For investors who seek despondent sellers, look no further than energy infrastructure in late 2018. The Alerian MLP Index made its all-time high way back in August 2014. It currently sits 43% lower (including dividends). Barring a strong recovery in the last days of December, returns for three of the past four years are negative. Not coincidentally, MLP distributions are down for their fourth straight year. The Alerian MLP ETF (AMLP) has cut payouts by 34%, with its most recent one last month. Investors don’t want dividend cuts, they want dividend hikes – and in 2019 they will see them.

The shift of MLP Distributable Cash Flow (DCF) from distributions to funding growth projects has been well documented (see Will MLP Distribution Cuts Pay Off?). Growth capex (i.e. where that money went) dipped in 2016 but has been robust since then. Valuations continue to be more reflective of Free Cash Flow (FCF), which is after capex, whereas we think DCF (before capex) is more relevant (see Valuing Pipelines Like Real Estate). But investors are skeptical that cash formerly paid out is being well spent, and resentful of the dozens of cuts. Rising payouts should help.

Pipeline company earnings calls are full of positive reports with optimistic guidance. Business has rarely been this good. In August, Energy Transfer (ET) CEO Kelcy Warren memorably said, “A monkey could make money in this business right now.” (see Running Pipelines is Easy). Business conditions have only improved since then. In November, ET reported another strong quarter, beating Street estimates of EBITDA by 11%. Yet ET’s stock slumped, and is down 33% from its late July “business is easy” level, even though that description seems accurate.

No other metric explains sector performance as well as the path of dividends (or distributions for MLPs).

.avia-image-container.av-12rzao9-eddff0d11633db323c3ae4fc4e693b11 img.avia_image{ box-shadow:none; } .avia-image-container.av-12rzao9-eddff0d11633db323c3ae4fc4e693b11 .av-image-caption-overlay-center{ color:#ffffff; }

It’s rare for an industry to cut dividends when profits are growing, but that’s exactly what this sector has done. Falling dividends are so often associated with poor operating performance that investors reasonably equate the two – especially yield investors. Pipeline management teams consistently report on terrific business conditions and lament their stock’s low valuation. Part of the reason is that management teams too often invest in new projects rather than buying back stock. Buybacks with DCF yields of 14% and higher must surely be more compelling (and less risky) than all but the most attractive new investments. It’s no wonder investors question their judgement.  Williams Companies (WMB) CEO Alan Armstrong recently said, “I don’t recall a time in my years in executive management when the business has been this healthy but the equity markets so poorly reflecting that.”

While business is booming and valuations are very attractive, Alan Armstrong and others still fail to appreciate (or at least don’t acknowledge) the crushing effect dividend cuts have had on investor appetite for their stocks. No other explanation fits the facts as well. Some blamed crude oil for the 2014-16 collapse, but MLPs only modestly participated in the subsequent crude rally. Recently we read an analysis that attributed stock weakness to rising leverage, but leverage peaked in 2016 at around 5.5X Debt/EBITDA and is comfortably heading lower. We estimate that our portfolio companies’ will exit next year at 4.1X, comfortably within the range that prevailed before the 2014 MLP market peak.

.avia-image-container.av-9cqrt-b436b8b9e264f3f6729f67f5e42d41d4 img.avia_image{ box-shadow:none; } .avia-image-container.av-9cqrt-b436b8b9e264f3f6729f67f5e42d41d4 .av-image-caption-overlay-center{ color:#ffffff; }

For almost a decade, Williams Partners (WPZ) investors were trained to expect gently rising distributions that came with a tax deferral and a K-1. This happy arrangement was abandoned when Shale Revolution growth opportunities presented themselves. The first cut came when WPZ combined with Access Midstream (ACMP), formerly Chesapeake’s midstream business before it was spun out. WPZ adopted the lower, ACMP payout which resulted in an effective cut for legacy WPZ holders. Two years later, partly due to concerns about leverage, WPZ imposed a second outright cut. The final one came when WPZ was folded into Williams Companies (WMB), in a “simplification”. WMB’s lower payout was applied to WPZ holders, along with a tax bill on recaptured income.

Long-time WPZ investors have endured a 53% cut in their payouts, which are back to the levels of 2006. Having been taught to focus on distributions and ignore market gyrations, they must find Alan Armstrong’s upbeat comments incongruous if not insulting.

Nonetheless, Alan Armstrong is right that business is good. It’s just that he and his peers have so mistreated their investors that his enthusiasm is less infectious than he might like.

A useful perspective on valuations is to compare pipeline companies’ current EV/EBITDA premium to the energy sector versus its long term average. Even by the unloved standards of the energy sector, midstream infrastructure is historically undervalued.

.avia-image-container.av-ue08nd-2ca6c37c923767b2883d7ba211437cae img.avia_image{ box-shadow:none; } .avia-image-container.av-ue08nd-2ca6c37c923767b2883d7ba211437cae .av-image-caption-overlay-center{ color:#ffffff; }

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies, and is 20% weighted to MLPs. Dividends paid by corporations have been more reliable than MLPs; 2018 dividends on the index are up 7%, following a 3% increase last year. By contrast, dividends on the Alerian MLP and Infrastructure Index, as represented by its index fund AMLP, are down 6% following a 16% drop in 2017. Since MLP payouts are a bigger portion of their available cash flow, they had farther to fall. But the limited investor base (largely U.S. individual investors) has inhibited their flexibility in managing cash.

