MLP Screening – Did The Market Overreact To Some 10%+ Yielding MLPs And Should We Value Them Differently?
Summary MLPs have held up relatively well against the commodity price decline until it recently plunged ~20% in the last 3 months. Alerian MLP ETF currently yields 8.5% with a select number of names trading well above 10% distribution yield. MLPs have largely been safe yield vehicles – will there be a shift in investor base and change in how investors value MLPs? Disclaimer: For avoidance of doubt, any reference to MLP excludes E&P MLPs for the purpose of this article. Alerian MLP Index (AMZ) Price Performance (click to enlarge) Alerian MLP Index Yield vs. Other Indices (click to enlarge) MLPs have been an efficient route for midstream asset owners to monetize their stake in assets that have largely contracted or recurring cash flow characteristics at valuations that far exceed private transaction multiples. For investors, it has been a very attractive/safe yield vehicle (and tax friendly) underpinned by a consistent and high growth profile as billions of new capital got deployed for new drilling and infrastructure developments. At a very high level, most MLPs service the upstream and/or downstream value chain in providing long-term recurring services. A recurring revenue stream ensures stable cash flow and given that 90% of distributable cash flows are required to be distributed in order to maintain MLP classification, investors enjoyed stable cash yield. Continued expansion of infrastructure and oil & gas exploration activities also led to high-single digit to double-digit growth in distribution. As a result, distribution yield (with growth embedded) kept falling and valuations kept going up. MLPs were also able to grow through acquisitions, using its extremely cheap cost of capital to acquire businesses at high multiples, which were still accretive from a distributable cash flow (“DCF”) point of view. While investors can view MLP businesses using more traditional valuation metrics such as EV/EBITDA and P/E, in real life, and in a grossly oversimplified form, valuations are quoted based on distribution yield. Again, in a very simplified manner, if you were to dissect distribution yield, the market essentially assigns a cost of equity (what level of levered cash flow the business should generate in perpetuity) and subtracts a growth rate on the DCF – and this dictates the distribution yield that the market bases its valuation/stock pricing for that particular MLP company. Let’s dig a little deeper in terms of this valuation concept. This was a perfectly feasible method of valuation for a number of reasons. 1) DCF for an MLP is actually very predictable and stable (EBITDA – maintenance CapEx – interest expense was very stable), 2) because it is very predictable and MLPs are required to distribute that DCF to investors, it made even more sense to value the business from a DCF/distribution perspective, 3) growth through backlog and continued capital spend in the broader oil & gas industry was also very visible and the implied valuation derived from a yield (or multiples if you invert the yield) standpoint was far in excess of general market valuation, and therefore, using EV/EBITDA or P/E where the general market trades at ~9-10x EBITDA and ~16-18x earnings obviates any sense of comparability. Said in a different way, DCF growth rate is what moved the needle from a valuation standpoint and was therefore the most important variable in determining how the stock price would move. To avoid any psychological biases, let’s remove the “MLP” classification for a second and just consider them as a normal c-corp business. Also, let’s work under the premise that there is no debate around the fact that the commodity price environment is challenging and there are lots of uncertainties and macro headwind pervading the market. For simplicity, let’s take out the near-term growth component and say there is no growth for the next year or two. Even without growth prospects, these are excellent businesses with contracted/recurring cash flows, minimal capital requirement to maintain earnings power, and minimal operational complications (often times there are pricing protection through contracts and even annual CPI escalators). How much would you pay for this type of business? Maybe there will be a slight dent in EBITDA this year or next year (not many names are really taking a hit on cash flow, they are just growing at a slower rate), but if the premise is that there is always cyclicality in the commodity market and things will turnaround to get back into a nice growth trajectory in a year or two from now, how much would you pay off next year or two-year forward FCF? To take a more draconian stance, even if there was no growth trajectory in a year or two from now, is it truly justifiable to say that many