#$amlp

We expect another distribution cut from Energy Transfer in the not-too-distant future. Its traditional free cash flow generation is still too meager to cover its now-reduced distribution level, and the energy markets are simply not cooperating. The energy sector has been among the worst-performing equity sectors for some time now, and investor appetite for new equity and debt issuance is waning as return expectations are ratcheted down in a troubled energy resource environment. We expect more pain to come for Energy Transfer’s stock. Our fair value estimate stands at $4 per share.

By Brian Nelson, CFA

On October 26, Energy Transfer (ET) put an axe to its distribution, cutting the payout in half to $0.1525/unit on a quarterly basis, or $0.61 on an annualized basis. We have been pounding the table on the hazards of the MLP business model for years, especially on the unsustainability of their payouts. [The riskiness of the MLP business is yet another theme covered in Value Trap.] Shares of Energy Transfer are now yielding 10.5% on a forward basis, but we are still not biting.

Energy Transfer is a massively-leveraged company that can’t cover its distributions with traditional free cash flow, as measured by cash flow from operations less all capital expenditures. In the company’s last quarterly filing from August, the firm showed a consolidated cash balance of $155 million against a consolidated long-term debt load of $51.3 billion. Through the first six months of 2020, Energy Transfer generated just $243 million in traditional free cash flow. Meanwhile, it paid out $2.44 billion in distributions over this time period.

Energy Transfer’s distribution cut does little to improve its free cash flow generation or mitigate its large debt load, as even after the cut, the company is still paying out substantially more in distributions than it generates in traditional free cash flow. The distribution cut may slow the hemorrhaging of cash a bit, but the reality is that we expect most pipeline entities to eventually set distribution policies whereupon distributions are paid out of traditional free cash flow, and that means another cut from Energy Transfer is coming.

One example of a company largely changing its dividend policy in substance to be more self-sustaining is Kinder Morgan (KMI). Though Kinder Morgan still holds a large net debt position (something we’re not at all fans of), the pipeline giant generated $1.93 billion in free cash flow during the first nine months of 2020, while it paid out $1.76 billion in dividends, good enough for sufficient traditional free cash flow coverage of the dividend.

On a side note, Kinder Morgan’s 8.5% dividend yield isn’t too bad on a risk-reward basis, but it will likely continue to be held back by its very large net debt load and large upstream division (pumping CO2 into the ground to extract oil from old fields in the US), which are two things that we just don’t like as COVID-19 continues to spread.

On the other hand, Energy Transfer’s meager traditional free cash flow generation (roughly $500 million on an annualized basis) suggests a distribution cut to $0.045/unit, or about $0.18/unit on an annualized basis is more appropriate (assuming 2.695 billion common units outstanding). This new rate would imply a distribution yield of about 3.1%, something more representative of its continuing operations (and something to build on), but it is also one that would not necessarily facilitate debt repayment, given the lofty payout of traditional free cash flow it implies.

As one can imagine given the company's terrible financials, we continue to expect Energy Transfer’s shares to sell off, and we maintain our view that the company is using the equity markets to keep its now-reduced distribution at unsustainably high levels (“Subsidiary units issued for cash” on the cash flow statement). We’re also maintaining our view that we are not huge fans of the pipeline MLP business model; when it comes to the high yield dividend investing space, however, while treacherous, it is difficult to avoid when attempting to capture elevated dividend yields.

With that clearly stated, one of the names we include in the simulated High Yield Dividend Newsletter portfolio is Enterprise Products Partners (EPD). We love the company’s transparency in showing ‘FCF’ right next to ‘DCF’ in its press releases. In Enterprise Products Partners’ second-quarter report, released July 29, in the three months ending June 2020, one can see how different a measure of traditional free cash flow (FCF), or $305 million, is to the industry’s measure of distributable cash flow (DCF), or $1.58 billion, the latter a misnomer and not to be confused with discounted cash flow as used in the discounted cash flow model.

All told, we expect another distribution cut from Energy Transfer in the not-too-distant future. Its traditional free cash flow generation is still too meager to cover its now-reduced distribution level, and the energy markets are simply not cooperating. The energy sector has been among the worst-performing equity sectors for some time now, and investor appetite for new equity and debt issuance is waning as return expectations are ratcheted down in a troubled energy resource environment. We expect more pain to come for Energy Transfer’s stock. Our fair value estimate stands at $4 per share.

If you are interested in high yield investing, give Valuentum’s High Yield Dividend Newsletter a try. See more info here.

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Here are some of the most noteworthy new highs and lows across the markets for Friday, November 15, 2019.