As a result, many large MLPs have converted to corporations, so an MLP-only view of energy infrastructure (as with the Alerian MLP Index for example), fails to fully represent the sector. Moreover, MLP investors invest for income, which has made them an unreliable source of capital when their income is being cut.

In 2019 we expect AEITR dividends to grow high single digits. MLP distributions should also begin growing for the first time since 2014, although not by as much. Corporations generally offer faster, more reliable growth.

We wish all of our readers a Happy Christmas and holiday season. Enjoy the time with family, and we’ll all look forward to a rebound in 2019.

We are invested in ET and WMB. We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Weakness in the pipeline sector over the past couple of years has caused soul-searching and changes to corporate structure. Incentive Distribution Rights (IDRs), which syphon off a portion of an MLP’s Distributable Cash Flow (DCF) to the General Partner (GP) running it, have largely gone. Many of the biggest MLPs have abandoned the structure entirely, leaving its narrow set of income-seeking investors to become corporations open to global institutions.

The debate among investors, management and Wall Street about how to unlock value received some useful ideas recently from Wells Fargo. In a presentation titled The Midstream Conundrum…And Ideas For How To Fix It, they make a persuasive case that stock buybacks offer a more attractive use of investment capital than new projects.

.avia-image-container.av-2607hjd-64c8c9a4f2d172475e9cb4a1a6ba4f08 img.avia_image{ box-shadow:none; } .avia-image-container.av-2607hjd-64c8c9a4f2d172475e9cb4a1a6ba4f08 .av-image-caption-overlay-center{ color:#ffffff; }

This would be a significant shift for MLPs. As recently as five years ago, they paid out 90% or more of their DCF to unitholders and GP (if they had one). The Shale Revolution was only beginning to demand substantial new infrastructure, so they had little else to do with their cash. New projects were funded by borrowing and by issuing equity through secondary offerings.

Shale plays were in regions, such as the Bakken in North Dakota and the Marcellus in Pennsylvania/Ohio, inadequately serviced by pipelines. This broke the model, because the amounts of investment capital required grew substantially. The capital markets loop of paying generous distributions while simultaneously retrieving much of the cash through new debt and equity was no longer sustainable. Dozens of distribution cuts and lower leverage followed, leading to projects being internally financed. This is the new gold standard for the sector – reliance on external capital to fund growth is out.

Wells Fargo takes this logic a step further, asking why excess cash always needs to be reinvested back in the business rather than returned to investors via buybacks. In spite of professed financial discipline, midstream management teams invariably find new things to build, all expected to be accretive (i.e. return more than their cost of capital). Pipeline companies are not alone – the entire energy sector has been dragged by investors to prioritize cash returns over growth. But MLPs rarely buy back stock. Free of a corporate tax liability, MLP distributions aren’t subject to the double taxation of corporate dividends, so raising payouts is a simple way to return cash.

The Midstream Story over the past several years has largely been about financing growth projects. Investor payouts were sacrificed, but rarely did a company admit that its internal cost of capital was too high to justify a new initiative. Wells Fargo is challenging management teams to regard buying back their own stock as a more attractive use of capital than building or acquiring new assets. This is capital management 101 for most industries, but unfamiliar terrain for pipeline stocks. Growth is embedded in the culture. The original justification for the GP/MLP structure with IDRs was to incent management to grow the business. CEOs in other industries find the motivation without such complexity.

In October, virtually every 3Q18 earnings call included an optimistic outlook from management, usually coupled with disbelief at the continued undervaluation of their stock. Attractive valuations mean a high internal cost of capital. Valued by DCF, or Free Cash Flow (FCF) before growth capex, midstream yields are in some cases higher than many companies’ stated Return on Invested Capital (ROIC) targets. Moreover, historic ROIC for the industry has often turned out lower than promised, although it has been improving.

Energy Transfer’s (ET) 16% DCF yield almost certainly offers a higher return than all but their best projects, and suggests they should be repurchasing stock. SemGroup’s (SEMG) DCF is 20%, twice the industry’s historic ROIC.

.avia-image-container.av-1q77ip5-7a52f8375b9c6b9beb42379f8c035b28 img.avia_image{ box-shadow:none; } .avia-image-container.av-1q77ip5-7a52f8375b9c6b9beb42379f8c035b28 .av-image-caption-overlay-center{ color:#ffffff; }

Growth caused the past four  years’ upheaval, and today’s low valuations are the result. Capital discipline has been less present than CEOs often claim, which is why they’ve apparently responded coolly to Wells Fargo’s buyback recommendation.

.avia-image-container.av-14wd7jd-825cc3bc4e0fa13e706e445b5438aa99 img.avia_image{ box-shadow:none; } .avia-image-container.av-14wd7jd-825cc3bc4e0fa13e706e445b5438aa99 .av-image-caption-overlay-center{ color:#ffffff; }

DCF yields of 10-14%  or more (as with ET’s 16%) are dramatically higher than FCF yields of 3%, because DCF measures cash generated before funding for growth projects while FCF is after.  FCF yields are set to rise sharply over the next few years, but this crucially relies on new investment coming down. The industry has a habit of showing that peak spending on new projects is imminent, only to push that back another year. 3Q earnings calls saw 2019 estimated capex creep up by almost 20%.

