The game is nearing an end for master limited partnerships (MLPs) in this energy cycle, in our view.
We no longer feel comfortable, if we ever did, including any MLP in the Dividend Growth Newsletter portfolio. Linn Energy (LINE, LNCO), of the upstream variety, may have taken on far too much debt as an E&P entity, but its free-cash-flow management during the first half of 2015 has actually been decent…stronger than better-known upstream and midstream operators.
Yet, despite Linn’s positive free-cash-flow execution, even after distribution payments, the entity’s bankers appear to be circling like sharks, ready to take a further bite out of its borrowing capacity (due to lower energy resource pricing). Fairly, the company simply can’t afford to take any chances and is flat-out worried that banks will cut its borrowing base yet again; this time to $1 billion at year-end.
Though we’d never in a gazillion years lever up as much as Linn had done (a big mistake in a commodity-producing industry), we can’t disagree with management’s decision to cut the distribution. Management is now running the company for survival, not to pad unitholders’ accounts with a distribution, though a strong and growing distribution had once been its goal.
Linn, having already disappointed income investors in cutting the payout prior to the news last week, was not getting what we would describe to be a “Kinder Morgan effect” with the valuation of its shares. We define a “Kinder Morgan effect” as a situation where a company is valued solely on the basis of its dividend, irrespective of actual free-cash-flow fundamentals or whether the dividend is organically generated (as opposed to financially-engineered).
Where Kinder Morgan is yielding ~5%, Linn Energy had been fetching a yield of 15% or higher, even as it generated positive free cash flow after paying distributions, unlike many, if not all, of its MLP peers. Since Linn’s high payout had not been facilitating a high share price at which capital could be raised (i.e. the “Kinder Morgan effect”), then there would be no point in paying the distribution…at all.
That’s why it cut the distribution entirely. For Linn, the dividend is a waste of cash without a “Kinder Morgan valuation paradigm.” In the words of Linn CFO Kolja Rockov: “we’re not getting much credit for paying the dividend.” But it’s now clear that the distribution had been supporting the price of the stock, at least in the context of the sell-off this past week.
Our guess is that Linn’s management thought the news of the positive free cash flow generation through the first half of 2015 would more than offset the unitholder disappointment regarding the distribution suspension. This is logical, and it probably should have. Plus, Linn’s management had been scooping up its debt at distressed prices prior to announcing the distribution cut, and this might have been partial motivation for making the move. For one, reducing cash payments to unitholders enhances credit quality and improves the recovery value of debt to creditors, a move that also increases the market value of debt. Ever-higher distributions/dividends reduce an entity’s credit quality, all else equal.
In this uncertain energy-resource price environment, we wouldn’t go near a company such as Linn Energy that has $10 billion in net debt and has only generated modest free cash flow generation through the first half of the year. From our perspective, ExxonMobil (XOM) is the only investable consideration within the upstream and midstream segments of the energy sector on the basis of its free cash flow (CFO less Total Capex; see above) generating capacity and manageable financial leverage. Holding 15% on ExxonMobil within it, the Energy Select SPDR (XLE) will soon be our only exposure to the energy sector in the Dividend Growth Newsletter portfolio, and it’s a very small holding at that. We’ve been telegraphing our move to remove Energy Transfer Partners (ETP) from the portfolio for some time, and we’ll do so early next week.
We’ve never liked the financial-engineering involved in the generation of an artificial valuation paradigm surrounding an MLP’s distribution rather than its free cash flow stream, and we still don’t. From the Dividend Growth Newsletter portfolio, we removed ConocoPhillips (COP) in May 2013 at $62.81 (now shares are at ~$50 each), Chevron (CVX) in March 2015 at $102.36 (now shares are under $90 each), Kinder Morgan (KMI) in June 2015 at $40 (now shares are under $35), and Energy Transfer Partners next week. Barron’s didn’t highlight Valuentum as a ‘Survival Guide for Oil Investors’ for no reason. We’ll likely include the ETP alert in the Friday weekly recap email to make sure that you don’t miss it.
By the way, Kinder Morgan has the net debt of oil giants Chevron and ConocoPhillips combined, as it generates less than 20% of their combined cash from operations, even in today’s depressed energy resource price environment. Be careful out there. We don’t believe the “Kinder Morgan effect” is sustainable.