magnitude of the bounce in recent weeks.”

Perhaps equally important, in early November, Valuentum outlined that the MLP business model itself is being shunned by industry insiders and listed several examples, supporting the view that the business model itself may not make it to the other side of this energy downdraft:

“On a fundamental basis, executive teams and investors alike continue to cast a cautious eye on the MLP business model. Kinder Morgan’s August 2014 actions to reconsolidate its master limited partnership (AMLP) structure under one umbrella may have marked the beginning of a trend that could proliferate in coming years. In May 2015, Williams Co (WMB) announced plans to buy up its master limited partnership Williams Partners (WPZ), and more recently Williams Co and Energy Transfer Equity (ETE) released plans to combine. Just today, there were two more significant events: Targa Resources (TRGP) announced that it would scoop up MLP Targa Resources Partners (NGLS), and Sempra Energy (SRE) announced that it won’t form a master-limited-partnership as the market sours on the business model...

…concerns by executive teams that they won’t be able to synthetically create equity market capitalization (not value) through the formation of standalone, publicly-traded yield-sensitive vehicles to take advantage of an ultra-low-interest rate environment may continue for the foreseeable future, in our view. The threat of rising interest rates on the “pricing” of MLPs, for one, lessens the attractiveness of these vehicles for investors “pricing” them on a yield basis versus other alternatives. The threat of rising interest rates on the “valuation” of MLPs offers a higher cost of capital used within any intrinsic value estimation framework, even multiple analyses. In the former scenario, the “risky” yields of MLPs (any asset that is not riskless is risky) become less attractive to the yields on “risk-free” assets (such as Treasury bills) as interest rates rise, while long duration cash flows are worth less in a rising interest rate environment under the latter valuation scenario.”

Valuentum has frequently warned about the fragility of the ‘valuation’ framework supporting MLPs and how theoretically any company with the backing of a strong credit rating could synthetically and artificially create market capitalization, but not generate any real tangible value in doing so. Here’s what we said in “Understanding Your MLP’s Financially-Engineered Equity Value” several months ago:

“The primary goal of this piece...is to reveal how warped the financial engineering has become with respect to MLPs, especially in the context of the “valuations” placed on them. When one sees how easily other corporates such as Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), or Qualcomm (QCOM) or any other entity with excess cash and a strong credit rating can create a shell conduit that is priced on a contractual pass-through to shareholders, or the substance of the distribution pass-through to unitholders of an MLP, for example, either one of two things may happen: 1) every capable company will or should create cash-flow-backed shell companies to artificially generate value at the parent, consequences unknown or 2) the MLP business model will be restrained, or dissolved in time...

...In the example to follow, we’ll show how an investment-grade company, with essentially no investment or ongoing commitment at all, can generate $120 billion in incremental equity value, to the tune of the equivalent of the entire enterprise value of Kinder Morgan, at the time the example was originally developed. To keep reading this breakthrough piece >>”

Barron’s reiterated Mr. Nelson’s work, “Why the MLP Business Model May Be a Goner,” just a few short months ago. We believe the master limited partnership model is still at significant risk.

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, PAA, SE, SEP, WES

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May everyone have a wonderful holiday season! Don’t forget to give the gift of a Valuentum membership today. Subscribe here.

By The Valuentum Team

How to interpret the mispricing of MLP shares in the image below: In this illustrative example that includes both growth capital spending and a marginal cost of capital of 10%, holders of MLPs will have to wait years before the intrinsic value of the security catches up to the present market price (comparison shown in orange). Said differently, units in this example are significantly overpriced in today’s market. 

President of Valuentum Securities Brian Nelson is reiterating the increasing likelihood of a “bust” scenario that may happen with respect to the master limited partnership universe, outlined several months ago. 

Published in late September as “Warning: The Master Limited Partnership Model May Not Survive” on www.valuentum.com, Barron’s had also highlighted Mr. Nelson’s concerns about the sustainability of the MLP business model in their write-up,  “Why the MLP Business Model May Be a Goner.” For more background on Mr. Nelson’s bold call on Kinder Morgan, please select here.

The risks continue to mount as commodity prices suffer and a contractionary monetary environment draws nigh. The late September article warning about the potential fallout in the MLP universe is provided for everyone’s convenience below:

Warning: The Master Limited Partnership Model May Not Survive, published September 28 by Valuentum’s Brian Nelson, CFA

Warren Buffett has famously said that, “only when the tide goes out do you discover who’s been swimming naked.” We now know what’s been swimming naked, and it’s the master limited partnership (MLP) business model during the latest downdraft of this energy cycle. A tremendous fall-out may still be ahead for MLPs, unfortunately, as energy markets weaken and as credit markets tighten.

