What to Buy: Inergy LP (NYSE: NRGY) < 25

Why Now: Inergy LP (NYSE: NRGY) has lost roughly half its value since early August 2010, the last time it increased its distribution. Investor perception of risk to its regular payout has grown as the core propane distribution operation has been challenged by high wholesale prices and as management has struggled to raise performance at recently acquired midstream energy assets.

Inergy has consistently maintained over the past year that it has the funds and willpower to maintain the current payout rate of 70.5 cents a quarter. And over the past couple months it’s strengthened its balance sheet with a partial public offering of its midstream assets as Inergy Midstream LP (NYSE: NRGM), raising a bit over $250 million with which to buy back debt while retaining control and most cash flow. Inergy Midstream’s IPO price was a bit below expectations, though we’ve subsequently seen six executives of the new company make additional purchases.

The key now is if cost reductions combined with expected operating improvements at Inergy Midstream will be enough to offset weakness at the propane operation. We’ll find out on or about Feb. 1, when Inergy is expected to announce fiscal 201X first-quarter results.

Meanwhile, the partnership units are clearly priced for a sizeable distribution cut and therefore a torrid rally should management demonstrate it can maintain the payout.

As with all Big Yield Hunting recommendations, Inergy should only be held by investors who understand the risks, and at that within a diversified portfolio.

We also strongly advise against succumbing to the temptation to average down in this or any open position.

There’s always another high yielder to buy out there, and some of these do stumble.

The Story

Over the past month the number of stocks yielding over 10 percent has fallen sharply, some due to dividend cuts but most because at least some investors appear to be regaining their appetite for risk. That’s made picking out new Big Yield Hunting picks more difficult.

This month’s pick–a propane distributor with energy midstream assets–appears to be an exception. Readers also have an opportunity to take some money off the table in several other picks.

Roger: I was reading over our discussion from last month and I couldn’t help but be struck by the change in risks at least some yield hunters are willing to take on.

Apparently not everyone has been listening to the tele-blab doom and gloom.

David: That’s not a word I’ve ever seen in a dictionary. Maybe I’ll try it out in Scrabble and see if anyone challenges me.

I agree, though, that it looks like it is “risk on” for some investors, and that’s a very big change.

Roger: The best of it is that it could run for a while.

I’ll bet not one in 10 investors is aware that Italy’s near-term government borrowing rates are half what they were just a few weeks ago. The European Union is actually adding members. Even growth in the US finally looks like it’s for real. CMS Energy (NYSE: CMS), an electric and gas utility operating in Michigan, reports industrial sales are back to pre-recession levels. That’s really astounding.

Obviously there’s still the chance for a calamity somewhere to send everything in reverse. And I still think the conventional wisdom among many investors is a repeat of 2008 is somehow inevitable.

But the more investors lose their fear and pay attention to what’s happening, the more these stocks are going to run.

David: The downside of that is we’re going to have a tougher time pulling out stocks yielding more than 10 percent that are worth buying.

In fact, I think it’s time we take another look at what we’ve recommended.

Roger: Agreed.

Obviously, there’s a huge opportunity for anyone who followed us initially into PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) to take some money off the table.

David: It’s basically a double at this point. But it’s really done that on its own merits. It’s gotten its production back on track, and the debt problems that seemed so daunting just a few months ago are facing. It’s reached a deal with lenders to boost its credit facility by CAD150 million to CAD1.5 billion and is set to issue CAD750 million in senior notes due 2020 through a private placement.

This will fund the tender offer for up to CAD450 million of the 3.125 percent convertible bonds due 2016, as well as pay down outstanding amounts under the credit facility.

Roger: The stock is still down almost 30 percent from its 52-week high and trades at less than half the price where it came out in 2009. I think it can get all the way back there if they execute and oil stays where it is now.

On the other hand, it has come a long way in a hurry, and it’s now back yielding less than 6 percent. To me that’s a signal to take some profits off the table.

David: Of course, the people who bought on our initial recommendation are still getting a yield well north of 10 percent on their investment. And selling now will also incur taxes next year, not at the long-term capital gains rate.

Roger: All true. But let’s reflect a little on what our objectives are here at Big Yield Hunting.

