#$paa

[speedycalls]

$PAA 31 Puts SELLING Activity expiring on 17th Feb, Vol 5836

[valuentumbrian]

Valuentum: Distributing Truth on MLPs

Image Source: Valuentum Securities (get more of Valuentum’s work here)

The near term outlook for many midstream MLPs has cleared up quite a bit, but our concerns with the long-term sustainability of the MLP business model remain.

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Key Excerpts

Falling US Treasury bond yields coupled with the reduced probability of additional federal fund rate increases by the Fed in 2016 thanks in part to ‘Brexit’ uncertainty may provide more “hot air” to inflate those equities employing the MLP business model via the ongoing easing of access to the capital markets.

The question on most investors’ minds, however, is how long the MLP merry-go-round will last (i.e. how long MLPs will be able to continue such an external-capital, self-perpetuating cycle without a massive fallout). Executive teams of MLPs are aware of the vulnerabilities of their business models, perhaps punctuated by Kinder Morgan’s (KMI) roll-up many moons ago.

More than 20 MLPs cut distributions in 2015, and most of those cuts came from smaller MLPs, which may be telling of the fragility and shaky future of this business model.

We expect the MLP business/financial model to eventually be reevaluated at the highest regulatory levels and deemed an “unfair” structure. That MLPs can recirculate capital raised from the financial markets (financing section of the cash flow statement) to pay distributions, which are widely followed by “trusting” investors and often used to value their equities is incredible.

In any business seeking to generate value for shareholders, which all are, investment growth capital therefore will always be funded first and foremost through a company’s operating cash flow, and since most capital investment and dividends, collectively, overwhelm operating cash flow generation (as in the chart above), most all MLP payouts are in part financially-engineered (i.e. supported by the financing section of the cash flow statement).

Though it may not happen anytime soon, we believe there will eventually be an “investor-led” crusade against this dangerous (MLP) business model. Such opposition doesn’t necessarily have to come from investors either. It could come from a corporate coalition. There are many corporates, for example, that have decent balance sheets and cover their dividends with traditional free cash flow, but have much less sanguine credit marks by the agencies relative to those of such overleveraged, “cash-burning” (after dividend payments) pipeline MLP plays.

Moreover, we believe the SEC should take a hard look at the industry’s definition of “cash flow,” which we believe is very misleading to even the most sophisticated investors. In particular, an MLP’s definition of distributable cash flow excludes the very growth capital spending that drives net income, which itself is included in the calculation of distributable cash flow. When analysts use distributable cash flow in valuation, they, by its very own definition, exclude a portion of the cash capital outflows (shareholder money) that are used to drive net income higher, a severe imbalance in the valuation equation.

By Kris Rosemann and Brian Nelson, CFA

The recent merger break-up fiasco at Energy Transfer Equity (ETE) and Williams Companies (WMB) has put the master limited partnership (MLP) conversation back into the spotlight, after the two entities were unable to finalize a merger that had been announced in fall 2015 and would have created the largest pipeline company in the US. The deal between Energy Transfer Equity and Williams was officially terminated by Energy Transfer Equity June 29 after a court ruled that the firm was legally able to walk away from the agreement when it was unable to deliver an opinion on the tax treatment of the transaction that was required by June 28. Williams has since stated that it will seek monetary damages from ETE for the failed transaction.

We have been warning of the dangers of a tie up of the two entities that are both so overleveraged, and it has become evident that disagreements at the top of both Williams and Energy Transfer Equity have led to a significant shakeup in their management teams and boards of directors. On June 30, nearly half of Williams’ directors resigned after failing to oust CEO Alan Armstrong, who was an opponent of the merger, and Energy Transfer Equity CFO Jamie Welch, who has been quotedreferencing the deal terms as “mutually assured destruction,” was released from his duties in early February. We can only imagine how much finger-pointing had been going on, and the activity by the Williams’ board following the failed transaction seems like mutiny, at least from our perspective. How can investors believe that a board that is so fast to dissolve is acting in their best interests? It’s very concerning from a corporate governance standpoint, and something tells us this isn’t the last we’ve heard about the ETE-WMB tie-up. Things could still get ugly.

Despite the news of the failed attempted merger, the near-term outlook for most midstream MLPs has improved since early 2016. The most transparent positive is improvement in the energy resource pricing markets, as the recent bounce in crude oil prices has alleviated some of the pressure pipeline operators had been experiencing. Remember when others were saying midstream equities were immune to commodity-price changes? How wrong they were. Additionally, the vast majority of midstream MLP firms are not exposed to the uncertainty surrounding ‘Brexit’ and ongoing concerns over economic growth in Asia, specifically China. Most recently, the former of these two concerns has had an impact on the yields on government bonds in developed countries across the globe (US 10-year Treasury bond yields fell to record lows July 1) as risk-averse investors attempt to avoid such uncertainty. This dynamic has only increased the demand for high-yielding stocks for income-oriented investors, and pipeline companies have traditionally fit this bill nicely, especially when considering their general lack of exposure to global economic uncertainty, even if energy market uncertainty is still prevalent.

