Editor's note: What follows below is Hedgeye's "Investing Term" of the week which was a part of this past weekend's "Investing Ideas" research product. "Investing Ideas" is designed for the savvy, longer-term self directed investor looking for fresh, exciting long-only opportunities. For more information please click here.
INVESTING TERM – MASTER LIMITED PARTNERSHIP
Hedgeye’s senior energy analyst, Kevin Kaiser, has gotten plenty of publicity over his analysis of oil and gas Master Limited Partnerships – MLPs. This week Charlie Gasparino interviewed Kaiser about his recent bearish report on Kinder Morgan Energy Partners (KMI), the granddaddy of all energy MLPs.
MLPs are favored by investors looking for safe, above-average returns. This includes a large percentage of folks in, or nearing retirement. And there’s no denying that many MLPs have provided impressive returns for the last decade or more. It has been a popular sector. According to the National Association of Publicly Traded Partnerships, the total MLP market is over $440 billion, of which $395 billion, or 89%, is in energy and natural resources. We estimate that some 70% of the holders of MLPs are retail investors.
Investors (“unitholders”) in an MLP, like shareholders of a public company, exercise no control over the business and have no liability beyond the amount of their investment. (Hence “limited” partners.) The partnership is managed by the General Partner – usually a separate legal entity that makes the business decisions and hires and directs management.
Unitholders receive regular cash distributions, which are generally specified in the partnership documents. The tax code allows certain companies, especially those in oil and gas production and transportation, to operate as MLPs, which exempts their income from most state and local taxes. This leaves a pool of cash for distributions to unitholders. The GP receives cash incentive payments when distributions are made, based upon the total amount of LP distributions. The bigger the distribution, the bigger the payment to the GP. And MLPs have a pattern of increasing payments, with the result that the GP takes in larger payments. Depending on whether you are a cynical stock analyst, or the GP, this is either a vicious cycle, or a virtuous one.
MLPs have many of their own accounting metrics. They have been permitted – we would say “incentivized” by a supine Congress and comatose regulators – to apply subjective accounting standards not in conformity with GAAP (Generally Accepted Accounting Principles, the fundamental standard metrics on which all businesses report their financial results). Companies generally use non-GAAP accounting if the result is justified by the unique realities of their business, and non-GAAP reports are sometimes presented alongside a GAAP near-equivalent, to permit clear comparison.
MLPs report an item called Distributable Cash Flow (DCF), which is the mother of all non-GAAP metrics. Logically, DCF is the money left over after paying the expenses of running the business. But as managements must smooth quarterly payments, and often increase them, the job of managing DCF can become far more important than the job of actually running the operating business.
Every MLP puts a slightly different spin on how they report DCF. Some of their measures appear vague, opaque, misleading, or simply wrong. Among the problems Kaiser identifies are: accounting for hedges on oil and gas production, accounting for the cost of acquiring other companies to capture their cash for distribution payments, and accounting for the cost of repairing and maintaining capital equipment such as pumps and pipelines.
Use of non-GAAP reporting could substantially understate the actual cost of doing business, and the MLPs often compound the issue by adding back expenditures to their stated asset base. Certain MLPs report capital expenditures as “expansionary,” when in reality a lot of the spending is basic maintenance without which their business would literally dry up.
These issues appear especially in “upstream” MLPs that produce oil and gas. Upstream MLPs got in trouble in the 1980s when many of them borrowed heavily to buy producing properties that were running dry, then were hit with price volatility and inefficient hedging markets. Upstream MLPs fell out of favor and were replaced by Midstream MLPs, middlemen who transport oil and gas through their pipelines. In the media debate around Kaiser’s latest research, you may have heard folks say “these companies are a toll road: they get paid every time something travels along their route.” That’s mixing apples and oily oranges.
“These companies” – the ones Kaiser is focused on – are upstream MLPs; their own oil and gas sales revenues are a critical part of their revenues. They must actually produce oil and gas, they must hedge efficiently, and the energy market has to be willing to pay a price that allows them to book a profit. They also really need functioning pipelines to deliver their production, and if Kaiser’s analysis is accurate, some of these pipeline MLPs may be starving their infrastructure of critical maintenance capital.
The upstream MLP segment has had a terrific run. Kinder Morgan has routinely been praised as one of the top companies in US industry, with good reason. Its founder and CEO, Richard Kinder, is an acknowledged giant among business leaders and a multi-billionaire who receives $1 a year in total compensation as CEO of Kinder Morgan. Since its creation in 1997, Kinder Morgan has provided approximately a 25% compound annual average total return to its unitholders. When Kaiser’s report on Kinder came out, the stock price sagged. Richard Kinder showed his faith in the operation, plunking down $18 million to buy half a million units in the open market.
So how can we be so negative on this company?
Kaiser’s analysis shows the MLP sector is fraught with accounting irregularities, all of which appear to be legal, and none of which appears to feature prominently on the radar of either Congress or the SEC. (Well, maybe Congress, considering the flow of campaign contributions and payments to lobbyists from the energy sector.) Among the most opaque and convoluted financial reporting, Kaiser’s analysis leads him to believe KMI’s true free cash flow is not anywhere close to the DCF number it reports.
Does this mean Kinder Morgan is a fraud? No, – they appear to be following the law to the letter. Does this mean the MLP sector as a whole is dishonest? Not at all. Particularly not on Wall Street (or in Washington), where the concept of “honesty” is on a par with the concept of “privacy” in the Age of Facebook (and the NSA.)
And it especially doesn’t mean that Kinder Morgan is about to spin, crash and burn. Kinder Morgan has produced outsize returns for an army of happy investors for a decade and a half, and there’s nothing to say that will stop today. But Kaiser is convinced it will ultimately stop. Like so many of the implosions we have seen in recent years, this will happen imperceptibly slowly – and then, all at once.
This is a huge story – there are some 100 energy MLPs. Kaiser has tackled five of them, and all have shown the same issues around transparency. There’s no immediate catalyst to make these stocks all go down. What there is, is – there are about $395 billion in natural resources MLP units held largely by individuals in, or planning for retirement. These are “safe” and conservative portfolios. What there is, is a large number of individual investors who sleep soundly at night, because they actually have no idea what they really own in their portfolios.
When they wake up, there could be hundreds of billions all racing for the exit, all at once.
Last Word: Just A Number
We haven’t overlooked the folks falling over one another to be the first to point out that Kaiser is “only” 26 years old, with the strong implication that, at that age, he should be seen and not heard. The rabbis of the Talmud observe that the finest old wines may be packaged in new containers and urge us to taste the wine, rather than criticize the barrel.
We note that at age 26, Napoleon saved the French Republic by single-handedly organizing the artillery defense of the Directorat. And it was purportedly at age 26 – or thereabouts – that Alexander sat and wept because there were no further worlds to conquer. Age is a number, not a measure of competence. Experience may be an excellent teacher, but most folks don’t pay attention in class.
Kevin Kaiser – and the rest of us at Hedgeye along with him – will either be right on this analysis, or we will be wrong. That’s a risk we take each day. To those who take exception with Kevin’s analysis, please show us where he’s wrong. We welcome the dialogue – it will make us better analysts. To those who publish snotty comments about Kaiser’s age, aren’t you ashamed for criticizing him over being something at age twenty-six that you were not?
- Moshe Silver
Moshe is a Hedgeye Managing Director and author of the Hedgeye e-book Fixing A Broken Wall Street