What to Buy: Memorial Production Partners LP (NSDQ: MEMP)

Why Now: With the market in selloff mode following news that the Federal Reserve is considering how to curtail its extraordinary easing, this master limited partnership (MLP) is trading near its late-2011 initial public offering price, while offering an enticing forward yield of almost 11 percent.

Although MEMP’s reserves are tilted toward natural gas, the MLP’s acquisition strategy, which includes dropdowns from its general partner, has helped diversify its production mix into natural gas liquids and crude oil. Equally important, these assets are long-lived, low-decline properties.

The MLP also has a disciplined hedging strategy that helps it lock in prices for the vast majority of its production, which should help contribute to the sustainability of its payout.

MEMP has raised its distribution for three consecutive quarters, so the payout has grown 6.8 percent year over year. And Wells Fargo analysts believe MEMP has the ability to grow its distribution 3 percent annually over the next five years, which should help push unit prices higher.

At present, units are down almost 9 percent from their 52-week high, which offers us an opportunity to lock in an attractive yield before other investors catch on to this relative newcomer.

Memorial Production Partners LP is a buy below 19.75.

Update on Market Conditions

Ari: Before we dive into this month’s recommendation, it’s important to discuss how dividend stocks have performed since early May. At that time, the Federal Reserve revealed that internal discussions were underway to determine the circumstances that could prompt the central bank to begin curtailing its extraordinary easing.

The first step would obviously entail winding down the Fed’s $85 billion per month bond-purchasing program, with the second step being an eventual tightening in short-term rates. Although Fed Chairman Ben Bernanke’s testimony before Congress later that month made it clear that any moves would be predicated on further improvement in economic data, traders simply assumed that his theoretical remarks were definitive, and that tapering was imminent.

Of course, such speculation was not entirely unfounded, since it’s well known that there are at least several hawks among the Fed’s Board of Governors who are concerned about the long-term effects of the Fed’s easing. Indeed, Wall Street Journal reporter Jon Hilsenrath, whose articles are closely monitored by Fed watchers since he’s known as one of the central bank’s favorite media conduits, filed a column on May 11, wherein he noted that at least one official was inclined to start tapering right away, while several others envisioned doing so this summer.

Regardless of these behind-the-scenes deliberations, dividend stock investors of all stripes–whether in staid fare such as utilities or riskier fare such as the high-yield equities that are the focus of this service–have watched their stocks sell off.

Since the beginning of May through June 20, the Dow Jones Utilities Average has fallen 12.5 percent, on a price basis, compared to a 2.7 percent decline for the Alerian MLP Index, a 3.6 percent drop for the Wells Fargo Business Development Company Index, a 19.5 percent plunge for the Dow Jones US Mortgage REITs Index, and a 0.35 percent gain for the S&P 500.

In other words, if you’ve lamented the performance of your dividend stocks over the past six weeks or so, you’re hardly alone.

And the aforementioned data include the broad selloff in the wake of Bernanke’s Wednesday press conference, where he once again sought to allay the market’s fears by stressing that any tapering would be based on a sustained trend toward robust economic data.

Now Bernanke happens to think that the data are moving in a direction where this could happen as soon as later this year. Of course, the Fed has a record of being overly optimistic with its economic forecasts, as this piece by the Washington Post notes. Regardless, traders don’t respond well to nuance, so now they’re assuming that a fall wind-down is simply a foregone conclusion.

Beyond that, one of the Fed’s most closely watched metrics these days is the unemployment rate, which currently stands at 7.6 percent. Bernanke stated that if the unemployment rate falls to 7 percent, then that would form an important part of any rationale to conclude stimulus altogether. But it’s taken a year for the unemployment rate to decline by 0.6 percentage points, and its dithering in recent months makes it difficult to assume that a decline of similar magnitude will happen much sooner than 12 months hence.

In fact, beyond the headline numbers of the most recent jobs report, the data were decidedly underwhelming. Although the US economy added 175,000 jobs in May, the temporary help and food service industries together accounted for almost 37 percent of that gain. Those types of jobs are hardly suggestive of a resurgent economy. And Bernanke has said that the Fed will be analyzing such data beyond the headline numbers.

Still, we’ll be monitoring these data each month, and if they start to truly show sustained, positive momentum, then we’ll have to adjust our expectations of future Fed policy accordingly.

Khoa: What happens to dividend stocks once we’re in a tightening cycle? Won’t they underperform the broad market at that point?

Ari: That’s the conventional wisdom, but actual performance data suggest otherwise. Because dividend stocks compete for investors’ dollars against other income-producing securities, such as bonds, traders assume that income investors will abandon dividend stocks once bond yields start to rise.

Since the 2008-09 downturn, the Fed’s strategy has been to push bond rates so low that income investors have been forced to invest in riskier assets, such as dividend stocks, to maintain current income. Of course, we’re talking about relative risk here–stocks are riskier than bonds, but solid dividend payers are generally far less risky than other types of stocks.

