#$sep

By Brian Nelson, CFA

On August 24, Enbridge (ENB) announced that it would enter into a definitive agreement under which the entity would buy Sprectra Energy Partners (SEP) at an exchange ratio of 1.111 common shares of Enbridge for each common unit of SEP, a near-10% increase from the exchange ratio announced a few months ago. As we have outlined in the past, most recently with respect to the following discussion on the Energy Transfer Equity (ETE) and Energy Transfer Partners (ETP) tie up, "ETE-ETP Rollup and Implied Distribution Cut," consolidations are slowly eliminating the MLP model via simplication efforts and many combinations are coming with implied distribution/dividend cuts, something that couldn't have been imagined in years prior.

The story of the demise of the MLP model is rather simple. From where we stand, the MLP model was used primarily as a financing mechanism that could raise equity for the corporate umbrella at a price that was reflective of a yield-based valuation, or one that is effectively priced on the concept of distributable cash flow, an industry specific term that ignores growth capital spending, but includes the net income within the measure that is driven by growth capital spending, "MLP Speak: A Critique of Distributable Cash Flow." This imbalance translated into equity unit prices for MLPs of bubble proportions that eventually popped as the energy resource markets began to swoon in late 2015 and early 2016, and funding dried up.

It is equally important to understand that part of our thesis in mid-2015 on the MLP space had to do with the idea that the group was not immune to falling energy resource pricing. Many industry experts had argued that midstream equity MLPs--due to their pricing arrangements--would not be impacted by the swoon in energy resource prices. Said differently, the idea that MLPs collapsed because energy resource pricing collapsed was a relationship that we were warning about, while others cried to the contrary. That MLPs collapsed alongside energy resource pricing only reinforces our original thesis given prevaling industry opinion at the time.

What we find to be most important in the Enbridge-Spectra announcement today is the language in the press release, and we applaud the entity for being so transparent. One sentence stands out, in particular, and represents the core of our thesis that we presented years ago. From the ENB/SEP press release August 24: "MLPs are dependent on consistent access to the capital markets at a reasonable cost of capital to grow their distributions." If there is any further doubt that MLPs are funding their distributions from the external capital markets, the naysayers are in denial. We've pounded the table on this concept time and time again.

There seems to be some confusion with respect to the timeline on our calls with respect to MLPs. In our first piece highlighted in Barron's in June 2015, "The Bear Case Against Kinder Morgan," we said the following with respect to MLPs:

Most, if not all, MLPs report distributable cash flow (DCF), which does not in the calculation consider growth capex, an important driver behind the generation of increased cash flow from operations in the future. When MLPs report distribution coverage ratios, this particular calculation also backs out growth capex from the equation, instead using only ‘sustaining capital expenditures.’

There are a number of contractual reasons why the data is presented in such a way, but from a valuation standpoint, we’ve always taken an issue with the MLP universe being implicitly valued on a future distributable cash flow stream that “covers” the distribution than on future free operating cash flow, which is a better measure of the free operating cash flow that a business generates.

The reason why free operating cash flow is more informative is quite straightforward. Distributable cash flow does not deduct the investment associated with driving future growth in an MLP’s cash flow from operations. Said differently, it’s like getting a free pass on all of the future growth spending that is required to drive incremental cash flow from operations, a severe imbalance in the valuation equation.

In valuing MLPs, we’ve circumvented the valuation imbalance by making the universal assumption that MLPs will continue to have access to the capital markets and that they will be able to issue equity and/or debt in such a way that is not value-destructive. Said differently, in our valuation models, we give MLPs credit for the future growth in cash flow from operations without deducting the growth capex that is required to drive it. We disclose this dynamic in every one of our 16-page reports within the MLP space.

We followed up our thesis, "Why The MLP Business Model May Be a Goner," in September 2015, and we generally went neutral on the MLP space in January 2016 as we noted that Kinder Morgan's (KMI) equity simply had fallen too far relative to our intrinsic value estimate at the time "Is Kinder Morgan on the Road to Recovery." For each midstream equity in our coverage universe, we calculate an intrinsic value estimate, and we use that to inform our opinion of the investment opportunity of each idea. MLPs, in early 2016, had fallen to better reflect enterprise free cash flow analysis, eliminating the systematic bubble of the MLP model that had been embedded in yield-based pricing, which we believed and still believe is an imbalanced way to approach equity valuation.

