EMO - EMO: This CEF Is No Longer Cheap (Rating Downgrade)

2023-12-27 12:29:03 ET

Summary

• ClearBridge Energy Midstream Opportunity Fund announced a new corporate action consisting of a tender offer for up to 50% of its outstanding shares.
• The announcement led to a significant rally in EMO shares and the narrowing of the CEF's discount to NAV.
• Existing shareholders have the potential to gain a 7% synthetic gain from the tender offer, while new investors should view EMO as a dividend yielder rather than a cheap buying opportunity.
• The tender offer is the result of the actions undertaken by activist shareholder Saba, which increased their stake in the CEF in the beginning of the year.

Thesis

ClearBridge Energy Midstream Opportunity Fund ( EMO ) is an MLP equity closed end fund. We started covering this name back in April, when we assigned the fund a 'Buy' rating based on its large discount to NAV, solid fundamentals and continued strength in the underlying commodities markets. The CEF has outperformed since, being up over 27% on a total return basis, handily beating the S&P 500:

Furthermore, in our initial analysis we detailed how activist fund Saba had a large stake in EMO, and we expected them to push for corporate actions that would narrow the significant discount to NAV exhibited by the CEF:

While EMO has a nice 7.5% dividend yield, the fund has a very large discount to NAV, which make potential capital gains very appealing. Saba Capital, an activist fund, has a large stake in EMO. Similarly with what we saw for Center Coast Brookfield MLP & Energy Infrastructure Fund ( CEN ) which we covered here , Saba is going to push for this discount to narrow. At the end of the day this is a risk free arbitrage - you have a pool of assets worth 100, yet the market is trading them at 86c/$ because of the CEF structure.

Saba has proven itself to be a very savvy activist investor, and we think they will continue to push their agenda for EMO until the discount becomes more palatable (i.e. sub -5%).

Our prediction became reality, with the funds announcing a massive corporate action that saw the shares rally over +5% on the day. In this article we are going to discuss the results of the corporate action, the current fund valuation and highlight why the entry point into this CEF is no longer cheap after the massive rally in the past ten months.

Saba won - the CEF announced a significant corporate action

The announcement regarding Saba's victory came out on December 26:

December 26, 2023 08:00 AM Eastern Standard Time

NEW YORK--(BUSINESS WIRE)--Saba Capital Management, L.P. and certain associated parties (collectively “Saba” or “we”) today announced that it has entered into a cooperation agreement with Franklin Templeton Fund Adviser, LLC. Under the terms of the agreement, three of the ClearBridge Funds – ClearBridge MLP and Midstream Fund Inc., ClearBridge MLP and Midstream Total Return Fund Inc., and ClearBridge Energy Midstream Opportunity Fund Inc. – each shall commence tender offers to purchase a maximum of 50% of their outstanding shares of common stock in cash. The tender offers provide all shareholders the opportunity to tender some or all of their common shares at a price equal to 100% of net asset value per share as determined as of the close of the regular trading session of the New York Stock Exchange on the next trading day after the expiration date of the original or extended tender offer. The terms of the agreement provide for Saba rescinding its nominees for director and shareholder proposals at each Fund’s next shareholder meeting and voting in favor of a merger between or among the ClearBridge Funds during its standstill period.

We are calling this a 'victory' because ultimately that is what it amounts to for shareholders. All the named CEFs experienced 5%+ gains yesterday, and shareholders in the fund can get further positive profit & loss performances if they tender in the shares and they are accepted. The corporate action shows that shareholder activism works, and Saba has proven time and time again that putting in the effort and legal fees can result in corporate actions which are highly beneficial to shareholders.

Discount to NAV impact

The shares in the CEF rallied +5.8% yesterday, mostly coming from the narrowing of the discount to NAV:

We can see the CEF having traded at a discount to NAV in a -12% to -14% range in the past year, with a sharp narrowing on the back of the corporate action yesterday. The tender offer has succeeded even before starting in narrowing the fund's discount to NAV, and we believe it will end up settling around the -5% mark, as it was stated in our previous article.

The tender offer is welcome from several viewpoints: on one hand it forces the market to react, thus narrowing the discount before it starts given the inherent arbitrage opportunities, while on the other hand it establishes a track record in showing the fund is serious about closing significant arbitrage opportunities, thus creating a floor in terms of future discounts to NAV. Basically, EMO should not trade anymore with discounts to NAV in excess of -10% going forward, unless we see another Covid-like market dislocation.

Valuation - no longer cheap

The fund components, namely the MLPs and C-corps in the portfolio have reached a market valuation average:

We can see the holding now exhibit a P/E ratio in line with the category averages, and a P/B ratio which is on the more expensive side. Fundamentally, the MLP asset class is no longer 'cheap', but a nice dividend yielder. All else equal expect a total return going forward equating the dividend yield here.

The cheapness in valuation at the start of the year came out of the massive discount to NAV which exceeded -15% at times, thus providing for a yield boost and a cushion to the fund's value. The recent corporate action has erased most of that, and while we still expect the CEF to trade with a very small discount to NAV, the current pricing cannot be considered as an appealing entry point anymore.

Tender offer arbitrage - it is not a guarantee

The way the tender offer arbitrage works is that holders in the CEF shares can tender them to the fund in exchange for NAV. At the current -7% discount to NAV that translates into buying shares at 93 c/$ and selling them at par. However the catch is that you do not know if your tender offer bid will be accepted. The fund is tendering 50% of its outstanding shares, which is a huge amount, but there are no guarantees on the exact amount that will be bought from each shareholder, and it is dependent on the overall tender interest.

Investors contemplating buying shares now to participate in the potential tender arbitrage need to understand this is a risky bet that can result in them holding shares longer term rather than be fully taken out by the tender offer. Existing shareholders on the other hand would do well to tender in all their shares since they could fully take advantage of this offer.

Let us say you hold 100 shares in the CEF and you participate in the tender offer. Furthermore, let us say everybody tenders in their shares and you get taken out on 50 shares at NAV. That will result in an instantaneous 7% gain on those 50 shares, and if the CEF continues to trade at a discount you can move right back into the fund the next business day by purchasing shares again. Again, moving back into the fund entails taking risk in the MLP asset class, and assuming an investor is comfortable with that they can crystalize a 7% synthetic gain from this corporate action.

In the current set-up, existing shareholders in the fund are favored over new money looking to take advantage of the arbitrage opportunity.

Conclusion

EMO is a closed end fund focused on MLP equity. The vehicle experienced a significant price gain yesterday of over +5% on the back of the announcement of a new tender offer for the shares. Activist shareholder Saba won its battle with the fund manager, which has now proceeded in announcing an upcoming tender for up to 50% of the fund shares. This announcement saw the discount to NAV for the fund narrow significantly. Existing shareholders would do well to tender in their shares, with the potential for an instantaneous 7% synthetic gain for their tendered and accepted shares, while new money can only view EMO as a dividend yielder rather than a cheap valuation buying opportunity. We are therefore downgrading the fund to Hold.

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