of these businesses should trade at 500-1000bps above debt instruments with equivalent credit ratings? When was the last time you were able to pick up a stock for 4-9x levered free cash flow even if there was a dim outlook for businesses that possess this quality? For the purpose of identifying “better” quality – off the top of my head, few high level components to look for in terms of evaluating the fundamentals of these businesses: 1) Contract structure (duration, minimum volume commitment, take-or-pay % vs. throughput %, fixed fee vs. commodity price dependent fee, inflation escalator); 2) Customer credit (liquidity, credit ratings, leverage), types of customers (E&P, refinery, other midstream, logistics, export demand, etc), customer diversity (having customer concentration through an excellent customer may sometimes be more favorable than having mediocre quality diversified customer base); 3) Liquidity (cash + RCF availability); 4) Geography (if volumes are growing at a certain geography or basin, it doesn’t matter if commodity prices are falling for the midstream provider); 5) Maintenance capital as % of EBITDA; 6) Growth capital need and payback period (some businesses like a pipeline are capital intensive in the beginning but it’s all about maintaining existing volume and increasing utilization whereas some businesses require continued capital spend to service both existing and additional customers; it’s a tough dynamic if you are in a spot today where you are asked to spend capital in hopes that you will utilize them in the future) While there was always some level of premium/discount for MLPs depending on sub-sector, commodity price exposure, contractual structure, maintenance/growth capital need to maintain cash flow profile, geographic footprint and size consideration, today’s market where many players are trading at yields that imply distribution cut and at a meaningfully compressed valuation relative to few months ago and versus the broader market, it definitely seems like an interesting environment where MLPs are interesting not just as a safe haven and perpetual dividend asset but an opportunity to generate alpha through capital appreciation. During this oil crash since summer of 2014, you have consistently seen sub-sectors get crushed, only to see a lagged pick up among “better quality” names (E&P, OFS, LNG, Petchems, etc). This sequence of overreaction immediately followed by a quick and steep rebound among quality names is common across all sectors during a market sell-off. While this article does not address a specific recommendation and may be repeating what is already well recognized among investors, I wanted to provide 1) a quick screening of MLP names that are under oversold categories and 2) perhaps a different perspective around decoupling from the prevalent methodology of looking at MLPs like a fixed income security to a more traditional equity security (especially in light of what the valuations imply at today’s price and for those who think investing in MLPs today is like catching a falling knife). Below is a quick screening based on MLPs trading above 10% 2015E distribution yield (I am sure I am missing a few names that have above 10% yields). Second table excludes names with net debt/’15E EBITDA above 5x. There is not much science for drawing the line at 5x but wanted to exclude names that may be trading at compressed valuations due to distress and/or were previously highly levered to rapid growth prospects. Again, I have no idea if the excluded names are truly in distress or sized debt prematurely with too much embedded growth – just wanted to make the bifurcation. MLP Universe (NYSEARCA: AMLP ) – Names trading above 10% distribution yield Source: Capital IQ – Crestwood Midstream (NYSE: CMLP ), Crestwood Equity (NYSE: CEQP ), Southcross Energy (NYSE: SXE ), Azure Midstream (NYSE: AZUR ), Hi-Crush (NYSE: HCLP ), Natural Resource Partners (NYSE: NRP ), CSI Compressco (NASDAQ: CCLP ), Cypress Energy (NYSE: CELP ), American Midstream (NYSE: AMID ), Teekay Offshore (NYSE: TOO ), Capital Product Partners (NASDAQ: CPLP ), Midcoast Energy (NYSE: MEP ), Martin Midstream (NASDAQ: MMLP ), Exterran Partners (NASDAQ: EXLP ), Targa Resources (NYSE: NGLS ), DCP Midstream (NYSE: DPM ), USA Compression (NYSE: USAC ), Teekay LNG (NYSE: TGP ), NGL Energy (NYSE: NGL ), Oneok Partners (NYSE: OKS ), Suburban Propane (NYSE: SPH ). MLP Universe – Names trading above 10% distribution yield and less than 5.0x net debt / ’15E EBITDA Source: Capital IQ – Crestwood Midstream, Crestwood Equity, Azure Midstream, Hi-Crush , CSI Compressco, Cypress Energy, Teekay Offshore, Capital Product Partners, Martin Midstream, Exterran Partners, Targa Resources, DCP Midstream, Oneok Partner , Suburban Propane. Disclosure: I am/we are long CELP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.