Alphabet $GOOGL Back Hitting All-Time Highs

Vanguard Total Stock Market ETF $VTI Hitting All-Time Highs

Health Care SPDR $XLV Hitting New All-Time High

Direxion 3X Financial Bull ETF $FAS Hitting New All-Time Highs

Alerian MLP ETF $AMLP Drops To All-Time Low

Tilray $TLRY Hits All-Time Low

If you’d like to see these charts as they come out in real-time, follow us on Twitter and StockTwits. And if you’re interested in the daily “all-access” version of all our charts and research, please check out our site, The Lyons Share. You can follow our investment process and posture every day — including insights into what we’re looking to buy and sell and when. Thanks for reading!

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We continue to believe that the MLP business model may be a goner, and the recent ETE-ETP rollup is the latest example. Though new capital may come into the space on expectations that there will be premiums in unit-for-unit rollup deals, most of the combinations are coming with implied distribution cuts.

By Brian Nelson, CFA

On August 1, Energy Transfer Equity (ETE) announced that it would roll up Energy Transfer Partners (ETP) in a unit-for-unit merger exchange. Energy Transfer Equity’s incentive distribution rights (IDRs) in Energy Transfer Partners will be eliminated, and the deal is scheduled to close in the fourth quarter of 2018. Energy Transfer Partners unitholders will receive 1.28 common units of Energy Transfer Equity for each common unit of Energy Transfer Partners owned. The deal is another in a long line of MLP rollups that serve to simplify business structures and work to regain confidence in the public following the massive fallout in midstream equity prices in late 2015, “Master Limited Partnership Simplifications on the Rise.”

We continue to believe that the days of the MLP business structure are numbered, “Nearly 60 Distribution Cuts Later, We Maintain Our View on the Hazards of the MLP Business Model.” Though we generally like the durable competitive advantages of the toll-road nature of midstream energy infrastructure (large percentage of the business is fee-based margin with minimum volume commitments), the financial models that MLPs are operating under generates far too risk for the shareholder and unitholder, particularly as it relates to capital-market dependence to support the distribution. Our view is that the MLP business model was primarily used as a source of external financing prior to the massive fallout during late 2015, and equity could be raised by the subsidiary at lofty equity prices as investors had been bidding MLP prices up on yield-based valuations.

With the self-perpetuating bubble now popped, investors have wised up to the MLP model, and management teams are choosing simplification maneuvers. Quite simply, it matters none to have a complicated organizational scheme if yield-based valuations could not be had on the subsidiary level. The market has now migrated closer to enterprise-based valuation considerations, so a convoluted partnership arrangement does little to benefit the parties involved. Ironically, however, as the MLP business model approaches obsolescence, the idea that there could be premiums offered during rollup plans may bring new capital to the equities. Here’s what we wrote in "FERC Clarifies MLP Tax Changes:"

In some ways, expectations for consolidations and more rollups are fueling buying activity across the group, as investors are hoping for premium pricing within consolidation scenarios. Ironically, it is the idea that the MLP model may not survive that is driving the recent excitement in the group, as speculators seek to embed buyout premiums.

The Energy Transfer Equity-Energy Transfer Partners deal is one such example. The unit-for-unit merger exchange between the two entities had offered an 11% premium to the pre-deal Energy Transfer Partnership common unit trading price (and a 15% premium to the 10-day VWAP). The advance in the Alerian MLP ETF (AMLP) from near-$9 per-share levels in March 2018 to over $11 per share today has, in our view, been largely driven by expectations that rollups will continue within the MLP space and that premiums will be offered to do so, even if they are non-cash-based. What was once unthinkable when we rolled out our thesis that the MLP model may not survive in late 2015, “Why the MLP Business Model May Be a Goner, Barron’s (September 2015)” has now become almost baseline expectations for many observers in the industry.

In the case of the ETE-ETP tie-up, the executive team expects to maintain the ETE distribution per unit, but we note that such a distribution remains a function of the availability of outside capital from the debt and equity markets. Management noted that the combined entity expects to fund the majority of growth capital spending with retained cash flow, but while this may sound great on the surface, it also implies that the combined entity still cannot fund both the distribution and maintenance/growth capital spending with operating cash flow. This is unlike Kinder Morgan (KMI), which following its simplification and dividend cut, is now managing its business in a more prudent manner, where operating cash flow is covering both distributions and all capital spending (both growth and maintenance), “Kinder Morgan Back on Track But We’re Watching Financial Statements Closely.”

By comparison, through the first six months of 2018, Energy Transfer Equity’s operating cash flow was $3.2 billion, while capital expenditures and distributions to partners and non-controlling interests were ~$5.9 billion combined, hardly sufficient coverage of all capital spending and the distribution with operating cash flow. The same story was true with Energy Transfer Partners during the first half of 2018, where operating cash flow (~$3 billion) was dwarfed by combined capital expenditure and distribution obligations (~$5.8 billion). We’ll have to see the regulatory filings post-combination to calculate the degree of capital market dependence, but from where we stand, the combined entity will still require new debt and equity to sustain run-rate distributions and expected capital spending.

