Description

We are pretty sure everyone is familiar with KYN. To summarize it is a closed end fund that owns a bunch of MLPs/companies which we will break down later. The fact sheet actually does a pretty good job of breaking it down.

Importantly for many folks, KYN does not give you a K-1 and the dividends are a mix of qualified and returns of capital. Here is a breakdown over the last 10 years:

The breakdown of the dividends vs. returns of capital comes down to whether or not KYN has accumulated profits, generally dividends following good years or capital returns following bad years.

Where KYN gets a little funky is they layer in leverage as well to increase their holdings. Obviously this cuts both ways. As of 7/31 leverage was about 32% of their total assets.  If you prefer less leverage AMLP, another fund with dividends not a K-1 is also an option although the underlyings are somewhat different. Given where the underlying MLPs/companies are trading we are ok with the leverage.

Additionally it is trading at a small discount to NAV (around 10%) which given the performance and leverage makes sense:

Closing the discount gap would just be a kicker. However, it acts as an interesting barometer of sentiment on the industry. As sentiment gets very negative (such as it did near the end of 2015) the forward returns become very strong.

Finally, chasing yield is really stupid but we should at least mention the dividend yield here is around 10.5% (the underlyings are around 6-9% the leverage jacks it up) and the 30 year Treasury is 1.95%...obviously credit worthiness of US gov’t significantly higher, but it’s worth noting.

Fund Holdings

Here are the top 9 holdings which are about 2/3 of the total value:

This data comes from Factset so we didn’t audit every number. Additionally MLPs have their own nuances due to the minority interests, unconsolidated subs, etc. For the purpose of this write-up the EV includes all of that. We also kept the EV the same for 2020 as currently as they are “mostly” funding internally and directionally it is correct.

Leverage is not nearly as bad as it once was and probably where most folks believe it currently is. Additionally, these are not bad business, EPD which of course is regarded as the best earns almost a 20% ROE and 8-10% ROA. Stable businesses with decades of future use are solid assets to own, especially when they have found (some) capital discipline.

Valuation

We arrive at the 2020E weighted average EV/EBITDA for these top holdings of around 9.90 with the implied dividend yield of around 10.5%. Here is a matrix of where KYN could trade under the following EV/EBITDA on 2020:

Note this is for the top 2/3 of the portfolio again not everything but here we show the value of the underlyings and the value of KYN adjusting for its leverage. We also show the yield but of course if these things are trading at 7x EBITDA the yield will be a lot lower as they will be cutting to stave off the death spiral (i.e. KMI circa 2015/2016). They would probably adjust the leverage depending on where these are trading.

Given the ongoing “recession” in energy stocks, we don’t need (nor expect) the valuation to return to five year historical levels to provide substantial upside over the next two years. If the valuation stays at current 2019E levels of ~11x EV/EBITDA, you add the dividend yield and you get some closure of the price to NAV, you are likely looking at over 50% upside from here by the end of 2020. If multiples expand, it could be substantially more.

Finally, a note on the oil and gas industry. Everyone hates it and there is good reason to hate it as returns have been atrocious. We get that 100% even though three of our write-ups have been in this industry for some reason. Maybe we just can’t help ourselves.

Return to the mean arguments have not worked for a very long time…mainly because the underlying companies have been eaten alive by the oil price recession or tech or a host of other factors. The quality of the businesses that need to “return to the mean” have also gotten worse generally.

However, we think this works for two reasons (i) these are generally quality long-lived recurring businesses that spit off a good amount of cash and are now required to be disciplined capital wise and (ii) the producers are simply going to have to fall in line as there is minimal new capital for them. This probably means production slows down (certainly from the recent growth) which means the MLPs themselves are more growth constrained but good assets with good ROIs will still be built and crude/gas will still flow.

Certainly, things can get worse and the risks are clear around economic recession and the like, but odds-wise this is a nice set-up, particularly if one wants to have some diversified exposure to a lower volatility component of the energy complex (compared to producers and many servicers).

Conclusion

KYN gives us a solid stable of recurring businesses with solid prospects that deliver a lot of cash (some of which is non-taxable when distributed) now and should deliver more in the future. For that we are paying around 7x that cash flow and collecting an annual distribution over 10% due to KYN leverage. As a small kicker we have the discount to the NAV which if anyone ever gets excited again about oil and gas (which you know they will at some point) will close/become a premium and increase the total return.

Disclaimer: 

This research report expresses our research opinions, which we have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author and his clients have a position in this stock and may add, reduce or sell out of the position completely without informing readers.

Catalyst

• Change in oil sentiment
• Everyone remembers these are pretty good businesses with solid yields when little are available