The American system may have plenty of flaws. But an inability to react to a clear and present danger isn’t one of them.
By late 2008 it was clear even to the man on the street that this country had become chronically over-leveraged. Too many people had taken on too much debt they couldn’t possibly service, and exposure to default was too widespread for the center to hold.
The overnight evaporation of Lehman Brothers a year ago was the last straw. Confidence vanished, and the global economy experienced the modern-day equivalent of a run on the bank.
Credit dried up, even for the lowest-risk borrowers. Led by Wall Street, world stock markets went into full retreat, and economic activity screeched to a half.
The cure for over-leverage is less debt. The process of improving balance sheets is often slow and painful, as the power industry’s experience since late 2002 illustrates.
That sector’s efforts to cut debt and operating risk paid off in extremely steady business performance over the past two years for most companies. Even in electricity, however, a handful of companies have faltered, largely because they were still too highly leveraged.
The leverage crisis of 2001-02 was largely confined to specific sectors, i.e. deregulating power, and communications and technology to a lesser extent.
This one has had far greater scope, sparing the victims of 2001-02 but encompassing banks, real estate and consumers. As a result, the damage to the real economy is much greater and, logically, it should take more time to work out.
That seems to be the message from the economic news that came in this week. The US Census Bureau released a survey this week reporting both a drop in median income and a rise in poverty to a record 13.2 percent of the population. Joblessness has reached its highest level since the early 1980s, and a consensus of economists is expected it to crest at well above 10 percent.
Foreclosure filings were down nationwide sequentially in August (from July), but were nonetheless up 18 percent year-over-year. Meanwhile, consumer spending and consumer credit continue to drop, as Americans pull in their horns to prepare for worse.
That’s a grim picture, but it’s only going to improve over time as American individuals and corporations improve their fiscal health. The silver lining is the US economy that will emerge will be far stronger than the one that went into this crisis.
Better, if the utility financial recovery that began in late 2002 is any guide, the speed and power of the strengthening will beat expectations. And there are real signs it’s already happening.
As I pointed out last week, the most hopeful development for the economy and stock market in recent months has actually been occurring in the bond market. Financially stronger individuals and corporations again have access to low-cost credit.
In fact, rates are at their lowest levels in decades, as US Treasury yields have remained near generation lows at the same time risk premiums have shrunk to pre-crisis levels.
Six months ago, for example, it was nearly impossible for a BBB-rated company to issue debt. Even A-rated utilities were paying 600 basis points and more above US Treasuries to attract buyers.
Today, A-rated companies are back to borrowing at rates as low as 125 to 150 basis points above Treasuries, for absolute rates of less than 5 percent to lock up 10-year loans. BBB-rated companies, meanwhile, are back to borrowing at 250 to 300 basis point premiums, for 10-year loans of 6 to 7 percent.
Lower interest rates mean higher earnings. For one thing, debt interest costs decline. For another, the cost of expanding and/or acquiring assets and operations declines, making more options viable and thereby firing up growth.
Higher cash flows can also enable companies to cut debt, further reducing interest costs and boosting cash flows. That’s a course many are pursing now.
The key to starting such a virtuous cycle in any industry is asset sales. In early 2003, some two dozen power companies were on the brink of bankruptcy, due mainly to a lack credit. Chronic overbuilding of natural gas-fired power plants had raised serious questions about what these assets were worth at a time when companies needed to roll over the loans used to build them.
Concerned about the potential for horrendous losses from writedowns of the value of these plants, banks were understandably unwilling to throw good money after bad. Then came the purchase of a power plant from Japanese firm Sumitomo Corp (OTCPK:SSUMY) in early 2003. The transaction set a price the banks could base loan value on. Credit began to flow once again, and the sector recovery could begin.
We may be seeing the beginnings of such a virtuous circle in the commercial property market, where Vornado Realty Trust (NYSE: VNO) is putting together a $1 billion fund to buy distressed office property assets. Apartment real estate investment trusts like Mid-America Apartment (NYSE: MAA) have also been buyers recently, inking the purchase of major development in the challenged Phoenix market this summer.
As badly as this industry has been beaten down, the potential opportunity to play its ultimate recovery is truly staggering.
The cautionary note here is that REITs and commercial property in general still face challenges--rising vacancies, falling rents and declining property values. We’ve already seen a record number of dividend cuts in the sector.
Even the historically stronger and less leveraged names have taken hits to the bottom line and the payout. Vornado has temporarily converted a portion of its dividend from cash to stock in order to shepherd capital.
The upshot is profiting from REITs’ next run is going to take patience, a willingness to absorb continuing risk and, above all, the discipline to buy selectively. Happily, there’s an alternative for those who want a faster payoff: master limited partnerships (MLP), specifically those that own energy infrastructure such as pipelines, storage facilities and processing centers.
Like REITs, MLPs suffered an extreme crisis of investor confidence in late 2008. That many of the initial public offerings from the new issue flood of early 2007 would flop in a stress test was no shock. But even the sector’s strongest, such as Enterprise Products Partners LP (NYSE: EPD), took extreme hits.
