In my recent article published on 5/1/2012, which was the MLP installment of my "Yield, Value, Safety" series, I had identified NuStar Energy L.P. (NS) as a potential candidate for income investors, although I did caution that it was "higher up on the risk spectrum" than several of the larger, more conservative MLP's profiled in the article. I have owned units of NuStar Energy L.P. for several years, and until just recently I had always considered the holding to be a long-term income investment.
Unfortunately, developments over the past couple of years have forced me to reclassify my holdings in NuStar as a speculation, should I decide to continue to hold the position. This was brought to my attention with renewed urgency as a consequence of the release of the Third Quarter 2012 Earnings Results, on 10/25/2012. That release, along with subsequent announcements, resulted in a precipitous price drop beginning on that date that did not find a bottom until 11/12/2012. While the stock has recovered a bit since then, it is definitely still under a cloud, as holders digest a management conference call and presentation which occurred on 11/29/2012. In the call, further details regarding a recently announced expansion in the Eagle Ford shale area were provided, along with plans and guidance for 2013-2014.
Note that for the remainder of this article, the terms NuStar, NS, the partnership, the LP, and the MLP all refer to the Master Limited Partnership known as NuStar Energy L.P. or predecessors, currently trading under the symbol "NS."
History and Developments Leading Up To Recent Concerns
The partnership began trading on 4/16/2001, after a very successful IPO, as Shamrock Logistics L.P. It was formed from assets of the former Ultramar Diamond Shamrock Corporation. It was renamed Valero L.P. later on that year after Valero Energy (VLO) acquired Ultramar Diamond Shamrock. Valero Chairman Bill Greehey stated at the time that Valero intended to "aggressively grow the L.P." going forward, which indeed occurred via numerous acquisitions and expansions over the next several years. In 2006, Valero L.P. separated from Valero Corporation, as a new entity, Valero GP Holdings, LLC, was formed to assume Valero's ownership in the L.P. In 2007, Valero GP Holdings, LLC was renamed to NuStar GP Holdings, LLC, and began trading under the symbol "NSH," while the LP was also renamed, logically enough, to NuStar Energy L.P., trading under the symbol "NS." Long-time holders in the LP had been well-rewarded to this point, with significant increases in both the unit price and distribution level having occurred since the IPO.
A strategy shift was initiated in 2007, as NuStar acquired CITGO Asphalt Refining Company. The intent was to diversify the business mix of the partnership to include asphalt operations, in addition to the petroleum liquids pipeline, storage and terminal operations which had been the primary business activity of the LP. Trends in refining observed by Greehey and the management team had led them to believe that the move into asphalt would pay off as a contrarian strategy, similar to how the move into refining by Valero in the late '90s had paid off. Additional asphalt operations were acquired in 2010, and in 2011 NuStar acquired a small refinery in San Antonio, along with other facilities, from AGE Refining.
Unfortunately, the move into asphalt has not worked out for NuStar like Valero's move into refining did in the '90s. The recession and financial crisis that began in 2008 resulted in a plunge in demand for asphalt, with the result being the asphalt operations have either lost money, or at best have only contributed marginally to results since being fully integrated into NuStar in 2009. The disappointing results from 2009 onward, considering the debt assumed and the increase in working capital that the asphalt operations have required, has meant that the distribution has not been covered by available cash for the past several years. After trying to wait it out for awhile, NuStar's management team, led by Greehey and CEO Curt Anastasio, finally determined in 2012 that a change in course was required. In July 2012, NuStar announced that the asphalt operations would be off-loaded into a 50-50 joint venture with a private equity firm, a transaction which was completed in September 2012. Under the terms of the joint venture, even after the operation becomes profitable, NuStar's joint venture partner will have some preferential rights to cash flows generated ahead of NuStar. The move also caused a significant non-cash impairment charge of $272 million against second quarter 2012 Results, as the asphalt assets were written down.