Mainly, we’re betting on high-potential situations that carry considerable risks. When you bet that way you take your returns where the market gives them. Even at a yield of 12 percent it would take PetroBakken investors eight-years-plus for dividends to equal the gains they can book now.

And as much as I like what PetroBakken is doing, I’m no prophet or–dare I say it–a long-distance mind-reader. As much as can go right here, we’re still talking about a company that’s drilling for oil in remote areas prone to fire, drought, breakdowns in logistics and a hundred other things that can interrupt output.

And they sell oil, one of the most volatile-priced commodities in the world. It wouldn’t take much to see half or more of the gain we have now disappear in just a few days.

As for the taxes, I don’t like paying them anymore than anyone does. But a 35 percent tax on a dollar profit still leaves you with 65 cents. If that dollar profit vanishes, you won’t pay a tax, but you won’t get anything, either.

David: What do you recommend?

Roger: I first came into this business during a major boom in North American mining stocks in the mid to late 1980s. One of the best pieces of advice I heard then from the guys writing about it was to always have the discipline to sell half of any stock that doubled and to take a ride on the rest.

Though the mining-stock rally ended with a crash, anyone who had done that multiplied their money many times.

David: But we’re talking about dividend-paying stocks here. Aren’t they different?

Roger: No, we’re talking about dividend-paying stocks that a lot of investors are betting won’t be able to keep paying those dividends.

These aren’t buy-and-lock-away stocks like we recommend in our advisories Utility Forecaster, Canadian Edge, MLP Profits or Australian Edge for that matter. We’re trying to maximize returns, which are a combination of dividends paid and, hopefully, share price gains. Our returns can be huge, or we can see the stocks fall back.

And we win or lose not only based on how well these companies perform as businesses. You know as well as I do that the vast majority of our recommendations in Big Yield Hunting have held it together as businesses. Our returns, however, have been deeply affected by investor perception of the risk to their dividends.

PetroBakken has been such a winner in good part because we recommended it at an emotional low for the market, when the fear of another 2008 was running high.

In contrast, we came into AvenEx Energy Corp (TSX: AVF, OTC: AVNDF) in late 2010, when a lot more investors were ignoring risk to chase high yields. The company has beaten my expectations as a business. We’ve done well by just buying and holding. But the stock has ridden some quite wild investor emotions up and down.

David: That makes sense. I guess I’m reluctant to sell a big winner, even partly.

Roger: So am I. And so is everyone else. But I think a policy of selling half of anything that doubles in such a short time is a time-tested strategy in volatile markets.

I want to take half of PetroBakken.

David: Done. What about the rest of the Open Positions? We’re actually back in the game in Data Group Inc (TSX: DGI, OTC: DFPIF).

Roger: Yeah, that’s a really good-looking chart, particularly since late November. It looks like the market was surprised by their cut-less conversion from Canadian income trust to corporation.

It just shows you that so long as the underlying business is sound, stocks will come back.

Congratulations on sticking to your guns on that one, by the way.

David: Thanks.

By the way, good call to sell Alaska Communications (NSDQ: ALSK) last month. That stock has really gotten hammered.

Roger: I really had no idea they were going to hack up the dividend by nearly 80 percent, and I thought the market was pricing in a lot of risk when we did bail out. But when there’s that much uncertainty I think we need to have the discipline to sell.

I also want to point out we’ve seen a nice run in Capital Product Partners LP (NSDQ: CPLP) since the beginning of the year. It’s heartening they’re extending leases on their tankers, and I’m more confident now they’ll be holding their dividend.

Telefónica SA (NYSE: TEF) and Superior Plus Corp (TSX: SPB, OTC: SUUIF) look like they’ve stabilized as they’re coping with challenges, though it may be a while before we see anything really move their stocks higher.

David: What about Otelco (NYSE: OTT) and France Telecom (NYSE: FTE)? They seem to have headed in the other direction.

Roger: For Otelco it looks like there’s been something of a growing panic that changes to the Universal Service Fund are going to take a bite out of revenue from rural telecommunications companies. Management isn’t saying that; in fact we’re still seeing some impressive insider buying. Unfortunately the stock has been affected by the same negative sentiment swing the entire rural phone industry has.

