“$130 Million Acquisition Could Send This High-Yield Oil Stock Soaring”

By Travis Johnson, Stock Gumshoe, March 9, 2010

Today we’re taking a look at what Carla Pasternak of High-Yield Investing is calling her “Income Security of the Month” for March. Pasternak uses these “security of the month” teasers to build up interest in her newsletter, of course, with plenty of opportunities to click, subscribe, and learn the name of the stock …

… and that’s why we’re here. To see if we can dig up some interesting investment ideas without subcribing … or, at least, to consider newsletter subscriptions in the harsh light of day instead of rashly signing up just to learn about a “hot” idea. So what is this “income security of the month?”

Here’s the basic pitch:

“If you’re looking for both high yields and enormous capital gains, then you need to learn more about our “Income Security of the Month” for March 2010. With a strong history of paying increasing dividends, this stock is currently yielding an eye-popping 10.2%. That’s double the 10-year Treasury yield, nearly three times what ‘AAA’-rated corporate bonds pay you and five times what you get from the S&P 500!

“The company behind our “Income Stock of the Month” is a booming oil & gas firm that has returned +177.5% in the past 52 weeks. The company has already raised its dividends five times since its 2007 inception, and today it’s cashing in on record levels of production and rising energy prices.

“Now is the perfect opportunity to lock in its safe 10.2% yield and collect a hefty dividend check by April 30th. But hurry… your window of opportunity may be closing fast: As we go to press, Wall Street is starting to take notice of this up-and-coming small-cap and bidding up its shares. Act now to lock in your 10.2% yield before it’s too late!

“PLUS: Just days ago company management announced the closure of a $130 million acquisition that could translate into tremendous profits (and dividend hikes) in the months ahead….”

And this particular stock is a Master Limited Partnership (MLP), a special flavor of company that I’ve written about a number of times in this space. Here’s some more:

“In today’s report we’ll profile a master limited partnership (MLP) with a history of dependable high yields and outsized capital gains.

“But this is no ordinary MLP. This company’s management employs a smart strategy that drives earnings and distribution growth through acquisitions: It buys proven fields, extracts the oil and gas from the ground, and then sells it to refineries. Meanwhile, the company protects itself with derivatives that appreciate whenever commodity prices fall.”

Leave aside the fact that it’s a bit of a stretch to say that the “history” of a company that’s only been around for three years can give a “dependable” vibe, and I can tell you that this must be …

Legacy Reserves (LGCY)

Legacy is indeed a young MLP, the company was formed back in 2005 but went public in 2007. They are somewhat similar to another producing LP, Linn Energy (LINE), which I’ve written about several times before, in that they aim to acquire producing (but not necessarily exciting) oil and gas properties that can be managed effectively to generate significant cash flow, and they use derivatives to hedge their exposure to changing commodity prices so that they can maintain a steady payout to their limited partners (that would be you, should you choose to buy in).

And they did make an acquisition that closed on February 17 — didn’t end up being quite $130 million, but it was about $125 million after the closing adjustments were made. They bought up 13 oil fields in Wyoming from St. Mary Land and Exploration. Reading up on that acquisition will give you a quick reminder that Legacy is focused on creating a stable (and hopefully growing, but mostly stable) cash flow into the future — as they were preparing to close on that deal they also entered into derivatives contracts that will help to smooth the income from those 13 oil fields over the next four years.

I don’t know exactly what their derivatives positions are, and I don’t know that they’ve been as clear about it as Linn has but the goal is certainly growing their production base and maintaining or increasing the distribution (a year ago Linn reiterated that they had hedges in place to make sure they could pay the current distribution through 2011, I haven’t looked them up to see if that timeframe has been extended or adjusted since).

LINE and LGCY, for what it’s worth, have each paid a constant steady quarterly dividend for about two years now (no raising or lowering), and at the moment the distribution yield comes in for both at a bit over 9% (LINE is at 9.2% now, LGCY 9.6%). Yes, LGCY shares have bumped up a little bit over the last couple weeks, so they’re no longer at quite 10.2% — but still, a 9.6% yield is nothing to sneeze at.