In the conference calls following both the Second and Third Quarter 2012 Earnings Releases, management reiterated that the company would be shifting their strategy back towards the basic fee-based businesses of transportation and storage, and away from the margin-based businesses of refining and asphalt operations.
In September 2012, a secondary offering of 7.13 million units, at $48.94 per unit, was completed. Encouraging to investors was the fact that Board Chairman Bill Greehey purchased 490,000 of the units being offered.
The Third Quarter Results released on 10/25/2012 were not well received by investors, as the asphalt and refinery operations continued to under-perform. Further, ineffective commodity hedges also contributed to the unimpressive results. On 11/8/2012, NuStar announced plans to expand operations in the Eagle Ford shale via a $425 million acquisition of assets from TexStar Midstream Services, to be financed under an existing credit facility and junior subordinated notes. Also, the company announced plans to sell the recently acquired San Antonio refinery. NuStar has now taken several major steps to achieve the strategic reorientation announced earlier this year. As noted in the opening paragraph above, a management presentation on 11/29/2012 provided further details on these expansion plans, along with guidance on how the management team sees the future unfolding as a consequence of these initiatives.
Stock Price and Distribution History
NuStar has paid out a quarterly distribution ever since distributions were initiated in July 2001. All historical payouts through year-end 2012 are presented in the following table:
The yield as shown represents the yield at the current payout rate if the stock had been purchased at the closing price on the day before the ex-dividend date. A few statistics which can be derived from the data are:
- Yields achievable, as per the closing prices prior to the ex-dividend dates, have ranged from a low of 5.05% (ex-dividend 5/4/2005) to a high of 9.52% (ex-dividend 11/7/2012). Generally, yield has been in the 5% to 7% range until just recently, when it has approached, and even briefly reached, double digits, due to the aforementioned price drop.
- Since payouts began, there have been 14 increases, with an increase usually occurring every four or five quarters historically. The current rate has been in effect since 8/5/2011, and no increase is likely for several years at best, until cash flows improve enough to support the payout.
- The distribution has increased by 118% in the eleven plus years since the first payout in 2001.
- The distribution has only increased by 11% in the prior five years, since November 2007, reflecting the decline in performance of NuStar in recent years.
- A unit holder buying at the IPO, or at least before the onset of distributions in 2001, would have received a total of $41.65 in payments through the end of 2012.
The stock has advanced to a high just above $70 on two occasions, in April 2007 and December 2010, after which it has declined substantially in both cases, to below $40. The most recent dip has just occurred, as noted in the opening paragraph. See the table for data regarding price extremes since the onset of the 2008 financial crisis.
Distribution Coverage History and Concerns
While the price and distribution history is interesting, the primary concern for an income investor is the sustainability of the payout and the prospects for it to continue, and hopefully increase. For an MLP, the key statistic is Distributable Cash Flow (DCF), the cash available for distribution to unit holders. Most MLPs report a value for DCF as part of their routine financial reporting, although there are variations in how individual firms derive it. NuStar, however, has not provided a value for DCF since the 2002 10K. I believe a reasonable, simplified approximation can be made using the Net Cash from Operations less Reliability Capital Expenditures, both available from the Statement of Cash Flows from all 10K and 10Q filings beginning with 2003. The total of distributions to the limited partners and the General Partner (GP) are also available from these filings. I have pulled all of these figures together and presented them in a tabular format in the table following, along with a calculated coverage level.
As can be seen, coverage has been subject to wide swings since 2007, coinciding with the changes in business strategy mentioned in the preceding paragraphs. The first really alarming shortfall occurred in 2009. It is noteworthy that the Incentive Distribution Rights agreement between NuStar L.P. and NuStar GP Holdings was amended in 2009 to award the GP just 25% of distributions above the threshold distribution level of $0.66, whereas before it had been 25% above $0.66, and then 50% above $0.90. This is the agreement currently in effect, per the most recent 10K (2011). What this means, I believe, is that the GP recognizes that the LP has a distribution coverage shortfall, and the GP has agreed to accept a lower Incentive Distribution payment, at least for the time being. As far as it goes, this is a plus for unit holders.