.avia-image-container.av-lq5dxl-43ae0b441b3ee586343f7f21fa04c580 img.avia_image{ box-shadow:none; } .avia-image-container.av-lq5dxl-43ae0b441b3ee586343f7f21fa04c580 .av-image-caption-overlay-center{ color:#ffffff; }

2018 is the fourth year of distribution cuts for MLPs, as reflected in the Alerian MLP ETF (AMLP). Corporations have fared better, and next year we expect dividends on the American Energy Independence Index to grow by 8-9%. If midstream companies are as financially disciplined as they claim, they’ll follow the advice from Wells Fargo in evaluating stock buybacks alongside new investments under consideration. It would complete their metamorphosis into more conventional companies.

We are invested in ET and SEMG.

We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Canada’s struggles to get its crude oil to market have been a source of immense frustration if you’re an Albertan oil producer, or a huge success if you’re an anti-fossil fuels activist. Last week, Alberta’s premier Rachel Notley imposed almost a 9% cut in production in order to raise prices. Shortage of available infrastructure had opened up a price discount as wide as $50 per barrel between the bitumen-based Western Canadian Sedimentary Basin, and the WTI benchmark. Unusually, it led to Canadian producers asking the government to intervene.

The heavy, viscous crude from Canada’s oil-sands is reviled by activists because its extraction is particularly disruptive to the local environment, as well as requiring substantial energy inputs to heat it. The Obama Administration repeatedly held up the Keystone XL expansion because of its view that this type of crude should remain in the ground. Alberta has been frustrated at every turn in obtaining cost-effective transport for its output. Earlier this year, Kinder Morgan (KMI) gave up on their Trans Mountain Expansion, intended to increase pipeline capacity west to British Columbia’s Pacific coast. Navigating inter-provincial politics threatened to derail the project, and KMI managed to unload it on the Canadian Federal government not long before an adverse court ruling added further delays (see Canada’s Failing Energy Strategy).

.avia-image-container.av-1okv1eg-b88934ba675f3aacee6f53cd44b9e8bd img.avia_image{ box-shadow:none; } .avia-image-container.av-1okv1eg-b88934ba675f3aacee6f53cd44b9e8bd .av-image-caption-overlay-center{ color:#ffffff; }

Canada has unique challenges, revealing the weak hand their Federal government has in dealing with its sometimes unruly provinces. But pipeline construction has been hampered in the U.S. too. Energy Transfer’s (ET) Dakota Access Pipeline (DAPL) was delayed by Obama because of concerns over its proximity to land held sacred by some native American tribes (others were supportive, generally depending on the likelihood of financial gain through the use of their land). Shortly after his inauguration Trump allowed DAPL to move forward. But ET has at times run afoul of regulators during construction, drawing hundreds of violations during the construction of two natural gas pipelines. The industry needs ET to do better.

Shortages of infrastructure in west Texas have led to flaring of natural gas as well as impeding the growth of crude production. The completion of new pipelines by late 2019 should help. The Energy Information Administration expects Permian output to grow by 600 thousand barrels per day next year, to 3.9 Million Barrels per Day (MMB/D). The new pipeline takeaway capacity could enable it to reach 5 MMB/D by 2020, bringing U.S. output close to 13 MMB/D.

New England suffers from too little investment in natural gas infrastructure, with the result that during cold winter months they import liquefied natural gas from Trinidad and Tobago (see An Expensive, Greenish Strategy).

In many parts of the country (apart from Texas and Louisiana), energy infrastructure is becoming steadily harder to build. The losers clearly include consumers, such as those in the north east who have to pay more for electricity. In Canada, clearly oil producers suffer from the steep discount on their production. But less growth in infrastructure increases the value of what currently exists. Because Permian crude can’t all get to its desired destination (usually Cushing, OK or Houston for refining/export) by pipeline, the price differential has at times exceeded $15 per barrel. Regional differentials can support pipeline profits, since when they exceed pipeline tariffs it reflects high demand. Plains All American (PAGP) has been able to charge higher prices on parts of its crude oil pipeline network in Texas for just this reason.

New pipelines enjoy network effects. Connecting a new pipeline to an existing network adds value by increasing destination choices for shippers. This has always represented a hurdle for new entrants to surmount. But the increasing role of judicial challenges by environmental activists serves to further entrench existing operators. The pipeline business is one in which companies needn’t worry too much about a disruptive new upstart taking market share. As a result, today’s big energy infrastructure companies are highly likely to be dominant for many years to come. If new pipelines are harder to build, existing pipelines must be correspondingly more valuable. An unintended consequence of pipeline opposition is to develop a pipeline oligopoly.

Last week Enterprise Products Partners (EPD) gave a presentation at a Wells Fargo conference which emphasized corporate (rather than MLP) measures of performance. By referencing more familiar terms, such as Cash Flow From Operations, rather than the MLP-oriented Distributable Cash Flow, they hope to draw more generalist investors to consider valuations, even while EPD has no plans to convert from an MLP to a corporation. We think it’s a good move – we recently highlighted EPD’s value using discounted cash flows (see Valuing MLPs Privately — Enterprise Products Partners). We also compared pipelines with buildings (see Valuing Pipelines Like Real Estate). A consistent theme from management teams is the disconnect between the strong fundamentals of their businesses and weak stock prices.

