(Editor’s Note: We are adding MEDNAX (MD) to our list of Investing Ideas, and we will issue a full Stock Report on MD next week. We will also have full write-ups on all Investing Ideas stocks in next week’s newsletter.)
Macro Theme of the Week: Slipping Up the Slope
“Better than expected.” “Robust.” “A healthy sign.” Comments on Friday’s jobs report are not quite so effervescent as reviews of a new musical, but in the normally staid language of economists and the reporters who cover them, you might say this is positively euphoric.
Here’s how the numbers break out in this week’s statistics, and what Hedgeye has to say about them:
Jobs – At 195,000, new jobs created for the month of June ran ahead of most analysts’ projections. Hedgeye Financials sector head Josh Steiner was looking for a report in this range, so the modest superlatives being tossed around in the financial press don’t apply here. In fact, Steiner says this is a near-ideal number, falling in the growth sweet spot of between 150,000 – 200,000 new jobs, which he considers enough to show that our growth thesis is well on track, but not so much as to spark inflationary fears.
The government also revised upwards the jobs numbers for April and May, which media commentators say bodes well for a stronger economy in the second half of 2013. In other words, the rest of the financial media are slowly coming around to the conclusion Hedgeye reached in the fourth quarter of last year – that a recovery in US growth was on track. The recovery has been slow – as we foresaw – but seems to be winning converts with each new economic datapoint.
Unemployment – Steiner continues to favor Non Seasonally Adjusted (NSA) jobless claims over the Seasonally Adjusted (SA) numbers relied on by both policy makers, and the majority of analysts and economists. Rolling NSA claims improved by 9.6% over last year, bringing what Steiner calls “another week of solid labor market improvement.”
SA claims were basically flat on a rolling 12-month basis – pointing up the discrepancy between what’s going on in the economy, and the way the government chooses to report it. We suspect the policy motivation for this is that using SA statistics tends to dampen the impact of large events, creating the appearance of smooth or gradual changes. If you’re Ben Bernanke, and if you understand this (we think he does, but you never know…) you use statistics to maintain calm in the populace while working up your next policy move.
Remember that, for all we have been critical of his “Helicopter Ben” approach of continuing to print dollars, Bernanke has to balance multiple constituencies. To get anything done at all, he has to keep a lid on Congress, the President, the press, Wall Street, and Main Street. How do you keep so many antagonists at bay at the same time? Well for one thing, it helps to manipulate the data.
This time around, the media were forced to concede that unemployment looked better, even using the flat SA number. Flat unemployment of 7.6% was attributed to more people coming into the workforce – a clear indicator of economic optimism. And the Labor Department reports that pay levels rose “sharply” in June, which means pay rates have outpaced inflation over the last twelve months.
Inflation – Speaking of growth, you shouldn’t think that there is no concern over inflation, just because you are getting a zero per cent return on your money market account. The biggest bond fund managers are acknowledging that the economy is performing better than expected, with the possibility that Bernanke may ease off the QE accelerator.
Financials sector senior analyst Jonathan Casteleyn points out that PIMCO, the world’s largest bond fund, owns 10% of the total market for TIPS – Treasury Inflation-Protected Securities – a special category of Treasury securities whose par value (the face amount, or amount payable at maturity) rises with inflation, as measured by the Consumer Price Index. The only larger holder of TIPS securities is the Fed, which holds 11% of the market.
Casteleyn says this signals that PIMCO has some concern over inflation, but perhapsmore immediately, it is indicative of a bond fund manager running low on investment options: the corporate bond and mortgage markets will suffer if growth continues and rates continue to rise. One of the few options left for PIMCO to profit from this scenario is if growth actually spurs inflation, which would benefit TIPS.
This week, investors pulled $9.6 billion out of PIMCO’s Total Return Fund, the largest mutual fund in the world, and one of the most successful in terms of historical performance. With some $268 billion remaining under management, PIMCO has to be right most of the time. It’s hard to be fleet of foot with these outsized and sometimes cumbersome positions in the $38 trillion bond market.
What Does This Mean For Investors? “The fundamentals of the labor market continue to improve at an accelerating rate” says Steiner, who says most observers are wrongly concerned about rising long-term interest rates, while missing the boat on improving credit quality. Meanwhile the housing market continues to move ahead in spite of higher rates. Major originators of mortgages should post solid second-quarter earnings, says Steiner, because the run-up in rates came at the end of the quarter. Steiner thinks this is a good environment to be buying some of his favorite “deep value” stocks that are levered to improving credit quality, like Bank of America (BAC).
He also cautions that investors should not discount the opportunity in the poor-credit end of the market. His featured Investing Idea Nationstar (NSM) stands to be a major beneficiary of the federal HARP program, the only place homeowners can go to get a bailout on their underwater mortgages.