Furthermore, in many of the MLP rollups, there have been implied distribution cuts in the combined entity, and this looks to be the case at ETE-ETP. By scooping up Energy Transfer Partners units, it swaps a $2.26 per unit distribution obligation for a $1.22 dividend obligation at Energy Transfer Equity, while Energy Transfer Partners’ unitholders only receive 28% more units. By our back-of-the-envelope math, that means the dividend/distribution equivalent of the swap for Energy Transfer Partners unitholders is a reduction from the $2.26 distribution to a $1.56 dividend ($1.22 x 1.28). On a yield-equivalent basis, as of data August 17, the implied yield following the transaction for Energy Transfer Partners unitholders is 8.7% (1.56/17.92) -- the exchange-ratio-based dividend of Energy Transfer Partners in new Energy Transfer Equity dividends divided by Energy Transfer Equity’s share price -- versus the current implied yield of 9.86% Energy Transfer Partners.

All things considered, we applaud these simplification transactions as it provides investors with better transparency and allows them to evaluate such structures on an apples-to-apples basis as a corporate, despite continued publishing of industry-specific measures such as distributable cash flow, which we have long criticized, “MLP Speak: A Critique of Distributable Cash Flow.” The idea that there would be so many distribution cuts and so many consolidations following our thesis on MLPs in late 2015 may have been hard to believe by many an investor. With each explicit or implicit distribution cut and each newly-announced MLP rollup, it seems today that our original thesis on the MLP space is only gaining greater acceptance within the investment community rather than greater controversy. This is good news.

Pipelines - Oil & Gas: BPL, BWP, DCP, ENB, EPD, ETP, GMLP, HEP, KMI, MMP, NS, PAA, SEP, WES

Related: AMZA

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With the announcement of three separate master limited partnership simplification transactions on May 17 alone, we must revisit our thesis that the business structure may not be in it for the long haul.

By Kris Rosemann

At Valuentum, we continue to believe the master limited partnership (MLP) business model is at risk over the long haul, and recent news from the space only seems to support the notion that the MLP model we once knew may be fading more quickly than some had expected. If there is nothing inherently wrong with the structure of MLPs, then the rate at which simplification transactions are occurring would certainly be an alarming development, but we continue to point to factors such as the need for robust levels of outside capital financing for growth and an industry-wide preference for selective cash flow measures that do not properly account for capital needed for growth but prop up lofty yields and distribution-based valuation as key causes for concern.

The detachment of fundamentals and analysis in the space may finally be coming to an end, but the acceleration of simplification transactions, which we had originally highlighted as a long-term concern, is due in part to the FERC ruling that MLPs are no longer allowed to receive credit for income taxes they do not pay. Nevertheless, the core of our thesis is based on the idea that MLPs should not be treated, valued, or analyzed differently than typical corporates, which is supported by the FERC’s ruling to eliminate the MLP tax allowance, in our opinion.

Three different simplification transactions were announced May 17, which we will address later in this note, but they are only a fraction of the restructuring activity we have seen thus far in 2018. Let’s take a quick look at some of those deals.

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Terra Nitrogen was swallowed by its general partner, Terra Nitrogen GP, which is a subsidiary of CF Industries (CF).

Legacy Reserves (LGCY) announced that it is working to transition to a C-Corp with the goals of attaining a less complicated balance sheet and enhanced ability to raise capital.

NuStar (NS) announced its merger plans with general partner NuStar GP Holdings (NSH), along with the elimination of its incentive distribution rights and a cut in its quarterly distribution.

Tallgrass Energy Partners (TEP) will be acquired by its general partner Tallgrass Energy GP (TEGP) and eliminated its incentive distribution rights, which is aimed at reducing its cost of capital.

Archrock (AROC) will acquire the remaining units it does not already own in Archrock Partners LP (APLP) in a deal designed to increase dividend coverage, improve its credit profile, simplify its capital structure, and lower its cost of capital.

Alliance Resource Partners (ARLP) and Alliance Holdings GP (AHGP) announced a series of simplification transactions intended to simplify the organization’s structure and increase investor transparency while attracting a broader investor base.

EQT Midstream Partners (EQM), EQT GP Holdings (EQGP), and Rice Midstream Partners LP (RMP) announced a midstream streamlining transaction that includes the purchase of Rice Midstream’s incentive distribution rights by EQT GP Holdings and efficiency gains that should offset the need for a not immaterial amount of incremental capital.

Though no official announcement has been made, Boardwalk Pipeline Partners (BWP) CEO Stanley Horton has suggested general partner Loews (L) may take the MLP private.

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We are not here to dissect the strategic rationale of these transactions.

We continue to be of the opinion that the majority of the businesses underlying master limited partnerships are sound and core to our economy (US energy production is strong and organic growth projects are prevalent), but their complex organization structures and industry-specific manner of operating and valuation are not sustainable over the long haul, in our view. The proliferation of simplification transactions across the MLP space seems to support this notion as organizations continue to work to reduce their cost of capital, a factor that is extremely important to entities that are dependent on outside funding.