The Fed had hoped that its implicit inflation of riskier asset classes would eventually flow through to the broad economy and lead to a strong rebound in economic growth. Instead, it appears that they’ve simple created a bubble in certain asset classes, to the benefit of corporations and bankers, but not necessarily the general public or the economy itself.

And now that traders are contemplating the beginning of the end to the era of easy money, they’re assuming that the resulting environment of rising interest rates will be bad for dividend stocks. But there are two big “ifs” underpinning this assumption:

1) Our nascent economic recovery: As we’ve discussed already, the Fed will only remove its stimulus should there be further evidence of an economic rebound. And based on the mixed economic data we’ve seen in recent months, that timeline seems far from certain at this juncture.

2) The belief that dividend stocks perform poorly in an environment of rising interest rates: Contrary to this assumption, dividend stocks don’t always perform poorly in an environment of rising interest rates.

In fact, Ned Davis Research conducted a study comparing dividend payers to non-dividend payers from the beginning of 1972 through the end of 2012 and found that even in a high interest rate environment (defined as a year-over-year rise in the Consumer Price Index (CPI) of 4 percent to 6 percent), dividend stocks massively outperformed non-dividend payers.

Over the Fed’s last seven tightening cycles, dividend stocks beat non-dividend stocks by an average of 15 percentage points annualized over the 36-month period following the Fed’s first rate hike after a declining or stable interest rate period.

And companies that grew their dividends over time performed even better.

The latter point gets to the core of our strategy at Big Yield Hunting, which is to identify high-yielding stocks that can maintain their payout and perhaps even grow it over time. As we’ve noted in previous issues, when it comes to the high-yield equity space, this can be a tall order, as many stocks have high yields because they’ve fallen out of favor with investors. To mitigate this risk, our goal is to find the least risky stocks in this otherwise highly speculative corner of the market.

And over the long term, the sustainability and growth of a dividend should ultimately flow through to the stock price itself. But in the short term, you might have to endure unpleasant episodes such as what we’re dealing with presently. Our hope is that a steady stream of income from our investments will enable you to better tolerate any short-term volatility for long-term gains.

This Month’s Recommendation

Khoa: Okay, can I talk now? You’ve been rambling on forever.

Ari: Sit back down! You get paid to listen.

Khoa: But I’m the one who found this month’s pick!

Ari: Oh yeah, that’s right. Feeling awkward now … Please proceed.

Khoa: Memorial Production Partners LP (NSDQ: MEMP) is an upstream master limited partnership (MLP) that primarily produces natural gas, but also natural gas liquids (NGL) and oil, from its mature, long-lived producing properties in Texas and California.

The MLP had its initial public offering (IPO) in December 2011, and it currently has a forward yield of 11 percent, based on its most recent quarterly distribution of $0.5125. It’s raised its distribution for three consecutive quarters, so the payout has grown 6.8 percent year over year.

And Wells Fargo analysts believe MEMP has the ability to grow its distribution 3 percent annually over the next five years, which should help push the unit price higher. At present, the unit price is currently down almost 9 percent from their 52-week high. In fact, they trade right around their IPO price.

Ari: When you first pitched this play, I was admittedly leery about recommending an MLP whose production is tilted so heavily toward natural gas. After all, the US energy renaissance underway in the prolific shale plays has resulted in an abundance of natural gas, which caused prices to crater last year.

Though gas prices have roughly doubled since their April 2012 low of $1.91 per million British thermal units (MMBtu), and supply shows further evidence of coming back into balance with demand, natural gas prices are still expected to remain depressed relative to their longer-term average for the next few years. At least, that will likely be the case until liquefied natural gas (LNG) infrastructure is in place to facilitate export overseas.

On the other hand, the sentiment against natural gas producers has become so overwhelming that as a natural contrarian I can’t help wondering when that bet will reverse. According to data aggregated by Bloomberg, analysts are recommending oil producers over natural gas producers by a factor of 1.13, which is the widest gap since the survey began eight years ago.

Still, it’s obviously a bit early for the fundamentals to start shifting in favor of natural gas. Fortunately, I noticed that MEMP’s production portfolio has quickly evolved since its IPO, so that while natural gas still comprises the majority of its reserve base, it’s not nearly as dominant as it was at the outset.

Khoa: That’s right. Thanks in part to asset dropdowns from general partner Memorial Resource Development, MEMP’s reserve base has shifted from a mix of 88 percent natural gas, 8 percent NGLs, and 4 percent oil at the time of its IPO to a mix of 63 percent natural gas, 21 percent NGLs, and 8 percent oil at the end of 2012.

At year-end, MEMP had total proved reserves of 771 billion cubic feet equivalent (Bcfe), 60 percent of which is proved developed, with a reserves-to-production ratio of 23 years. These assets also have a decline rate of just 7 percent over the next 10 years, which is below the median of 10 percent for its peers.

Additionally, the MLP has a robust hedging program to help lock in prices for its commodities to ensure that it doesn’t have to sell its product for less than the cost of production, while increasing the stability of its distributable cash flow (DCF). Management aims to hedge 65 percent to 85 percent of production on a rolling three- to six-year basis.