Needless to say, those that heeded our warning on MLPs in mid-2015 did incredibly well as much of their capital was saved. An index tracking the share prices of MLP business models (AMLP), for example, has collapsed since mid-2015, while the broader S&P 500 (SPY) has surged. Furthermore, there have been nearly 60 distribution cuts since we outlined our thesis in mid-2015, and the list of MLP consolidations and roll-ups is long and growing since then. The number of newly-announced MLPs has been practically nil during the past few years, too, another sign that the MLP business model is on its way out. We maintain our view: The Days of the MLP Model Are Numbered.

But that may be okay. Much of the froth has already been removed from MLP midstream valuations as most have systematically reverted to enterprise discounted cash flow valuations, in our view, and the idea that there could be premiums issued within consolidation scenarios is bringing new capital into the sector. This is, in part, why we may see the MLP midstream group advance as a whole as speculative premiums are built into subsidiary unit prices. Though rollups may eventually cause the demise of the MLP business model, on the way out investors may have an opportunty to reap some final gains. Until the next MLP rollup announcement...stay tuned!

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

Related: AMZA, TGE, APU, TRP

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A myopic view on the energy sector may lead one to ask the question whether the distributions of energy master limited partnership are safe. A broadminded view would answer that question in two words: absolutely not.

Through the first six months of 2015, almost every energy-related MLP has spent more in total capital expenditures and distributions than they generated in cash flow from operations. Business models with financials such as these cannot be sustainable over the long haul without infinite access to capital via the debt or equity markets. We learned that housing prices don’t always go up (and that they can fall on a national scale) during the Financial Crisis, and we’ll eventually learn that debt-infused business models that collectively spend more in capital and dividends than they generate in operating cash flow have limits, too.  

From our point of view, dividend safety stems from significant free cash flow generation, as measured by cash flow from operations less all capital spending, and a pristine balance sheet that is flush with net cash. The financial structures of MLPs offer investors distribution risk, not distribution health. A view of the dichotomy we speak of is evident in looking at financial performance of asset-light, cash-rich entities such as Apple, Microsoft, and MasterCard, as shown in the table above. If investors are truly looking for strong cash-flow generation and pristine balance sheets, such a combination that translates to dividend health is simply difficult to find within the energy sector.

We’re starting to see cracks in the business models of MLPs. Literally.

The Plains All American crude oil spill near Santa Barbara, California has garnered a fair share of news as of late, and it has become apparent that the pipeline was not in proper operating condition. The entity has reported that it will incur a net charge of $65 million in its second quarter related to the incident ($257 million in total offset by $192 million in insurance), but in its second-quarter earnings call, management stated that it would not raise its maintenance capital expenditures in 2015. This comes even after a second, smaller spill took place in southwest Illinois.

Plains All American is not the only major pipeline operator to have its infrastructure fail in recent months. Most recently, Kinder Morgan had a natural gas pipeline rupture--not its first major infrastructure failure this year--sending thousands of pounds of highly volatile gases into the air in rural Texas, and Energy Transfer Partners experienced a much larger natural gas rupture accompanied by a fireball shooting into the Texas countryside in mid-June. Despite these recent events, the companies have done little in their quarterly reports to acknowledge the developments, let alone plan an increase in maintenance spending to ensure they or a more serious event--like this one in 2010--do not happen again.

Investors like to champion the low maintenance requirements of pipeline operators, but are pipelines truly low maintenance? Or are operators just not spending enough to prevent such disasters? Our view is that investors really don’t know the quality of the assets in the ground, and we fear that they’re holding aged infrastructure in need of massive reinvestment in coming years. The events of just the past few months support this view.   

Plains All American shocked MLP investors when it said on its second-quarter conference call that it may have to potentially defer distribution growth until 2017. The MLP had been targeting 7% distribution growth in 2015 (now 6%), but its $660 million in cash flow from operations through the first half of 2015 was far less than the near ~$1.3 billion in capex and ~$550 million in distributions it paid during the same period. Only Kinder Morgan has both a greater cash shortfall during the first six months of the year and more leverage on the balance sheet (net debt/annualized CFO). If Plains All American will have trouble sustaining a high-single-digit pace of distribution growth over the next two years, we think Kinder Morgan’s plans to fund 10% annual growth in its dividend through 2020 is a pipe dream.

