As part of an experiment comparing High Yield investing versus Dividend Growth investing, I created two portfolios, a Dividend Growth Champions portfolio and a High Yield Income Champions portfolio (you can see them here and here). One of my High Yield Income Champions is QRE Energy (QRE) and as part of my follow up research it is important to analyze whether this Upstream E&P MLP deserves to be part of my, or any investor's portfolio.
First it's important to clarify some things about MLPs, so one knows what is most important in performing due diligence on a potential investment. A Master Limited Partnership is a form of investment that, unlike a corporation, gains tax benefits if it passes on almost all of its cashflow to unit holders as distributions. The benefit to unit holders is that, rather than being taxed as regular income, (as are dividends) distributions are treated as return on capital (ROC) and instead act to decrease your average purchase price. If one holds an MLP long enough to reduce your purchase price to 0, then all future distributions are treated as regular income, just like a dividend. If you never sell your MLP, then the deferred taxes, (which would come out as capital gains) remain unpaid.
Along with the tax benefit of MLPs, comes the tax preparation headache of K1 forms. Depending on how your MLP operates, one may be forced to file taxes in several states, and if you hold MLPs in a tax exempt account such as an IRA, then UBTI (unrelated business income tax) may cause you to owe taxes in such an account. For those reasons its best to hold MLPs in a non tax deferred account and to use a tax preparer or advanced software such as Turbo Tax Premier, in order to file taxes.
The most important thing to realize about valuing MLPs is that traditional valuation metrics such as payout ratios and PE ratios are meaningless. Because of the high depreciation nature of the energy industry and accounting changes such as derivatives gains/losses from hedging output, EPS for an MLP can swing wildly and PE ratios can often be sky high or negative. To analyze an MLP one must instead look at 3 things:
1. EBITDA (earnings before income, taxes, depreciation, amortization), this is revenues minus cap-ex, (the cost of running and expanding the business). It serves as a proxy for cashflow.
2. Distributable cashflow (DCF): the portion of cashflow that goes towards making distributions to limited partners, (which are unit holders).
3. Distribution Coverage Ratio: DCF/cost of distribution, to both limited partners and the general partner.
As long as the coverage ratio is above 1 the distribution and yield are sustainable and safe.
All capital gains from MLP units is based on distribution/unit. As long as the partnership is growing and distributions are safe, it does not matter what happens to the price of units. The lower they go, the higher the yield and the better the distribution reinvestment is in building an exponentially growing river of income.
Now, specifically focusing on QRE Energy we see a fast growing MLP.
We can see that since their IPO:
-production has grown at a rate of 67% CAGR
-distribution has grown at 6.5% CAGR
-revenues have grown at 16.9% CAGR
-EBITDA has grown at 30.6% CAGR for the last 4 years
With their general partner Quantum Energy Resources having several billion in energy assets that can be dropped down (ie, sold) to QRE, the potential for future growth remains strong.
Beginning in January 2014 QRE changed to a monthly distribution of $.1625/unit, a slight decrease of .3%. Overall, this could be seen as a positive move, since monthly distributions allow for greater flexibility in using income to pay expenses and increase the compounding effect of distribution reinvestment.
However, despite the above data, which suggests a fast growing MLP with distributions that will keep on rising, beginning in Q1 of 2013 there was one fly in the ointment that perhaps threatened to destroy the entire investment thesis of QRE.
G&A expenses, which pay employees and for the running of the administrative side of the company (think head office expense), ballooned to over $10 million per quarter and were projected at $32-$35 million for the year. This represented a tripling of G&A expenses and resulted from the expiration of a 2 year service contract that limited this kind of expense for the first 2 years of the partnerships.
CFO Cedric Burgher explained during the Q1 2013 conference call, "For the full year we expect to incur $32 million to $35 million of cash G&A which implies that we will slightly lower cash G&A in the second half of the year as a result of our sponsored second plan which will assume a portion of the total G&A pool."
This massive increase in G&A expenses had caused EBITDA to decline by 11%, despite increased production and revenues up 8%. It also caused DCF to decrease by 18% and the distribution coverage ratio dropped from 1.2 to 1. This possibly indicated that out of control administrative expenses were threatening the sustainability of the current distribution, much less any future growth. Typically a coverage ratio of 1.1-1.2 is needed to keep a distribution sustainable. Any dip below 1.1 means that investors need to keep a strong eye on DCF and what is eating away at it.
Perhaps the second quarter would show improvement and expound more on this troubling development. However, instead EBITDA decreased 4%, DCF declined to $28 million, (from $32 million in Q1) and the coverage ratio declined to .9.
