“$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.

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Why would you choose LGCY over another? Well, it’s got less of a history than Linn Energy, and certainly gets less attention in the press, so you could simply bet that it closes the small valuation gap with LINE and gets bid up by a couple dollars for that reason, though that’s perhaps a stretch. Or you could believe that LGCY made a wise acquisition in Wyoming, and will continue to make wise acquisitions and grow their dividend (Carla, in the tease, points to that “average dividend growth” of 8.9%, but if we assume I’m right in sniffing out LGCY as her pick, that’s just averaging out some big increases that they made early on in 2007, they haven’t increased the dividend since early 2008).

I had never heard of LGCY myself a year or two ago — it has outperformed LINE already since inception, but by a fairly narrow margin, and with more volatility, but, to tell you the truth, I find myself personally more interested in the large, stable and newly growth-oriented Enerplus than I am in either LINE or LGCY. LINE was an extraordinarily compelling buy at a 20% yield a year or so ago, when they were promising to maintain that yield for two or three years, but it’s less of a “no brainer” at 9%, and though I haven’t looked at LGCY in the same detail, I get much the same feeling from this new stock.

MLPs carry some significant advantages for many investors, so that may help sway your investment decisions if you’re comparing Legacy Resources to Canadian trusts or other high-yielding energy investments. Those advantages can including tax deferral (these companies don’t often have taxable income, thanks to massive depreciation charges, so the cash flow distributions are often treated as return of capital and not taxed until you sell your shares), and some estate planning benefits.

They also come with headaches, including additional tax forms from the partnership … and they’re also not generally “allowed” in IRAs (you can buy them with your IRA, but the income becomes taxed over a certain level — and there may be additional rules beyond that). Then again, it’s not generally advised to hold a foreign stock in your retirement accounts if the country withholds taxes from your dividends, as Canada does with the trusts (not sure if that will continue with the conversion), since I don’t think you’re allowed to claim foreign tax credit for non-taxed accounts. (Please don’t count on my opinion for any of your tax and investment decisionmaking, of course — I am far from being a tax expert or financial adviser, and I have enough of a headache doing my own taxes).

If you’re looking for other ideas in the “high income energy” sector beyond MLPs and Canadian trusts (which will soon be corporations), there are also closed-end trusts in the US (“closed end” means they can’t acquire new oil fields like MLPs can), like Sabine (SBR) or Prudhoe Bay (BPT); Closed-end funds (in this case, closed-end means there are a set number of shares unlike traditional mutual funds and ETFs, though they can always create and sell more in an offering like any company) like those from Kayne Andersen and Tortoise that largely hold MLPs and get you an easier tax situation (but also other risks, like leverage and management); and, lest we forget, actual oil companies — ConocoPhillips (COP) yields 4%, BP (BP) and Shell (RDS, either A or B shares) yield more like 6%, just to name a few. That’s not to say that any of these are necessarily wonderful investments, these are just a few examples that came immediately to mind … this is mostly just a reminder to think about the 9% distribution from LGCY in comparison to its real “near peers,” not to the 1% you’re getting in a CD or the 2% you get from an S&P 500 index fund.

So what do you think? Looking for a high yield in the oil patch? Think Legacy looks good, or Linn, or someone else? Let us know with a comment below. And if you’ve had any experience with Carla Pasternak’s High-Yield Investing, please click here to review it for your fellow investors — thanks!

Full disclosure: I currently own shares of Verizon and Boardwalk Pipeline Partners (another pipeline MLP), but do not own any of the other stocks or partnerships mentioned, and will not trade in any covered investment for at least three days per my disclosure and trading rules.



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March 9, 2010 3:00 pm

With regard to the Canadian Oil Trusts becoming corporations, not all of them are reducing distributions – – in fact quite a few have indicated they will continue distributions equal to those before incorporation.

The main problem for u.s. investors is that while the government has completed negotiation of accords with Canada that are supposed the exempt equities in “tax-advantaged accounts”, the investment brokerage houses are still deducting a 15 per cent tax on distributions and forwarding it to the the IRS. Then, when you go to cash in your IRA you are taxed again whether the funds are trust/corporations distributons or not.

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March 9, 2010 4:29 pm

I bought some LGCY awhile back, in a regular “taxable” account, but it would be okay in an IRA, according to what I’ve read. This, from the Miller/Howard Investments website:

“…if you have UBTI from MLB’s, the custodian of your account is supposed to file a form 990T and pay tax from funds in your account on the net income from your MLB’s. In practical terms, we would not expect this to happen. Last year, for example, the aggregate K-1’s showed a substantial net loss for tax purposes, even though we received substantial cash from our investments. There was no “ordinary income” to be considered for UBTI.
This “no ordinary income” isn’t guaranteed every year, but any UBTI qualifying income is likely to be de minimus. ….an account would have to be of institutional size (say, $5 million and up) before it would possibly generate any UBTI above the exclusion.”

Sooo-o-o-o-o-o, I think I might put some MLP’s in my IRA, too.

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March 9, 2010 8:21 pm

hi gumshoe
i actually found this one this afternoon. still i wasn’t sure until your article. awhile back she gave away mwe which i bought and have been happy with. i also bought clmt and pvr which i came up with on my own. all are doing very well. i am wavering on lgcy but will probably take a small position if it will pullback a bit. kind of feeling vz may end up a good one too. seeing that