Falling US Treasury bond yields coupled with the reduced probability of additional federal fund rate increases by the Fed in 2016 thanks in part to ‘Brexit’ uncertainty may provide more “hot air” to inflate those equities employing the MLP business model via the ongoing easing of access to the capital markets. Can you believe it? Spreads on some of the lowest-rated (highest-yielding) debt, for example, have improved drastically since the near term peak earlier this year. As we have been articulating for some time now, MLPs are far too dependent on the capital markets (i.e. issuance of new debt and equity capital) for them to be considered rock-solid, independently sustainable entities. However, as long as the debt and equity markets remain open to them to provide the financing cash flow generation to cover cash distributions, most MLPs will continue to be able to operate in their current form as dividend-hungry investors bid up shares on the basis of yield considerations, despite what we consider to be egregious business-model risk (promulgated by regulations that favor MLPs over traditional corporates).

Image source: PAA 2016 Investor Day presentation

Let’s take a quick anecdotal look at Plains All American (PAA) to illustrate what we mean, for example. The MLP expects its expansion capital spending to be funded by at least 55% new equity, as well as excess “cash flow.” However, excess “cash flow” may be hard to come by as it projects its distributable cash flow distribution coverage to be well below 1 for the second consecutive year. (The chart above provides a visual representation of the firm’s distribution “coverage,” or better yet lack of it.) You might say – “this is ridiculous.” How can Plains All American keep paying out this distribution when even its own measures of internal cash flow before capital outlays related to growth spending are coming up short?

The answer is quite simple – ever more debt, more equity. Plains All American is not only admitting it will issue more equity in a bid for growth, but it recently floated a sophisticated convertible offering, which also came to the rescue of the distribution. It’s almost as though operating performance doesn’t matter within the MLP universe as much as access to new capital does–if an MLP can float more debt and equity, all will be well. If it can’t, trouble is on the horizon. This is what makes handicapping the MLP space so difficult for investors; in many cases, credit access and energy resource pricing trump firm-specific operating fundamentals. Industry veterans have a hard time accepting this fact.

The question on most investors’ minds, however, is how long the MLP merry-go-round will last (i.e. how long MLPs will be able to continue such an external-capital, self-perpetuating cycle without a massive fallout). Executive teams of MLPs are aware of the vulnerabilities of their business models, perhaps punctuated by Kinder Morgan’s (KMI) roll-up many moons ago. More recently, however, Plains All American, acknowledged the many flaws of the MLP business model, if not explicitly then indirectly via a discussion of the viability of the long-term sustainability of the MLP model. In its 2016Investor Day presentation, the entity stated that it will continue to evaluate structure simplification alternatives, specifically a simplification transaction between PAA and its general partner. To us, this in itself is an acknowledgement from a major player in the MLP space that changes are necessary in its corporate structure.

Even if energy resource pricing has offered a nice reprieve, the vulnerabilities of the MLP business model have been exposed. If the examples of Kinder Morgan and Plains All American weren’t enough, in late 2015, Targa Resources (TRGP) rolled up Targa Resource Partners, and around the same time, Sempra Energy (SE) backtracked on its plans to form an MLP. The path to recent distribution cuts across the MLP space have been devastating for many: NGL Energy Partners (NGL), American Midstream Partners (AMID), and Crestwood Equity Partners (CEQP) all cut their distributions in April 2016, and Southcross Energy Partners (SXE) cut its distribution in January 2016. More than 20 MLPs cut distributions in 2015, and most of those cuts came from smaller MLPs, which may be telling of the fragility and shaky future of this business model. Many know that Boardwalk Pipeline (BWP) cut its distribution in February 2014, and now-bankrupt LINN Energy’s distribution cuts were foretold by the entity’s abysmal Dividend Cushion ratio. Even the ALPS Alerian MLP ETF (AMLP) cut its quarterly dividend ~20%.

During its investor day, Plains All American also highlighted a number of changes it expects to come in its operating environment over the near-term and intermediate/long-term time horizons, both of which it expects to be very different from what we have seen in recent years. The energy boom following the Great Recession of late last decade drove unbridled growth in the businesses and assets in the MLP universe, causing the overall quality of the space to deteriorate significantly, and as a result of quantitative easing and lax monetary policy, a large number of MLPs became dependent on unrestrained access to low costs of capital. This is where things will begin to change. Relative to the “good old days,” it has become much more difficult for MLPs to fund their growth projects, forcing them to look elsewhere for sources of expansion. A renewed focus on rationalization and optimization can be expected, but this will bring increased competition, meaning that many of the smaller MLPs that benefitted from the ease of access to low costs of capital may become competitively disadvantaged as larger operators with higher-quality assets benefit from scale and capacity utilization on existing infrastructure.

Midstream pipeline MLPs are also expected to look to industry consolidation and asset acquisitions as sources of growth as large organic growth capital programs will become a thing of past the for much of the space. However, the recent implosion of the ETE-WMB tie-up brings the viability of such a strategy into question. While the two firms are among the most-leveraged in the industry, many others are not far behind (see chart at top of article). Perhaps the best-case scenario for MLPs then is exactly what Plains All American has hinted at in its Investor Day presentation: a consolidation of it and its general partner. Such a move would reduce its dependence on the capital markets, but it may be the best way for the firm to remain a legitimately healthy operator over the long term. After all, the very pioneer of the MLP business model, Kinder Morgan, has abandoned it. We have long been positive on the underlying businesses of the midstream space, but the MLP business/financial model fouls up the investment prospects of the industry, in our opinion.