CEO Alan Smith declared that it was due to some downtime and maintenance in the Jay Field of the Florida panhandle. It was also stated that a small Q2 acquisition of additional East Texas assets, (representing about a 6% increase in reserves and production capacity) would bring the coverage ratio up in the future.
During the third quarter conference call we learned that the Jay Field was up at full capacity. The East Texas acquisition had closed smoothly and revenues had increased by 20%, sending EBITDA soaring and DCF up an impressive 26% quarter over quarter. This resulted in an increase in the distribution coverage ratio from 0.9 to 1.1. Unfortunately CFO Cedric Burgher told us:
"We expect cash G&A to stay in the $9 million to $10 million level in the fourth quarter, with full year cash G&A expectations to be in the $35 million to $36 million range."
This continued G&A expense was still potentially threatening the distribution sustainability, certainly curtailing future distribution growth and full year administrative expenses had increased by $3-$4 million. The previously promised decreases in G&A costs had not thus far shown themselves.
So what does this mean for QRE as an investment? Well there certainly are potential growth drivers, such as continued acquisitions and drop downs from the general partner. In fact during the third quarter of 2013 QRE had a $50 million increase in their line of credit, leaving the partnership with $350 million in liquidity to fund future acquisitions.
However, the recent increase in G&A expenses is troubling for two reasons. First, because the expenses represent about 10% of revenues, they seem to deeply cut into DCF and potentially threatens the sustainability of the distribution. Second is the fact that G&A expenses almost always increase as acquisition activity increases. Thus far QRE investors can not be certain what kinds of economies of scales they will get with the partnership. If G&A expenses remain a fixed $10 million/quarter as they are now, with revenues, EBITDA and DCF increasing, then the coverage ratio will recover to a safe 1.2-1.3 level. On the other hand, Vanguard Natural Resources, (VNR) a very well run E&P MLP with a long history of growing distributions, has a worse average distribution coverage ratio, so perhaps QRE's thesis still holds.
|Quarter||Distribution ratio||quarter||Distribution Ratio|
|Q2 12||1.3||Q2 12||0.61|
|Q3 12||1.1||Q3 12||1.12|
|Q4 12||1.2||Q4 12||1.15|
|Q1 13||1||Q1 13||1|
|Q2 13||0.9||Q2 13||1.05|
|Q3 13||1.1||Q3 13||1.1|
If we compare G&A expenses as a % of revenues then we see a clear trend, one of declining administrative expenses, though perhaps not as fast as VNR.
|Year||Revenue||G&A QRE||% G&A QRE|
|Year||Revenue||G&A VNR||% G&A VNR|
On March 3, before the opening bell, QRE will release its Q4 2013 and full 2013 results. I will be interested in seeing the results, specifically to make sure that G&A expenses as a proportion of revenues continues to trend down, indicating growing efficiencies at the partnership that should result in better EBITDA, DCF and distribution growth moving forward.
So does the high yield distribution growth thesis hold for QRE? Can investors expect years of sustainable, dependable and slow growing distributions from QRE as they have received from VNR and other, more established E&P MLPs?
Right now I am giving a tentative "yes" to this question and declaring that I believe QRE to be a high quality, well managed MLP that should provide years of high, steady and growing monthly income for unit holders. This is due to two major reasons:
1. Aggressive and effective hedging: QRE is 100% hedged through 2014 and a majority through 2017. Their average hedged price of oil is $99.18 and $5.87/Mbtu of NG. This will ensure steady and predictable cashflow to support the distribution.
2. Acquisitions and growth: Thus far QRE has completed $1.3 billion in acquisitions, either drop downs from Quantum Resources or a third party. With $350 million in liquidity available, CEO Alan Smith, in the Q3 2013 conference call indicated that the partnership is looking into further acquisitions, ones that would be immediately accretive to EBITDA and DCF. and would thus work to strengthen the distribution coverage ratio.
Though QRE is too new a MLP to be a "fire and forget" company such as VNR, I feel that as a part of a diversified high yield income portfolio it is a good match. Management will need time to prove themselves and economies of scale will need to be established. This includes lower administrative expenses as a portion of revenues as well as larger and less expensive lines of credit than the current 10% interest debt the partnership is working under. All these things will require time and patience. I recommend long term, high yield income investors give QRE Energy the chance to pay them 11% monthly distributions while they prove themselves.
Current technical indicators indicate that QRE has been moderately undervalued recently and is now gaining positive momentum, so this is a good time to open a position ahead of earnings.