It is probably important to note that although Pasternak teases the potential of capital gains in addition to the high distribution, any capital gains in the future could be a lot harder to come by than they were over the past 12 months — LGCY is up huge from the lows, it got down to near $5 or so for a little while, in part because of their reliance on bank debt to growth through acquisition, and had (along with LINE) a huge snapback rally that brought big capital gains for investors who had the foresight to buy when we thought the world was going to end … but this MLP IPO’d back in early 2007 at about $20 and got up to a high of near $30 for a little while that same year as they increased dividends, so if you bought in early, when oil was rushing to new highs, you haven’t seen any capital gains (LGCY is at $22.75 right now, a hair from hitting a new 52-week high). If the share price climbs dramatically from here that’s likely to be either because all income-oriented investments are “repriced” for some reason and investors demand less yield for their risk, or because they’re increasing production and increasing their payouts.

Of course, this is an MLP, and essentially all MLPs are built to pay out large distribution yields — but most of them are not oil and gas producers, they tend to be concentrated in the historically much more stable transportation and midstream businesses (pipelines, processing plants, etc.)

Those big and relatively stable pipeline MLPs, like Kinder Morgan, also have “wasting assets” in the form of pipelines and equipment that depreciates, but their assets don’t actually go up in smoke the way that oil and gas do — and they also generally are not completely dependent on commodity prices like producers are. Pipeline companies operate much more like toll roads, taking a fee for moving product and not necessarily caring whether what passes through the toll is a Mercedes or a Yugo. And frankly, the pipeline MLPs, while perhaps appealing, are definitely not cheap anymore. One of the first times I wrote about the MLP sector in this space, back in the Spring of 2007, the yields had fallen to 5 or 6% on many of the big MLPs, a level where, like REITs, they start to look a lot less appealing.

Now Kinder Morgan (KMP) yields 6.5% and most of the other big, stable players have similar yields — the JP Morgan ETN that tracks the MLP sector yields a hair under 6%, so the huge outsize yields that attracted investors to the space after the market crash are not nearly as “outsize” any more. When you get roughly the same yield from owning Verizon or AT&T as you do from owning Kinder Morgan, that can often be a sign that the gap between MLP yields and utilities, Treasuries, REITs and other income investments has narrowed a bit too much.

I’ve gotten off track, though — if only to mention that yes, this is still a high-yielding MLP compared to most of the players in the MLP space, but it’s also a very different kind of company, much more like the traditional Canadian royalty trusts which are built to buy up oil and gas fields at reasonable prices, manage them effectively and try to grow through those acquisitions, and distribute essentially all of their income to unitholders — there is always a thirst for more acquisitions to keep the distributions going (and growing), so you have to count on finding management that pays good prices, builds diversified assets, and manages those assets well. Of course, over the coming year all of the Canadian trusts will be effectively converting to corporations, which will undoubtedly mean less of an income focus for many of them, so that also might help bring additional interest to MLPs as an income investment for energy-enthused investors. Then again, one big “blue chip” in the trust space, Enerplus (ERF), has already announced that they expect to remain an income-focused company and dividend out a substantial portion of free cash … obviously there’s some uncertainty there, but ERF currently also yields, you guessed it, just about 9%.

So the 9-10% range seems to be the standard for “somewhat uncertain” high yield oil and gas producers who try to pay out almost all of their available cash to unitholders — and there are a few other producing MLPs who are similar to LGCY and LINE, including Encore Energy Partners (ENP), which was formed by Encore Acquisition (which itself is being bought by Denbury, as we mentioned in a different oil teaser about “Project Bronco” last week), Pioneer Southwest (PSE), and Breitburn Energy Partners (BBEP), among probably some others that I’m neglecting to mention.