With that in mind, let’s dig in to the three freshest simplification announcements. A little more than a year after the Williams family’s double equity raise and distribution cut, “MLPs: Williams’ Double Equity Raise,” general partner Williams Companies (WMB) has agreed to acquire the remaining units of Williams Partners (WPZ) it does not already own, which is ~26% of the limited partner, for a premium of just over 6% of Williams Partners’ May 16 close price.

Williams Companies will issue 382.5 million shares in the proposed transaction, and Williams Partners unithodlers will receive 1.494 shares of the general partner for each unit owned, assuming the deal closes before Williams Companies’ third quarter dividend record date. If the transaction closes as scheduled, Williams Partners' unithodlers will receive five payouts in calendar 2018, which management estimates equates to a ~15% increase over its previously expected distributions in the year. The 2018 payout projection was near the top of a list of highlights for Williams Partners unitholders provided by management, but the team made no effort in explaining what the dividend will look like in 2019 and beyond compared to the limited partner’s current distribution.

Williams Companies’ current annualized dividend of $1.36 per share implies an annual payout of ~$2.03 for Williams Partners unitholders after considering the exchange ratio (1.494 x 1.36). It appears as though there will be a meaningful reset of the payout for the MLP’s unitholders following the unique case of 2018. A 15% increase (management expects 10%-15% annual dividend growth in 2019 after the ~13% increase in 2018) from $1.36 reveals an annualized dividend of ~$1.56 per share for 2019. Assuming the proposed transaction closes as scheduled, this implies a payout of ~$2.34 per share for Williams Partners' unitholders in 2019, which compares unfavorably to its current distribution of $2.46 per unit.

Enbridge (ENB), the largest energy infrastructure company in North America, announced that it will acquire all of the outstanding equity securities of Spectra Energy Partners (SEP), Enbridge Energy Partners (EEP), Enbridge Energy Management (EEQ) and Enbridge Income Fund Holdings (TSX: ENF). Enbridge announced in December 2017 that it was assessing a potential streamlining and simplification of its organizational structure, and management points to the recent reversal in FERC policy as a cause of its decision as the ruling would weakened Enbridge Energy Partners’ and Enbridge Energy Management’s credit profiles and viability as financing vehicles for Enbridge’s growth. Direct ownership in Enbridge and an enhanced dividend growth profile were also offered as key rationales for the simplification from the point of view of the to-be-acquired entities.

Enbridge also notes that in order for Enbridge Energy Partners to retain its investment grade credit ratings, the MLP would have to raise a significant amount of equity at an unattractive cost of capital and materially cut its distribution in early 2019, which would come on top of its previous distribution cut in 2017. However, the announced simplification transaction includes an implied dividend cut for unitholders. Enbridge Energy Partners will receive 0.3083 share of Enbridge for each unit owned, and the two entities’ most recent quarterly payouts were $0.35 (EEP) and $0.671 (ENB). The exchange ratio implies a reset of its quarterly payout to ~$0.21 (0.3083 x 0.671), which is not immaterial even if dividend growth prospects are enhanced as a result of the transaction.

The third simplification transaction announced May 17 comes from Cheniere Energy (LNG) and Cheniere Energy Partners (CQH). Cheniere Energy is offering 0.45 of its share per share of Cheniere Energy Partners in a tax-free exchange. The proposal offered no guidance regarding future dividend payments, but Cheniere Energy does not currently pay a dividend. Shares of Cheniere Energy Partners currently yield more than 7%. Cheniere Energy already owns ~92% of Cheniere Energy Partners.

Recent actions taken by master limited partnerships only seem to reaffirm our thesis that the complex business structure is not sustainable over the long haul. The need for access to outside capital may never totally go away, but if the typical structure of MLPs is an attractive one, then why must so many simplification transactions be pursued?

This will not be the end of the simplification movement either, and while some who prefer to champion the business model over objective analysis may point to smaller operators simplifying as not representative of the attractiveness of the structure, Williams and Enbridge will not be the last of the high-profile names to consolidate. For example, the Energy Transfer (ETE, ETP) family is evaluating its organizational structure and points to late 2019 as a potential timeline for an internal restructuring transaction.

Valuentum members should not be surprised by any of the recent developments in the MLP space, and the recent regulatory change (FERC ruling) has only accelerated what we had originally pointed to as a long-term concern.

