TRP:CC - Not All Debt Is Bad: Understanding Debt From A REIT And Midstream MLP Perspective

2023-04-03 06:30:00 ET

Summary

• This article shares the secret trick for making any growing company that owns hard assets, such as many REITs and midstream energy firms, look like they are in trouble.
• I show you from the numbers how to make such a firm look like a disaster, or like a conservatively run, sensible operation.
• Proportionate debt that supports the purchase or construction of income-producing hard assets is a good thing.

On Seeking Alpha, we not infrequently see articles in which authors go into areas of their own ignorance. Whatever conclusions they draw are at best unjustified and at worst ludicrous.

In the ludicrous category are often found articles about REITs and about midstream energy companies. The reference here is to publicly listed firms. What these two types of firms have in common are these aspects:

• They own expensive, long-lived assets
• Those assets inherently produce cash earnings
• They operate with leverage, with a 40% ratio of Debt to Gross Total Assets being common
• The assets tend to increase in value with time
• As a result, GAAP Depreciation (and EPS) have zero relevance

A subset of articles makes a systematic argument showing that some of these firms are in trouble. They predict dividend cuts or other dire consequences.

Below I show you how they do it and then what the true reality is.

Representative Numbers

We start with representative numbers for a midstream company and a triple-net-lease REIT. Both are actively adding assets and debt, like nearly all REITs and some but not all midstreams today.

But neither one is issuing stock. They are growing from retained earnings instead, paired with leverage-neutral debt.

Here, in random order, are the only large numbers from the cash flow statements. These are modeled after specific firms but adjusted for convenience. More importantly, the relative magnitudes of the numbers are representative of this sort of firm in each sector.

One sees for such firms that Cash from Operations, or CfO, is the largest number. There is some net New Debt. And Dividends and Capex are comparable.

The numbers balance to roughly no change in cash held, with CfO and New Debt offsetting the other two.

Disaster Awaits

Here is how an author can stack up these numbers to predict disaster.

Many of these authors belong to what I think of as the Church of Free Cash Flow . They are not deterred by the many definitions of Free Cash Flow one can find. For them, it is ordained that Free Cash Flow means Cash From Operations minus all Capex.

This leads them to first generate the line in purple and shaded green, showing the Free Cash Flow by this definition for each firm. Then they look at the dividends and apply the second precept of their church: Free Cash Flow MUST cover all dividends .

Since this second precept is violated, these authors conclude that the companies cannot afford their dividends. Their view is that circumstances are so dire that the company has been forced to take on new debt. Their view seems to be that All Debt Is Bad .

When you set things up this way, the natural conclusion is that the only way back to virtuous behavior is this: cut the dividend and stop issuing any debt.

So such authors predict that a dividend cut is on the horizon. This argument is often seen .

Creating Cash For Expansion

Let's back off from the apparent edge of this cliff and ask what companies with long-lived, hard assets need to do and not to do.

The financial markets overall implement many divisions of labor. In many cases, there are those who provide capital at some cost and those who employ it to generate earnings above that cost.

Consider an apartment building. The landlord operates the building and receives the rents as revenues.

But most landlords do not own the buildings outright. That is because lenders are available who will provide a good fraction of the value of the building in return for interest payments. By taking the opportunity posed by these lenders, the landlord can reduce the capital invested and gain a higher return on their equity.

Consider the implication. To buy another building, the landlord does not need to have the full cost available as cash. They just need enough capital to cover the rest of the cost after whatever they can get from a lender.

This is the essence of the story for the firms of interest here. They do and should operate with some Debt Ratio (meaning Debt to Gross Total Assets).

And when they buy or build a new asset they do not need all the money as cash. They just need enough to get to their target Debt Ratio.

Here is how the same set of numbers stack up for that approach.

The top section here shows the Cash from Operations, the Dividends, and the Capex needed for maintenance of the existing assets. Authors without expertise are often frustrated by this last.

Maintenance Capex is not listed on the computer-generated summaries of the SEC filings. It is nearly always disclosed somewhere, sometimes even explicitly on the version of the Statements of Cash Flows in the 10-K.

Or maybe you have to open up the 10-K and do some searching in order to find it. But it is nearly always there, or in the 8-K Supplemental.