We now believe the financial operating structure of the MLP may not survive in its current form, even as we say that most businesses using the MLP model are good ones. Our view continues to be that most master limited partnerships including Energy Transfer Partners and most midstream corporate business models including Kinder Morgan are dependent on external capital market assistance to fully fund the current levels of their distributions and dividends, respectively. Their distributions and dividends are not sustainable via internally-generated, traditional free cash flow generation, as measured by cash flow from operations less all capital spending.

However, most traditional brokerage houses have set the price targets of these entities on the faulty belief that their dividends and distributions are a clear and reliable reflection of their underlying operations, as they are with most other corporates. In light of the external capital market assistance that is necessary to support the payouts, however, such dividends and distributions are not; in our view, they are far from it. The industry’s definition of “distributable cash flow,” which completely ignores the very growth capital that drives future net income, which itself is included in distributable cash flow, further complicates this severe valuation imbalance.

With seemingly infinite support from the external capital markets and investor thirst for income, most master limited partnerships and midstream corporates have been holding on to the belief that their distributions and dividends are invincible, and some may still believe this to be true. After all, they may argue, with unlimited access to incremental external financing via new equity and debt, which entity couldn’t grow its dividend or distribution to the moon? This line of thinking comes with a kicker, too. As long as the brokerage houses price such equities on these “financially-engineered” dividends, the price of their stocks would also be propped up, and in turn, the creditworthiness of the entity, its corporate credit rating, would be healthy, too.

But this self-perpetuating, debt-infused “bubble” is coming to an end, in our view, now that bankers are re-evaluating price decks and borrowing capacity and as the energy markets swoon. Most master limited partnerships and midstream corporates may have to make the difficult decision to either cut their distributions/dividends or suspend growth plans in them altogether, a move that would completely negate forever the dividend-based equity pricing framework used by brokerage houses, leading to a further unraveling of equity prices. Falling stock prices would then weaken credit quality, and a bust would truly ensue, as shares finally revert back to traditional, tried-and-true free cash flow valuation processes, as opposed to one based on a financially-engineered payout.

That the merger between Energy Transfer Equity and Williams, announced September 28, fetched a price far below levels of just a few months ago (now $33 billion was $48 billion) means that the environment continues to deteriorate at a pace faster than even we are observing, and in our view, participants are becoming desperate in the face of adverse conditions. Many MLPs and midstream corporates, for example, may no longer be able to hide behind their 2015 slide decks as investors are now demanding the sensitivity of their operating assumptions to present-day, real-life energy resource pricing levels and their impact on projected performance in 2016 and 2017.

As existing hedges for most midstream entities roll off, either material pressure on cash flow from operations would then ensue once new hedges are put in place at lower prices, or a significant increase in their sensitivity to the spot rate of key commodities would prevail, by a factor that perhaps executive teams may not even know. The very idea that OPEC continues to produce to put the clients of most midstream operations out of business means that MLPs and corporate midstream entities will never be able to truly escape the reality that they, too, are inextricably tied to commodity prices.

Several midstream MLPs have already warned that distribution growth would disappoint including Plains All American, and upstream players including Linn Energy have already ripped the Band-Aid off with an outright suspension. We think the stock market will eventually demand that such entities pay their distributions and dividends out of earnings and traditional free cash flow, like most every other dependable dividend-paying corporate out there, and that means the sledding in their share prices will continue. The corresponding hit to credit health across the sector in the event of further weakness in equity prices then might very well create the unraveling we had outlined several months ago.

The MLP business model, as we know it today, may not make it through the other side of this downdraft of the energy cycle. Storm clouds are gathering.

We hope you have benefited from the unique insights and the predictive, forward-looking nature of the Valuentum process, which considers an in-depth discounted cash flow valuation, relative valuation assessment, and technical/momentum indicators. Our best wishes to all, and we trust you saved as much as half of your capital by heeding Mr. Nelson’s warning.

Mr. Nelson’s body of research on the midstream space and follow up to the rebuttal of this article, also published by Barron’s, can be accessed at www.valuentum.com.

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May everyone have a wonderful holiday season! Don’t forget to give the gift of a Valuentum membership today. Subscribe here. We’re also hosting a workshop detailing our concerns with the MLP universe here. Don’t delay; reserve your spot today.

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