We second Plains All American’s “desire to inject caution.” From our perspective, Linn Energy changed the game MLPs were playing. Not only was Linn one of the only MLPs, if not the only MLP, that generated positive traditional free operating cash flow less distributions paid during the first half of 2015, but it was the only one on this list that suspended its distribution! We reiterate our opinion that the artificial valuation paradigm centered on debt-infused financially-engineered dividends won’t last, and we think bankers have already started to tighten the noose on overleveraged entities as losses on debt paper across the energy sector mount.

There is a limit to an entity’s debt capacity, and we’ve already passed it in this cycle with respect to most pipeline operators, in our view. The MLP business model is weakening, much like the walls of their failing pipelines, and we think the equity fall-out has only started to begin. Investors simply don’t know the quality of the assets in the ground, and the operators’ financials aren’t much to speak of in light of much safer dividend growth opportunities elsewhere. We prefer organically-driven dividends, not financially-engineered ones. Buyer beware.  

The oil and gas sector has taken a beating during the past few months, with the CBOE Oil Index down approximately 19% from its September high, despite last week’s attempt to bounce back.

With the excess supply still in the market, oil is expected to remain weak during the near term. You would be forgiven if you believed there isn’t a bright spot to be found among the oil and gas companies.

Even though this sector may sound a bit risky for a short-term trade, there is one group that is poised to rally during the next three months, and I can show you how to take advantage of this hidden gem.

Natural gas pipelines hold the best opportunity when the price of oil is tanking. Investors start to panic when they see a major commodity, such as oil, drop so far so fast. In fact, black gold is down about 50% since June. As a result, investors have sold anything even remotely related to oil.

The link between the two is simple: If oil is cheap, demand for natural gas gets reduced. And if the energy world operated in a vacuum, then that relationship would very well be the case.

But the fact is that natural gas is still a cheaper, cleaner alternative and in high demand. The link mentioned above doesn’t account for contracts to supply a certain amount of natural gas that will likely keep demand at least stable into the later part of next year.

A Bargain in Natural Gas

I have uncovered several pipeline opportunities, but there is one that my Pure Income readers just locked in at a 19.5% gain — Spectra Energy Partners (NYSE: SEP).

Spectra is one of the largest Master Limited Partnerships (MLPs) in the U.S., operating more than 17,000 miles of pipeline. It also owns interest in storage facilities for natural gas and crude oil. It is the largest transporter of natural gas to New England and the second largest to New York City. Indeed, it controls 12% of all gas consumed in North America.

When I placed the trade back in September, it was hard to find a cheap MLP in the natural-gas business — but that was exactly the opportunity Spectra represented.

The security was trading at just 11 times earnings, compared to an average of 25 times amongst its peers. The shares were a bargain because the sector is going through a correction, and Spectra was one of the high-fliers that investors had singled out for profit taking.

So when investors decided to jump back into the pipeline plays, Spectra was going to be a favorite because it was so cheap. And that’s exactly what happened.

To take advantage of the rebound in Spectra, I sold a December $50-strike put option in September. All I needed was for the stock to close above $50 on the date of expiration, which was last Friday. Shares finished at $55, which was 10% above our strike price. As a result, subscribers who sold the December put collected 19.5% in income over just three months.

Spectra is a stock that I will be returning to again and again. And it’s a company you should be considering as well.

A Steady Income Stream

The company has proven over the long term that it is able to return increasing amounts of cash to shareholders. Spectra operates a string of natural-gas storage and transportation assets that generate a safe, stable stream of cash flow for the firm.

Since Spectra went public in 2007, it has increased its dividend payment each and every year. And take a look at the projections for the next couple of years:

That’s the type of dividend growth I like to see in a company. Spectra wrapped up its 28th consecutive quarter with an increase in its dividend.

It has several open projects right now, and plans to expand its project book to $36 billion.

The stock currently pays out a decent 4.2% dividend yield.

I would follow these shares closely, and if you get a pullback below $53, I will be looking to sell puts against the stock — especially if it involves an oil-driven price drop.

Regards,

Chad Shoop