AMZA: A Compelling Monthly Income Story And Annualized Yield Topping 8% (NYSEARCA:AMZA)

Here at Value Hunters, we “hunt” for high-yield contributors to our income investment portfolio and believe we have found a gem in InfraCap MLP ETF (NYSEARCA:AMZA). Dare we write the words “high & reliable income stream” in today’s economy? Our thesis for a 2024 investment in AMZA lies with this ETF’s investment approach centered on midstream energy MPLs and their many forecasted economic and regulatory tailwinds, as well as its strong, seasoned management team.

Investment Philosophy and Management

AMZA is an actively managed ETF with a concentrated focus in the midstream energy space. The same two portfolio managers have run the ETF since its inception in 2014. Management targets a monthly income stream that is currently producing an annualized yield of over 8%, with a 30-day SEC yield topping 9%. To enhance total return the managers increase the ETF’s beta, by pursuing a modestly leveraged approach. Twenty to thirty percent of the ETF is leveraged through covered calls and other option strategies. Additionally, AMZA may opportunistically take short positions to hedge against interest rate movements or oil price changes. If added beta is a concern, remember volatility creates opportunity in the form of potential increased price appreciation. This proven active management, coupled with a solid yield, is why AMZA is worth consideration for income-seeking investors.

Note the total return performance in the chart below where we compare the performance of AMZA to the Alerian MLP ETF (AMLP), as well as the broader S&P 500 Index. Alerian’s AMLP is the behemoth of midstream ETFs and one we watch closely in our universe. In contrast to AMZA, AMLP is passively managed and seeks to replicate the performance of its proprietary benchmark, the Alerian MLP Infrastructure Index. While all of AMLP’s holdings are also holdings of AMZA, AMZA has another 13 holdings plus its use of leverage. As these 3-yr cumulative total returns indicate, AMZA has combined its active management and use of leverage to produce a 23% superior performance when compared to its biggest competitor and the broad market.

Holdings Show A Pointed Focus

AMZA’s holdings play an important role in this ETF’s outperformance. Its concentration in only 25-35 MLPs (including LPs, LLPs, and GPs), with the top 6 positions representing 85% of its holdings, is why we call this a focused ETF. Note when analyzing the holdings of AMZA, most sources cite 65ish holdings. This is due to the options strategies the management team is executing, not more companies in the portfolio. While some view this degree of concentration as risky, in the context of an overall portfolio, Value Hunters sees focused ETFs playing an important role. Each investor needs to determine if a fund’s concentration is a positive or negative for their overall objective. In the case of AMZA, it is our opinion that management has chosen quality MLPs and we like the fact they continue to monitor their choices.

Top 10 Holdings Subject to Change*

Click to enlarge

*Source AMZA Factsheet

As the graph below shows, the individual performance of a handful of components can vary and impact the performance of AMZA, driving home the importance of management’s skill. Because this is an actively managed ETF, the managers perform bottoms-up fundamental analysis, which means they are deeply involved in modeling and are in communication with the management of the individual companies. This combination of deep fundamental and technical analysis, as well as using modest leverage, has provided the ETF with superior returns over the years.

Why Midstream?

Midstream US energy operators are middlemen. They own energy infrastructure assets, including pipelines, processing plants and storage facilities for oil, natural gas, and LNG. This gives midstream operators the ability to hook up domestic exploration with both local and global demand. Their assets are long-lived and considered “toll-like” with contracts of 1-25 years in length that have built-in inflation and other cost-related adjustments. Hence, AMZA is able to generate substantial free cash flow not dependent on commodity pricing, which can take investors and exploration companies along for a ride with their frequent wild price swings.

Catalysts Supporting AMZA Growth & Stability

We caution investors to not underestimate the potential rewards we expect the 2022 Inflation Reduction Act (IRA) to offer the energy and utility industries. Additionally, the expected explosion in LNG projects forecast by the International Energy Agency (IEA) will be another catalyst.

As the world marches towards green and renewable energy, the 2022 IRA provides generous tax incentives for utility and midstream operators to build-out the US infrastructure to support electrification. Because our electric capacity is woefully inadequate for future energy needs, the build-out, repurpose and rebuilding of our energy infrastructure is supported by the IRA. This is a multi-decade proposition that will need to piggyback on the existing infrastructure while new capacity is being built. This puts utilities and midstream operators in a sweet spot for enhanced earnings and growth as the tax incentives offered at the federal level should offset the new costs and not just be passed through to customers.

Keep in mind not only is the US in need of energy capacity, but so is Europe. In fact, the European Union has reclassified natural gas and nuclear energy as renewable green energy sources. The Ukraine-Russian conflict has exacerbated the EU’s shortage of energy with its slashed Russian natural gas imports. Norway and the US have increased production, particularly in the LNG arena, to try to make up the difference.

The Role of Liquified Natural Gas (LNG)

AMZA’s holdings of MLPs help process, store, and facilitate the export of US LNG. The IEA reported in its 2022 World Energy Outlook that natural gas constituted 23% of the world energy consumption and in their 2023 IEA Outlook, the Agency projected LNG projects will have increased by a whopping 45% in 2025. These LNG projects hold a pivotal role in the transformation to worldwide clean and renewable energy and AMZA’s MLPs will likely benefit.