.avia-image-container.av-17vty7s-4d92b72a2465de1db1be792280692cae img.avia_image{ box-shadow:none; } .avia-image-container.av-17vty7s-4d92b72a2465de1db1be792280692cae .av-image-caption-overlay-center{ color:#ffffff; }

.avia-image-container.av-kunk0o-1de2310d563045cfee5581a914289180 img.avia_image{ box-shadow:none; } .avia-image-container.av-kunk0o-1de2310d563045cfee5581a914289180 .av-image-caption-overlay-center{ color:#ffffff; }

Retail sentiment remains poor. Our friend John Cole Scott of Closed End Fund Advisors notes that discounts to NAV on MLP closed end funds are at 8%, more than twice the three year average and 10% wider than the best levels of last spring.

In the Britcom Fawlty Towers, the manic hotel manager Basil Fawlty (played by Monty Python’s John Cleese) is told during one crisis, “…to remember there’s always somebody worse off than yourself.” To which he replies, “Well I’d like to meet him, I could do with a laugh.” (see here at the 1:25 mark).

In that vein, pipeline investors who nowadays believe they’re in the world’s least loved sector should spare a thought for energy services, which have recently exceeded the lows of the 2008-09 financial crisis.

.avia-image-container.av-w2dlbs-f0b265b7932d9416ea38250355387f18 img.avia_image{ box-shadow:none; } .avia-image-container.av-w2dlbs-f0b265b7932d9416ea38250355387f18 .av-image-caption-overlay-center{ color:#ffffff; }

For energy infrastructure investors, we think rising dividends will finally put to rest the concern over serial cuts in payouts.  The American Energy Independence Index contains North America’s biggest pipeline companies, which are mostly corporations but include a few MLPs. It yields 6.25%, and we expect 7-8% dividend growth next year.

We are invested in EPD, ET, KMI and PAGP

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Around this time of the year we typically write about MLP seasonals. That’s because the “January effect” has been an enduring pattern of investor activity, far more pronounced than in the broader equity market. Prices would reliably dip in November before firming in December and shooting higher in January. This was due to the combination of income-seeking individual investors with K-1s. Because of the additional tax preparation costs, if you’re planning to sell an MLP in January, you might as well act in December and avoid one more K-1. Similarly, a December purchase delayed until January also avoids a K-1.

.avia-image-container.av-1bfczyj-65553775ff34562fb86bfbf0ac174f8c img.avia_image{ box-shadow:none; } .avia-image-container.av-1bfczyj-65553775ff34562fb86bfbf0ac174f8c .av-image-caption-overlay-center{ color:#ffffff; }

Quite possibly, the natural inclination to take stock of life, including investments, around the holiday season resulted in a decision to allocate cash to MLPs. Two years ago, in Give Your Loved One an MLP This Holiday Season, we noted the historic pattern and why purchasing MLPs in early December had worked so consistently.

Although the year-end pattern was most pronounced, there’s also an intra-quarter one. MLP investors love their income. Distributions tend to be declared in the first month of the quarter, payable a few weeks later. Sellers tend to hang on long enough to be a holder of record for the quarter, creating the Jan/Apr/Jul/Oct cycle of positive months.

Much has changed over the past five years. MLPs can no longer be relied upon for steady income. The Alerian MLP ETF (AMLP) recently cut its distribution again, resulting in a 34% cumulative reduction since 2014. Not only did some MLPs with high yields cut their dividends outright to fund growth projects and reduce leverage, but many were purchased by their much lower yielding parent companies, providing “backdoor” distribution cuts to MLP. The consequent betrayal of income-seeking investors has had many casualties, including still-depressed sentiment oblivious to attractive valuations.

Another change has been the breakdown of the seasonal pattern. Having been mistreated, income-seeking investors no longer act so predictably. Over the past five years the January effect has completely gone. So has the quarterly pattern – years ago, when the sector was stable and fairly unexciting, holding your investment a few more weeks so as to get that extra distribution wasn’t inordinately risky. MLP investors have learned to appreciate risk differently, and it’s clear that the calendar bears very little on the timing of today’s buyers and sellers. What’s striking about the past five years is both the randomness of the monthly returns, as well as that the average month is -0.3%. From 1996-2013 it was +1%.

.avia-image-container.av-wghkbv-ce8f51fe5abc6df12073544c626c12ac img.avia_image{ box-shadow:none; } .avia-image-container.av-wghkbv-ce8f51fe5abc6df12073544c626c12ac .av-image-caption-overlay-center{ color:#ffffff; }

The loss of the seasonal pattern is further evidence that the traditional investor, with her predictable habits developed over years of happy results, has left. It’s why the sector is cheap, because the former buyers have fallen out of love. Thus spurned, large MLPs have converted to corporations in search of new suitors, such that less than half of U.S. midstream infrastructure now retains the MLP format. Many believe the MLP model is irretrievably broken.

