A Beaten Down MLP With a Safe 11% Yield

One reason investors like the energy sector is high yields. Some of the highest yields come from master limited partnerships (MLPs), which pay out the vast majority of their profits to unitholders in the form of distributions. Investors usually must choose between MLPs with high yields and slow distribution growth or lower yields but faster growth. Occasionally the market presents a chance to purchase an MLP that offers both. 

Calumet Specialty Products Partners  (NASDAQ: CLMT  ) is a specialty refiner of petroleum products. 70% of gross profits come from sales of its 3,500+ portfolio of specialty industrial products such as waxes, fracking solvents and high performance automotive oils. The remaining 30% of gross profits come from traditional fuels such as gas, diesel, jet fuel, and asphalt.

Short-term industry challenges
Oil refining is a cyclical, low-margin industry.

Company Operating Margins Net Margins Return on Assets Return on Equity
CLMT 1.7 -0.2 -0.5 -1.2
PSX 3.3 2.1 7.6 17.4
VLO 2.9 2 5.9 14.5
MPC 3.4 2.1 7.6 18.7
HFC 6.2 3.7 7.2 12.2
Industry AVG 3.2 2 6.6

16.3

Data from Morningstar

As seen below, Calumet and its larger competitors like Phillips 66 (NYSE: PSX  ) , Valero Energy (NYSE: VLO  ) , Marathon Petroleum (NYSE: MPC  ) , and HollyFrontier (NYSE: HFC  ) are facing margin pressure. This is for two main reasons.

CLMT Profit Margin (TTM) Chart

Source: YCharts

The first reason is rising input costs. West Texas Intermediate (WTI) oil has been trading at a discount because the oil is priced in Oklahoma (where most oil from the Texas fracking boom goes). The last few years Texas has seen increases in oil production of 30% annually. 

This cheap oil resulted in high margins -- as much as $34/barrel in the third quarter of 2013. 

Traders are speculating that increased pipeline construction will shrink the oil glut in Oklahoma, causing WTI prices to rise. Margins fell to $16/barrel in the third quarter of 2013.

The second reason margins have declined is the increase in cost of renewable energy credits (RINs). The EPA changed its ethanol mixing requirements in 2013 and caused a spike in RINs from $0.02/credit in 2012 up to $1.18/credit in 2013. Calumet saw its 2013 RIN expenses soar to $90 million.  

The EPA has recently decreased its requirements and RIN costs have fallen to $0.5/credit.While increased RIN expenses and compressed margins caused declines throughout the industry, Calumet faced one additional hurdle. 

The partnership had to perform regular maintenance at three of its refineries in 2013. Maintenance is performed every four years, and it resulted in decreased output from the facilities in addition to maintenance expenses.

Catalysts for future growth
The recent downturn in the refinery industry caused by the above factors has resulted in a temporary decrease in distributable cash flow (dcf). Distributions are paid out of dcf. Calumet's dcf declined by 93% from 2012 to 2013, which panicked the market (likely pricing in a distribution cut). This fails to account for four catalysts that secure the distribution and make future growth likely.

The first catalyst is the WTI/Brent spread has hit a low of $0.86/barrel in September and has since recovered to $6.54. Analysts are predicting the spread will stabilize at $11.5/barrel through 2015.Management has seen a 25% improvement in margins during the first half of Q1. 

The second catalyst is that Calumet has five investment projects underway. These will cost $500-$550 million and generate $190-$215 million in Adjusted EBITDA by the end of 2016. 

Management has an excellent record of growing through acquisitions (the third catalyst). The partnership has purchased refineries in key areas close to cheap oil sources (Texas, Montana, and Wisconsin). Calumet also buys makers of other specialty products such as Royal Purple and then feeds into its supply chain to grow sales. 

In 2014 Calumet has made three acquisitions:

  • Bel-Ray: maker of 1,000+ specialty products sold in over 100 countries. 
  • United Petroleum: maker of Quantum brand of lubricants, sells 160 products through 50 distributors in 35 states.
  • Anchor Drilling: Leading provider of fracking fluid. 

The final catalyst protecting Calumet's distribution is the $593 million in liquidity the partnership started the year with. 

Recently the partnership sold $900 million in 6.5% senior notes due in 2021. $235 million will pay for the Anchor Drilling acquisition and $500 million to refinance debt. This leaves $165 million for other expenses.Also, Calumet recently filed paperwork for a $300 million equity offering. 

With over $1 billion in liquidity (after the upcoming secondary offering) Calumet represents an amazing opportunity. The size of the offering will result in 20% dilution that will likely drop the unit price 15%-20%. This will give long-term investors the chance to lock in a secure 13%-13.5% yield.

Bottom line
Calumet is a partnership whose management has a proven track record of accretive acquisitions and wise investments. The refining industry's recent downturn has caused a knee-jerk reaction due to fear of a distribution cut that is unlikely. Management has secured sufficient liquidity to continue paying the current distribution, invest in growth, and continue making acquisitions.

The combination of improving industry margins, future acquisitions, and organic investments will ensure the long-term security and growth of distributions. As Calumet's margins recover and distribution grows the unit price should experience strong capital gains on top of generous distributions.