The concern is, how can the distribution be maintained at the current lofty level, much less be increased, given the performance of the business in recent quarters? The obvious answer was, and still is, that it cannot be sustained, unless things change for the better, and soon. In recognition, management took the somewhat dramatic actions outlined above, to move back to primarily fee-based businesses, and exit the more cyclical asphalt and refining operations. The most recent announcement, to acquire crude oil and natural gas liquids infrastructure in the Eagle Ford shale, was another major step in this direction. The acquisition will cost around $425 million, plus an additional $400 to $500 million to fully integrate these assets into NuStar's existing operations. It seems that NuStar is basically planning to fund the existing distribution and capital spending plans with debt, at least to the extent that the cash generated by existing operations falls short of the required funding. As the new Eagle Ford investments, along with other capital projects, come on stream and contribute to cash flows, distribution coverage is expected to recover by 2014. At least, that is the plan.
While a distribution cut is not imminent, much has to go right and very little wrong over the next couple of years for things to work out. The market's reaction the past few weeks tells the story, as far as how investors view the likelihood of a distribution cut being avoided. As evidenced by the yield advancing into double digits, compliments of a drop in the unit price, the market is definitely pricing in a distribution cut.
Before I conclude, in the interest of full disclosure, I want to note that I am not a financial professional, nor am I certified in any way as a financial advisor. I am an independent, individual investor, focusing on dividend paying stocks exclusively.
Before presenting my thoughts on the advisability of acquiring units of NuStar, or even holding on to an existing position, it may be helpful to reflect on Ben Graham's definition of investment vs. speculation. Ben Graham is recognized as the "father" of value investing, and was a mentor to a young Warren Buffet. It states, "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Considering that statement and the facts as I understand them, acquiring or holding on to units of NuStar today has to be considered a speculation. There is nothing wrong with speculation, as even Graham agreed, as long as the practitioner realizes that speculation is indeed what one is engaging in, when that is the case. Anytime a stock yields anywhere close to 10%, it is most likely a speculative investment.
So, if you want to make an investment in an energy MLP, I would advise you to avoid NuStar. On the other hand, if you want to speculate, NuStar might not be all that bad of a choice, as long as the risk is recognized and accepted. If the MLP can grow the fee-based businesses fast enough to cover the distribution and avoid a cut, and later on even resume increases, units acquired in the low $40s or better will pay off with an excellent yield, and probably a substantial capital appreciation eventually as well. Even if a cut occurs, if it is not too severe, the investor will still see a reasonable yield, although a capital loss will likely result in the near term. Even if that occurs, NuStar could still eventually recover. The worst case is that conditions continue to deteriorate, the planned turnaround fails to materialize, and one or more distribution cuts occur, which will undoubtedly result in corresponding unit price declines, to levels even lower than today's depressed level.
Finally, be aware that the stock is going to be quite volatile for awhile, especially around earnings releases. If a speculation in NS is your cup of (Texas) tea, I would suggest starting small, establishing a maximum position size, and adding more, up to the defined maximum, upon declines. As with all speculations, also determine a stop loss price level, and / or perhaps a time limit, such as one year, at which point the quest is to be abandoned. Wait for meaningful, panic-driven declines to add units. It will probably take several quarters before it can be determined whether the new strategy is working out or not.
Disclosure: I am long NS. I recently added to my position, taking advantage of the recent swoon. Even though I had not originally considered NS as a speculation, I now view it as such, and I am prepared to accept the consequences of the decision to hold on. NS represents around 4% of my total portfolio value, close to my absolute maximum 5% allowable for a single holding.
Note: This article was originally published on Oilprice.com on 11/28/2012. The article has been updated to reflect that the NuStar management presentation scheduled for 11/29/2012, as referenced in the original article, has since occurred.