Eventually, and possibly quite soon, rising dividends will draw in a new set of buyers. They’ll buy corporations that were formerly MLPs, as well as some of the remaining MLPs. They’ll rely on discounted cash flow analysis (see Valuing MLPs Privately — Enterprise Products Partners). They’ll look beyond the betrayals (see Kinder Morgan: Still Paying for Broken Promises). They’ll find a sector with 11% free cash flow yields before financing new projects, and dividend yields of 6%+ growing at 10% (our 2019 forecast for the American Energy Independence Index).

We are long EPD and KMI. We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Too few writers covering energy infrastructure admit to the many distribution cuts inflicted on MLP holders. Instead, they identify numerous other problems whose resolution will draw in buyers. Incentive Distribution Rights (IDRs), the payments made by MLPs to their General Partners (GP), have drawn scorn for the past couple of years. Eliminating them is fashionable and now virtually complete, with only a handful of holdouts. Other solutions include self-funding growth projects. Common practice was for MLPs to pay out most of their cash and raise equity for new projects. It worked until the new projects became big. The Shale Revolution was responsible for that. Selling non-core assets is another piece of advice – it’s rarely controversial. Few companies admit that any assets are non-core, until selling them.

All this free advice is directed both publicly and privately to help draw in new investors and lift stock prices. What’s rarely mentioned are the widespread and substantial cuts in distributions that have alienated the income-seeking MLP investor base. Alerian has a chart showing “AMZ Normalized Distributions Paid”, which shows a cumulative 25% cut 2015-17, if you do the math. Dividends on AMLP are down 34% from their high in 2014, although you won’t find this on their website. Promises have been broken, and the buyers know this.

One reason others don’t dwell too much on this issue is that many distribution cuts have been via mergers and simplifications. When a lower yielding GP acquires its MLP, the MLP investors are subjected to a “backdoor” distribution cut through owning a new security with a lower yield than the one they gave up.

.avia-image-container.av-kzu0wv-f408f1013009f7d7ddea05897c52d113 img.avia_image{ box-shadow:none; } .avia-image-container.av-kzu0wv-f408f1013009f7d7ddea05897c52d113 .av-image-caption-overlay-center{ color:#ffffff; }

Energy Transfer has excelled at imposing such “stealth distribution cuts”. Over the past four years they’ve rolled four publicly traded entities into one. In each case, the lower-yielding entity acquired the higher-yielding one, resulting in a lower distribution for investors in the acquiree.

What’s striking is to overlay the normalized distribution history of the four entities: Energy Transfer Equity (ETE), Energy Transfer Partners (ETP), Sunoco Logistics (SXL) and Regency Partners (RGP). ETE is the surviving entity, now renamed Energy Transfer (ET).

ETE investors have seen a five-fold increase in distributions since 2006, a 13% compounded annual growth rate. They’ve increased distributions every year.  That shouldn’t be surprising, because ETE was always the vehicle of choice for CEO Kelcy Warren and the management team. SXL holders had a good run – in 2016 they folded in higher-yielding ETP but retained the ETP name, which gave them a 14% distribution growth rate to that point. But then they were “Kelcy’d”, as ETP adopted ETE’s lower payout in a subsequent combination, leading to a 31% effective cut. Original investors in ETP and RGP did worse.

ET’s price peaked in 2015 (it was ETE back then), when Kelcy embarked on his ultimately unsuccessful attempt to buy Williams Companies (WMB). It’s a measure of how far sentiment has fallen, in that ETE’s yield briefly dipped below 3% in May 2015. Since then, its distribution has risen from $1.02 to $1.22. They dodged the WMB deal, have reduced leverage, completed the Dakota Access Pipeline and expect to cover their distribution by 1.7-1.9X next year. Nonetheless, today ET yields 8.5%, with an estimated 2019 Distributable Cash Flow yield of 15.9%. No wonder Kelcy Warren is back in buying the stock.

It’s true that ET’s management has earned a reputation for self-dealing. During the protracted WMB merger negotiations , ETE issued very attractive convertible preferred securities to the senior executives, but didn’t make them available to other ETE investors (see Will Energy Transfer Act with Integrity?). Although they won the resulting class action lawsuit, it’s clear that if management can get away with something that benefits them but not shareholders, they will. Even so, the current valuation seems excessively pessimistic.

.avia-image-container.av-ms6zen-39af891613af457b6042b6dc36db6705 img.avia_image{ box-shadow:none; } .avia-image-container.av-ms6zen-39af891613af457b6042b6dc36db6705 .av-image-caption-overlay-center{ color:#ffffff; }

Kinder Morgan (KMI) and Plains All American (PAGP) drew unwelcome attention for each delivering two distribution cuts to their investors. KMI’s first cut was through combining with their MLP in the technique later used by ETE. They followed this up with a second, unambiguous cut in response to rating agency concerns over leverage.  PAGP’s management administered two direct cuts, stunning investors both times. Oneok (OKE), Targa (TRGP), Semgroup (SEMG), and Enlink (ENLC) all folded in their respective MLPs, delivering backdoor distribution cuts to their MLP holders but maintaining their dividends at the GP level.  But many others avoided cutting their dividends at all.  Antero Midstream (AMGP), Tallgrass (TGE) and Western Gas (WGP) all rolled up their MLPs with no change in payouts.