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, HEP, KMI, MMP, NS, OKS, PAA, SE, SEP, WES

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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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The High Yield Dividend Newsletter, Best Ideas Newsletter, Dividend Growth Newsletter, Nelson Exclusive publication, and any reports and content found on this website are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of its newsletters, reports, commentary, or publications and accepts no liability for how readers may choose to utilize the content. Valuentum is not a money manager, is not a registered investment advisor, and does not offer brokerage or investment banking services. The sources of the data used on this website and reports are believed by Valuentum to be reliable, but the data’s accuracy, completeness or interpretation cannot be guaranteed. Valuentum, its employees, independent contractors and affiliates may have long, short or derivative positions in the securities mentioned on this website. The High Yield Dividend Newsletter portfolio, Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Performance, including that in the Nelson Exclusive publication, is hypothetical and does not represent actual trading. Actual results may differ from simulated information, results, or performance being presented. For more information about Valuentum and the products and services it offers, please contact us at [email protected]

Image Source: Brian Cantoni

Valuentum has been highlighting the inherent risks associated with the master limited partnership (MLP) structure for some time now, but we are not alone in acknowledging the limited sustainability of such structures. Internal simplification transactions may only become more common moving forward as management teams seek to optimize the structure of their entities. Readers should continue to cast a skeptical eye on this business model.

By Kris Rosemann and Brian Nelson, CFA

Quite possibly, Valuentum made the “call of the century” when it outlined its warning on MLPs in June 2015, embedded in its Kinder Morgan (KMI) “call,” and more explicitly in September 2015, “Why the MLP Business Model May Be a Goner.” There was a rebuttal to our take “MLPs for the Long Run,” that tried to poke holes in our independent, authentic thesis. At the time, we were very surprised, but we appreciate varying opinions on the matter, as that’s what makes a market. When debate and discussion happen, investors win!

Let’s fast-forward to today. The firm that had issued a rebuttal to our opinion in 2015 noted that, “in fact, more MLPs cut distributions (21) in 2015 than in any other year in the sector’s history (March 2016).” Further that same firm noted in a subsequent October 2017 piece that “companies in the Alerian MLP Index have reduced distributions 56 times, including 45 explicit cuts and 11 stealth cuts over the last 3 years.” The very crux of our thesis in mid-2015 had been that MLPs were being “incorrectly” valued on the basis of a distribution yield. Here’s what the firm that had rebutted our thesis in 2015 is now saying, from that same 2017 piece:

Investors in the U.S. midstream energy sector should be aware of the number and level of dividend cuts announced by MLPs and understand that distribution yield may not be as effective a valuation metric as it once was (source).

Certainly, it has been a wild ride for investors in MLPs during the past few years, and we think our “warning” on the space in mid-2015 saved throngs of investors from multiple income disappointments. There have been dozens of instances of companies “cutting” their distributions in the Alerian MLP index since our call in mid-2015, and I don’t think we could have done a better job getting out there, helping investors get ahead of what we thought was to come. Our assessment that MLPs were being “valued” incorrectly on a structural basis, a collapsing crude oil price environment at the time, and tightening credit market conditions with deteriorating credit quality in the customer base were but three of many colliding criteria that led to our major concerns.  

Today, we maintain our view that the sustainability of the MLP structure (AMLP) may be in jeopardy over the long haul, as in our view, the primary reason why we think the MLP model had existed in the first place--to capture a “yield valuation” mispricing in the market to raise funds--has effectively gone away. It had been our contention that prior to the collapse of the MLP space in mid-2015, MLPs acted as a vehicle to take advantage of favorable capital-funding conditions, where MLPs would sport prices and issue equity on the basis of market “yield valuation” approaches. The issuer could float (create) an MLP and the market would end up pricing MLP units on the basis of their “yield,” instead of on organically generated free cash flows, which include growth capital spending. Since most MLP distributions approximate an MLP’s measure of distributable cash flow, the energy complex effectively had been using the MLP business model to raise external capital within the corporate umbrella at a lofty price on the basis of the market’s “yield valuation,” instead of on the basis of internally-generated free cash flow.

A systematic mispricing had occurred in an environment of ultra-low interest rates during 2015, and when the energy complex faced a massive threat given the collapse in crude oil prices, many owners of midstream MLPs realized that midstream equities were not immune to the troubles of their customers, as even fixed and seemingly iron-clad contracts could be broken during the chapter 11 process. Even some of the stronger oil and gas producers, for example, were facing tough times, and even while many midstream MLPs had a small percentage of direct exposure to energy prices, through their customers, the exposure was quite large. Unless the market goes back to valuing MLPs on the basis of “yield,” we doubt the MLP business model will catch much favor again, and we continue to expect it will not last over the long haul.

For starters, many MLPs do not generate sufficiently positive free cash flow, as measured by cash flow from operations less all capital expenditures (both maintenance and growth) in any given year, but most continue to pay lofty and growing distributions to unitholders, with “safety” represented by the industry-specific coverage measures using distributable cash flow, which ignores the growth capital spending that helps to drive net income, the core component of distributable cash flow. When it comes to the concept of distributable cash flow, there remains an imbalance, see: “MLP Speak: A Critique of Distributable Cash Flow.” We think the market may have wised up on how to “value” MLPs, and we continue to see instances where MLPs are being consolidated or folded up.