If you do even more work and find an Investor Presentation, you will generally find a description of how the rest of the Capex is being spent. But if you have allowed only a few hours to pump out an article that may be too much for you.

It's even easier for the REITs that operate almost entirely using triple-net leases in sectors where Capex for retenanting is small. Under these leases the tenant covers all maintenance, insurance, and taxes. For such REITs, the maintenance Capex is effectively zero, as shown in the table.

Back to the main story, these firms have substantial funds left over after subtracting dividends and Capex for maintenance. This cash is retained earnings, available for reinvestment.

Now consider that some firm with a target Debt Ratio of 40% has raised some cash as retained earnings and plans to invest it. What do they do? They add debt. This is not a sin.

The Resulting New Earnings

Here is how that leverage-neutral cash gets turned into new earnings.

The numbers here are representative, and not specific to any particular firm. The ratio of Cash Costs (mainly General & Administrative and also maintenance capex on the new properties) to CfO may vary.

For Triple Net REITs it is typically less than 10%. I'm personally less clear on the numbers for midstream firms, but all the exact value does is change the exact resulting return on equity.

That return is shown in the first row shaded gold. It produces new cash earnings as shown. The row shaded green is the fractional increase in CfO.

The point here is that such firms, said to be on the path to dividend cuts by the Church of Free Cash Flow, are in fact able to grow earnings. They will be able to increase dividends as a result of this (and of other increases in previous CfO.)

Alternatives to Adding Debt

Of course, any firm investing retained earnings has the option not to add debt and to grow more slowly or not at all.

If they take on no new debt, they will deleverage via the resulting growth. A firm might choose to do this if their sector is moving toward lower leverage. We see some of this in midstreams now.

That firm also might avoid new debt if the capital markets are unfriendly or disrupted. And they should avoid those markets if the available interest rates are so high that the returns on new investment are unreasonably low.

As one example, after years of hearing how evil they are and of seeing political pressure to exclude their industry from the capital markets, Enterprise Products Partners ( EPD ) decided to move to a model that requires no capital markets access. No new stock. No new debt.

But if all the midstreams did that then we would see the transport of oil and gas develop massive dislocations within a few years. If you can't get all the production to market, you can't produce profitably. Enough new capacity is needed that retained earnings alone can't build it all fast enough.

Alternatively, a firm might use those retained earnings to buy back stock. We have been seeing this in the midstream sector, and even a bit in REITs.

At times buybacks may be the best use of capital. But it may not. One should judge that based on the specifics of the business, and not on the edicts of the Church of Free Cash Flow.

Are these alternatives without new debt safer? Yes. Do they lead to lower earnings growth? Yes.

But do they produce a big change in dividend sustainability? No.

The reason is that the new assets and new debt are generally a small percentage of the totals. CfO runs less than 10% of total assets. And the new assets are well below half of CfO.

Takeaways

Certainly bad luck or bad management can impact the earnings from any assets, new or old. This can reduce dividend growth and if severe enough can lead to dividend cuts.

Taking on modest amounts of leverage-neutral debt is not the cause of such negative events.

Don't walk away, run, when some author starts talking about Free Cash Flow in the context of REITs, midstream energy firms, or other firms dependent on cash-generating hard assets. That is a sign that they have no clue how the businesses actually work.

Some midstreams do discuss their own version of free cash flow, most often "cash flow after all capex and distributions."

Similar stories to those told above can be told even when such firms issue some stock. Issuing stock just adds to the capital raised and dilutes all earnings too.

I do not own ENB, although Enbridge seems likely to do well enough to me. They seem to be a frequent target of this nonsense. I do own TC Energy ( TRP ) and Keyera ( OTCPK:KEYUF ), about which similar tales can be told.

In the REIT space, one can spin a similar disaster story around EPR Properties ( EPR ) or Spirit Realty Capital ( SRC ), both of which I own, among many others. Spirit has an impressive minus $700M of Free Cash Flow, on $1200M of capex over $500M of CfO.

I hope you can see from the above that any growing firm of these sorts can quite reasonably have Dividends above Free Cash Flow. Along with a few other details, the Capex is what enables them to grow cash earnings.

What really matters is two things. First is whether they are operating with a business model that can reliably increase per share cash earnings. Second is how they manage their debt.

It takes real work to understand these things. Do the work and you can reap the rewards.

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