We expect the MLP business/financial model to eventually be reevaluated at the highest regulatory levels and deemed an “unfair” structure. That MLPs can recirculate capital raised from the financial markets (financing section of the cash flow statement) to pay distributions, which are widely followed by “trusting” investors and often used to value their equities is incredible. How can you be sure that our perspective is worth considering? Ask one question: what would happen to MLPs if the capital markets shut down? The answer: They would have to cut their distributions as cutting off growth and investment would be a bonehead move in light of potential positive NPV projects. In any business seeking to generate value for shareholders, which all are, investment growth capital therefore will always be funded first and foremost through a company’s operating cash flow, and since most capital investment and dividends, collectively, overwhelm operating cash flow generation (as in the chart above), most all MLP payouts are in part financially-engineered (i.e. supported by the financing section of the cash flow statement). External capital is not the primary source of growth funding.

Though it may not happen anytime soon, we believe there will eventually be an “investor-led” crusade against this dangerous business model. Such opposition doesn’t necessarily have to come from investors either. It could come from a corporate coalition. There are many corporates, for example, that have decent balance sheets and cover their dividends with traditional free cash flow, but have much less sanguine credit marks by the agencies relative to those of such overleveraged, “cash-burning” (after dividend payments) pipeline MLP plays. Moreover, we believe the SEC should take a hard look at the industry’s definition of “cash flow,” which we believe is very misleading to even the most sophisticated investors. In particular, an MLP’s definition of distributable cash flow excludes the very growth capital spending that drives net income, which itself is included in the calculation of distributable cash flow. When analysts use distributable cash flow in valuation, they, by its very own definition, exclude a portion of the cash capital outflows (shareholder money) that are used to drive net income higher, a severe imbalance in the valuation equation.

Individual investors and financial advisors deserve better: the truth.

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

Image Sources: Simon Cunningham, Images Money, Trading View. No alteration has been performed on the pictures.

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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. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

Valuentum: Time May Be Running Out for MLPs

Image published June 18, 2015. © Valuentum Securities. Pictured: The circular flow of unsubstantiated support that continues to unravel, previously supporting the prices of the MLP universe. 

The image above was taken from Valuentum’s President Brian Nelson’s article published on www.valuentum.com June 18. If you’re interested in learning more about how to identify mispricings in the stock market such as that with Kinder Morgan when it was trading at $40 per share (now ~$15), please consider becoming a member to www.valuentum.com. You’ll gain access to Brian Nelson and the Valuentum Team. Click here to subscribe today!

Forward-looking, cash-flow based dividend analysis has proven its worth once again.

Shipping giant Teekay LNG Partners (TGP) made a tidal wave in its stock recently, knocking income investors over, after it cut its distribution by 80% December 17 in order to fund capital requirements on its future growth projects, reduce debt, and eliminate its need to access equity capital markets in the near term.

The Valuentum thesis on MLPs continues to suggest that distributions related to the business model continue to be fueled by external capital market assistance; this circular flow of unsubstantiated support is evaporating, in our view. We fear there are many more shoes to drop, and we point to the Energy Transfer empire (ETE/ETP) and Plains All American (PAA) as next in line, among the more heavily-followed pipeline MLPs.

Prior to the cut at Teekay LNG Partners, the entity registered a capital-market supported 0.9 adjusted Dividend Cushion ratio or a dividend safety rating of POOR (please note that Teekay registered a POOR rating even with our expectations for capital-market assistance). Without such benign adjustments, we expect the company’s unadjusted Dividend Cushion ratio to be -3.9 after the distribution cut. We continue to believe that the unadjusted Dividend Cushion ratio is an efficacious measure of a firm’s true distribution/dividend risk, as it omits help from the external capital markets.

Here’s how we felt about Teekay LNG Partners, "Don't Be Fooled By Teekay LNG's Yield," in November:

…we are not particularly fond of its dividend, no matter how high the yield. Long-term debt of nearly $2 billion and sizeable capital requirements are the key reasons we think there are better dividend growth options available on the market. The increased risk of a coming interest rate hike does not benefit the MLP's dividend prospects, which are dependent on the capital markets.

The Dividend Cushion ratio, coupled with the qualitative assessment of Teekay’s operating environment, put Valuentum members ahead of its distribution cut and the subsequent collapse in its stock price. To emphasize, this distribution cut was not expected, as evidenced by the near-50% slide in the entity’s stock price.

We have been railing against the MLP business model for some time now, hoping to help investors of all types, and it remains our view that MLPs and their outsize yields are in increasing danger, as capital-market assistance dries up. We continue to emphasize that retirees that are dependent on them for income should be cognizant of the myriad risks associated with their business model (not the least of which is the circular flow of unsubstantiated support shown in the image above).