None of the Canadian midstream companies cut their dividends, reflecting their more conservative approach. This highlights that the distribution cuts were due to the flawed MLP practice of paying out virtually all available cash flow, relying on tapping the capital markets for growth projects. There were a few exceptions, but in general MLP distribution cuts were not due to deteriorating fundamentals in the midstream sector.

MLPs are still cutting payouts. Distributions on AMLP, which is MLP-only and tracks the Alerian MLP Infrastructure Index, are down 6.9% this year. By contrast, distributions on the American Energy Independence Index, which includes the biggest North American pipeline corporations and MLPs and is therefore more representative of the overall sector, are up 6.6%.

We are invested in AMGP, ENLC, ET, KMI, OKE, PAGP, SEMG, TGE, TRGP, WGP and WMB. We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

If pipeline stocks moved with natural gas rather than crude oil, their long-suffering investors could look back on a good week. On Tuesday crude was down $5 per barrel for the week, before recovering $2 by Friday. It’s tumbled $20 since early October, bringing Brent Jan ’19 to $66. By contrast, the Jan ’19 natural gas contract stormed out of its $2.90 to $3.50 per Thousand Cubic Feet (MCF) range that has constrained it all year, almost reaching $5 on Wednesday. Rarely have oil and gas been so disconnected.

.avia-image-container.av-2a1cyp1-6f5ceb55b988d1a505c77ce03c87375f img.avia_image{ box-shadow:none; } .avia-image-container.av-2a1cyp1-6f5ceb55b988d1a505c77ce03c87375f .av-image-caption-overlay-center{ color:#ffffff; }

.avia-image-container.av-2f9m86d-1494c97afaaef5db6d05f26f5c42c7ff img.avia_image{ box-shadow:none; } .avia-image-container.av-2f9m86d-1494c97afaaef5db6d05f26f5c42c7ff .av-image-caption-overlay-center{ color:#ffffff; }

The energy sector moves to the rhythm of crude. It’s is a global commodity, relatively easy to transport, which allows regional price discrepancies to be arbitraged away. Oil can move by ship, pipeline, rail or truck. Transportation costs vary from a few dollars per barrel for pipeline tariffs or waterborne vessel to $20 or more by truck. Although Canada’s dysfunctional approach to oil pipelines has led to deeply depressed prices, in most cases transport costs are a portion of the cost of a barrel.

By contrast, natural gas (specifically methane, which is used by power plants and for residential heating and cooking) generally only moves through pipelines or on specially designed LNG tankers in near-liquid form. Long-distance truck transportation isn’t common because liquefying methane to 1/600^th of its gaseous volume requires thick-walled steel tanks. Methane moved as Compressed Natural Gas (CNG) is only 1% of its normal volume (i.e. requires 6X more storage volume than LNG) which generally renders long-haul truck transport uneconomic. LNG shipping rates from the U.S. to Asia are $5 or more per MCF, more than the commodity itself. The 10-15,000 mile sea journey is worth it because prices in Asia are $8-15 per MCF, compared with normally around $3 per MCF in the U.S.

.avia-image-container.av-1i6ga6d-09dce5ffbd354bc57b1242b6c3ddf9f9 img.avia_image{ box-shadow:none; } .avia-image-container.av-1i6ga6d-09dce5ffbd354bc57b1242b6c3ddf9f9 .av-image-caption-overlay-center{ color:#ffffff; }

The result is that natural gas prices vary by region far more than crude oil.

There are price discrepancies within the U.S. too. The benchmark for U.S. natural gas futures is at the Henry Hub, located in Erath, LA. This is where buyers of $5 per MCF January natural gas can expect to take delivery. By contrast, 700 miles west in the West Texas Permian basin, natural gas is flared because there isn’t the infrastructure to capture it. Gas is flared because it’s worthless. Mexican demand is coming, but construction south of the border is running more slowly than expected.

The price dislocation in U.S. natural gas highlights the ongoing need for additional pipeline and storage infrastructure. Price differences in excess of the cost of pipeline transport translate into pipeline demand. Although the spike in Jan ’19 natural gas futures reflects a temporary supply shortage that can’t be alleviated by a new pipeline given multi-year construction times, such events are generally good for  midstream energy infrastructure businesses.

.avia-image-container.av-1dfrb1h-774b9cfdca3fdaa57d74dc726f2541de img.avia_image{ box-shadow:none; } .avia-image-container.av-1dfrb1h-774b9cfdca3fdaa57d74dc726f2541de .av-image-caption-overlay-center{ color:#ffffff; }

The oil price dislocation was at least partly due to hedging of option exposure by Wall Street banks that had sold put options to producers, such as Mexico. It has very little to do with midstream infrastructure. Having fretted for months over U.S.-imposed sanctions on Iran, the market was surprised by waivers that are softening the blow for Iran’s oil customers. It’s likely to create a reaction (see Crude’s Drop Makes Higher Prices Likely).

Long term forecasts of natural gas demand are less varied than for crude oil, and are driven by Asian consumption at the expense of coal for electricity production.  Crude oil demand forecasts vary more, generally because of differing expectations for electric vehicle sales. Although both are growing, a bet on natural gas looks the safer of the two.