I say stick with it, but I really hope people aren’t trying to average down these stocks.

David: I think you’ve stated your objections to doubling down enough. What about France Telecom? How about the French government downgrade.

Roger: Frankly, I think the credit rating agencies except Fitch are basically a joke. I do think that had an impact on the share price, but we’re still very much in the game with this one. The euro’s ups and downs will have an impact, but this company isn’t going anywhere. And sooner or later investors will decide it’s “risk on” for Europe.

David: That leaves BreitBurn Energy Partners LP (NSDQ: BBEP), which I guess we’re teasing in promotions for this service.

It’s definitely up, though not nearly so much as PetroBakken.

Roger: Yeah, I think it’s in very good shape and is going a lot higher.

In November they increased their distribution for the sixth consecutive quarter. They sold 10-year notes at an interest rate of just 7.875 percent despite a deep “junk” credit rating. (These ratings really are worthless aren’t they?) And they gave some really nice guidance in a conference call a couple of weeks ago.

The strategy is to buy high-quality producing properties, boost production and lock in prices with hedging. That’s ideal for building cash flows and dividends. And because of this company’s troubles in the past, the stock still trades at a discount to peers.

I think it rates a buy up to 20 for anyone who hasn’t already bought in.

David: I’m feeling a little sellers’ remorse for taking profits on Telstra Corp Ltd (ASX: TLS, OTC: TLSYY) last year. It’s such a great company, and the National Broadband Network deal looks set to hand them $11 billion.

And it still yields north of 12 percent.

Roger: I like Telstra as well, which as you know is a charter member of our Australian Edge Portfolio. We did sell it, though, at about the current price and after a rather large gain.

I’m certainly not averse to re-entering it once the NBN issue is finally in the bag.

David: Good enough. And we do still have exposure via AE, so I’m not really that bummed.

Roger: That’s the only sale we’ve made so far where I do feel like we left something on the table, though, what you call “seller’s remorse.”

New Flyer Industries Inc (TSX: NFI, OTC: NFYIF) looks headed for more tough times as municipal buyers of buses pull in their horns. Cellcom Israel (Israel: CEL, NYSE: CEL) may have the worst regulation in the world, and that’s against some pretty stiff competition. Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF) should hold its current dividend level but doesn’t appear to have resolved its production problems, as PetroBakken has.

Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF) is still facing a big drop in cash flow if its dispute with Air Canada doesn’t go very, very well. FP Newspapers Inc (TSX: FP, OTC: FPNUF) and DUET Group (ASX: DUE, OTC: DUETF) haven’t blown up yet but are still losing ground as businesses. Big yields but the business prospects are very iffy. In fact, we just saw DUET cut its dividend by about 20 percent.

David: Good riddance.

Roger: Yeah. It’s always better to sell too early from one of these stocks than too late. That’s a lesson I’ve learned the hard way all too many times in this business.

David: So on to this month’s pick. Like you, I’m no fan of technical indicators as a rule. But NRGY’s “relative strength indicator” fell below 30, a key threshold. The Relative Strength Index, or RSI, is a technical analysis indicator created by a guy named J. Welles Wilder to measure momentum on a scale of zero to 100. According to J. Welles, in his book New Concepts in Technical Trading Systems, a stock is considered to be “oversold” if the RSI reading falls below 30.

Roger: You’re right. That doesn’t impress me at all.

What does, though, is this company has been given up for dead by investors.

In fact, since the last distribution increase–which was declared Jul. 26, 2010–the stock has been steadily falling. The yield is now well over 12 percent, despite management’s continued assurances the payout won’t be cut, and what appears to be a swarm of insider buying in recent weeks. Analyst opinion is also pretty bullish.

David: A “swarm”? Your imagery gets better and better.

But this is a propane distribution company that has thus far underachieved investing in midstream assets. Isn’t there real distribution risk here?

Roger: Absolutely. Take a look at the masthead, kid.

There’s no stock yielding more than 10 percent that doesn’t have distribution risk. The key is if investors are pricing in too much risk, and if the company can perform.

My opinion is that’s the case here.

David: I happen to agree with you on this. Because I read MLP Profits.

And I was the one who suggested you look at this one. I guess that got lost amid what must have been an aggravating proof-read of UF this morning. Sorry about that.