For instance, MEMP currently has 85 percent of its overall production hedged for 2013, including 92 percent of its natural gas production, 79 percent of crude oil production, and 67 percent of NGL production. For natural gas, its hedges have locked in a weighted average price of $4.55 per MMBtu, which is 20.1 percent higher than where prices stand today and 21 percent higher than their year-to-date average.

In the first quarter, MEMP’s hedges boosted the average sales price for its commodities by 12.9 percent, to $5.95 per thousand cubic feet equivalent (Mcfe). That resulted in a cash margin that was 5 percentage points higher than would have been the case in the absence of hedging.

And 80 percent of expected production is already hedged for 2014, while 62 percent of 2016 production has been hedged. Thereafter, the MLP has between 48 percent and 57 percent of production hedged each year through 2018. So they’re really doing what it takes to mitigate the risk of volatile commodity prices.

Ari: You mentioned asset dropdowns from its general partner (GP). Tell me more about the deals it’s done, as well as its longer-term acquisition strategy.

Khoa: Like other MLPs, MEMP hopes to grow its production and, therefore, its distribution over time by regularly adding new acreage to its portfolio. The MLP has completed six accretive acquisitions since its IPO, including three dropdowns from its GP, which is generally a cheaper way of acquiring productive assets than competing for them against other bidders on the open market.

Two other deals were with third parties, though on one deal MEMP was a joint bidder with its GP. And the sixth deal was a drop down of sorts, as it was an acquisition from Natural Gas Partners (NGP), which is a private-equity group that invests in energy assets. NGP owns 50 percent of MEMP’s incentive distribution rights (IDR), which incentivizes it to provide more such accretive deals in the future.

Altogether, these acquisitions cost $643 million and added 457.6 Bcfe to MEMP’s proved reserves, which roughly doubled the size of its total reserves.

Ari: How did MEMP fund these acquisitions?

Khoa: The MLP tries to finance its acquisitions with a mix of 55 percent equity and 45 percent debt. That means it will do secondary issuance from time to time. Although investors tend to balk at the prospect of dilution, these issuances are one of the main sources of financing that MLPs use to grow. And because units tend to sell off following a secondary issuance, that can be a great time for long-term investors to add to or start building their positions.

Thus far, MEMP has completed two follow-on offerings since its IPO. In mid-December, MEMP issued nearly 12 million units. Then in late March, the MLP issued 9.8 million units to fund the dropdown of WHT Energy Partners LLC from its GP.

As far as long-term debt goes, MEMP recently issued $400 million in 7.625 percent senior unsecured notes due 2021. It also has about $372 million of liquidity remaining on its credit revolver, which can remain drawn through 2018.

Ari: How does MEMP do as far as covering its distribution? That’s key for the sustainability of its payout.

Khoa: Although the MLP had a coverage ratio of 1.27 for 2012, its first-quarter coverage ratio fell to 0.82. Cash flow failed to cover the distribution for the quarter by about $4 million.

However, this was largely due to temporary downtime for maintenance at one of its properties in California. And management expects the full-year payout will be covered by cash flow, with a coverage ratio ranging form 1.0 to 1.1, while Wall Street analysts model a coverage ratio of at least 1.0.

Beyond that, management projects annual production will rise from 24.6 Bcfe in 2012 to a range of 37 Bcfe to 39 Bcfe for full-year 2013, with the low end of that range a substantial 50.4 percent greater than last year’s results. And that should increase adjusted EBITDA (earnings before interest, taxation, depreciation and amortization) from $110.1 million to a range of $154 million to $158 million, with the low end of that range almost 40 percent higher than last year.

Even so, we’ll have to keep a close eye on that coverage ratio. If it dips below 1.0 for too many consecutive quarters, then we’ll have to reconsider MEMP’s long-term prospects.

Ari: What does sentiment look like among Wall Street analysts?

Khoa: The MLP currently has eight “buys” and three “holds,” with no “sells.” The consensus 12-month price target is $21.43, which is 11.4 percent above current unit prices.

As for tax considerations, MLPs should be owned in taxable accounts, as a significant percentage of the distribution is tax-deferred. Of course, that also means contending with a Schedule K-1 at tax time, but the high yield coupled with the ability to shelter income from taxes more than offsets the tedium of dealing with this tax form.

Memorial Production Partners LP is a buy below 19.75.

Portfolio Updates

Now that earnings season is over, there isn’t much company-specific news to report.

Natural Resource Partners LP (NYSE: NRP) is still suffering from the effect that weak global steel demand is having on metallurgical coal prices, which are near multi-year lows. For Central Appalachian coal to be cost competitive as a fuel source, natural gas needs to rebound to $4.50 per MMBtu to $6 per MMBtu.

Management is focusing on diversifying away from Central App coal. The company is looking to expand its exposure to the Illinois basin, as well as oil and natural gas markets. According to Wells Fargo Securities, the distribution is safe through year-end, but may be not be longer-term due to the aforementioned challenges for Central App coal. Natural Resource Partners remains a buy below 22.

On May 22, PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) changed its name to Lightstream Resources (TSX: LTS, OTC: PBKEF).

PetroBakken remains a buy below 10.