When a company returns nearly 10% in dividends annually to shareholders, investors rightly chomp at the bit. Breitburn, however, burned some investors a few years back when it cancelled its dividends (or "distributions"). Perhaps that is why the shares currently sell at a lower valuation compared to some of its peers, like Linn Energy (LINE). But selling at a lower valuation in the dividend world implies, all else being equal, a higher yield. So just how safe is Breitburn's yield? And could investors be burned again by another suspension of distributions?
Given the run of optimistic articles written about this oil and gas venture (see here: I, II, and III) it is prudent to indulge in skepticism, with the hopeful conclusion of protecting ourselves on the downside.
Breitburn Energy (BBEP) is an oil and gas company. It produces oil in California and Florida; natural gas in Michigan, Indiana and Kentucky; and a balanced mix in its Wyoming properties. See Breitburn's geographic locations below:
(Source: Breitburn 2010 Annual Report (pdf))
The map above unfortunately lacks Breitburn's recent acquisition in the Permian basin in Texas.
A Quick Note On MLPs
Breitburn is an MLP, or a Master Limited Partnership, which means that the company doesn't pay regular corporate income tax. Rather, the income "flows through" to the investor, who is called a "unit holder." The unit holder pays the taxes on the partnership's distributions. Not to complicate matters, but some distributions are tax-free, because it is considered a return of capital. Further, and at other times, an individual will owe taxes on their "income" even while they did not receive dividends. That said, the investor will receive a K-1 statement from the company at year end, which the investor will need to include on their taxes for the year.
The Current Dividend and Its History
If we look at Breitburn's 2011 Statement of Cash Flows (partially included below), we can compare its level of dividends to its operating cash flow and earnings:
(Source: Breitburn 2011 10-K, p. F-6)
Green Lines and Boxes
The green box represents the amount of capital which could conceivably be returned to shareholders. Measuring the coverage of the distribution this way is slightly different to what is called "distributable cash flow," which is a number reported by many MLPs -- but not Breitburn. The number seems sometimes subject to adjustments which don't seem to actually reflect historical cash payments. (And sometimes the person using the phrase "distributable cash flow" means free-cash-flow , for instance as in the MLP glossary here.)
Therefore, it is better to compare the dividend (or "distributions" as it is put above) with the operating cash flow or FCF or, perhaps, with net income. In this case, however, comparing distributions to net income doesn't help since the net income figure includes hedging activities which result in frequent non-cash charges . So briefly, since I will return to this, note that dividend distributions accounted for 79% of operating cash flow and that is before we account for capital expenditures. But, that operating cash flow figure might be a underselling Breitburn for reasons stated next.
Yellow Boxes - Historical Cash Maneuver
In the second half of 2009, Breitburn triggered a debt covenant and had to suspend dividend payments. I have highlighted in yellow above the various line items which help tell the story of Breitburn's cash re-allocation: the cancellation of distribution, the decreased capital expenditures, the lowering of working capital and, with that, a large pay down of debt.
With those adjustments Breitburn was able to achieve a FCF figure of $195 million in 2009 -- which all basically went to paying off debt. For 2011, Breitburn's FCF figure was only $50 million, down from the $115 million in 2010 due to increased working capital and increased capital spending. This is merely to note that management was effective at adjusting the flow of cash through its business -- which ought to give us a moderate degree of confidence in the ability of management to mange cash flows in the future. This is a little awkward to say since initially the suspension of the dividend in 2009 could be considered to reflect poorly on management. While that is true, management handled the situation timely and well.
While operating cash flow is still healthy and while the company's successful 2009 maneuvers shows it can fix cash flow problems, the present level of the dividend is approaching its (current) ceiling.
And of course, the closer the dividend is to the ceiling, (1) the more dividend growth will be tied to the price of oil and natural gas, and (2) the more important hedges will be to maintaining the dividend. As for the second point, Founder Randall Breitenbach said in the second quarter conference call:
"Our production is hedged at 75% in the second half 2012, 74% in 2013, 69% in 2014, 66% in 2015, and 20% in 2016. Average annual prices during this period range from $88.12 and $99.96 per barrel per oil, and $4.18 and $7.10 per MMBtu for gas."
We can assume, in the short term anyways, that as long as the company continues to successfully hedge, the dividend will be safe from any mandatory reductions due to cash-flow or debt covenant problems.
One important point of interest for us, however, is that while Breitburn grew its distributions per share in the 4th quarter 2011 by 9 percent year-over-year, it grew its total cash distributions for the year by 57.5 percent.
As one can see above, Breitburn grew its units outstanding by some ten percent since last year . By growing both units outstanding and cash distributions (even if the units outstanding are to fund acquisitions) Breitburn rapidly closes the gap between what can be paid out and what is paid out.
This is important because it is improbable that Breitburn will be able to continue growing its dividend as it grows its units outstanding -- the excessive growth of either will limit future distributions, barring a major advance in the price of oil. (Although, the price of oil seems pretty likely in the long-run to continue "upward and to the right.")
Because Breitburn pays such large dividends, it is mostly valued in the market place according to the dividend payments -- rather than say (1) the present value of reserves or (2) common valuation multiples like P/E or P/FCF.