Part of the selling was simply due to portfolio liquidation by panicked investors. But much was also due to concern that MLPs would have trouble accessing credit on terms that would allow ongoing projects to continue, or even for debt to be refinanced.
Those fears proved well founded for the likes of US Shipping Partners LP (OTC: USSPQ), which eventually went bankrupt.
And there are still several dozen MLPs that could follow its dire fate because they, too, have taken on excessive debt and operate businesses ill-suited to paying out a high percentage of cash flow in dividends.
Other MLPs--including the popular AllianceBernstein Holding LP (NYSE: AB)--are basically financial constructs that are in the crosshairs of the Obama administration on the “carried interest” issue. They haven’t cracked entirely yet. But if they’re at risk of losing their MLP tax status over the next year, an event that would no doubt be catastrophic for both dividends and share price.
Fears of a credit crackup, however, have proven well off the mark when it comes to energy-based MLPs. These MLPs make their cash flow mainly from fees that are unaffected by the ups and downs of energy prices.
Even throughput--the energy moved through these assets--has been little affected in recent months, despite one of the worst depressions the energy patch has seen in decades.
That’s because these assets are vital to a functioning economy. And some are tied to capacity rather than throughput, meaning customers must pay the fees whether they ship, store or process the energy or not.
We haven’t reached the point in this country where owners of infrastructure have taken a “build it and they will come” approach. Rather, owners and builders aren’t turning the first spade of earth on projects until they’re almost fully contracted.
That conservatism restricts the number of new projects to those where demand is clearly demonstrated, thereby preventing any oversupply. And, given the severity of this downturn, the psychology is bound to prevail for some years, keeping the supply/demand balance in our favor.
Most of the asset expansion we’ve seen recently has been in the form of “drop-downs.” These are effectively transfers of assets from diversified parent companies organized as corporations to affiliates that are organized as MLPs.
By putting a pipeline into an MLP affiliate, for example, a parent can realize greater post-tax cash flow than it could by keeping it under corporate taxation. MLP unitholders, meanwhile, get an asset at a good price that will immediately boost cash flow and dividends.
Drop-downs are win-win for everyone. But because they’re basically internal transactions, they’re not a good gauge for sector-wide asset values. Happily, MLPs have seen some of those as well.
The purchase was a bargain for Spectra, immediately lifting cash flows and dividends. But it also established a floor for these assets that’s now rising and provided lenders considerably more cause for confidence and a reason to keep the credit flowing.
Investors feared otherwise. But even in the depths of the credit crunch, energy infrastructure MLPs were able to access credit. That enabled them to continue with ongoing projects through the turmoil, building the base for higher cash flows.
Now they’re able to borrow money once again at the low risk premiums of a couple of years ago--and the result is already more profitable projects and higher cash flows.
This underlying business strength has kept energy infrastructure MLP dividends rising as well. For example, Enterprise Products Partners--an owner of mainly Gulf Coast energy transportation and storage assets and a favorite of The Energy Strategist Editor Elliott Gue and I--has boosted is payout 23 consecutive quarters. It almost surely will again with its fourth quarter payment, and it’s far from alone.
As they’ve held up so well as businesses to the credit crunch, it’s no great surprise that energy MLPs have already begun their recovery from last year’s lows. But the best is yet to come, as the energy patch works out of its depression.
Even MLP current yields are attractive--ranging from 7 to 10 percent--and they’re hardly taxed as well. Rather than being taxed at the corporate level, MLPs push their pre-tax cash flow directly to investors, making for a much higher yield on the same cash flow than ordinary corporations.
The tax burden, of course, also falls to the investor. But it’s largely offset by the MLPs’ non-cash expenses, which are also carried through. And anything that is owed is almost entirely return of capital (ROC), on which no current tax is due. Rather, the ROC dividend is deducted from your cost basis until you sell.
Added to the nominal yield, that translates into tax equivalent yields on even the most secure MLPs of well over 10 percent. And that’s in addition to the dividend and capital growth that will flow from their steady expansion of assets.
Unlike REITs, MLPs are already well off their lows of earlier this year. They’re also much further along in the recovery cycle as businesses, so the risk is much lower and the potential for dividend growth much higher.
In short, they’re generally a better choice for conservative investors now. And there are also some real opportunities on the aggressive end, such as battered energy producers that have locked in selling prices for their output like Linn Energy (NSDQ: LINE).
If you’re interested in more information on MLPs, my colleague Elliott Gue and I have launched a new product, MLP Profits, focused on the best sector opportunities for everything from conservative income to aggressive growth.
In addition, our How They Rate table covers every MLP in the US, at least a third of which are sells.
To further highlight this opportunity, we’re holding a webinar on Thursday, September 17, including a presentation of our strategy and top recommendations, followed by a question-and-answer session with attendees. Click here to register.