An Investment Strategy That Works - Investors Alley

May20162016Vol.Vol.11IssueIssue33MayAn Investment Strategy That WorksFellow Investor,Thank goodness that we are seeing some volatility in thestock markets. In case you didn't know, volatility is thecode word for falling stock prices. No one worries ordiscusses volatility when share prices are going up.So, you might ask, why am I excited to see falling stock prices?The results of the Automatic Income Machine over the firstfew months and since the launch have greatly exceeded myexpectations for short-term results. Lower share prices onsome of our portfolio stocks lets us know that in the shorterterm, share price can move down, no matter how great thecompany or how safe the dividend.In This IssuePhilips 66 Partners (PSXP) . 3Extra Space Storage Inc. (EXR) . . 4Two Trade Recommendations . . 5Portfolio Update . . 5Current Portfolio . 6At its core, the Automatic Income Machine focuses on findingthe companies that can grow their dividend payments byseeking out large, sustainable dividend growth rates. In this issue, I give some more details on two portfolio stockswith dividend growth forecasts of 20% and 30% over the next year. These high dividend growth rate should, andmostly likely will, pull up share prices to match the dividend increase rates. It is a purely mathematical function. If astock yields 3%, for example, and the dividend is increased by 20%, the share price must increase by the same 20%to keep the yield at 3%. The result is a 20% share price gain plus the 3% dividend for a 23% total return.However, in the shorter-term, the stock market completely ignores this mathematical truth. Share prices move upand down driven by whatever hot topic of the day CNBC reports. As I write this, the markets are down quite a lot onthe "Fear of a Global Economic Slowdown". Why that fear should affect a company involved in the U.S. mortgagemarket or factory outlet shopping centers doesn't make a lot of sense, but these "fears" drive almost all stockprices. This is the cycle of the stock market; every day, week, month, or year there is and will be a new "Fear" or"Good News".In contrast to the short-term focus of the stock market as a whole, the results from individual companies move at amuch more measured pace. It takes years to build a portfolio of shopping centers, self-storage units, or energyinfrastructure assets. As companies move through the years and decades, cash flow grows and so can dividends –with a well-managed company. The result is that when the investment focus sticks to the dividend growth rate, thelonger-term average annual returns will work out to the dividend growth rate plus the average yield. However,along the way we live through the not so pleasant feelings produced by market corrections and bear markets.So by now I hope you understand my approach, that I look at and make decisions based on individual companyfinancial results and my projections (based on management statements and guidance) of future revenue and cashflow potential. Share prices have little affect except for the resulting yield on an individual stock compared to the1

May 2016 Vol. 1 Issue 3projected dividend growth rates. This means that, in most cases, when share prices fall, I am going to recommendthat you buy more shares. Not sell them. While we all get that to make profits, you have to buy low and sell high,most of the questions I receive about lower share prices is "should I sell?". My answer is that if the company'sbusiness remains the same, lower share prices are a time to buy.The math based power of dividend growth gives us the ability to push past those fear emotions when our stocks aredown and do the right thing by buying when prices are cheap. This allows us to either sell when the price goes up,or at a minimum, supercharge the growth profile of our dividend cash flow stream.I appreciate all of the emails, both questions and general discussions. I also look forward to next week's livestrategy session that will take place on May 10th at 7:00 p.m. ET / 4:00 p.m. PT. We'll send out an email with thereservation link later this week.I will be in Las Vegas to make presentations at the Las Vegas MoneyShow, so from my end the live session will befrom the Caesars Palace Las Vegas Hotel.If you have specific questions, ideas, or concerns that you would like me to address, please email them to me attim.plaehn@investorsalley.com. I will make sure to address them and love to hear what’s on your mind.Best Regards,Tim PlaehnEditorAutomatic Income Machine2

