Surfing the IPO Pipeline
Although Facebook’s (NSDQ: FB) recent initial public offering (IPO) and the stock’s subsequent performance have soured many investors’ appetite for new listings, those who favor dividend-paying stocks shouldn’t forswear the IPO market completely.
Many brokerage and financial websites incorrectly report recently listed stocks’ yields until these companies have paid a full year’s worth of dividends, a quirk that provide savvy investors with an opportunity to purchase the most promising dividend payers before the herd catches on.
Investors mulling a position in a recently listed stock should pay close attention to two key dates: the quiet period, when investment banks underwriting the IPO are barred from issuing research reports or earnings estimates on the firm; and the lock-up date, when company insiders are prohibited from selling their shares.
At the expiration of the quiet period, brokerage houses involved in the IPO often issue lengthy research reports trumpeting the fledgling stock’s growth prospects. Nothing drives trading volume and price appreciation like a slew of positive initiations from analysts at the big investment banks.
Recent IPOs sometimes come under near-term selling pressure when the lock-up date passes, as company insiders seek to monetize some of their stakes. Investors shouldn’t necessarily regard these sales as a portent of future disappointment; insiders with an outsized proportion of their wealth tied up in the company’s stock may look to raise cash and use the proceeds for other purposes.
For income-seeking investors, IPOs of master limited partnerships (MLP) can be a lucrative opportunity to buy into long-term growth stories at favorable valuations. In many cases, MLPs grow their distributions at the fastest rate during their first two years as public companies; there’s nothing like a growing distribution to drive price appreciation and total returns.
Consider the case of Conservative Portfolio holding Western Gas Partners LP (NYSE: WES), which went public in May 2008, grew its quarterly distribution by 23 percent in its first eight quarters as a public company.
However, not every MLP is poised for greatness; selectivity is the key to outperformance. Investors must have a thorough understanding of the publicly traded partnership’s business and growth prospects, especially as the universe of MLPs expands and diversifies.
All too often, investors gravitate toward the highest-yielding publicly traded partnerships without understanding the underlying risks.
Many energy-related MLPs managed to maintain their distributions throughout the financial crisis and Great Recession, overcoming frozen capital markets and plummeting oil and gas prices. MLPs that own midstream assets such as pipelines proved the most resilient; these names tend to garner much of their cash flow from fees and are relatively insulated from fluctuations in commodity prices.
Much of the marketing literature associated with the more than 30 MLP-focused funds that have launched within the past two years touts the toll-like regularity of the sector’s cash flows.
But the increasing popularity of MLPs among individual and institutional investors–a subject we covered at great length in The Case for MLPs–has led to a profusion of new offerings, some of which entail additional risks that inexperienced investors may overlook.
Over the past five years, 41 MLPs have gone public to varying degrees of success. For example, IPOs from the financial sector have underperformed, largely because of their subpar distribution yields, fluctuations in cash flow and concerns that the government will crack down on a loophole that allows “carried interest” to be taxed at a lower rate. (Elliott addressed the latter risk in Don’t Get Carried Away.)
More recently, a number of unconventional MLPs have debuted on the New York Stock Exchange.
Of the 22 partnerships that have filed S-1 statements since June 2011, Northern Tier Energy LP (NYSE: NTI), PetroLogistics LP (NYSE: PDH) and Alon USA Partners LP (NYSE: ALDW) have significant exposure to commodity prices and don’t set a minimum quarterly distribution.
In 2011 CVR Partners LP (NYSE: UAN) and Rentech Nitrogen Partners LP (NYSE: RNF) went public and, thus far, have generated solid returns for investors, though their distributable cash flow also ebbs and flows with the prospects of the global fertilizer industry.
CVR Partners’ S-1/A filing from April 2, 2012, acknowledges this this difference:
Investors who are looking for an investment that will pay regular and predictable quarterly distributions should not invest in our common units. We expect our business performance will be more seasonal and volatile, and our cash flows will be less stable, than the business performance and cash flows of most publicly traded partnerships. As a result, our quarterly cash distributions will be volatile and are expected to vary quarterly and annually.
This approach doesn’t necessarily make CVR Partners and Rentech Nitrogen Partners bad investments; when the supply-demand balance in the fertilizer market is bullish, these MLPs can reward unitholders with substantial distributions. However, investors should closely monitor these names for potential weakness.
Although we’re bullish on agricultural commodities and fertilizer in the long term, seasonal price gyrations and those related to global supply and demand conditions are inevitable. Both MLPs disburse all of the distributable cash flow generated each quarter; none will be set aside to invest in the business or to meet future distributions.
For these reasons, CVR Partners and Rentech Nitrogen Partners differ dramatically from their peers. Most MLPs are set up to generate predictable, fee-based cash flows that support a steady distribution. Over time, MLPs look to buy or build new fee-generating assets that allow them to grow their payout. The group’s traditional modus operandi has been to avoid distribution cuts at all costs and gradually increase payouts over time. Even upstream partnerships that produce oil, natural gas and natural gas liquids tend to hedge aggressively and often target a higher distribution coverage ratio to buffer against fluctuations in commodity prices.
Prior to 2011, Terra Nitrogen Partners LP (NYSE: TNH) and Dorchester Minerals LP (NSDQ: DMLP) were the lone variable-distribution MLPs available to investors. If Alon USA Partners goes public, the ranks of these unconventional MLPs will have swelled to seven.
Investors looking to profit from newly listed MLPs will be spoiled with choices in coming months, as 16 partnerships have filed S-1 registration statements in anticipation of a potential IPO.
The range of businesses that have embraced the partnership structure also continues to grow, with Hi-Crush Partners LP (NYSE: HCLP) becoming the first MLP to specialize in sand for hydraulic fracturing and Northern Tier Energy becoming the first publicly traded partnership to own an interest in a bakery.