In July 2016, for example, Plains All American (PAA) represented one of many instances, as the limited partner issued new common units in exchange for the incentive distribution rights of its general partner, “Plains All American to Undergo Simplification Transaction.” The simplification also resulted in a reset of the distribution, which was necessary for the limited partner to arrive at more optimal levels for its cost of capital and distribution coverage moving forward.

The Energy Transfer family (ETE/ETP) announced a simplification transaction in late 2016, too, that resulted in an implicit distribution cut and consolidation of its ownership structure, but its IDRs were maintained. At the time we said, “We view this simplification transaction as a short term alleviation of what will eventually turn out to be long-term pressures.” Energy Transfer management appears to agree with our opinion that additional measures will need to be taken to secure the long-term health of its businesses as it has noted multiple times in recent presentations to investors that it “Will evaluate optimal structure for the family, but do not expect any internal restructuring transaction to occur before late 2019.”

In early 2017, Williams Cos (WMB) underwent a simplification that resulted in the general partner (Williams Cos) waiving its IDRs in limited partner Williams Partners (WPZ) and exchanging its general partner economic interest for new issued common units of the limited partner as it sought to lower it cost of equity capital, “MLPs: Williams’ Double Equity Raise.” However, the issuance of new equity from Williams Partners resulted in the need for a reduction in its quarterly distribution. Even with the elimination of IDRs, many MLPs find it necessary to reset their distributions to achieve the stated goals of the simplifications.

More recently, shareholders in beleaguered master limited partnership StoneMor (STON) have begun to push for the entity to reconsider its structure as an MLP and convert into a C Corp. The movement officially began with Axar Capital Management, which owns a 17.5% stake in StoneMor. According to a recent SEC filing dated March 9, (The Reporting Persons refers to Axar) “The Reporting Persons believe that the recent reductions of corporate tax rates effective for 2018 make the conversion of the Issuer into a C corporation more attractive than under prior tax rates. The Reporting Persons also believe that a conversion of the Issuer into a Subchapter C corporation, together with addressing the Issuer's incentive distribution rights, would result in a more liquid market for the Issuer's equity securities, improving the Issuer's opportunities for capital raising, senior management recruitment and other strategic transactions.”

While this may only be the latest example of the MLP business model fading away, it is yet another data point on the continuance of the “investor-led” push against the hazards of the MLP business model, further explained in July 2016, “Distributing Truth on MLPs.” Regardless, we expect the typical MLP structure to come under increasing levels of scrutiny, particularly as ongoing income disappointments for retail investors continue to pile up. We maintain our view that the long-term sustainability of many distribution growth trajectories within the space should be met with increasing levels of skepticism, and we are reiterating our opinion that the MLP business model may not survive over the long haul as "yield-valuation" pricing effectively goes away.

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Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.

Kris Rosemann and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. Valuentum is not a money manager, broker, or financial advisor. Valuentum is a publisher of financial information. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

There is not much love going around for the MLP sector these days. So far in 2017, the Alerian MLP Index (AMJ) has underperformed the S&P 500 by a whopping 27%. There are several potential reasons for the move:

* Large MLPs are projected to slow distribution growth in the coming years to focus on capital expenditures.

* The rise in crude oil is deemed to be fleeting and some are calling for peak shale production.

* Investors are focused on tax-loss selling as 2017 comes to a close.

Regardless of the reason for the drop in prices, the sector has become cheap relative to some standard benchmarks. Many analysts compare the yield of MLPs to the average yield in the junk bond market. The correlation is quite strong through the credit cycle as MLPs need to continually tap the market for new debt to fund expansion. As debt costs rise, growth prospects diminish. Also, many investors look to the MLP market for yield, so the sector is often compared to corporate bonds as an income alternative.

On this measure, the MLP sector is inexpensive. The Alerian MLP Infrastructure Index now yields 2.3% more than the Barclays High Yield Index- the most in the last 10 years.

MLPs were caught in the energy sector downdraft in 2015 as the price of oil plummeted and yields on energy-related issuers widened. However, the leverage in the sector has since declined and so have debt spreads. For example, the spread to US Treasuries on 10-year Kinder Morgan debt is now 114 bp, down from almost 500 bp at the end of 2015.

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Let’s talk about a controversial metric that is used in master limited partnership (MLP) reporting. Just how useful is it, and should it be allowed?

To subscribe to Valuentum’s investment research services, please read more about it here.

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--> Handout 1: Pitfalls of Distribution Yield Analysis (pdf)

--> Handout 2: Linking P/DCF to Enterprise Free Cash Flow Valuation (pdf)

By Brian Nelson, CFA

It’s been a few years since the fallout in the prices of most master limited partnerships (AMLP), but to me, it still feels like yesterday. We continue to have many concerns about the longevity of the business models of MLPs, and we maintain our view that the operating structure will be challenged over the long haul.

