Who needs yields, anyway? (Breitburn Energy Partners LP)

September 27, 2009

pig_appleSome of you may recognize our old friend the yield hog from the Windstream article, but we should ask ourselves what a dividend signifies. For bonds, yields are typically all we get, but for stocks? True, a big dividend yield will amortize our margin balance if we choose to buy on margin, but as Seth Klarman puts it, margin is unnecessary for the value investor, and indeed is often counterproductive.

But, if the firm does not distribute its free cash flow in the form of dividends or some other way, that money is still sitting inside the firm and still belongs to the shareholders. Of course, Ben Graham’s quick and dirty valuation formula valued dividends at three times undistributed earnings, but in his day dividends were viewed as an integral part of the return from equity investment, whereas now they are viewed as a distraction from the corporation’s management trying to build their empire.

In theory a corporation should only hang onto its excess cash if they can produce higher returns by keeping it than its shareholders can produce by receiving it and investing it themselves. Cash has fairly low returns, so building up cash just to keep it built up on the balance sheet should be viewed as robbing the shareholders. Benjamin Graham actually tried to engineer a hostile takeover to get a firm to disgorge its unnecessary investment holdings.

Breitburn Energy Partners LP (BBEP) suspended its dividend last year on the grounds of enhancing liquidity, and predictably the price of the shares tanked. As with Linn Energy, apparently Breitburn was viewed a dividend factory rather than a corporate empire type. But, also like Linn Energy, it seems to be a convincing one. In fact, they have adopted the same hedging strategy running for years into the future, so a buyer is betting on their competence as a natural gas and oil producer rather than on the movements of oil and gas prices. Using the technique of doubling current earnings they will earn $200 million this fiscal year, giving the company a P/E ratio of 2.5, or 5 based on last year’s pre-tax full year earnings. They have been increasing the pace of their operations, though. In fact, if Breitburn had not eliminated its dividend they would be yielding almost 20% at current prices. Now, rather than piling up their cash, they are paying down debt (ironically, piling up cash would be the most liquidity-enhancing move of all). Going by their books, they have cut their liabilities considerably since they started preserving money. However, the interest rate they pay currently is about a fourth what their cost of equity is as determined by their PE ratio so if they wanted to fix cost of capital instead of liquidity they are going about it the wrong way.

So, if you liked a productive, hedged producer like LINN, and are willing to forego a dividend until Breitburn’s managers decide that they are sufficiently liquid, Breitburn should be the ideal stock.

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