http://www.barrons.com/articles/mlps-the-worst-isnt-over-1454736638
MLPs: Is the Worst Over?
Andrew Bary
Kaiser says the worst isn't over yet for MLPs. Photo: Matthew Furman for Barron's
The brash young energy analyst who has scored with bearish calls on such companies as Kinder Morgan , Linn Energy , and Chesapeake Energy , says the worst may not be over for investors in battered master limited partnerships. "We're in the early innings of the MLP down-cycle," says Kevin Kaiser, a managing director at Hedgeye Risk Management, a research boutique based in Stamford, Conn. "We had a 15-year up-cycle, and now we're a year and a half into the downturn."
It's hard to name another equity analyst who has caused as much of a stir and bagged as many big targets in recent years as Kaiser, 29, who graduated in 2010 from Princeton University, where he was a co-captain of the hockey team. Kaiser's views run counter to those of MLP bulls—mostly Wall Street analysts and dedicated MLP investors—who argue the sector is deeply undervalued now that the benchmark Alerian MLP index is down 45% in the past year and yielding 10%.
Kaiser outlined a series of challenges facing MLPs in a recent report. He cited overinvestment in infrastructure by MLPs in recent years, a potential downturn in U.S. energy production, rising competition, slowing growth, high leverage, aggressive accounting, and counterparty risk due to contracts with financially distressed energy producers.
"For MLPs to be more compelling investments, the sector has to absorb more pain, and that pain has to come in the form of distribution reductions," he tells Barron's. (Distributions are the MLP form of dividends.) "That's the way the sector is going to solve its leverage problem. Cutting distributions is the right decision for an overleveraged industry entering a downturn." MLPs are loath to cut distributions because investors, mostly retail buyers, prize those payouts and punish companies that cut them.
Kaiser is coming off his biggest coup, following Kinder Morgan's surprise move in December to slash its once-sacred dividend by 75%. Its stock, at $15, is down 60% in the past year. Barron's has been bearish on both Kinder Morgan (ticker: KMI), the leading energy pipeline company, and Linn (LINE). Kaiser's comments and analysis have figured in our articles on them.
Kaiser needed plenty of nerve to take on Kinder Morgan and its legendary chairman, Rich Kinder. Kaiser was the only bear among more than 20 analysts covering the company. Kinder dismissed Kaiser's analysis as all wrong and issued a dare to critics in early 2014 on a conference call: "You sell, I'll buy. And we'll see who comes out best in the long run." The stock then traded at $35. At its high, Kinder Morgan had a market value of almost $100 billion.
Kaiser was dismissed and mocked as an inexperienced attention-getter, thanks to his provocative reports and his use of Twitter to stoke interest in his research and tweak his opponents. He looked bad in late 2014 when Kinder Morgan consolidated its MLPs, spurring a sharp rise in its stock, which peaked at $45 in April 2015. Despite the heat, he stuck to his guns. Kinder Morgan, he insisted, was overvalued based on traditional financial measures like net income, carried too much debt, and was paying a dividend that wasn't supported by its sustainable earnings power.
"Kevin was known as a pressure hockey player at Princeton, and he handled the pressure here like a veteran," says Keith McCullough, Hedgeye's CEO. "I don't know which is the greater tragedy—that all these retail investors got sucked into owning these stocks for the yield, or that Wall Street's analyst community couldn't beat this rookie analyst." Hedgeye is a leading independent research firm with 40 analysts covering a range of industries.
The MLP sector, which totaled over $600 billion at its peak—it's now $300 billion—has long been popular with retail investors thanks to high yields and tax benefits. Our negative coverage of Kinder Morgan and Linn Energy probably generated more reader backlash than any other articles we have done in recent years.
KAISER BEGAN WORKING AT Hedgeye in 2010 as an assistant to the firm's energy analyst after earning an economics degree. He was promoted in 2012 when the analyst left the firm. Kaiser caused a stir with his initial call in March 2013: a short recommendation on Linn Energy, then a company with a $9 billion market value and a group of passionate supporters in the investment community. Kaiser took aim at Linn's accounting for derivatives, arguing that its distribution wasn't sustainable based on its core business, and that the company needed a constant series of acquisitions to grow.