New equity and debt funding (issuance) continues to, in part, fuel the distributions of most MLPs, and we think it is fair to call most MLP distributions financially engineered. As in almost all MLP cases, traditional free cash flow, as measured by cash flow from operations less all capital expenditures, is less than cash distributions paid, and most MLPs “use” the financing section of the cash flow statement to make up for the shortfall--in essence, issuing new equity or new debt. Hence, most distributions are, in part, financially engineered.

The poster child we often use to explain this unique circumstance is Energy Transfer Equity (ETE). Looking at its GAAP financial statements for the six months ended June 30, 2015, for example, the entity generated $1.1 billion in cash flow from operations, but distributed north of $1.6 billion in cash to noncontrolling interests and partners. Meanwhile, capital spending during the half-year was $4.2 billion.

Traditional free cash flow generation was -$3.1 billion (negative $3.1 billion) during that 6-month period, and after accounting for the $1.6 billion shelled out as cash distributions, the cash burn came to -$4.7 billion (negative $4.7 billion). The shortfall was financed by issuing net new debt of $4.1 billion ($15.4 billion in proceeds from borrowings less $11.3 billion in repayments of long-term debt), as well as another $1.8 billion in subsidiary equity offerings.

Has anything really changed since then? Not really. During the three months ended March 31, 2017, for example, traditional free cash flow at Energy Transfer Equity was still decidedly negative, and net cash provided by operating activities ($893 million) fell short of distributions to noncontrolling interests ($752 million) and partners ($251 million), or ~$1 billion. Interestingly, again, the shortfall is made up from ~$800 million in net new borrowings and even more new funds from units issued for cash. New debt and new equity used to pay existing shareholders? That’s how some see it.

The problem for the common investor is that he or she is being provided a different metric for MLPs than what is in the GAAP financial statements, and it is often lightyears apart in substance. Looking at the press release accompanying second-quarter 2015 earnings, for example, Energy Transfer Equity raised its quarterly cash distribution by 39% on a year-over-year basis that July 2015, as the company noted that its distribution coverage ratio was 1.2 times during the period (1.2 times!), despite burning through an estimated ~$4.7 billion. There’s just something terribly wrong about the measure “distributable cash flow” as a useful metric to investors.

Not only does “distributable cash flow” not reflect the economic reality of cash moving in and out of the business on an net operating basis, but the measure itself houses an imbalance that simply lacks consistency. The reconciliation of net income to adjusted EBITDA and distributable cash flow for most MLPs (see example here) begins with net income but yet, it doesn’t include the growth capital spending that is used to propel the very net income included in the “distributable cash flow” calculation in future periods. In many ways, MLPs are getting a free pass on growth capital (as if it were not unitholder money), especially if investors are “valuing” MLPs on the basis of distributable cash flow, or yield. Here’s some background from Energy Transfer Equity:

“Distributable Cash Flow and Distributable Cash Flow, as adjusted, are also important non-GAAP financial measures for our limited partners since these indicate to investors whether the Partnership’s investments are generating cash flows at a level that can sustain or support an increase in quarterly cash distribution levels. Financial measures such as Distributable Cash Flow and Distributable Cash Flow, as adjusted, are quantitative standards used by the investment community with respect to publicly traded partnerships because the value of a partnership unit is in part measured by its yield (which in turn is based on the amount of cash distributions a partnership can pay to a unitholder). The GAAP measure most directly comparable to Distributable Cash Flow, and Distributable Cash Flow, as adjusted, is net income for ETE on a stand-alone basis (the “Parent Company”).”

The large problem with “valuing” a partnership unit on the basis of yield (see here for more) is that when looking at the GAAP accounting, it becomes clear that an MLP's distributions do not reflect the economic reality of the business. In the calculation, “distributable cash flow” ignores growth capital spending, which itself is used to propel future net income, which is a core component of distributable cash flow, per reconciliation. Not only that, but because traditional measures of free cash flow, as measured by cash flow from operations less all capital spending, fall short of distributions paid, and are often negative, for most MLPs, distributable cash flow becomes a near-meaningless metric. Most MLPs are funding traditional free cash flow shortfalls with new equity and debt issuance, and it is clear as day on the GAAP cash flow statement.

But why am I bringing this up again? Well, the reason for this piece is not because I am having a bit of nostalgia, but rather because of an article published July 5, “SEC Tells Companies to Be Careful How They Talk About Free Cash Flow.” First and foremost, we applaud the SEC’s move to caution companies on how they present free cash flow, and we’re hoping that we may eventually see a systematic measure of free cash flow as a mandatory release for all companies--hopefully one as simple and straightforward as cash flow from operations less all gross capital spending (companies sometimes like to use net capital spending). The transparency and consistency that this one move would make across the financial markets would be phenomenal, and we hope one day we will see this.

That said, in the SEC’s May 2016 guidelines for free cash flow, it reads (Question 102.07) in response to a question that defines free cash flow as cash flow from operations…less capital expenditures: “Companies should also avoid inappropriate or potentially misleading inferences about its usefulness. For example, "free cash flow" should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure.” The guidelines make a lot of sense to us.