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Read/Post Comments (10) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 28, 2014, at 12:04 PM, quantuon wrote:

    Adam - This is your 4th article on CLMT in about a month. Why are you so bullish on this name, particularly since they are doing a secondary public offering? Sounds like a pumper thumper

  • Report this Comment On March 28, 2014, at 12:04 PM, quantuon wrote:

    and, yet, you have no position? hmmmm

  • Report this Comment On March 28, 2014, at 6:08 PM, AdamGalas wrote:

    This is my fourth article on Calumet because I truly believe in the company. As for the upcoming secondary offering, that is an essential part of my investment thesis.

    The secondary causes the price to drop and yield to rise. The secondary provides sufficient liquidity to secure the distribution until the investments provide the DCF to cover it long-term.

    Its exactly because of the secondary that I feel Calumet is such a great opportunity.

    And as for having no position, this is two fold.

    One, I currently have no money. I was forced to sell all my investments and cash in my life savings because of a series of family financial and medical disasters.

    My family and I are just now getting back on our feet.

    Second, the secondary offering is coming up in the next few months. That will make for an excellent entry point. Thus I wait. If I have discretionary income soon after the secondary I will buy Calumet and be a proud long-term owner.

    Thank you for your comments and thank you for following my writing so closely. I truly do appreciate it.

  • Report this Comment On March 28, 2014, at 9:29 PM, 95isuzu wrote:

    I am not aware of any evidence of a secondary offering. I would question the wisdom of one due to the fact the share price is already depressed. I am surprised you are so convinced a secondary is forthcoming. You state they have filed paperwork for a secondary. Where is the evidence?

  • Report this Comment On March 28, 2014, at 10:28 PM, AdamGalas wrote:

    http://biz.yahoo.com/e/140311/clmt8-k.html

    The secondary offering is likely to come to come in the late spring or summer. This is because the first 2 quarters are typically the best time for refiner's margins. Thus a good earnings report would send the unit price up and reduce the amount of units that need to be sold and issued.

  • Report this Comment On March 28, 2014, at 10:31 PM, AdamGalas wrote:

    http://biz.yahoo.com/e/140311/clmt8-k.html

    Earnings typically do better for refiners in the first 2 quarters of the year. Thus its likely we'll see the secondary occur after the price recovers. The higher the price, the less dilution occurs.

  • Report this Comment On April 01, 2014, at 10:37 PM, Shirley1 wrote:

    Bottom line here is that nothing pays 13%.

    It's a fools gamble to think that the dcf is safe with the MLP down 30% in the past 6 months. That's got to tell you there is trouble ahead.

  • Report this Comment On April 02, 2014, at 8:45 AM, AdamGalas wrote:

    The unit price decline doesn't directly affect the distribution coverage. As I stated in the article I feel that the market is overreacting to short-term difficulties and that management is working hard to secure the distribution.

    It is true that there is risk here, a 11% yield is hard to find without some risk. However, the investment thesis of my article was that a 13-14% yield might be obtained purely on the basis of a secondary.

    In other words, the secondary offering, which raises money that can be used to pay the distribution until the cap-ex projects bring in enough permanent DCF, is the reason the yield will rise from 11% to 13%-14%.

    That doesn't increase risk at all, it decreases risk. It dilutes existing unit holders (who benefit from a secured distribution) but offers new investors an incredible opportunity.

    Normally a 13-14% yield means that the stock/unit is a mREIT or something is very wrong. But sometimes market overreaction offers a special opportunity to lock in a yield that appears risky but is actually safe.

    That is the thesis of my article. You are free to disagree and I respect your alternate view. That is why there is a stock market in the first place. In order for an investor who believes in CLMT to buy units it takes someone who thinks the partnership is in trouble to agree to sell them.

    Only time will tell who is right. There are no certainties in life, only probabilities.

  • Report this Comment On April 10, 2014, at 5:12 PM, RedNosePlaya01 wrote:

    A definitively well stated article Adam. I believe in CLMT and their dividend performance. I am anxiously waiting for the upcoming secondary offering, to add to my existing shares. Dividends in excess of 10% are rare from MLP's.

  • Report this Comment On April 10, 2014, at 10:48 PM, AdamGalas wrote:

    I appreciate the sentiment and agree. I am eagerly awaiting the secondary, hoping to lock in a 12% or better yield.

    However MLPs that yield double digits are not necessarily rare. E&P MLPs that have 10+% yield or higher include:

    QRE, LINE, EROC, LRE and BBEP if it dips a bit.

    Of these I would rank them in order of quality:

    BBEP

    LINE

    QRE

    LRE

    EROC

    As I recently wrote in an article about this sector, EROC is a bottom of the barrel company and not investment grade.

    http://www.fool.com/investing/general/2014/04/09/dont-go-dum...

    I would advice sticking to BBEP, LINE and QRE in this space.

    Personally, when I have the funds available within the next several months, I intend to add QRE due to the exceptional yield and special opportunity represented by the buyout of its general partner.

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