Present Value Of Reserves
For me, oil and gas firms are best valued according to (1) the size of reserves, (2) the speed at which it will recover those reserves, and (3) the ability of management to replace the depleted reserves. Depending on the ability of management, debt can play a big role in valuations, if, say, management appears unable to replace reserves.
There is something called the "Standard Measure," which is a required estimated after-tax returns of the proved reserve base, discounted at 10% per annum. For Breitburn this figure is approximately $1.66 billion . For me, a lower discount rate could conceivably be appropriate, which would push the standard measure upward in value. Further, that figure does not include future increases in the price of oil or "probable" reserves.
Let us put their reserves in perspective.
Breitburn currently has a market capitalization of $1.37 billion and debt of approximately $0.973 billion . Adding those together, we see that it has an "Enterprise Value" of about $2.34 billion. Therefore, if an estimate of the present worth of Breitburn's reserves approximates a figure of $2.34, the company would be fairly-valued as it stands today.
For instance, given the reserves and production levels published in its 2011 10-K, if we assume that the long-term oil price increases at about 4% year-over-year (WTI Crude has increased at about a 13% year-over-year for the past 10 years) and the natural gas price increases at about 4% over the long-term, then Breitburn would be basically fairly valued as judged by the present value of the future cash flows which would be derived from Breitburn's current reserves at those prices.
That is really a complicated why of saying that, using Breitburn's own estimates, it is fairly-valued by the market if oil and natural gas prices increase at a rate of 4% per year over the life of its current properties. Such an assumption is pretty palatable.
We can also look at Breitburn's current share price some other ways.
If we consider Breitburn as a going concern , and if it are able to avoid triggering debt covenants, we can deduce the following conclusions given these different scenarios:
If Breitburn continues paying the present dividend rate forever, how much is Breitburn worth? If you believe that the proper discount rate is lower than 9.4%, then you think Breitburn's shares are undervalued by the market. Given that its an oil and gas company, that oil and gas prices are likely on a long-term incline, and that the use of hedging can moderate the volatility in prices -- then one could make an argument that a lower discount rate could be used. For instance, Breitburn's long-term debt due 2022 have a stated interest rate of 7.875% -- if we discounted the dividend payments at that rate the shares would be worth $23.36 a share.
If Breitburn continues to grow dividends at the present rate, and it continue to replace its reserves, how much is Breitburn worth? As I noted above, Breitburn cannot continue to grow both unit count and its dividend payout -- something has got to give. But if it stopped growing its unit count and continuously increased its payout at a 9% clip, then there shares would be significantly undervalued. But, this is the least probable scenario I believe.
Lastly, if Breitburn didn't pay out dividends, how much would it be worth? For me, the best measure of "profit" is the amount of cash from operations less the amount of money spent on replacement and/or new revenue generating assets, or what is frequently defined as FCF, or:
Free-Cash-Flow = Operating Cash Flow - Capital Expenditures
Breitburn, for the six month period ending June 30th, 2012, has a FCF of approximately $63 million. Annualized, that is $126 million. At that rate, Breitburn shares currently have a P/FCF ratio of about 10.8, which is well below the average of the DJIA.
(It is noteworthy, again, to point out that Breitburn's FCF the first half of 2012 was nearly equal to the distribution for the same period. FCF was $63 million and the dividend was $60 million. This further indicates that future dividend growth could be restrained.)
For those looking for dividend paying stock which returns 9.4% to shareholders, there is nothing intrinsically problematic about Breitburn.
There are, however, warning signs which if not observed could come back to haunt the investor. Breitburn would need to be watched and occasionally reevaluated. Since MLPs are supposed to pay off all their profits as dividends, the thin margin between what can be paid out and what is paid out is not surprising. But, it would be certainly be incorrect to expect a continuous 9% annualized increase in the dividend. Management's modest goal of 5% growth looks to be challenging itself in the context of increasing unit counts. And, of course, we would need to reevaluate in the unlikely scenario that oil prices fell for a significant period of time.
- Free-Cash-Flow = FCF = Operating Cash Flow - Capital Expenditures
- It is humorous, I think, that hedging creates predictable cash flow and unpredictable earnings. The accounting standard of mark-to-market, specifically with hedging derivatives, makes the GAAP net income figure significantly worse as a measurement (for instance, see Sandridge's (SD) recent net income).
- For the most recent reporting period, that of the three month period ending June 30th, Breitburn had a total unit count of 69 million -- up from the 59 million of December 31st, 2011. That alone will bring Breitburn's total dividend payments up 16.9 percent, excluding any dividend increase for unit holders.
- The "Standard Measure" is a formal measure that oil and gas companies are required to disclose. It assumes a few things, including: (1) average annual oil and gas prices continue into the future, (2) operating expenses and capital expenditures in the future are similar to those today, and (3) a 10% discount rate.
- Breitburn's debt as of June 30th, 2012 was $773 million. On September 28, 2012, it issued an additional $200 million (see the 8-K). Therefore, its total debt -- I believe -- is currently about $973 million.
- Note: that also assumes that Breitburn's "margin" implied in its 2011 'Standard Measure' is accurate. It appears as if it assume that it can turn 34.5% of revenue into FCF.
- In this case "going concern" means that management will be able to replace reserves continuously for such a period of time as to make the fact that there exists a finite quantity of oil reserves unimportant.