If you are not comfortable holding master limited partnerships (MLPs) in your portfolio, please contact your financial advisor.

On an unrelated note, but relevant as it relates to the Dividend Cushion methodology, Joy Global (JOY) also recently slashed its dividend, and the Dividend Cushion ratio appropriately warned members in advance of this risk, too. The firm registered a 0.2 Dividend Cushion ratio, or a dividend safety rating of VERY POOR.

The weak operating environment in the mining sector has been no secret, and as a manufacturer of mining equipment, Joy Global is dependent on the spending of mining companies. The firm reported that its customer capital expenditures were down ~18% in its fiscal 2015, which ended October 31.

The dividend cut followed the company’s reporting of a net loss of $12.02 per diluted share in fiscal 2015. Full-year bookings fell 25% on a year-over-year basis, giving little hope for a near-term improvement. In this context, the dividend cut makes sense as it relates to the health of the company as it struggles through this downturn in the end market it serves.

For those still getting familiar with our unique financial analysis, the Dividend Cushion ratio considers the firm's net cash on its balance sheet (cash less debt) and adds that to its forecasted future free cash flows (cash from operations less capital expenditures) and divides that sum by the firm's future expected cash dividend payments over a discrete five-year period. All of this data and analysis is homegrown at Valuentum.

At its core, the Dividend Cushion ratio tells retirees whether the prized stock in their income portfolio has enough free cash flow to pay out its dividends in the future, in our view, while considering its debt load. If an entity has a Dividend Cushion ratio above 1, it has the flexibility to cover its dividend, in our view, but if it falls below 1, trouble may be on the horizon. This was the case for both Teekay LNG Partners and Joy Global.

As always, please do keep monitoring the Dividend Cushion ratios of companies in your portfolio, especially if you’re dependent on them for income. We expect to update our 16-page valuation reports and dividend reports on Joy Global and Teekay LNG Partners soon. Subscribe to Valuentum today. Please click here.

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

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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. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

The Dividend Cushion Ratio Predicts More Dividend Cuts

The Dividend Cushion ratio has once again warned investors of more dividend cuts in advance. Read more about Valuentum’s call on KMI here. To access Valuentum’s updated valuation and dividend reports on all of the companies it covers, consider subscribing here.

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By The Valuentum Team

Retirees know that a dividend cut could be disastrous to their income portfolio, as future income is not only reduced but it is also very likely that capital is permanently impaired. The Dividend Cushion ratio, an integrated leverage and liquidity metric, is designed to provide the income investor with a trusted and independent opinion of the safety and future growth potential of a firm's dividend. It not only has shown to predict dividend cuts, but the 'cushion' behind the Dividend Cushion reveals just how much capacity a firm has to continue growing its dividend into the future.

Technically speaking, the Dividend Cushion ratio considers the firm's net cash on its balance sheet (cash less debt) and adds that to its forecasted future free cash flows (cash from operations less capital expenditures) and divides that sum by the firm's future expected cash dividend payments over a discrete five-year period. At its core, it tells retirees whether the prized stock in their income portfolio has enough cash to pay out its dividends in the future, while considering its debt load. If a firm has a Dividend Cushion ratio above 1, it can cover its dividend, in our view, but if it falls below 1, trouble may be on the horizon.

A question comes up frequently about why we use a 5-year discrete forecast period in the Dividend Cushion calculation. In short, we think it is a great way to rank dividend risk across companies, combining in one metric insight with respect to both leverage and liquidity analysis.

As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity, for example. Said differently, a poor Dividend Cushion ratio of below 1 or even negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow.

That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash (and those with limited financial flexibility have fewer options), and that means the dividend becomes increasingly more risky. Lofty net debt positions and extremely capital-intensive business models often spells disaster.

We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.

Adding to the list found at, “Dividend Cushion Ratio Predicts Two More Cuts,” released July 2015, the Dividend Cushion ratio has yet again warned investors of risk in the payout of several companies in advance of their cut. Though one company was a much larger company, the Dividend Cushion revealed its efficaciousness in both scenarios. It’s very important to note that the Dividend Cushion ratio warned about the risk of a dividend cut in advance and that the metric is a real-time, forward-looking metric that readers can use now to assess the risk of a dividend cut in their income portfolios.  

One extremely high-profile case, Kinder Morgan (KMI), cut its dividend by 75% December 8, as its overleveraged, commodity-price dependent, capital-intensive business model felt the weight of more cautious equity and debt markets. Though management stated internal measures of “distributable cash flow” would be sufficient to cover 6%-10% dividend growth in 2016 on December 4 (just 4 days before it cut its payout), the firm’s significantly negative Dividend Cushion ratio spoke to considerable risk.

Kinder Morgan may be the first of many notable midstream companies to slash its dividend, as cash flows continue to weaken across the highly-leveraged sector. This slide deck highlights the scenario surrounding Kinder Morgan and potential for more cuts in the space. We continue to point to Plains All American (PAA) as next in line of the major MLPs to cut its distribution, and we fear the Energy Transfer “empire” in Energy Transfer Equity (ETE) and Energy Transfer Partners (ETP) will succumb to a much more cautious credit market.