Sector Spotlight: Energy - Dustup at the Wellhead
Energy sector senior analyst Kevin Kaiser has taken a sharp look into the world of oil and gas producing Master Limited Partnerships. With his recent work on LINN Energy he appears to have bitten off more than the challenger at the annual Nathan’s Famous Coney Island July Fourth hot dog eating contest.
It was in March that Kaiser first ventured into what was quickly to become a minefield when he suggested LINN’s accounting practices raised more questions than answers. Since then, Hedgeye and Kaiser have been criticized by LINN management, have seen Kaiser’s work mentioned approvingly in the financial press (see Barron’s "Twilight of a Stock Market Darling") and have been the target of both professional challenges, and ad hominem attacks from money managers.
But enough about us…
MLP Investors
For many years, investors have turned to the oil and gas industry for income as a combination of tax incentives permit operators to roll up their financing needs and pay out above-average revenue distributions to investors. This is done through master limited partnerships (MLPs) that allow individual investors to benefit from tax-advantaged cash flows. [NOTE: Hedgeye does not provide tax advice. Nothing in this article is intended as guidance on the tax treatment of MLP revenues, or the consequences of investing in MLPs.]
The tax code provides MLP status for certain activities, particularly in natural resources. MLPs turn most of their cash flows over to unitholders in periodic distributions, so the most significant challenge facing the MLP is often how reliable its own top-line revenues are, and whether any unforeseeable major costs might impinge on that revenue stream. MLPs will generally give guidance on upcoming distribution payments, setting expectations for unit holders. These expectations are so strong that analysts routinely value MLPs primarily (or solely) on the basis of projected upcoming distributions. Obviously, cash-flow management is critical to the management of the MLP.
In order for it to be deemed “distributable,” the IRS requires that 90% of MLP cash flows be derived from “qualifying” activities, such as the extraction, processing, and transportation of oil and gas. Most energy MLPs are pipeline companies, distributing out revenues generated by charging producers and refiners for the transportation of raw and finished product. While operating a pipeline may not be a sexy business model, it makes for relatively predictable throughput volumes. The sourcing of actual gas and oil in the ground becomes someone else’s problem, and the threat to the revenue stream is idle capacity, but not actual financial losses associated with sinking dry wells.
Bear in mind also that the general partner’s performance is judged by unit holders on both the reliability of the quarterly distribution, and the price the units fetch in the market. The GP is generally paid a fee tied to the quarterly distribution: the higher the distribution, the higher the fee. So it is in the GP’s interest to inflate the distributions, and this is frequently the case. Energy MLPs routinely use a bit of “financial engineering” – primarily creative non-GAAP financial measures – to keep raising distributions to unitholders. Wall Street considers them good, stable investments for income-oriented investors.
In fact, nearly all MLP analyses – whether performed by individual investors deciding what to do with an extra $5,000, or by an analyst at a major Wall Street firm – calculate the market price of the unit on the basis of upcoming distributions. What these analyses do not consider is whether the MLP is accurately depicting the safety of those upcoming distributions, or whether the standard MLP financial template fully and accurately represents the risks and potential of their business.
E&P MLP – Yeah, You Know Me…
A few MLPs are actually in the E&P business, deriving their revenues from wellhead production of oil and gas. They are more in the business of producing than of exploration, and thus are known not as E&P MLPs, but as “upstream” MLPs. Still, one does not have to be a crack Energy sector expert to recognize that revenues from the production of oil and gas are likely to be erratic. How, then, does an upstream MLP sustain its promised quarterly distributions?
Most upstream MLPs buy established producing fields with low “decline rates,” meaning the inventory of oil or gas in predicted to decline slowly, as calculated from the operating history and proven reserves of the property. There are currently 11 publicly-traded upstream MLPs in the US. LINE is bigger than the other ten combined.
Kaiser believes Wall Street values the upstream MLP group wrong – and LINN in particular, given both its size and the extent of its fancy accounting footwork. Rather than take the announced yield as an article of faith, Kaiser treats upstream MLPs like actual E&P operators. He digs into the asset portfolio to arrive at a valuation based on the future free cash flows that the producing properties can generate, rather than on what management announces as the upcoming distribution target.
To quote but one discrepancy in Kaiser’s work, versus LINN’s disclosures, Kaiser reviewed of the valuation of producing properties held in LINN’s portfolio – properties earmarked for future sale to raise money for distributions.
Kaiser compared LINN’s stated valuation of their producing properties to recent prices paid for actual acquisitions of oil and gas producing acreage in the same regions. Using LINN’s numbers, Kaiser arrived at a valuation of $35,000 / acre for properties in a region where the most recent actual transaction, in May of this year, was done at only four thousand dollars an acre. This puts LINN’s valuation at nearly nine times the latest actual price paid for neighboring properties. LINN values these properties at between $3.3 billion - $5.2 billion. Using the “last sale price,” Kaiser comes up with a value of $380 million.
