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What the Heck Are MLPs?

Takeaway: When MLP investors wake up, there could be hundreds of billions racing for the exit, all at once.

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

 

What the Heck Are MLPs? - mlp1

 

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 

 


European Banking Monitor: Portugal Continues Inflection

Below are key European banking risk monitors, which are included as part of Josh Steiner and the Financial team's "Monday Morning Risk Monitor".  If you'd like to receive the work of the Financials team or request a trial please email .

 

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European Financial CDS - Europe's financial system continues to heal. Swaps tightened notably last week with an average decline of 9 bps and a median decline of 10 bps. Spanish, Italian, French and German banks all saw swaps tighten sharply. 

 

European Banking Monitor: Portugal Continues Inflection - zz. bankk

 

Sovereign CDS – Portuguese swaps remain one of the few areas globally that continues to show steady signs of deterioration. Portugal's swaps rose another 24 bps last week, bringing the spread to 557 bps. They were higher by 24 bps last week and are now up 122 bps vs the prior month. Elsewhere around the world, swaps were largely uneventful with the next largest move coming from Italy at +6 bps W/W. 

 

European Banking Monitor: Portugal Continues Inflection - zz. sov1

 

European Banking Monitor: Portugal Continues Inflection - zz. sov2

 

European Banking Monitor: Portugal Continues Inflection - zz. sove3

 

Euribor-OIS Spread – The Euribor-OIS spread was unchanged at 13 bps last week. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

European Banking Monitor: Portugal Continues Inflection - zz. euribor

 


Morning Reads on Our Radar Screen

Takeaway: A quick look at some stories on our radar screen.

Keith McCullough – CEO

Summers Pulls Name From Consideration for Fed Chief (via New York Times)

Geithner Said to Remain Uninterested in Fed Chairmanship (KM note: Thank God … via Bloomberg)

Looking To Twitter To Reignite Tech I.P.O.’s (via DealB%k)

U.S. Navy says reports of fatalities in Washington Navy Yard shooting  (via Reuters)

 

Morning Reads on Our Radar Screen - lsumm3

 

Jonathan Casteleyn – Financials

Gross’s Trade Sours as Bonds Lose Faith in Fed Guidance (via Bloomberg)

In Lehman's Shadow, Ex-CEO Fuld Carries On, Quietly (via WSJ)

 

Kevin Kaiser – Energy

Summers and Heroin (via TheStreet)

Companies weigh up Canada gas options (via Financial Times)

Repsol Hunts for Oil-Firm Acquisition in North America (via WSJ)

 

Brian McGough – Retail

BofA/Merrill Lynch Adds Dick’s Sporting Goods to US 1 List (DKS) (BM note:  I'll take the other side of this morning's $DKS upgrade anyday...via Dividend.com)

 

Matt Hedrick - Macro

Germans Export Grandma to Poland as Costs, Care Converge (via Bloomberg)


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EXPERT CALL TOMORROW: Brent Willis Discusses New Excitement in Electronic Cigarettes

EXPERT CALL TOMORROW: Brent Willis Discusses New Excitement in Electronic Cigarettes - victoryDIALIN 09.17.13

 

The Hedgeye Consumer Staples team hosts an expert call on electronic cigarettes featuring Brent Willis, a leading consumer products executive and Chairman and CEO of Victory Electronic Cigarettes. The conference call will be held tomorrow, September 17th at 11:00am EDT.

 

 

CALL OBJECTIVE 

Mr. Willis will contribute his expertise to Hedgeye's ongoing research on the electronic cigarette category.

 

 

KEY CALL TOPICS WILL INCLUDE

  • The industry landscape: What does the future hold for e-cigs?
  • Key metrics to evaluate the industry
  • Competition in the marketplace
  • Big vs Small: E-cigarette companies take on Big Tobacco

 

ABOUT BRENT WILLIS, CEO OF VICTORY ELECTRONIC CIGARETTES

Mr. Willis is an accomplished executive in the consumer packaged goods industry. Prior to directing a number of companies in which he remains a significant private equity investor, Mr. Willis served as the CEO for Cott Corporation, the world's largest retailer-brand beverage company. He previously was the Global CCO and President at InBev, where he developed and implemented the strategies that led the Company to become the world's largest beer company. Prior to creating InBev, Mr. Willis was a President in Latin America for The Coca-Cola Company, where he led the most successful turnaround in the company's history and won recognition as one of Latin America's top senior executives. Mr. Willis has also served as senior marketing executive for Kraft Foods, Inc., with wide operational and strategic responsibilities. Mr. Willis is a graduate of West Point and a decorated Army veteran, where he attained the rank of Captain.