We expect this trend to continue apace, as companies seek to feed income-seeking investors’ appetites for fare that offers an above-average yield. Accordingly, the pipeline of prospective publicly traded partnerships remains robust.
Comments from various management teams suggest that investors should expect new MLPs in traditional upstream and midstream business lines, as well as in nontraditional industries such as oil-field services and deepwater drilling. The appeal of the structure is simple: Many of these assets will earn a higher multiple as part of an MLP than within a traditional corporate structure.
Here’s a review of quarterly conference calls from the past six months that have included discussions about spinning off assets as an MLP. Note that this informal (and undoubtedly incomplete) survey doesn’t include private-equity firms that may be looking to monetize assets.
- CenterPoint Energy (NYSE: CNP): CFO Gary Whitlock on May 3 told analysts that spinning off the electric utility and natural gas distributor’s transportation, gathering and processing assets hinges on “ensuring that we have visible long-term growth opportunities that merit the formation and use of an MLP.”
- Clean Energy Fuels Corp (NSDQ: CLNE): The builder and operator of natural gas-fueling stations for vehicle fleets indicated that the firm would likely need to raise capital in the next two years to fund its ambitious expansion plans. CEO Andrew Littlefair explained the rationale behind this move in a conference call to discuss first-quarter earnings: “We’re trying to be very mindful of the fact that we don’t want to dilute all of our shareholders. So, we’re trying to look at other ways to have the capital that we need….We’re actually looking at a couple MLP ideas with some of our existing assets. So, we’re trying to explore all options.”
- Dominion Resources (NYSE: D): In response to an analyst’s question, CFO Mark McGettrick acknowledged that an MLP “will be one of the options we evaluate” when deciding how to finance the utility’s Cove Point LNG (liquefied natural gas) export terminal.
- GasLog (NYSE: GLOG): CEO Peter Livanos acknowledged that the seaborne-transport company, which owns a fleet of LNG carriers, is evaluating the MLP structure and would consider going down that road if such a move would create value for shareholders. The popularity of Golar LNG Partners LP (NSDQ: GMLP) among investors suggest that converting to an MLP could unlock additional value.
- Magnum Hunter Resources (NYSE: MHR): The small-cap exploration and production company is expanding its Eureka Hunter pipeline system in the West Virginia portion of the Marcellus Shale into Ohio and plans to spin off these assets as an MLP as early as 2013. CEO Gary Evans told analysts, “We do want to get to the MLP market as soon as we can, but we want to do it the right time.”
- National Fuel Gas (NYSE: NFG): In response to an analyst’s question, CEO David Smith recently acknowledged that firm could spin off its midstream assets as a publicly traded partnership: “[A]s we move forward and look to devote more capital to the Pipeline and Storage segment, in the Midstream segment, and we have a higher tax basis assets there, we would be looking much more toward an MLP at that point.”
- NiSource (NYSE: NI): The regulated distributor of natural gas had registered to list some of its midstream assets as an MLP but backed out of the transaction when the financial crisis and Great Recession devastated equity markets. CEO Robert Skaggs recently acknowledged: “[W]e continue to look at our ability to generate midstream projects, other pipeline growth projects on a consistent basis to see whether they might be amenable to drop down, and whether they might be better financed with a MLP sort of vehicle.”
- Northern Oil & Gas (NYSE: NOG): CFO Ryan Gilbertson recently told analysts, “We remain optimistic and believe that the MLP opportunity is a very attractive one for our set of assets.” This small-cap exploration and production company owns non-operating interests in the Bakken Shale, a strategy that Linn Energy LLC (NSDQ: LINE) has pursued on a limited basis.
- Phillips 66 (NYSE: PSX): Spun off from ConocoPhillips (NYSE: COP), Phillips 66 owns and operates an extensive portfolio of downstream, midstream and petrochemical assets. Management continues to explore monetizing the firm’s midstream assets by creating an MLP. At the UBS Global Oil and Gas Conference, Phillips 66’s senior vice president of strategy and corporate affairs told analysts that management should decide whether to form an MLP by the end of the year.
- SeaDrill (NYSE: SDRL): In the contract driller’s past three conference calls to discuss quarterly earnings, management has acknowledged that the company continues to explore the possibility of spinning of a handful of rigs as an MLP. The assets held in this structure would operate under long-term contracts.
- Sempra Energy (NYSE: SRE): CEO Debra Reed told attendees of the company’s recent Analyst Conference, “We believe that an MLP will be the best way to integrate and grow our midstream business.” This MLP would likely go public in late 2013 or early 2014 and initially would include the company’s pipeline assets. The firm’s proposed LNG export facility would also slot into this structure upon completion.
- Tsakos Energy Navigation (NYSE: TNP): The seaborne transport company aims to have five LNG carriers by 2014 and four shuttle vessels. Management indicated that Tsakos Energy Navigation would finance these purchases by spinning the assets off as an MLP in which the firm held a majority stake.
- Unit Corp (NYSE: UNT): In response to an analyst’s question at the BMO Capital Markets Unconventional Resource Conference, management noted that the contract driller would prefer to generate annual earnings before income, taxes, depreciation and amortization of between $75 million and $100 million before considering a spin-off of its midstream assets.
Regardless of whether these companies follow through with plans to form MLPs, the frequency with which these conversations are occurring and the breadth of energy-related firms considering the structure suggests that the pipeline of IPOs will remain robust.
Although many MLPs are designed to grow their distributions rapidly in their first few years as a public company, investors should closely evaluate the firm’s business prospects, the stability of its cash flow and the growth potential–either via drop-down transactions from its parent or opportunities for organic expansion.