The key to Bernie Madoff's success was that he offered two things that income-needy investors desperately wanted:
1. Above-market yields
2. Steady payouts.
Retirees, widows and others that must live off of a fixed amount of savings are extremely vulnerable to be seduced by Ponzi-like schemes that offer both of these benefits. And at no time has the vulnerability of this class of investors been greater than at present. Due to the US Federal Reserve's ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) policies, income-seeking investors are desperate to find above-market and steady sources of income, and they are prone to believing in just about any type of scheme that will offer it to them.
MLPs offer exactly what this most vulnerable class of investors so dearly desire: High income (relative to alternatives) with steady and growing payouts. It seems oh so good. Almost, too good to be true. And it is.
Not all MLPs are Ponzi-like. However, it is unfortunate that the MLP sector is filled with Ponzi-like schemes, and skilled promoters that are going to leave legions of vulnerable investors broke and in tears.
Linn Energy (LINE), which has been one of the most touted investments by dividend stock promoters, is just the first of what is going to be a very long procession of painful disasters in the MLP space and the high-dividend yield sector more generally. I think it will be useful to briefly review this case because it is a harbinger of things to come.
Seeing A Ponzi-Like Scheme A Million Miles Away
LINE was touted by many MLP promoters, as well as many "dividend growth" pundits, as a stock that would provide investors with high income yields and steady and rising payouts for as far as the eye could see.
You really need to think hard about the seriousness of any analyst that ever touted this stock. The signs of trouble could be seen a million miles away.
First, any decent analyst should have asked themselves the following questions that would have warned them to stay away from LINE:
1. E&P stocks generally only pay dividends of 0.5% to 3%. How does LINE, which is in this same sector, provide a distribution yields that is orders of magnitude higher (6%-7%)? Doesn't it seem too good to be true? Or is it that we think that changing the corporate structure from a C-Corp to an MLP somehow magically enables a company to mint money for its shareholders?
2. So how is it that LINE, which has consistently lower metrics on ROE, ROA, ROIC, operating margin, and most every other measure of profitability relative to its industry peers such as Apache (APA), Devon (DVN), EOG Resources (EOG), or Noble (NBL), is able to sustain a yield that is orders of magnitude higher? Isn't the fact that LINE earns less profit from its operations and actually pays out more in dividends/distributions than its industry peers a red flag? Or does the fact that you slap the moniker "MLP" enable a fundamentally unprofitable company to generate superior profits to its investors?
3. Isn't E&P a highly cyclical industry? So how does LINE manage to keep distributions so steady? Yes, LINE hedges. But isn't hedging expensive? And wouldn't the cost of that hedging have to reduce cash flow to equity in the long-run and actually reduce distributable cash-flow to shareholders vis a vis other E&P producers?
4. How can LINE possibly grow its dividend over time if it is so overloaded with debt? It can only do so by diluting current shareholders with share issuances, right? Isn't the "strategy" of growth through "accretive acquisitions" a Ponzi-like promise? This promise assumes that LINE will be able to perpetually use its overvalued shares to buy companies with undervalued shares. Isn't it naïve to believe in the sustainability of this Ponzi-type scheme that is essentially based on the "greater fool" theorem?
5. Isn't the fact that LINE has a low and declining reserve base a major red flag? Shouldn't the fact that the company's long-term survival depends on purchasing mature reserves be a hint that the company adds little or no economic value and that it therefore cannot grow without diluting shareholders via debt and share issuance?
The MLP DCF Myth
Many MLP promoters like to wax lyrical about DCF ("Distributable Cash Flow") rather than more generally accepted metrics such as revenue, earnings, cash flow, free cash flow or EBITDA. This would not be a problem in and of itself if the DCF figure were not so naively believed at face value by so many MLP investors.
Contrary to popular belief, the reality is that DCF is manipulated in highly questionable ways by MLPs very much the same way that net earnings is manipulated in questionable ways by C-Corps. LINE is a prime example.
In the case of LINE, the SEC is investigating LINE's failure to account for its hedging expenses when calculating DCF. Apparently, LINE management felt that the massive amounts of shareholder value expended via derivatives transactions (putatively for hedging) was not the sort of thing that was relevant to the accounting of "distributable cash flow."