 

 

ABOUT VICTORY ELECTRONIC CIGARETTES 

Victory Electronic Cigarettes describes itself as "dedicated to providing a cleaner and healthier alternative to smoking and is one of the leading companies in this rapidly emerging and fast-growing industry. The Company began online sales in 2012 and expanded to retail early in 2013. Since that time, the growth rate of the firm has been exponential. Victory offers consumers a full product portfolio that incorporates the highest quality and latest technology, and has been ranked superior for real tobacco taste amongst major brands. Recently public through a reverse merger, Victory's new but experienced management team is positioned to leverage its clearly differentiated and well-recognized brand. Victory is well positioned with an established online presence and a low-cost infrastructure to accelerate growth and drive significant value for its shareholders. Victory is listed on the OTC market under the ticker ECIG."

 

Disclosures: Victory (ECIG) is a newly-public company with limited trading history and liquidity. Hedgeye has no investment opinion on Victory and no current plans to publish research on the company. Certain Hedgeye executives may become involved in a transaction with Victory or related entities.


MONDAY MORNING RISK MONITOR: CRICKETS ...

Takeaway: Portugal (sovereign credit risk) continues to go the wrong way while the rest of the world remains stable.

Key Takeaways:

 

* U.S. Financial CDS -  Assured (AGO) and MBIA (MBI) widened sharply last week, tacking on 69 and 107 bps, respectively, to their 5-yr credit default swaps. Elsewhere in the Financials complex, however, just about everything was green. The median US Financial tightened 1 bp last week .Overall, swaps tightened for 20 out of 27 domestic financial institutions. From an equity standpoint, MS and GS saw the best returns last week, rising 4.9% and 4.7%, respectively.

 

European Financial CDS - Europe's financial system continues to heal. Swaps tightened notably last week with an average decline of 9 bps and a median decline of 10 bps. Spanish, Italian, French and German banks all saw swaps tighten sharply. 

 

* Asian Financial CDS - Risk appears to be diminishing across Asia, as Indian bank swaps are finally moving lower. Chinese bank swaps also moved sharply lower this past week. We're a bit surprised to see the divergence between Indian bank swaps and equities.

 

* Sovereign CDS – Portuguese swaps remain one of the few areas globally that continues to show steady signs of deterioration. Portugal's swaps rose another 24 bps last week, bringing the spread to 557 bps. They were higher by 24 bps last week and are now up 122 bps vs the prior month. Elsewhere around the world, swaps were largely uneventful with the next largest move coming from Italy at +6 bps W/W. 

 

Financial Risk Monitor Summary

 • Short-term(WoW): Positive / 4 of 13 improved / 1 out of 13 worsened / 8 of 13 unchanged

 • Intermediate-term(WoW): Negative / 3 of 13 improved / 3 out of 13 worsened / 7 of 13 unchanged

 • Long-term(WoW): Negative / 4 of 13 improved / 4 out of 13 worsened / 5 of 13 unchanged

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 15

 

1. U.S. Financial CDS -  Assured (AGO) and MBIA (MBI) widened sharply last week, tacking on 69 and 107 bps, respectively, to their 5-yr credit default swaps. Elsewhere in the Financials complex, however, just about everything was green. The median US Financial tightened 1 bp last week .Overall, swaps tightened for 20 out of 27 domestic financial institutions. From an equity standpoint, MS and GS saw the best returns last week, rising 4.9% and 4.7%, respectively.

 

Tightened the most WoW: C, COF, SLM

Widened the most WoW: MBI, AGO, MMC

Tightened the most WoW: COF, MET, AXP

Widened the most MoM: MBI, AGO, MMC

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 1

 

2. European Financial CDS - Europe's financial system continues to heal. Swaps tightened notably last week with an average decline of 9 bps and a median decline of 10 bps. Spanish, Italian, French and German banks all saw swaps tighten sharply. 

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 2

 

3. Asian Financial CDS - Risk appears to be diminishing across Asia, as Indian bank swaps are finally moving lower. Chinese bank swaps also moved sharply lower this past week. We're a bit surprised to see the divergence between Indian bank swaps and equities.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 17

 

4. Sovereign CDS – Portuguese swaps remain one of the few areas globally that continues to show steady signs of deterioration. Portugal's swaps rose another 24 bps last week, bringing the spread to 557 bps. They were higher by 24 bps last week and are now up 122 bps vs the prior month. Elsewhere around the world, swaps were largely uneventful with the next largest move coming from Italy at +6 bps W/W. 

