Washington’s Big Week
This was a consequential week for income investors on the political front.
First, the president nominated Jerome Powell to succeed Janet Yellen as chair of the Federal Reserve. For dividend-stock investors, this should be good news.
Powell, who has served on the Fed’s Board of Governors since 2012, is perceived as a quiet consensus builder who will continue the gradual monetary tightening begun under Yellen.
From time to time, he has advocated for certain policies behind the scenes, but never dissented during any meetings of the board.
Powell’s most noteworthy policy push was to team with two other central bankers to persuade Bernanke to begin winding down the central bank’s extraordinary stimulus. That led to the market’s so-called Taper Tantrum, an experience from which Powell emerged suitably chastened.
Given this experience, I would expect his tenure to be marked by the same careful management of market expectations that was characteristic of his predecessors.
The one area where he might make his mark is in loosening certain financial regulations, at least compared to Yellen and Bernanke.
Overall, this is a solid pick that should allay investor fears of a more hawkish Fed.
Tax Reform’s First Cut
The other big piece of news is that the House GOP finally unveiled its proposed tax-reform bill.
First, it’s important to remember that this reveal is really only the second step (the first being the budget that was passed early last month) in what could be a protracted process of negotiations between legislators, not to mention pressure from powerful lobbies. Indeed, the bill still needs to make its way out of committee.
Although there could be numerous changes before it becomes law, here’s what we know as of now.
Obviously, the headline number is the one of greatest import: The corporate tax rate would be permanently slashed from a top marginal rate of 35% to a flat rate of 20%.
While many companies have an effective tax rate well below the top marginal rate, the lower rate would still be a boon to businesses as well as the stock market.
Given our portfolio’s sizable exposure to the energy sector, let’s focus on how things might shake out for our favorite pipeline companies and midstream master limited partnerships (MLPs).
Since many MLP customers and sponsors are oil and gas producers, we need to consider any changes that would affect that industry.
Fortunately, the initial proposal preserves important tax-saving measures relating to valuing energy supplies and reserves, as well as deductions for drilling costs. Previously, industry players had been concerned they would be eliminated.
Obviously, the lower corporate tax rate would help producers as well. By contrast, as pass-through entities, MLPs won’t directly benefit from this change.
For capital-intensive industries such as the energy sector, the ability to fully and immediately expense new investments instead of depreciating them over the useful life of the asset should be quite helpful. However, this measure could sunset after five years, at which point, presumably we would revert to the current policy unless the new one were extended.
Junk-rated entities could find the new limit on deducting interest expense–anything in excess of 30% of adjusted taxable income–to be a problem. But that limit may not apply to natural gas pipelines.
The one question that’s more theoretical at this point is how tax reform might affect demand for MLPs, both from retail investors, as well as the entities that create them, finance them, and feed them with assets. In general, I’d imagine the MLP structure will remain quite valuable for all parties, though demand could end up being lower than what it was previously.
The one risk to tax reform is the Senate GOP’s narrow majority. This thin margin is what killed the healthcare bill that would have repealed and replaced Obamacare.
Though I would assume a tax-reform bill has greater odds of winning Senate approval, a few Republican senators are already balking at certain details in the bill, while others want to find more ways to offset the shortfall in revenue it would create. So there’s a lot more horse-trading that will occur between now and final passage.
On the earnings front, let’s take a look at two companies that Igor previously identified as among his top picks.
Gaming and Leisure Properties Inc. (NYSE: GLPI) grew third-quarter funds from operations (FFO) per unit 4% year over year, to $0.56. This performance was slightly ahead of management’s previous guidance, though it narrowly missed Wall Street forecasts by 1.2%.
The $7.8 billion real estate investment trust (REIT), which owns a portfolio of 38 properties that it leases on a triple-net basis to casino operators, credits this performance to increases from variable rents, as well as solid results from the two casinos it owns and operates.
For the quarter, adjusted FFO, which excludes noncash items, covered the payout 1.26 times. The REIT pays a quarterly distribution of $0.63 per unit, or $2.52 annualized, for a forward yield of 6.9%.