May 2016 Vol. 1 Issue 3Philips 66 PartnersThe Growth ModelPhillips 66 Partners LP (NYSE:PSXP) is a prime exampleof one of the best uses of the master limitedpartnership (MLP) business structure. Refining companyPhillips 66 (NYSE:PSX), as the sponsor of the MLP, is in aposition to reap the maximum cash flow return benefitsfrom sustaining the high distribution growth rate at theMLP level. We, as individual investors get to go alongfor the ride. The PSXP business model is one of theinspirations for the Automatic Income Machineinvesting strategy.With the spin off, Phillips 66 Partners received only asmall portion of the total amount of infrastructureassets owned by the sponsor, Phillips 66. To generatecash flow growth to support the high rate ofdistribution growth, once or twice a year Phillips 66 sellsadditional assets to the MLP. In the jargon, these salesare referred to as drop downs. Here are the details ofthe most recent drop to illustrate how the processworks.BackgroundOn February 17th, 2016, Phillips 66 Partners announcedit reached an agreement with Phillips 66 to acquire a 25percent controlling interest in Phillips 66 Sweeny FracLLC, which owns the newly constructed SweenyFractionator One and Clemens Caverns storage facility,for total consideration of 236 million. PSXP will putanother 7 million of capital spending into the projectbringing its total cost to 243 million. The projectedEBITDA from PSXP's share of the facility is 25 million.The price vs EBITDA ratio is usually quoted in themanner that PSXP paid 9.7 times EBITDA for the assets.Phillips 66 Partners came to market with a July 2013spin off IPO. Phillips 66 transferred enoughinfrastructure assets to ensure PSXP would generateenough free cash flow to cover the partnershipagreement minimum distribution of 0.2125 per unitper quarter. As a nifty piece of forward thinking, theMLP also received all of the cash proceeds from the IPO.The business of Phillips 66 Partners is to owninfrastructure assets that support the refining andchemical production businesses of Phillips 66. To dothis, PSXP owns energy infrastructure assets such ascrude oil gathering systems, pipelines, tank storagefacilities, and loading and unloading terminals. Theseassets are leased to Phillips 66 on a fee for service basiswith minimum contracted payment amounts from longterm leases. The locked in, minimum payment leaseswith Phillips 66 ensure that Phillips 66 Partners willgenerate enough cash flow to handily cover thedistributions paid to limited partner (LP) unit owners.For the last four quarters, PSXP generated distributablecash flow (DCF) that covered the distributions paid by1.35 times. In the MLP world that is very healthy DCFcoverage.Flip the price ratio over, and you get an EBITDA cashflow rate of 10.2% on the purchase cost. PSXP pays forthe drop down with some combination of new LP unitsissued either into the market or directly to PSX andtaking on some additional debt. PSXP gets to ride on thePSX investment grade credit rating, so borrowing costsare in the low single-digits. This particular drop downwas paid for with 24 million in newly issued PSXP unitsand the assumption of 212 million in notes payable toPhillips 66. Including incentive distribution rights paid tothe general partner, the PSXP cost of equity capital is4.2% per year. Debt interest is something less than that,so in round numbers, PSXP pays a 3% cost of capital tobuy an asset that generates 10% plus in free cash flow.That 7% arbitrage is a perfect example of the powerful3

May 2016 Vol. 1 Issue 3cash flow accretive results of the MLP drop downstrategy, especially when the equity and debt costs ofcapital are low.Extra Space Storage, Inc.On May 2nd, Extra Space Storage, Inc. (NYSE:EXR)released its 2016 first quarter earnings results, and Iwant to pass along the highlights.Based on the 2016 first quarter EBITDA of 74 million(up 51% year over year), PSXP has an annual EBITDA runrate of about 300 million. The company's goal is 1billion of annual EBITDA in 2018. This goal will beobtained through additional drop downs from Phillips66 and the MLP's own organic growth projects.As the name clearly indicates, this real estateinvestment trust (REIT) owns and operates self-storagefacilities across the U.S. The company owns 249facilities and operates as the third party manager foranother 353 facilities. Extra Space uses an integratedcomputerized system to attract new customers and tomaximize occupancy and rental rates.PSX Wins and Investors WinAs the sponsor, Phillips 66 owns the general partnerinterests and what are called incentive distributionrights (IDRs). With the IDRs, each time PSXP increasesthe quarterly distribution rate, the quarterly IDRpayment to PSX increases by the same dollar amount.PSX also owns 73% of the PSXP LP units. Only about 27%of the LP units are in public investor hands. This meansthat each time PSXP increases its distribution rate,about 85% of the cash payments increase goes rightback to Phillips 66. This is a great deal for Phillips 66: itsells an asset to its controlled MLP and then receives alarge majority of the cash flow payments that assetgenerates for the MLP. This structure results in PSX asthe general partner to be very highly motivated tocontinue the growth rate of the MLP distributionpayments. As I noted earlier, we just go along for theprofitable ride.Since its August 2004 IPO, EXR has produced an averageannual return for investors of 23.3%. That return ratewould have turned 1,000 into 11,689. Over the lastdecade the dividend rate has grown by 9.4% per year,with that growth rate jumping to over 40% per year forthe last five years.Very Good First Quarter ResultsFor the first quarter, Extra Space reported these growthnumbers:Increased same-store revenue by 9.1% and same-storenet operating income by 12.3% compared to the sameperiod in 2015.Increased same-store occupancy by 70 basis points to92.8% as of March 31st, 2016.PSXP increased its quarterly distribution by 5% for thefirst quarter payment that will be paid on May 12th.Year over year, the distribution rate is up 34.7%.Management guidance is for 30% annual payout growththrough at least 2018. I expect PSXP to be an AutomaticIncome Machine holding for at least the next severalyears.Acquired 21 wholly-owned operating stores and twostores at completion of construction for a total ofapproximately 225.2 million.Acquired two stores at completion of construction withjoint venture partners for a total of approximately 34.5million.These growth numbers resulted in adjusted funds fromoperations (AFFO) of 0.86 per share for the quarter, up24.6% compared to a year earlier. The current dividendrate is 0.59 per share, or 67% of the first quarter AFFO.4