We do recognize the political risks associated with natural gas. Despite the rapid growth of LNG, the Biden Administration announced a pause on US LNG exports to non-FTA countries just yesterday due to climate concerns (FTA stands for Fair-Trade Agreements). The “pause” will allow the Department of Energy to evaluate the impact of LNG on the climate by creating new assessment criteria. However, the pause is not absolute in that exceptions would be made for unanticipated and immediate national security reasons, including allowing LNG exports to continue to Europe to reduce their reliance on Russian natural gas. This has created some confusion for companies in the space, as well as their capital markets. We expect this will be a multi-month-long process to sort out the implications of this “pause”.

2024 Forecasted Interest Rates Support AMZA

With inflation moderating, many economists are expecting a continued hiatus of Fed interest rate hikes and many believe rate cuts will be part of the Fed policy in 2024. This could allow price appreciation in the sector as the cost of capital potentially lessens in this capital-intensive industry. We believe total return (price appreciation + distribution) will remain high and stable in 2024. There is, however, always a risk that unforeseen macro events could change our interest rate outlook.

MLPs Advantages inside an ETF Wrapper

The unique tax structure of MLPs allow investors to earn distributions (the equivalent of dividends in a stock) without double taxation. MLPs are a pass-through business not subject to corporate taxation. The government gets it due when the unit holder sells his/her units and then pays taxes; unlike corporations that pay income tax and then distribute dividends which are taxed again at the shareholder level. The MLP structure can create nightmares for investors at tax time due to the complexities of K-1 reporting. However, the ETF wrapper around individual MLPs helps an investor avoid the potential K-1 reporting headache: MLPs still pass through distributions when in an ETF; however, these distributions are reported on a simple 1099 generated by the ETF, not through a K-1.

Attractive Valuation

As an experienced equity analyst, one metric often used to ascertain the value of a stock is the near-term (next 12 to 18 months) forecasted P/E ratio relative to its historic P/E and its peers. Our proprietary database calculates an ETF’s P/E ratio by considering each holding’s percentage of the portfolio, along with its corresponding P/E, to determine a weighted average P/E for the overall fund. In AMZA’s case, the weighted-average of the individual MLPs held in the fund have a forecasted near-term P/E ratio of 11.1. Comparatively, competitor AMLP’s forecasted weighted-average is 11.7. However, juxtaposing these two fund’s on the basis of their 12-month trailing P/E’s paints a different picture. Alerian’s ETF TTM P/E of 13.2 versus AMZA’s 12.3 suggests AMZA’s is trading at a 16% discount relative to AMLP’s 5% discount, when comparing forecasted P/Es with their past 12 month ratios. In turn, AMZA could be attractively positioned for multiple expansion and price appreciation in 2024. As a value and dividend investor, the focus remains on total return through price appreciation and distribution yield; AMZA could fit that goal in 2024.

Potential investors should draw their attention to the hefty expense ratios both AMZA (1.64%) and AMLP (0.85%) charge. While a higher expense ratio is expected with an actively managed ETF like AMZA, even AMLP’s expense ratio is relatively high for the sector. The median expense ratio is 0.49% according to Seeking Alpha’s metrics and rates AMZA’s Expense Grade an F, with ALMP only slightly better at D-. Large expense fees can weigh on total performance.

Risks To Our Investment Thesis

AMZA is highly concentrated with 85% of its portfolio in only 6 MLPs. Should any one MLP have a corporate hiccup or worse, the ETF’s overall performance could be negatively impacted.

This is a modestly leveraged ETF (20-30% of the portfolio represented by 65ish option positions) which increases its beta, creating more volatility and more risk. Additionally, management primarily employs a covered call strategy which allows them to collect option premiums to support distributions. However, this strategy can impose a temporary ceiling on price appreciation. Should management choose the wrong option strategies resulting in the market moving against them, performance could suffer.

AMZA is a relatively small ETF with only $348 million AUM. As such, its daily trading volume is only 40,000 shares a day, 9.5% lower than the median of all ETFs. Seeking Alpha rates AMZA’s liquidity at a C+ with only $1.4 million average daily dollar volume trades. This is 0.4% of its AUM. A larger daily trading volume could support potential large drawdowns with lower price volatility.

As noted earlier, with a stroke of a pen, LNG processing and transportation, an important forward-looking catalyst to our investment thesis, can be put on an indefinite pause in the US. This can potentially happen in other countries as well, reducing the demand for LNG overall.

AMZA: Wrapping it Up

Income investors can potentially count on high-quality elevated monthly distributions from AMZA and eventually achieve potential price appreciation, as well. We rate AMZA a cautionary Buy with its seasoned management team and investment philosophy. The nature of MLP’s long-lived assets with their protected “toll-like” earnings and solid distributions that build in a modicum of inflation protection make for an appealing investment. There is extraordinary potential for distribution growth for decades through the IRA tax incentives and the predicted LNG project explosion as the world marches toward green and renewable energy alternatives. As noted, the definition of natural gas being “green” or “renewable” has diverging meanings in the US and Europe, which creates a political risk to the LNG piece of AMZA’s companies. However, with the possibility of stable to lower interest rates in 2024, price appreciation could be outsized this year. While no investment is guaranteed and past performance is not indicative of future performance, we cautiously lay our bets on AMZA this year.