Looking ahead, GLPI is on track to grow FFO by 7% for the full year thanks in part to rent escalators, though expectations for next year are muted.
Of course, that outlook could change materially as the young REIT grows via acquisition.
But right now, GLPI’s leverage is moderately above its target level of 5.0 times net debt to EBITDA (earnings before interest, taxation, depreciation, and amortization), though management expects to hit that number by the end of the year.
That means there’s not a lot of room to close any deals prior to that, though management is comfortable allowing leverage to temporarily hit 5.5 times if it finds an acquisition that would be accretive to cash flows.
While such leverage would be high for other sectors, it is actually below the weighted average for the North American REIT sector. Still, it’s good to see that management is mindful of not pursuing growth at the expense of undermining the balance sheet.
In the bigger picture, the main risk for GLPI is that its portfolio is essentially split between two tenants—Penn National Gaming Inc. (NSDQ: PENN), from which it was spun off back in 2013 and Pinnacle Entertainment Inc. (NSDQ: PNK).
I would prefer to see far greater diversification among tenants, especially considering that both PENN and PNK are considered speculative-grade credits by the major rating agencies.
The good news is that GLPI gets paid rent before its tenants’ debt holders get paid principal and interest. And regional casino operators face less competition and have lower exposure to the boom-and-bust cycle of their peers in Las Vegas and Atlantic City.
Even so, let’s not be overly glib about this risk. It’s still a big one, even when taking those considerations into account.
Further, with GLPI above the upper limit of its targeted leverage, it could take a while for it to acquire new properties that would diversify its tenant base.
Despite my concerns about tenant concentration, GLPI remains a buy.
This year’s long drift downward in the MLP space continues, even as oil prices head higher.
As expected, Hurricane Harvey weighed on Enterprise Products Partners LP’s (NYSE: EPD) third-quarter performance, and cash flows missed forecasts by about 3.2%.
Nevertheless, distributable cash flow still grew 8.9% year over year, to $1.07 billion, for 1.2 times coverage of the MLP’s quarterly distribution.
Unlike other MLPs, EPD typically retains a portion of its distributable cash flow (DCF) to help fund future growth projects. And this quarter was no exception. EPD retained $152 million of DCF, bringing total retained DCF to $533 million year to date.
Despite all of its attributes, EPD, which is also one of my top picks in Utility Forecaster, has been rangebound for much of the past 18 months, trading between $25 and $27 per unit.
In fact, that trading range appears to have been one of the lesser factors behind management’s decision to moderate distribution growth. They didn’t feel like the market was giving them any credit for growing EPD’s payout, even in this challenging environment.
In mid-October, EPD announced a slower distribution growth trajectory, with increases of $0.0025 per unit each quarter through 2018, down from the previous rate of $0.005 per unit each quarter. That would mean distribution growth of around 3.3% annualized over the next 12 months compared to the prior year’s payout. Over the past three years, distribution growth averaged around 5.3% annually.
Management’s primary rationale for this move was to help retain more cash flow to fund future growth projects. Since MLPs typically fund new projects with a 50/50 mix of debt and equity, this would reduce the need for dilutive equity issuances, while affording greater financial flexibility.
In fact, the partnership believes that by 2019 it can fund the equity portion of its annual growth spending via internally generated cash flows. And management says it may be able to afford buybacks down the road—so greater fiscal discipline comes with a potential sweetener, though one that income investors generally don’t find all that compelling.
Further, distribution growth has been outpacing growth in cash flows over the past two years. As a result, while distribution coverage is still ample, at 1.2 times, it’s tightened considerably. This move will help restore this crucial buffer to former levels.
Income investors hate slower distribution growth. And the market hates any admission of weakness. But to its credit, this move underscores what we’ve always liked about EPD: Unlike its peers, it will not continually chase growth at the cost of undermining its financial strength. With a forward yield of 6.8%, EPD remains a buy.