As humans, we suffer a tendency to classify events according to easy-to-access theories of the world: A duck is a duck because it looks that way. Even when it's not. The superficially dissimilar ends up dismissed, ignored, or cast aside. So goes the story of CorEnergy Infrastructure Trust (CORR +0.00%). Formerly a business development company (BDC), the company restructured a little more than a year ago to become an energy infrastructure-focused real estate investment trust (REIT).
Though the move was well-telegraphed, the stock's become (or remained) something of an orphan. CorEnergy's structure and business model is not particularly mainstream; it's tiny and, by market standards, it's a new kid on the block. As shares sit at 11 times AFFO, or adjusted funds from operation -- the REIT measure of free cash flow -- we have the opportunity to buy a high quality set of assets and capable management on the cheap, and collect a tidy 7.1% yield.
So I'm buying a position equal to 3% of my Real Money Portfolio today.
A less-customary REIT
CorEnergy Infrastructure Trust is a unique animal. The company invests in energy infrastructure assets -- think pipelines, gathering lines, storage terminals, or transmission lines -- on a non-operated basis.
Consider an example: An exploration and production, or E&P, company owns a bunch of pipelines and gathering facilities. They produce steady-as-she-goes cash flow and solid returns. The market's habit is to chronically undervalue these assets, however, because their cash-generating capacity's obscured as part of a much-larger entity, and they're not sexy. On an opportunity cost basis, it makes more sense for a growing E&P company with solid prospects to drill wells. The trouble is, these assets are strategically important -- it needs to process and move natural gas and oil to market.
That's where CorEnergy enters the fray. It purchases and leases these assets back to the E&P company on a long-term, triple-net basis, which means that the lessee, the E&P company, bears all operating and maintenance costs. The benefits are mutually symbiotic. CorEnergy derives a recurring, virtually costless, and inflation-adjusted cash flow stream. The E&P retains operational control, and unlocks value from a previously captive asset.
In this regard, CorEnergy serves a distinct role: Capital-constrained E&Ps often possess ambitions that are larger than their balance sheets, many of these transactions are too small to be needle-moving for larger MLPs, and private equity cannot provide a permanent source of capital. With the North American energy renaissance's bounty, the need for new energy infrastructure is tremendous. For CorEnergy, that affords a prime opportunity.
As currently structured, the company owns five primary assets:
- A liquids gathering system (LGS) leased to Ultra Petroleum (UPL +0.00%) in the Pinedale, one of the more prolific gas-producing regions in the United States
- An oil and petroleum products storage terminal in Portland
- A 40% interest in a New Mexico transmission line, slated to be sold on 4/1/15
- A $11.5 million loan at a 12% rate, to finance construction of a water disposal facility in Wyoming
- A Missouri natural gas pipeline servicing a military facility under a long-term contract
The company also holds a 6.7% stake in Lightfoot Capital Partners, a 40% owner of Arc Logistics Partners (NYSE: ARCX), and an 11.1% interest in VantaCore Partners, owner and operator of aggregates facilities.
All these provide recurring inflation-adjusted cash flows, possess limited commodity price risk, and require zero maintenance spend on CorEnergy's part. Equally significant, these assets are often strategically important to regional energy infrastructure, difficult to replace, and subject to high barriers to entry. As it stands, the Pinedale LGS facility contributes the vast majority of CorEnergy's distributable cash flow -- about 50% of 2013 fee-based revenue, by my estimate.
A virtuous cycle?
It might seem that CorEnergy shouldn't trade at a meaningful discount to fair value. Its cash generation and assets are reliable quantities, and its business model is easy to understand. Likewise, in an era of zero-interest rate policies, the market isn't in the habit of letting 7.1% yields stay under the radar. And yet, it is. I see three sources of mispricing: CorEnergy's relative youth, as a company and vehicle; a few oddities associated with its corporate structure; and misunderstood risk, alongside the potential for value-accruing deals.
1. A misunderstood makeover
About a year-and-a-half ago, CorEnergy undertook the first step in a dramatic reinvention -- from a BDC, which made minority equity investments in energy infrastructure companies, to an energy infrastructure REIT -- acquiring Ultra Petroleum's LGS facility, by issuing a slug of equity. Despite the transaction's value accretive properties, the market didn't take kindly to the share issue, sending the shares plummeting in the days that followed. At 11 times my estimate of normalized AFFO, they remain cheap.
CorEnergy occupies the realm of what special-situation guru Joel Greenblatt might call an orphan stock. On a cursory evaluation, it's easy to understand the why and how. The first of its kind, an energy-infrastructure REIT, only recently formed, and quite small -- sporting just a $230 million market cap -- CorEnergy remains misunderstood. To wit, If memory serves, the last conference call lasted just 20 minutes, and was attended by two analysts. In time, that will change.
2. A strange animal
Part and parcel to its Frankensteinian organization, CorEnergy is structured in a way that might raise a few eyebrows. And make no mistake... they bear watching. CorEnergy is what industry folk call an externally managed REIT -- meaning its managers are not employees of the company, but instead, employed at will. Likewise, managers' compensation is based on a simple metric -- 1% of net assets under management, as measured by the dollar value of deals, net of debt assumed -- with many prospective conflicts of interest. The prospective sources of concern: Management might make deals at inflated prices to juice its compensation, conflicting with CorEnergy shareholders' interests, walk out the door with little notice, or all of the above. For these reasons, a good number of investors won't touch an externally managed REIT -- and that's not unreasonable.
But a closer examination reveals a capable and experienced management team, with every incentive to do right. David Schulte, the principal managing director, founded one of the largest fund managers you've never heard of -- Tortoise Capital Advisors, a $17 billion energy infrastructure investor, focusing on the MLP space, specifically. First and foremost, Schulte's history of execution is superlative. Its oldest fund, the Tortoise Energy Infrastructure (TYG +3.42%) fund, has generated 13.6% annualized returns. Schulte's reputation and golden goose, Tortoise Capital, will suffer if he behaves badly. Not to be discounted, in CorEnergy's brief history, management's deal making has been on the mark, completing three transactions at roughly 10 times AFFO apiece.
3. Of risk and more deals
That gets to the last bit. As CorEnergy completes deals, establishes its network, and convinces the broader market of management's deal-making savvy, there's potential for a virtuous cycle. There's the very obvious: Good deals accrues value to shareholders, and make money. But there are several less-apparent benefits. By establishing itself as a capable operator and partner, CorEnergy might build a beachhead -- as a partner of choice in energy infrastructure deals. Instead of competing for deals in marketed assets, or hunting for them, prospective sellers might seek CorEnergy, affording access to transactions and deals on favorable terms. This is a strategy that shopping-center REIT Retail Opportunity Investments Corp (ROIC +0.00%) has employed to meaningful effect.
While CorEnergy's revenue is relatively concentrated right now, that will change. Future deals will diversify its revenue stream, and investors will change their perception of the risk inherent in CorEnergy's model, affording a lower cost of capital. That's good in two less-apparent ways: a more valuable currency for deals, and lower costs of borrowing. Both accrue cash to investors' bottom lines.
What we get
On a combination of inflationary price increases, leverage from scaling general and administrative costs, and higher volumes at the Ultra LGS facility and Portland storage terminals, I peg the shares' worth at $9.50, which includes $1.00 attributed to balance-sheet investments. Coupled with a 7.1% yield and a slug of boring, competitively advantaged, and reliably cash-generative assets, that's a tasty treat. That's why I'm buying shares today.