However, when we think about such guidelines for free cash flow, a punitive metric that deducts for allcapital spending, it becomes questionable whether distributable cash flow, because it does not deduct for growth capital spending, is a useful measure at all. After all, the general partner determines a discretionary reserve with respect to distributions, distribution coverage ratios vary quarter-to-quarter and are not fixed at 1, more than 20 MLPs have opted to cut their distributions since we warned about their business models in mid-2015, and many have chosen to pursue business-model simplification initiatives, rolling up subsidiaries and adjusting their payouts along the way. Yet, distributable cash flow continues to set MLP distribution policy, enabling “yield,” which then may drive equity “valuations,” something that we believe contributed to the bubble in early 2015 (see here on how traditional enterprise valuation can be used to value MLPs).

The bottom line: If traditional free cash flow should not be viewed as a measure representing “the residual cash flow available for discretionary expenditures,” including dividend policy (which is discretionary), some may reason that distributable cash flow should probably not be used either to set MLP distribution policy, itself discretionary to a large degree. It is our view that only when debt and equity funding becomes more prohibitive in the face of rising interest rates or tumbling energy resource prices will we see (again) just how much MLPs depend on the healthy functioning of the capital markets to fund their distributions--and how little "distributable cash flow" reflects the underlying “value” of the MLP business model.

Oil & Gas - Major: BP, COP, CVX, PTR, RDS, TOT, XOM

Pipelines - Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, OKS, PAA, SE, SEP, WES

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Image: A clipping of Valuentum's dividend report on StoneMor Partners.

No surprises here. If there ever was an MLP that was at serious risk of cutting its distribution, it was StoneMor Partners. We can only hope you heeded our warning.

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By Brian Nelson, CFA

We continue to defend the individual investor!

StoneMor Partners (STON) is about the most risky entity in all of our coverage universe, and it showed why after the trading session, October 27, by cutting its distribution! Yes, yet another MLP! For those that listened to us about the severe risks of its business model, we salute you. The MLP has been what we call a double whammy--it’s on Valuentum’s most overvalued list here, and it had a Dividend Cushion ratio of 0.1 (anything less than 1 is risky, but close to 0 significantly heightened risk). Shares are indicated down 25%.

Before going further, I am pleading with you. If you are still reading free research and analysis, which told you that StoneMor’s dividend was okay (or is included in some “model” portfolio), I am begging you to stop reading the source of the work…for your own sake. You know that we continue to exceed the benchmark performance in the respective newsletters, and our efforts to help the income investor have been second to none! We are a paid service for a reason! It showed why in an absolutely huge way today.

Okay – enough of my pleas. Here’s what we said about StoneMor’s distribution in its Dividend Report (pdf):

Key Strengths

There’s nothing that any bullish (optimistic) holder of Stonemor’s units could ever say to make us feel comfortable with an investment in the MLP. Its free cash flow is insufficient, and its balance sheet is “buried” under a significant amount of debt. The MLP is incredibly capital-market dependent and has used the issuance of new units (equity) to fund operating cash flow shortfalls to keep its distribution “alive.” In the past three years alone, Stonemor has issued ~$290 million in new equity (dilution). The company’s personal care trust funds are tied to market activity, and its pre-need business causes severe business cash-flow imbalances. Stonemor’s distribution may not make it through the most difficult times.

Potential Weaknesses

We’re going to call it how it is: Stonemor’s distribution is far from safe. The master limited partnership (MLP) business model is one that we’re not particularly fond of, and while some investors are comfortable with the term distributable cash flow, we are not. We prefer the traditional measure of free cash flow when evaluating the health of a payout, and Stonemor’s cumulative free cash flow generation during the past three years (2013-2015) of ~$5.3 million is a mere fraction of its cash distributions paid over the same time period ($190+ million). Long-term debt of ~$640 million relative to a negligible cash balance of $15 million should send income investors running for cover. We’d be scared “to death” holding Stonemor for income purposes.

When a company’s or MLP’s Dividend Cushion ratio flashes a dangerous signal, my goodness, please take it seriously. It doesn’t guarantee disaster, but it spells significantly heightened risk given that the entity simply doesn’t have a lot of cushion to work to cover the payout. In StoneMor’s case, it didn’t have the capital it needed to support revenue initiatives, and therefore had to use cash that otherwise had been going to unitholders to do so. Our fair value estimate for StoneMor is $17 per share. By the way, check out page 3 of the March 2016 Dividend Growth Newsletter here (pdf) – “StoneMor’s Shares Are Gravely Overpriced.” You can download StoneMor’s full report here (pdf).

Please let us help! In order to make sure your membership is current, please contact us [email protected]. Don’t let free research and analysis cost you dearly! We’ll be here for you. Valuentum isn't going anywhere. We got yet another one spot on.

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