On a fully-consolidated basis, including all subsidiaries, Energy Transfer Equity is more than 7x leveraged, as measured by net debt to annualized EBITDA. We outline the calculation in the following piece, “Alert: Energy Transfer Equity Is More than 7x Leveraged!”

The Dividend Cushion ratio also effectively warned investors of the coming cut in Alleghany Technologies’ (ATI) dividend. The firm cut its dividend by 56% December 10 due to challenging market conditions in its ‘Flat Rolled Products’ segment and ‘Grain-Oriented Electrical Steel’ products. Alleghany’s Dividend Cushion ratio was -2.2 at the time of the cut.

We continue to reiterate our view that forward-looking, cash flow-based dividend analysis is a great way to determine the future safety and capital-market dependence of a company’s payout. Please do keep monitoring the Dividend Cushion ratios of companies in your portfolio, especially if you’re dependent on them for income. To access Valuentum’s Dividend Cushion ratios, please consider subscribing here.

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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. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

Not So Happy Holidays at Kinder Morgan

Once the third-largest energy company in North America, Kinder Morgan has fallen from investor favor. The pipeline operator announced it will cut its dividend by ~75%.

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Be sure to read, “Recapping The KMI Call Made By Valuentum’s Nelson, What Next?” Want more analysis like Valuentum’s call on KMI, consider subscribing to Valuentum here.

In a sharp reversal from just a few days ago when Kinder Morgan (KMI) said it would generate sufficient “distributable cash flow” to fund dividend growth of 6%-10% in 2016, the executive team opted to cut its dividend December 8 by ~75%, to $0.50 per share annually, a move that despite our best efforts has still managed to surprise the market, as evidenced by shares indicated down in after-hours trading. Though we plan to tweak our valuation model to account for the impact of recent acquisitive activity and the slide in energy resource pricing on Kinder Morgan’s intrinsic value, we’re reiterating the low end of our fair value estimate range at this time. We plan to update our 16-page valuation and dividend report on Kinder Morgan by 10am CST tomorrow. Gain access to these updated reports by subscribing here.

There are a few lessons to take away from the recent dividend cut. First, entities that are capital-market dependent, meaning that they need access to both the equity and debt markets, have substantially higher risks to their dividend profile than other companies that have cash-rich balance sheets (sufficiently more cash and short-term investments than long- and short-term debt) and generate an excess in free cash flow, as measured by cash flow from operations less capital spending, above their expected cash dividends paid. Second, it is imperative to emphasize that with the recent craze of dividend growth investing across many corners of the web, executive teams have been using the dividend as a way to please investors like no time before in the history of the equity markets, in our view. In this light, it’s important to note that boards can do what they want with the dividend, until simply they can’t. Hard to believe today, but Kinder Morgan raised its dividend 16% as recently as October 21 – that’s less than two months ago.

We like to use the Dividend Cushion ratio, a forward-looking cash-flow-based liquidity and leverage metric, to ascertain a company’s dividend health and the degree of a company’s capital-market dependence. Such a financial metric helps add perspective around management’s plans for the dividend, as in most cases, investors may be flying blind, hanging on every word of the executive team for their income needs, instead of digging deep into the financial statements. The risk of putting too much emphasis on a historical track record is evident in Kinder Morgan’s case as it has been in every other case like it. Only by looking intensely at the future expected financials can investors truly gauge the capacity for dividend increases. Eventually, stretching too far to please income investors catches up with the executive team when conditions deteriorate. Be sure to read about the Dividend Cushion ratio here.

We’re maintaining our view that, while Kinder Morgan is not a master limited partnership, many across the MLP universe could face a similar fate. We believe Plains All American (PAA) is next in line to cut its distribution among the more heavily-followed midstream equities, and we would expect the credit rating agencies to eventually begin demanding more prudent and debt-friendly actions across several MLPs, particularly as crude oil price decks are updated and financial flexibility is reduced. On the basis of net debt to annualized adjusted EBITDA, we believe Energy Transfer Equity/Energy Transfer Partners (ETE/ETP) will likely see a credit downgrade deeper into junk before this cycle is over, but a dividend/distribution cut is equally likely.

In our piece, “3 Anomalies Across Pipeline Entities,” released August 11, the free cash flow shortfall relative to dividends/distributions paid for Energy Transfer Equity/Energy Transfer Partners was nearly 4 times greater than that of Kinder Morgan (-$4.7 billion versus -$1.38 billion). We find it somewhat puzzling that in late September Moody’s raised Energy Transfer Equity’s credit-rating Ba2 outlook to positive following its deal with Williams Companies (WMB), which in our view, was in as worse a shape as Kinder Morgan in terms of its free cash flow shortfall relative to cash dividends paid through the first half of the year. In light of the meager, yet meaningful, direct commodity exposure of Energy Transfer Equity’s collection of MLPs, their capital spending plans, and massive dividend obligations, bondholders at Energy Transfer Equity should be looking for more prudent capital allocation now rather than later. A dividend cut would provide that option. 

Kinder Morgan is not the first midstream equity to cut its dividend, and it won’t be the last.

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. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

This MLP's Distribution Is At Serious Risk

Kris Rosemann wrote this article.