Arguably, even more egregious has been the treatment of LINE's rapidly depreciating asset base. MLPs (not just LINE) habitually understate the amount of expenditure required to maintain their asset bases. LINE and many other MLPs essentially disguise depleting asset bases through two techniques: 1) Unsustainable Ponzi-like "greater fool" acquisition strategies; 2) "Creative" accounting of both "maintenance capex" estimates and acquisition expenses. This enables these MLPs to continue to make large and even growing payouts even as the fundamentally based intrinsic value of the company is deteriorating.
LINE Stock Price Is Still Very Expensive After Being Cut In Half
Let's just review a few facts about the current valuation of LINE, after its stock price has been cut almost in half since its peak.
1. LINE is highly indebted relative to its industry peers. LINE's proven reserve base, which is valued at $6.1 billion is worth the same amount as the company's total debt. What this means is that the residual value of LINE's asset base (unproved reserves plus PP&E) to equity unit holders is only worth about $1 billion, or $4.25 per share. Since LINE's stock price is currently $22.79, this effectively means that the market price is naively assigning a value of well over $18.50 (or over 80% of the value of the stock) to LINE's equity based on the ability of current management to essentially "make something out of nothing." Supposedly, the management will do this by magically using its demonstrably overvalued shares as a sort of "funny money" to purchase undervalued assets from "greater fools." Good luck with that long-term strategy, folks.
2. EV/EBITDA is a metric that is difficult to fudge without resorting to outright fraud. LINE's EV/EBITDA is more than 2 times the E&P sector average.
3. EV/Revenue is a metric that is very difficult to fudge without resorting to outright fraud. LINE's EV/Revenue is more than 2.5 times the E&P sector average.
Please note that paying attention to points #2 and #3 above would have saved investors from getting fleeced by Enron. But, of course, back then there were many pundits that claimed that those metrics did not apply to Enron and that those that stubbornly insisted on such comparisons simply did "not understand" the unusual "structure" of the company, its unique business plan and its savvy management all of which presumably made Enron incomparable to the other companies in similar industries.
Have investors learned anything since Enron? Since the Royalty Trust fiascos? Since Madoff?
Given the choice of many profitable companies in the E&P sector with large and promising asset bases, why would anybody pay two, three or more times the sector average on most metrics for a company like LINE with an embarrassingly inferior asset base and poor profitability?
Oh, yeah, I forgot: They pay a big, stable and growing dividend. That is all that matters; the dividend.
LINE will not be the last company that is currently paying out high dividends and/or distributions whose share price is going to collapse and whose dividend will collapse soon thereafter. What has happened to LINE is just a warning.
Unfortunately, there are many companies with Ponzi-like characteristics in the MLP and other high-dividend producing sectors that will experience a similar fate.
Not all of the companies in these sectors are equally Ponzi-like. However, caveat emptor.
If it looks too good to be true, it probably is, folks.
Stop believing in fairy tales about MLPs and other high-dividend stocks that are supposedly "under-followed by institutions" and/or which are purportedly "misunderstood by Wall Street." How convenient it is that you will be the lucky beneficiary of these oversights by full-time professional investors (with far more analytical resources at their disposal than you will ever have), and the blessed finder of all of this money that is being left on the table by Wall Street!
Folks, in case you haven't noticed, Wall Street has not been "overlooking" the MLP sector. Wall Street investment bankers have been selling this stuff into the market like hot-cakes in all flavors (MLP IPOs, ETFs, leveraged ETFs, holding companies, Exotics). Interestingly, Wall Street has been powerfully assisted by well-meaning stock market amateurs that have been re-selling the story with the zeal of converts via personal blogs and sites like Seeking Alpha. Main Street masses that are desperate for yield have been buying all of it hook, line and sinker. And guess whom it is going end badly for?
You have been warned. Again. Unless you are a true investment professional that knows how to do real in-depth due diligence, you should stop buying individual stocks. And you should in particular stay away from the MLP sector, and most high-dividend paying sectors, if you are purchasing them as fixed-income substitutes. Individual exceptions aside, many stocks in this sector, at current valuations, at this very late stage in the interest rate cycle, are quite dangerous.