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 18

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 3

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 4

 

5. High Yield (YTM) Monitor – High Yield rates fell 11 bps last week, ending the week at 6.46% versus 6.57% the prior week.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 5

 

6. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 4.0 points last week, ending at 1808.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 6

 

7. TED Spread Monitor – The TED spread rose 0.1 basis points last week, ending the week at 23.9 bps this week versus last week’s print of 23.84 bps.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 7

 

8. CRB Commodity Price Index – The CRB index rose 0.2%, ending the week essentially unchanged at 291. As compared with the prior month, commodity prices have decreased -0.5% We generally regard changes in commodity prices on the margin as having meaningful consumption implications.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 8

 

9. Euribor-OIS Spread – The Euribor-OIS spread was unchanged at 13 bps last week. The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States.  Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal.  By contrast, the Euribor rate is the rate offered for unsecured interbank lending.  Thus, the spread between the two isolates counterparty risk. 

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 9

 

10. Chinese Interbank Rate (Shifon Index) –  The Shifon Index rose 2 basis points last week, ending the week at 2.97% versus last week’s print of 2.95%. The Shifon Index measures banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 10

 

11. Markit MCDX Index Monitor – Last week spreads widened 10 bps, ending the week at 94 bps versus 104 bps the prior week. The Markit MCDX is a measure of municipal credit default swaps. We believe this index is a useful indicator of pressure in state and local governments. Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 16-V1.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 11

 

12. Chinese Steel – Steel prices in China fell 0.9% last week, or 33 yuan/ton, to 3561 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity, and, by extension, the health of the Chinese economy.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 12

 

13. 2-10 Spread – Last week the 2-10 spread tightened to 245 bps, -2 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 13

 

14. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF shows 1.8% upside to TRADE resistance and 1.0% downside to TRADE support.

 

MONDAY MORNING RISK MONITOR: CRICKETS ...  - 14

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT


THE M3: MACAU ELECTIONS; MOCHA CLUBS; HK CRUISE CASINOS

THE MACAU METRO MONITOR, SEPTEMBER 16, 2013

 

 

DEMOCRATS LOSE OUT IN MACAU ELECTIONS AFP

Casino bosses and pro-Beijing candidates dominated poll results in the Chinese gambling enclave of Macau, with democrats conceding defeat on Monday.  Preliminary election results showed democrats had secured just two out of the 14 directly-elected seats in the city's lawmaking body, down from three in the previous election in 2009.  A government spokesman told AFP that results would be validated in the next few days, with any appeals going to court.

 

A record 145 candidates were vying for seats, but turnout was down 5% on 2009 with around 152,000 voting, the government said.  The remaining 19 seats in the 33-strong legislature are either appointed by the chief executive -- who is selected by Beijing -- or chosen by business and industry groups.

 

MOCHA CLUBS TO SHUT DOWN TWO SLOT MACHINE PARLOURS Macau Business

MPEL subsidiary Mocha Clubs will shut two slot machine parlours on November 26, the Portuguese-language Jornal Tribuna de Macau reports.  MPEL CEO Lawrence Ho said the Mocha Hotel Taipa Best Western and the Mocha Lan Kwai Fong parlour would close.  The Mocha Marina Plaza parlour in the city centre would be moved.

 

A Gaming Inspection and Coordination Bureau spokesman said of the five slot parlours that must be relocated until November 26, only one Treasure Hunt Slot Lounge, run by SJM Holdings Ltd, has applied to suspend their operations.  New rules will permit parlours inside five-star hotels, within 500 metres of a casino or at resorts in less densely populated areas.

 

 

FLOATING CASINOS FROM HONG KONG STEALING MACAU GAMBLERS Businessweek

Visitors on the eight casino boats that leave Hong Kong each night rose 9% to 615,328 in 1H 2013, aiding operators such as Success Universe Group Ltd and Genting HK Ltd.  

 

“The cruise ship can be a good substitute for mainland tourists,” said Hoffman Ma, deputy chairman of Success Universe, which doubled profits from its casino ship to HK$2.15 million ($277,000) in 1H 2013.  Success Universe’s boat and other Hong Kong ships leave port late each evening, open their casinos once in international waters, and allow patrons to gamble through the night.  A big benefit is that the boats pay no taxes on their receipts, according to Success Universe, versus the 39% gaming levy paid on gross revenue by Macau’s casinos.

 

Rooms in Macau averaged $175 a night in July, according to the government, while a room on a Hong Kong casino boat can cost as little as HK$400 ($52).  Mainland tourists don’t need a separate visa to board the cruise ships once they are in Hong Kong, an added perk for affluent business people who want to stay under the radar.


Casino operators say they’re not worried about the competition.  The casino boats offer little in terms of dining and shopping and do a fraction of the business of Macau’s gambling industry.  Their impact “is minimal,” Ambrose So, SJM's CEO said.  “The pie is growing bigger and some money overflows there.”


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