Roger: Well, terrific. And?

David: Oh, right, Inergy.

Well, my first impression, of course, was “biggest loser.” Inergy was the biggest loser in the MLP Profits Portfolio in 2011, to the tune of 32 percent. I’ll also note that that’s the first time you and Elliott have had that kind of annual loser in the MLPP model portfolio.

But based on what I read, investors have totally overreacted here.

Roger: Hold on. I want to make clear that my conclusion on that stock from my December annual wrapup for MLP Profits–that within the context of a long-term portfolio the stock is a hold–stands.

And on that note we should start with the fact that, despite the fact that it hasn’t cut it payout to date and the fact that management hasn’t publicly stated its intent to do so, management hasn’t generated enough distributable cash flow to cover the distribution in recent quarters.

David: The market is clearly pricing in a cut at these levels, with the stock down about 39 percent over the past 12 months. At $22.81 this afternoon it’s down 46 percent from a high of $42.03 in February 2011. That puts the yield at about 12.4 percent.

But there was some good news for the stock at the end of what was obviously a semi-disastrous year from a unit-price perspective.

Roger: Here’s what I wrote in MLP Profits:

First, the MLP placed an initial public offering for its 16 million units of its energy midstream operations, dubbed Inergy Midstream LP (NYSE: NRGM). The new MLP will use the $252.3 million raised, along with $82.7 million from the revolving credit facility, to pay off $255 million of debt assumed from parent Inergy LP. The spin-off will also pay a special cash distribution of $80 million to the parent to reimburse capital expenditures incurred.

Inergy LP now owns 78.5 percent of Inergy Midstream and, as the general partner, is entitled to 78.5 percent of the new MLP’s cash flow. That percentage would drop to 75.2 percent if the transaction’s underwriters exercise their maximum allotment, but Inergy LP would then receive another $39 million.

Finally, as GP, it will own IDRs for 50 percent of the cash distributed in excess of 37 cents per unit per quarter. That’s the initial rate Inergy Midstream will pay, giving Inergy LP a healthy cut of any growth. Inergy Midstream is projected to grow its cash flow by at least 65 percent in fiscal year 2012 (ended Sept. 30) as additional storage and transportation capacity comes online.

David: And as you also note in MLPP, this should ensure solid coverage as well as regular distribution increases.

Roger: I don’t know if I go that far. In the short term these moves cut debt and expenses while maintaining the LP’s exposure to cash flow from Inergy Midstream. But selling a 21.5 percent to 25.8 percent stake also means it’s giving up some potential cash flow.

David: Wasn’t Inergy Midstream priced to pay a high yield relative to other midstream MLPs?

Roger: You have been paying attention. Yes, and that presents an additional, riskier element for the cash-flow profile. But recall, too, that Inergy should see at least a 23 percent jump in cash flow, not counting the benefit of reducing debt.

The key factor from an operating perspective will be numbers from the propane distribution unit. A spike in wholesale propane costs encouraged customers to reduce the size of their orders last year. Year-over-year comparisons won’t suffer nearly as much in 2012, if for no other reason than wholesale propane sales were coming off low levels.

David: We’ll know around the first of February whether we have a decent read on this or not. Assuming operating results are in line with expectations, the distribution should be safe. We’re betting on management not meeting the expectation for a cut. If there’s no cut, we should see some upside from here, no?

Roger: The current unit price certainly reflects risks of a dividend cut, and one would expect solid numbers on the ground to ease some of the fear that’s reflected in the market.

David: This looks like a pretty compelling opportunity to me. What do you say: Buy Inergy LP up to 25, with risk capital, understanding that a dividend cut in the very near future is possible?

Roger: On that basis, who could say “no”?

David: OK, then. Inergy LP is a buy up to 25 for those who understand the risks, have a diversified portfolio within which this represents a reasonable portion of the “risk” section, and who promise not to “average down,” or at least to hold us harmless from any results thereof.

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < CAD10.30, USD10, SELL half
  
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD18
• December 16, 2011: Telefonica SA (NYSE: TEF)–Buy < USD20
• January 23, 2011: Inergy LP (NYSE: NRGY)–Buy < USD25
  

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)