The Keystone XL pipeline has been perhaps the most talked about issue surrounding midstream operators in recent years. The rejection of the proposed pipeline by the US government has brought increased attention and bravado to pipeline opponents, while also highlighting the increased risks associated with midstream entities.

Specifically, pipeline opponents are now turning their attention to Kinder Morgan’s (KMI) Trans Mountain pipeline in southern Canada. Environmental advocates are pushing for a similar result that was realized along the northern Pacific coast of Canada, where the Canadian government will ban crude oil tankers, effectively ending the usefulness of Enbridge’s (ENB) Northern Gateway pipeline. These developments are both damaging to pipeline operators immediately and in the future, as these types of situations will make future pipeline expansion increasingly difficult.

However, there are far more risks associated with pipeline operators than simply the rejection of expansion projects. The underperforming equity prices of MLPs across the midstream space have brought the issues of capital market access and the cost of capital much greater attention, and rightfully so. According to Fitch Ratings in August,

Equity prices remain suppressed and the ability and willingness to fund capital spending with equity is becoming a more prominent concern for midstream issuers. Access to capital markets remains intact despite the rising cost of capital. We believe access to markets could deteriorate as commodity and equity prices continue to languish and potential interest rate increases from the U.S. Federal Reserve loom.

This situation is one that we have been warning about for some time now, and it continues to gain momentum as commodity prices are not expected to rebound in 2016 and regulatory risks increase.

MLP and pipeline operator Plains All American (PAA) has seen its share price nearly halved since early May, just before the first of two high-profile pipeline failures that occurred under the firm’s watch. The company has become a poster-child of sorts for the turmoil that is currently taking place across its industry. It has been affected by falling crude oil prices, failing infrastructure, supplier bankruptcy risk, and, inevitably, the potential of interest rate increases.

In the third quarter of 2015, Plains All American reported revenue being nearly cut in half, diluted net income per limited partner unit more than halved, and EBITDA fell 8% from the year-ago period. The oil price slump, production cutbacks, and shutdowns from the pipeline ruptures earlier this year were key contributors to the weak quarterly results. Further, the company does not expect Line 901, the California pipeline that ruptured, to be back in operating condition in 2015. Excluding the loss of revenue, Plains All American estimates the total costs from the incident to be ~$257 million. The Pipeline and Hazardous Materials Safety Administration (PHMSA) has also called for the company to fully close and purge nearby Line 903, which has been almost fully closed since May but has remained full of oil. PHMSA has claimed “similar corrosion characteristics” to Line 901. If these two lines in such a small radius are both in such poor condition, how many others are in similar shape across the nation?

Bringing further risk to Plains All American, and more importantly to midstream entities in general, is the increased risk of bankruptcy of upstream operators. Pipeline operators will not be spared from the carnage in the supply chain due to the sharp drop in commodity prices. A prime example of this is the rapid cash-burn situation taking place at Chesapeake Energy (CHK). Sales from Chesapeake Energy to Plains All American accounted for 11% of Chesapeake’s total revenue, or just over $2.3 billion. The fact that one of the largest oil and gas producers in the US is in such dire straits only further emphasizes the inherent risks developing in energy markets in general. Midstream pipeline operators are not immune to falling crude oil prices. 

We’ve said it before, and we’re saying it again.

After reporting poor third-quarter results, Plains All American announced it expects that “2016 will be a challenging year.” The company plans to cut its 2016 capital spending program and may sell some assets to counter the challenging operating environment that is expected to continue through the end of 2016; it is cash hungry. The 2015 capital budget of $2.2 billion--which is the same amount as its adjusted EBITDA guidance for the year--is expected to be cut by up to 30% in 2016. A more precise number will be released once the firm gains a better understanding of how upstream capital spending will pan out in the coming year.

Nevertheless, the firm increased its distribution in the quarter, albeit by a marginal amount. This comes after management indicated that distribution growth was at risk in 2016 due to falling volumes and margins. The company’s goal is to maintain 105% distribution coverage, but if the originally planned distribution growth trajectory is maintained, it would result in a continued period--distribution coverage is expected to come in at 94% for the full-year 2015--of subpar distribution coverage. Management stated it was not prepared to comment on the distribution for 2016 in its third-quarter earnings call. A sustainable rebound in crude oil prices is not expected before the end of 2016, and management’s dedication to its distribution will certainly be tested.

At current levels, Plains All American’s raw, unadjusted Dividend Cushion ratio--which does not take into account the capital-market assistance that many MLPs are accustomed to having--see an in-depth explanation here—is well below 1. Given the company’s outlook for 2016, we would not be surprised to see a distribution cut. Management will have to take a significant amount of cost saving measures while maintaining business in order to drive the cash flow needed to properly support the distribution it wishes to pay to shareholders. Considering the risks specific to the entity coupled with those prevalent across the industry, we find this increasingly more unlikely.