"Why was an energy exploration-and-production company like Linn trading for 10 to 11 times Ebitda [earnings before interest, taxes, depreciation, and amortization], when much better E&P companies, like EOG Resources (EOG), with better growth prospects and better reserves, were trading at six? It didn't make sense," he says.
The reason was that investors and analysts focused on the distribution—the yield was then 7%—above all else. Kaiser later broadened his attack on so-called upstream MLPs that focus on energy production, including Vanguard Natural Resources (VNR) and Breitburn Energy Partners (BBEP).
"If you think the same way as everybody else, you're not going to make a difference for investors or have a good business model," Kaiser says. "I've had success in a short period of time by exposing businesses that were valued first and foremost for their dividends and saying the dividends weren't representative of the sustainable cash flows that companies could deliver over time."
THE MLP SECTOR was a ripe target because Wall Street analysts were almost uniformly bullish and offered little critical analysis. Why? One possible explanation is that MLPs generated large investment-banking fees for the Street from debt and equity deals to fund aggressive pipeline expansion. Research analysts surely knew this and didn't want to rile big banking clients.
Kaiser's critics will say that he was lucky because the collapse in energy prices brought down the entire sector. "I'd say two things on that. You don't get far in this business without a little luck, and while I obviously can't prove it, I think these would have been good calls irrespective of the commodity moves," Kaiser says.
Another bearish call, on Chesapeake Energy (CHK), the heavily leveraged natural-gas producer, shows how Kaiser puts the pieces together in his analysis. Using his knowledge of the pipeline industry, he focused on Chesapeake's unfavorable transportation contracts with pipeline operators. He issued a Sell recommendation on the stock last June, at $13.
"On both Linn and Chesapeake, we said those stocks could be going to zero," Kaiser says, "and I think we're going to be right." Chesapeake trades at $3.
Linn is getting close to zero after a decline of 70 cents to 50 cents on Friday after the company announced it would "explore strategic alternatives" related to its capital structure. Analysts interpreted the move as a potential prelude to a bankruptcy filing by the debt-laden company that could wipe out shareholders. Reflecting Linn's distress, the company's unsecured public debt traded Friday for just two cents on the dollar.
Kaiser argues that MLP distributions are vulnerable because distributable cash flow—the basis for MLP distributions and the industry's preferred financial metric—overstates sustainable free cash flow. "In many cases distributable cash flow is a complete joke," he says. It generally reflects only a small portion of capital expenditures. DCF is an MLP-generated financial measure that doesn't conform to generally accepted accounting principles.
Kaiser is skeptical of a key argument made by MLPs, that they need to spend a fraction of their depreciation expense to sustain the profits of their pipeline networks. "Maintenance capex," the amount of capital expenditures that MLPs argue is sufficient to sustain their pipelines, averages about 25% of depreciation. Only maintenance capital, not total capital expenditures, is reflected as an expense in calculating DCF.
Kaiser's work, however, shows that over the past two decades, major natural-gas pipelines have spent more on capital expenditures than reported depreciation, not less, based on Federal Energy Regulatory Commission data.
"Over 20 years, these pipelines have grown cash flow at 3% on average annually and spent over 200% of depreciation on capex," he says. "There is no empirical evidence that these businesses can sustain their cash flows with capital spending that is a small fraction of depreciation."
Kaiser maintains that MLP valuations, while down sharply, "still aren't compelling" with MLPs trading for 10 to 11 times estimated 2016 Ebitda. Electric utilities are similarly valued and have better financial outlooks, less risk, stronger balance sheets, and more creditworthy customers.
While most of the damage has occurred in Kinder Morgan's stock, Kaiser thinks it could fall further, to below $10. His view: Kinder Morgan is still overleveraged with $41 billion of net debt—more than five times annual cash flow. He thinks its distributable cash flow overstates its sustainable earnings power.
What's Kaiser focused on now? He says publicly traded general partners of MLPs could be vulnerable because they are often leveraged and depend on MLP distributions for the bulk of their cash flow. If MLP distributions are cut, the GPs could be in trouble. He isn't mentioning any names yet.
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