Thursday, July 31, 2008

Risk Factors Are Not Just For Show

Last weekend, the Div Guy did a solid write up of the problems over at SemGroup Energy Partners, L.P. (SGLP), the publicly traded midstream entity that lost 80% of its value when SemGroup L.P., its General Partner, lost $2.4 billion on a bad bet on oil prices. There are just a few points I want to make on the situation.

Every Initial Public Offering (IPO) prospectus contains a list of boilerplate risk factors that investors are made aware of. Here are a few excerpts from the S-1 for SGLP:

"We depend upon SemGroup, L.P. for a substantial majority of our revenues, and any reduction in these revenues would have a material adverse effect on our results of operations and our ability to make distributions to our unitholders."

"We are exposed to the credit risk of SemGroup, L.P. and any material nonperformance by SemGroup, L.P. could reduce our ability to make distributions to our unitholders."

"SemGroup, L.P. controls our general partner, which has sole responsibility for conducting our business and managing our operations. SemGroup, L.P. has conflicts of interest with us and limited fiduciary duties, which may permit it to favor its own interests to your detriment."

How does all this tie into Value Investing?

1) Don't buy what you can't understand. This may seem like the old Warren Buffett cliche, but it does make sense. I have reproduced below the "simplified organizational structure" of SGLP post IPO that was in the S-1. This organizational chart alone should give anyone pause before investing.



2) These midstream companies are sold to investors by Wall Street as safe, stable and dividend paying entities, or as SGLP put it in one of its presentations: the company has "sustainable and stable fee-based cash flows." SGLP also noted that revenues are 100% fee based, under a long term contract and indexed to the inflation rate.

Almost all other publicly traded midstream companies are structured the same way as SGLP. I once worked for a Portfolio Manager who had a very specific rule - he would never buy a stock if it had more than 15% of its revenues from one customer. It was too much risk and not enough of a margin of safety for him.

This article was written by The Stock Market Prognosticator. You may email questions or comments to me at info@brittaincapitalmanagement.com.

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