Why A 1,315% Growth Rate Tells Us Little…
A Note from Kent: My next Oil & Energy Investor will be coming to you Friday morning, while I am in transit to Russia.
But today I wanted to let you know – personally – about some fantastic news.
I started out a couple years back wanting to provide first-hand information and analysis for the “regular guy” looking to make a buck in the energy markets. Yet lately, they are moving faster than ever – faster than me, certainly. So many new developments crop up, every day, that I have a hard time handling it all in just two installments.
I need someone qualifiedto help me cover all of this opportunity.
So I am delighted to introduce you to James Baldwin.
A former Wall Street and energy consultant, James has crafted unique leadership roles in financial publishing, competitive and market intelligence, corporate advocacy, and financial planning. He's also a bona fide journalist. He's covered the financial crisis, corporate governance, executive leadership, and the oil and energy markets. These days, he's concentrating on energy policy. And that's what really made him stand out as the man for the job.
(The opportunity came along to lock him in just before Thanksgiving,and I jumped all over it.)
Each Wednesday – starting today – James will be writing an additional, third column for OEI readers.
I hope you find his perspectives interesting and profitable. Because remember: Energy remains the single most lucrative segment in today's investment markets.
Why A 1,315% Growth Rate Tells Us Little…
by James Baldwin
Dear Oil & Energy Investor,
While Kent prepares for his trip to Moscow this weekend, I'm settling into my new office for a little light reading…
On tap: catching up on a stack of earnings reports and press releases that built up over the Thanksgiving break. (Don't worry; I actually enjoy this sort of thing.)
My attention turns to a familiar topic: Midstream oil and gas plays poised for growth in this new age of domestic energy production.
But in the last two weeks, there has been a lot of talk about the huge boost in year-over-year earnings-per-share (EPS) from these players, particularly in the Master Limited Partnerships (MLPs).
This was highlighted by the jubilance of investors that Genesis Energy's (NYSE: GEL) forecasted EPS-growth rate soared to 1,315% just last week.
Now, the average investor might see that percentage and think it warrants a boost to the long-term share price.
But we have to be careful in these waters.
It's critical that you understand something about EPS and MLPs – something that some analysts are just now beginning to recognize…
EPS Doesn't Tell the Full Story
It's quite simple to understand why.
No doubt about it: Midstream operations remain hot right now.
Remember, the midstream players connect those producing fields (upstream) with refineries, distribution, and retail sales (downstream). With oil and gas flowing, the market needs operations in transportation, processing, storage, and marketing. There has also been a flurry of M&A activity in the sector.
And they're just getting started.
The intense boost to recoverable North American shale oil and gas and our growing energy needs will push domestic midstream investments to more than $8 billion per year through 2035, according to the Interstate Natural Gas Association of America.
So, with job growth and production booming in shale fields around the United States, there’s good money to be made in this portion of the value chain.
And a 1,315% forecasted year-over-year growth rate is an astonishing figure… on the surface.
But the reality is, we have to be very careful when we evaluate stocks based on metrics like EPS (MLPs actually use a similar figure, but they call it earnings-per-unit).
This metric doesn't tell the full story of the partnership's potential performance.
And if you look at the chart below, you'll see immediately why Genesis' forecasted growth rate is misleading…
The yellow lines represent the consensus EPS forecasts for each quarter through September 2012. The grey represents GEL's actual earnings.
The 1,315% is a calculation of the December 2011 forecast divided by the company's actual EPS in December 2010.
As you can see, in the fourth quarter of 2010, GEL reported earnings of two cents per share.
So why is growth of 1,315%, moving forward, misleading?
Because the 2010 figure includes a great deal of management compensation expenses tied to its general partner from previous years. At that time, Genesis also acquired large stakes in Marathon Oil's interests in several pipeline systems. This included a 28% interest in Poseidon Oil Pipeline, a 29% interest in Odyssey Pipeline, and a 23% interest in the Eugene Island Pipeline System.
In other words, two cents in 2010, compared to a relatively mild 26-cent forecast for December 2011, makes it appear that the company popped… even though the stock has remained in a similar price range year-over-year.
This doesn't mean the company is a good or bad investment; it just paints an incomplete picture.
Now, this EPS “problem” should only be a concern to an investor if they are trying to gain both a yield and price appreciation. Short a complete collapse, the yield will still be strong even if the stock price is experiencing temporary negative pressures.
So if earnings-per-unit isn't complete, what is the best way for us to measure our MLPs growth potential?
Look at Distributable Cash Flows Instead
The most honest way to measure an MLP's profitability is by sizing up its distributable cash flows (DCF).
These cash flows accurately take into account pipeline depreciation and other ways that the partnership reduces its tax burden and passes profits along to investors.
And that's what we're really interested in.
When you invest in a MLP, taxes are only garnered one time on the quarterly cash distributions. Therefore, its revenues are not taxed at the entity level like a typical equity. They essentially offer a short-term tax shelter from corporate taxes, which you would have paid twice on a traditional dividend stock.
As a shareholder and “owner” of a traditional equity, you pay dividend taxes two times: at the entity level when the firm pays corporate taxes, and when your individual check arrives.
But remember, the MLP will not pay out all of its cash distributions at once. It's necessary for these partnerships to retain some of their resources. Management may need to expand operations or ensure that it can continue to pay its distributions at the same yield level in the future (or even raise them).
And a strong history of raising yields and the company meetings its dividend obligations should be a signal of good things to come.
MLPs remain a major advantage for the income-seeking investor, whether the EPS stacks up or not.
Just one note: You'll want the yield to remain in or close to double digits.
And remember, given that midstream MLP operations generate fee-based revenues on fuel volumes going through the pipeline, these companies enjoy less exposure to price volatility – a very welcome sign to the risk-adverse investor.
And if we know the best ways to measure their potential, that's even better.
I'll keep my eye out for you, to make sure you have the complete picture.