Someone’s going to be wrong here.
Since diving into LINN, Kaiser has cast his baleful eye across the upstream MLP sector. In April, Kaiser presented a short case for EV Energy Partners (EVEP). And when Kaiser posted a negative note on Breitburn Energy Partners (BBEP) this week, the stock lost over 10% on the day. Somebody out there is reading our work – and paying attention.
For the record, Hedgeye has invited LINN management to participate in client calls where Kaiser discussed his work in detail. In addition to an army of retail investors, LINE has substantial high-profile money managers among its shareholders, some of whom have used the bully pulpit of their own name recognition to attack the credibility of Kaiser’s work. Hedgeye has also invited these professionals to participate.
We have always said that our work speaks for itself. We’ll either be right (most of the time, we like to think) or wrong. The thrust of Kaiser’s message has been that LINN’s accounting is hard to decipher, much less to justify. The message to investors has been that an SEC inquiry might derail the pending acquisition of Berry Petroleum (BRY) a $4.8 billion deal that will provide LINN with sufficient cash flow to cover distributions for the next several quarters.
You read correctly. LINN intends to acquire a major company so it can turn around and take the cash flow from that acquisition to pay required distributions to its unitholders. LINN has publicly positioned itself as an “acquisition machine,” saying its ongoing program of acquiring operating companies will continue to fund its distributions. The problem, says Kaiser, is that the numbers keep not adding up – and the more they don’t add up, the greater the risk to the distribution payment. LINN is counting on the BRY acquisition for upcoming distributions (note that Hedgeye also offered Kaiser’s research to BRY shareholders.) Delaying the deal could severely affect LINN’s distributable cash flow. Kaiser says it’s difficult to say when, but sooner or later LINN will end up cutting their distribution. Like oil in the ground, publicly traded companies are a finite asset. Like the Bernanke Fed, sooner or later LINN will either run out of companies to buy, or the means to buy them.
For a short seller the question is, can you remain short the units for as long as it takes? LINN pays a healthy distribution of $3.08 per unit, which a short seller must pay out for as long as they remain short the units.
As we go to press, the SEC has launched an inquiry into LINN’s use of non-GAAP accounting and other techniques it uses to bolster cash flows, precisely the risk that Kaiser raised. (We didn’t plant the Forbes headline, honest we didn’t…“LINN Energy: SEC Looking At Reported Sketchy Derivatives Accounting To Hide Costs, Stock Tanks”). This is precisely the risk Kaiser has been highlighting to investors. LINN’s accounting was so unusual, even the regulators noticed. LINN’s publicly traded units are down substantially this week. LINE closed last Friday at $33.18, and closed Wednesday July 3rd at $22.79. LNCO closed last Friday at $37.27. On July 3rd it closed at $26.95.
What Next?
We have no way of knowing where the SEC’s inquiry will lead. But we believe the SEC may find itself between a rock and a hard place on the LINN / BRY transaction. Outside of some important fund managers who are deeply involved in LINN stock, the majority of LINN shareholders are actually retail investors. This puts the Commission in a bind, as it appears they failed to monitor aggressive accounting in a sector with a large number of retail investors.
Newly-appointed SEC chair Mary Jo White – a rock-star lawyer rock star lawyer, with deep experience as both prosecutor and defender – has her hands full establishing her own credibility, and the Commission’s. We think her first order of business is to not let the clock run out on the financial crisis-era cases, most of which are on the cusp of the statute of limitations. White can blame her predecessor for the fact that no banker has done jail time for these excesses so far. But now the docket is in her lap, we think she needs to move swiftly to get a couple of highly visible wins.
As far as the LINN / BRY deal itself, our gut tells us the SEC will require LINN to make some accounting changes, and LINN will agree. The SEC will likely not stand in the way of the deal – the upstream MLP game may be up, but we think White does not want her tenure at the Commission to kick off with her being responsible for thousands of people losing the income they have relied on for so long.
Of course, with the lights turned up, we think BRY shareholders will walk away. At current prices the stock swap – 1.25 LNCO shares for each BRY share – is no longer attractive to BRY holders. Much of the stock is owned by the family that created the business and has been in their possession for a century. We think they will not be willing to sell their patrimony for a mess of pottage.
Toot! Toot!
The jury is still out on LINN, but from where we sit, Kaiser has done more to create transparency and to educate investors about the company than all the rest of Wall Street combined.