Even if cost savings may delay what we consider to be immediate trouble, they may be futile in saving the distribution at present levels if the potential for more costly regulations--which we highlighted months ago here—become reality. What actually counts as maintenance for pipelines is quite a political issue. For example, we don’t consider fixing a pipeline after failure maintenance, no more than we would consider swapping out a combustion engine after it fails as maintenance. Changing the oil prior to combustion engine failure is what we call maintenance, the equivalent of which seems to be lacking across much of the pipeline industry when it comes to maintaining infrastructure, given the number of well-publicized ruptures. In any case, the oil and gas pipeline industry continues to lobby against recent proposals for increased standards of maintenance. Though we use Plains All American as a specific example, the risks highlighted by the firm’s situation are not unique to the company; they are rampant across the midstream space.

All things considered, the mounting risks across the midstream and MLP space are far too great to draw our interest. We continue to emphasize the risks related to distribution cuts as a result of the tremendous pressure on participant’s operations, and we point to Plains All American as next in line. We prefer to err on the side of conservatism. Income investors beware. Our dividend report on Plains All American will be updated shortly.

Interested in more insights and analysis from Valuentum? Visit us at www.valuentum.com.

Related ticker symbols: AMLP

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

Valuentum (val∙u∙n∙tum) [val-yoo-en-tuh-m] Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.

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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. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

Creditor Risk Aversion Rises Considerably in Energy, Metals & Mining Sectors

Image Source: GotCredit

In a recent Moody’s ‘Capital Markets Research’ report, according to a tabulation performed by Credit Suisse, bond spreads have widened an incredible 385 basis points for high-yield metals/minerals companies and 367 basis points for energy companies in the one-year period ending July 8, 2015. We continue to underweight these sectors within the newsletter portfolios. Creditor risk aversion continues to swell in these two sectors, and the worst has yet to come, in our view.

Not all is well with commodity producers.

Moody’s has been very quick to point out that “the latest plunge by base metals prices and the renewed slide (in) crude oil prices are more ominous for corporate credit than was the earlier plummet by crude oil prices amid relatively steady industrial metals prices.” The credit rating agency’s industrial metals price index has dropped more than 10% in the past 20 days ending July 9, reaching levels not seen since the depths of the Financial Crisis in 2009. Moody’s industrial metals price index has fallen an incredible 25% since the same time stamp last year, something we’ve been witnessing anecdotally.

The International Energy Agency recently warned that the bottom in crude oil prices “may still be ahead.” Crude oil prices have fallen to three-month lows, with Brent crude ~$59 per barrel and US WTI ~$53 per barrel. Global oil demand growth is slowing, with the agency stating that “world oil demand appears to have peaked” in the first quarter of 2015. Meanwhile, global oil supply is surging as both OPEC and non-OPEC countries increase output, with OPEC supply hitting three-year highs in June. Iraq, Saudi Arabia, and the UAE keep producing at a breakneck pace. Supply growth from Non-OPEC producing entities is expected to “grind to a halt” in 2016, with potential negative implications on US-based pipeline entities, where volume growth is key to distribution/dividend expansion.

What may not be completely factored into such credit models, however, has been the frantic dislocation in the Chinese equity markets, which have been falling like a rock as of late. Conditions in China are best described as nothing short of a panic, and implications across the country that imports the most oil have yet to be hammered out, but they can’t possibly be positive for the energy complex. Our latest equity report update across the energy space has forced us to implicitly assume billions and billions of incremental debt and equity capital issuances in 2016 to balance their models. Such a dynamic has not been lost on the credit rating agencies, nor have the high-yield markets ignored their risky-capital market dependency.

According to a post from zerohedge, “the renewed plunge in oil prices is kicking off a fresh round of debt concerns” with Bloomberg reporting that, according to Bank of America Merrill Lynch data, “yields on (speculative-grade energy securities) debt have climbed to an average 9.34%...levels that indicate investors view the typical security at high risk of default. Zerohedge has reported that bonds for Energy XXI and SandRidge are trading at 80-90 cents on the dollar, which doesn’t bode well for implied equity values at all. Bloomberg has reported that Swift Energy is having a difficult time finding buyers for a $640 million loan, and some are calling the high-yield energy market a “silo of misery.”

From our perspective, we’ve yet to see the long-term implications of $40-$60 crude, as many implied equity prices across the energy space assume a return to $90-$120 prices. This has not been lost on us. We are forecasting a return to normalized conditions by Year 5 of our valuation models, but in many cases, normalized conditions are an ever-moving target, and a return to any sort of “normalcy” cannot be guaranteed, particularly in light of OPEC’s market-share retention tactics and talks of lifting sanctions on Iran. We would expect Iran to claw for market share should sanctions be repealed.

We view the following list of companies most exposed to ongoing creditor risk aversion. Of companies on the list, we only hold Energy Transfer Partners in the Dividend Growth Newsletter portfolio, and we may look to eliminate the MLP on any upward advance in its share price. The pile of bad energy loans continues to increase.

Image Source: Valuentum Securities

[jamesdondero]

7 MLP opportunities for investors

Mid-April has seen a consecutive multi-day rise in oil prices, with West Texas Intermediate briefly hovering around $57, its highest level since last December. This comes as the Department of Energy reported declining crude production, along with a small rise in inventories.  Additionally, OPEC has predicted a decline in U.S. crude production for the second half of 2015. Escalating global conflict has also given prices a boost.