.avia-image-container.av-om3o11-89a264413e876eeac045ca4e073a015d img.avia_image{ box-shadow:none; } .avia-image-container.av-om3o11-89a264413e876eeac045ca4e073a015d .av-image-caption-overlay-center{ color:#ffffff; }

Nonetheless, crude oil moves the energy sector and U.S. pipeline stocks tag along. On Tuesday when crude oil was -6.6%, the S&P Energy ETF (XLE) and Williams Companies (WMB) both slid 2.3%. Jan ’19 natural gas was +9.1%. WMB derives virtually all its value from transporting and processing natural gas and natural gas liquids. Its inclusion in XLE probably causes it to move with the sector more than its business would suggest.

3Q18 earnings for pipeline companies have been largely equal to or better than expectations. The fundamentals remain strong – investors continue to ask when sector performance will reflect this. Although the recently declared dividend on the Alerian MLP ETF (AMLP) is 34% below its 2014 level, we expect corporations will start increasing dividends, with the American Energy Independence Index likely to experience 10% growth in 2019.

We are long WMB and short AMLP.

MLP valuations show that the trust of the traditional MLP investor has been lost, perhaps irretrievably. In Kinder Morgan; Still Paying for Broken Promises, we showed how that company’s history of investor abuse via two distribution cuts and an adverse tax outcome continues to weigh on its stock price. In Magellan Midstream: Keeping Promises But Still Dragged Down by Peers, we showed how even well-run companies that have honored promised distributions remain hampered by the abuse of others in the sector. The Alerian MLP ETF (AMLP) lowered its quarterly dividend again last week, by 7.5%. It’s now 34% below its 2014 high. The persistent cheapness of pipeline stocks reflects understandable wariness by MLP investors, who bought for the tax deferred income and had it partially removed.

Valuing such stocks on yield alone inadequately captures the past history of distribution cuts. Another common metric, EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization), is a blunt tool making little distinction between appreciating versus depreciating assets, or long term versus short term contracts.

Private equity buyers tend to look at cashflows. Using Enterprise Product Partners (EPD) as an example, Discounted Cash Flow (DCF) analysis reveals underappreciated value. DCF is often used to refer to an MLP’s Distributable Cash Flow, cash available for paying distributions to investors. To avoid confusion, in this article we will only use DCF as initially defined, the present value of future cashflows

EPD is the largest MLP. It is one third owned by the Duncan family and its well respected management team is ably led by Jim Teague. Their pipelines, storage assets and processing facilities handle crude oil, natural gas, natural gas liquids (NGLs) and refined products. They have a huge presence in along the gulf coast and include vertically integrated businesses that, for example, capture, moves, fractionate and export ethane.

EPD’s P/E ratio is unremarkable. Based on a consensus estimate of $1.67 for 2019, they trade at 16X, approximately the same multiple as the S&P500.

EPD’s EV/EBITDA is 11X. By comparison, KMI is 9.4X (penalized for past transgressions) while Oneok Inc (OKE) is at 14.7X, still feeling the love after last year’s successful conversion from an MLP to a corporation. Magellan Midstream (MMP), subject of last week’s blog, is 12.6X. On this measure, EPD could be described as moderately cheap versus its peer group.

While those traditional measures of valuation are unexciting, DCF analysis reveals a truly undervalued asset. Below is simplified look at cash flow analysis based on consensus EBITDA estimates:

2018: $7.0BN

2019: $7.4BN

2020: $7.75BN

2021: $8.3BN

2022: $8.65BN

===========

2019-22 Total $32.1BN

Financing EPD’s $26BN in debt costs $1.17BN (4.5% borrowing rate) annually. This year they’ll generate around $5.83BN in cash before taxes (which they don’t pay as an MLP). Depreciation and Amortization are non-cash expenses that typically don’t reflect the growing value of their assets, which is why earnings multiples such as P/E aren’t that useful.

For example, EPD owns underground salt caverns in Mont Belvieu, used for storing NGLs. This is wholly different than, say, a coal-burning power plant, which is why EV/EBITDA comparisons with utility stocks make little sense. Pipelines, when properly maintained, generally appreciate in value. As communities grow up around and over them, and other pipelines link into them, it becomes prohibitively expensive to build competing infrastructure.

.avia-image-container.av-17pkw7s-450e923dfbcefadcbf5cdf31b5c9e2b8 img.avia_image{ box-shadow:none; } .avia-image-container.av-17pkw7s-450e923dfbcefadcbf5cdf31b5c9e2b8 .av-image-caption-overlay-center{ color:#ffffff; }

.avia-image-container.av-ruwwvs-42b301aed21bc8f8bd3a4a32e8db849a img.avia_image{ box-shadow:none; } .avia-image-container.av-ruwwvs-42b301aed21bc8f8bd3a4a32e8db849a .av-image-caption-overlay-center{ color:#ffffff; }

With a Debt:EBITDA ratio of <4.0X, EPD is comfortably investment grade with a strong balance sheet. This allows them to rely on debt to finance their backlog of new projects. The Shale Revolution continues to create demand for new infrastructure in support of America’s growing production. Companies like EPD are financing and building it.

EPD’s backlog of new projects over the next four years is estimated at $9.5BN and they’re expected to spend $1.35BN in maintenance capex, which is money spent on their existing assets to maintain their capability.