If you haven’t been following the jousting, Hedgeye and our supporters – and especially detractors – have been all over the place with the LINN saga, both in the Twittersphere and in the pages of Barron’s. Some of our biggest supporters have chided us for pushing our own agenda aggressively in the social media – to which we respond that we have a product to sell, and if we don’t beat our own drum when we get things right, we can hardly expect our competition to do it for us. Investment research is the classic business of When I’m Right, No One Remembers – When I’m Wrong, No One Forgets. Our work speaks for itself – but that doesn’t mean we can’t use a megaphone once in a while.
Investing Term of the Week: Regulatory Inquiry
The SEC describes itself as “first and foremost a law enforcement agency,” but don’t envision a troop of accountants bursting into the executive suite like NCIS and shouting “Clear!” after they find the shredding bin is empty.
The SEC requires entities subject to their authority to fully, transparently and properly disclose all relevant information. Public companies are required to publish regular financial reports, and banking and brokerage firms are subject to a wealth of rules covering everything from reporting of trades, pricing of securities, and disclosure of trading venues for customer orders, to investment banking disclosures around securities offerings, and proper registration of individuals, entities and securities.
According to the Commission, informal inquiries and formal investigations are generally triggered by concerns over misrepresentation or omission of information, market manipulation, theft of customer assets, the sale of unregistered securities, violation of brokerage and investment banking firm obligations of fair treatment, and of course, insider trading.
A preliminary fraud investigation generates a file called a MUI – a Matter Under Inquiry. These are tracked in the computerized Case Activity Tracking System (CATS). In recent years the Commission has been criticized for not following up on MUIs (as in the Madoff case), and then for routinely destroying MUIs even when cases had not been developed, a practice that may have been illegal, and which the Commission reversed, but not soon enough to escape a nasty article by “Rolling Stone’s” Matt Taibbi.
Preliminary investigations are “informal” and the person or entity under scrutiny is not required to announce publicly that the Commission is looking at them. “All investigations are conducted privately,” says the Commission, with SEC staffers and attorneys examining company records and interviewing employees. This week’s press release by LINN Energy says they “Voluntarily Disclose Informal SEC Inquiry,” and notes that “the SEC has requested the preservation of documents and communications…” But regulated entities are anyway required to keep all “material” records of their business. The purpose of this directive is to create another legal hurdle, should the SEC proceed to a formal investigation and to bring charges.
As you will notice from the drop in the price of LINN’s publicly trades units, the “informal inquiry” is not construed as a positive thing.
But wait, there’s more…
The next level is a Formal Investigation, generally conveyed in what the SEC calls a Wells Notice, a letter from the regulator putting your formally on notice that they are investigating a certain matter. A registered financial firm or person who receives a Wells Notice is required to reflect it on their license, registered with FINRA, the umbrella industry self-regulatory body. The formal notice of a regulatory investigation is then available for viewing on the public investor tab of the FINRA website (go to FINRA.org and select “broker check”) which will not disclose details of the matter, but will tell you if your broker is under formal investigation.
A Wells Notice is notification of an investigation – but not of an actual charge. The recipient of a Wells Notice theoretically has the option to argue their case – though as one regulator says, “When we Wells someone, we charge them.”
The SEC doesn’t bring criminal charges – for that it must coordinate with the Justice Department. This was brought to the fore dramatically in recent insider trading cases – notably the convictions centering around Galleon hedge fund founder Raj Rajaratnam. The SEC itself brings civil charges and can also bring administrative charges.
Civil actions can result in monetary fines, disgorgement of profits from improper activity, and injunctions to prevent future illegal activity. Administrative actions can also result in firms or individuals being formally censured or even barred from the securities industry.
This all sounds like a lot of ammo. In actual practice though, the SEC has a long history of settling cases without requiring an admission of guilt. These “consent decree” settlements have taken in large amounts of cash, but they have resulted in Bad Actors being recycled back into the financial system. (See our Hedgeye e-book Fixing A Broken Wall Street) for our own rants about this practice.) Until the Commission requires actual admissions of wrongdoing, these settlements will not achieve their true aim of policing the markets. With the advent of Mary Jo White, and in the aftermath of the financial crisis, there has been some talk of requiring firms to name individuals in the settlement process. We shall see…
This week the Commission announced the formation of a new Financial Reporting and Audit Task Force, “dedicated to detecting fraudulent or improper financial reporting.” The focus is to support the Enforcement Division’s work on disclosure and reporting fraud. Using new quantitative analytics, the Task Force will focus on “fraud detection and increased prosecution of violations involving false or misleading financial statements and disclosures.”
This is not quite slamming the door on aggressive “creative accounting.” Until Congress directs companies to provide transparent financial reports, such agencies as the FASB (Financial Accounting Standards Board) and the SEC are operating with one hand tied.
It remains to be seen just how much clout the SEC’s free hand will wield.