It’s too soon to say whether this recent upsurge will continue and typically markets take time to digest a steep rout in oil prices. Bears would say there’s more downside in oil prices to come; we feel prices have seen their lows for the year.

But irrespective of oil or gas price movements, we believe specific midstream MLPs that were hit hard along with the broader energy sector might represent a compelling alternative yield product for investors.

As is the case with REITs, not all MLPs are created equally.

Upstream MLPs have rightfully experienced the worst decline along with oil; because they focus on production, they are heavily exposed to the price swings of commodities.  As commodity prices have been extremely volatile to the downside, many upstream MLPs have cut distributions.

Midstream MLPs, on the other hand, focus on storage and transportation. They have long-term contracts that are largely fee-based or take-or-pay, often with built-in inflation adjustments. They may not offer yields as high as the upstream MLPs, but they are far less sensitive to commodity prices, and coverage ratios are typically better. Nonetheless, the midstream sector also fell approximately 20% due to the negative sentiment, as investors panicked and sold all related names, regardless of commodity sensitivity.

Seven companies in particular appear to have the greatest potential to experience sizeable price appreciation as the ratio between high quality midstream MLPs and high quality REITs converge. All have experienced some gains as industry insiders recognize the buying opportunity. Investors may also want to consider taking advantage of an unjustly battered sector since the convergence may be far from finished.  

Kinder Morgan (KMI) and Enterprise Products Partners (EPD) are two of the largest and most diversified companies in the space, and Plains All American Pipeline (PAA) is one of the largest midstream providers in North America. Given their large established asset footprints and relative yield spreads, all three look particularly compelling right now.

In addition, Energy Transfer Equity (ETE), MarkWest Energy Partners (MWE), Targa Resources (TRGP) and Williams Companies (WMB) look attractive, as they all have underappreciated asset footprints, potential to participate in M&A and/or high perceived commodity price sensitivity.

The return potential of these companies is illustrated in the following graphs, where the current yield spreads of the individual names are compared against their historical average (each versus the high-quality REIT index). 1 These reflect potential returns from spread compression only; company-specific growth or other factors could provide even more upside.

Disclaimer

This commentary is provided as general information only and is in no way intended as investment advice, investment research, a research report or a recommendation. Any decision to invest or take any other action with respect to the securities discussed in this commentary may involve risks not discussed herein and any such decisions should not be based solely on the information contained in this document. It should not be assumed that any securities discussed in this commentary will increase in value. Highland Capital Management Fund Advisors, L.P. (“Highland”) will not accept liability for any loss or damage, including, without limitation, any loss of profit that may arise directly or indirectly from use of or reliance on such information.

Statements in this communication may include forward-looking information and/or may be based on various assumptions. The forward-looking statements and other views or opinions expressed herein are made as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated and there is no guarantee that any particular outcome will come to pass. The statements made herein are subject to change at any time. Highland disclaims any obligation to update or revise any statements or views expressed herein.

In considering any performance information included in this commentary, it should be noted that past performance is not a guarantee of future results and there can be no assurance that future results will be favorable. Nothing contained herein should be deemed to be a prediction, projection or guarantee of future performance. Any targets contained herein have been prepared and are set out for illustrative purposes only, and no assurances can be made that they will materialize. They have been prepared based on our current view in relation to future events and various estimations and assumptions made by us, including estimations and assumptions about events that have not occurred, any of which may prove to be incorrect. Therefore, the forecasts are subject to uncertainties, changes (including changes in economic, operational, political, sovereign or other circumstances) and other risks, including, but not limited to, broad trends in business and finance, legislation and regulation, monetary and fiscal policies, interest rates, inflation, currency values, market conditions, all of which are beyond our control and any of which may cause the relevant actual, financial and other results to be materially different from the results expressed or implied by such forecasts.

No representation or warranty is made concerning the completeness or accuracy of the information contained herein. Some or all of the information provided herein may be or be based on statements of opinion. In addition, certain information provided herein may be based on third-party sources, which information, although believed to be accurate, has not been independently verified.

Highland and/or certain of its affiliates and/or clients hold and may, in the future, hold a financial interest in securities that are the same as or substantially similar to the securities discussed in this commentary. No claims are made as to the profitability of such financial interests, now, in the past or in the future and Highland and/or its clients may sell such financial interests at any time.

The information provided herein is not intended to be, nor should it be construed as an offer to sell or a solicitation of any offer to buy any securities. This commentary has not been reviewed or approved by any regulatory authority and has been prepared without regard to the individual financial circumstances or objectives of persons who may receive it. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Highland encourages any person considering any action relating to the securities discusse herein to seek the advice of a financial advisor.

1 Source: Bloomberg, 12/31/12-4/17/15; REIT Index is comprised of an equal weighted index of the following indices: (1) FTSE NAREIT Industrial/Office Property Sector Index, (2) FTSE NAREIT Retail Property Sector Index, (3) FTSE NAREIT Residential Property Sector Index, (4) FTSE NAREIT Diversified Property Sector Index, (5) FTSE NAREIT Health Care Property Sector Index