Because their EBITDA is growing, by 2022 they’ll be able to carry debt of $32.44BN (2022 EBITDA of $8.65BN multiplied by their 3.75X desired Debt/EBITDA multiple – the low end of their guidance range of 3.75 to 4.0x Debt/EBITDA). That’s $6.44BN more than their current debt, which means they could, if they chose, borrow to finance ~60% of their $9.5BN in new projects and $1.35BN in maintenance capex, allowing more cash to be returned to equity holders. Only $4.4BN needs to be sourced from cash generated, so there is no need to issue dilutive equity.

Since new projects can be self-financed, it simplifies the valuation of the business. Suppose you had $59BN in cash with which to acquire the company at its current market capitalization (although as you’ll see, it’s doubtful the Duncan family would sell).

.avia-image-container.av-85gsfs-3747049df36d2bb85516bbf754314bac img.avia_image{ box-shadow:none; } .avia-image-container.av-85gsfs-3747049df36d2bb85516bbf754314bac .av-image-caption-overlay-center{ color:#ffffff; }

Over four years, the business will generate $32.1BN in EBITDA, less its interest expense of $4.7BN (4 times $1.17BN) and new investments funded from cash flows of $4.4BN, leaving $23BN. Returning this excess cash reduces the purchase price to $36BN by 2022. Deduct annual interest expense of $1.46BN (since there’s now more debt because of the growth projects) and maintenance capex of $350M, and the business is generating $6.84BN in cash, annually. On the $36BN purchase price, that’s a 19% cash flow yield.

.avia-image-container.av-1sokofs-0b5d4bbb0275445dcb339736870cb82b img.avia_image{ box-shadow:none; } .avia-image-container.av-1sokofs-0b5d4bbb0275445dcb339736870cb82b .av-image-caption-overlay-center{ color:#ffffff; }

Even half that cash flow yield would be attractive, which would value EPD 20% above its current market cap after paying out ~40% of its market cap in cash.

Future growth projects add further to the potential value. New energy infrastructure projects generally have required returns from as low as 10-12% to 20%+, depending on the degree of risk. Suppose EPD is able to reinvest 20% of its $6.84BN in annual cash, or $1.37BN, into new projects that have an expected unlevered return of approximately 14.3%. This equates to an EBITDA multiple of 7X (i.e. $100 invested to earn $14.30 is a multiple of 100/14.3, or 7) which is in the middle of the expected range for EPD’s current projects of 6-8X.  Sticking to their 3.75X leverage multiple, they could finance 54% of the project with debt (i.e. 3.75X desired debt multiple divided by 7X project multiple). The rest would come from equity, which would be sourced from current cashflow.

The result would be an investment of $1.37BN in equity ($6.84BN times 20%) along with $1.58BN in debt, for a total of $2.95BN. The 14.3% expected return on the $2.95BN project would generate $421MM annually, contributing to future EBITDA growth. After interest expense of $71MM (same interest rate of 4.5% assumed throughout) and maintenance capex of $21MM (estimated to be 5.0% of EBITDA), there would be $329MM of incremental cash flow for distribution.

By 2022 the business would have $5.47BN in annual distributable cash flows ($6.84BN in cash after interest & maintenance capex less the $1.37BN for new projects). Distributions to the owner would be growing at 4.8% annually. This comes from taking the $329MM generated by new projects, multiplied by an 80% payout ratio, since we’re assuming 20% of cashflow gets reinvested back in the business ($329 times 80% divided by $5.47BN = 4.8% growth rate).

.avia-image-container.av-p57oig-0716972236ce5c2d70b4d7d77c0f2a60 img.avia_image{ box-shadow:none; } .avia-image-container.av-p57oig-0716972236ce5c2d70b4d7d77c0f2a60 .av-image-caption-overlay-center{ color:#ffffff; }

By comparison, Utilities have a dividend yield 3.5% and REITs 4.25%, both with similar growth rates.  If EPD was simply valued at the same yield as REITs, the $5.47BN in 2022 cash flow would be worth $128.7BN. Add back the $23B in cash received to that point gets to $151.7BN. Discounted back to today at the risk free rate of 3%, gives a market value of $134.8BN. Divide by EPD’s current share count of 2.19BN units gives a price of above $60/unit, more than double today’s unit price.

.avia-image-container.av-qmbjo8-dcd8c7491af63708eb5517006c1e7e92 img.avia_image{ box-shadow:none; } .avia-image-container.av-qmbjo8-dcd8c7491af63708eb5517006c1e7e92 .av-image-caption-overlay-center{ color:#ffffff; }

Cash flow analysis presents a very different picture of MLP valuation than looking at conventional multiples such as P/E or EV/EBITDA.

The problem for public market investors is that EPD units come with a K-1. This generally rules out tax-exempt and foreign institutions, as well as non-U.S. individuals. The remaining investor base is narrow, consisting of older, wealthy Americans who want stable income. This group is still smarting from the 34% drop in MLP payouts, as reflected in AMLP. The MLP model may not be broken, but the trust of many of the traditional MLP investors is, which in effect means the same thing.

Cash flow analysis is how private equity buyers tend to value companies, although EPD is probably too big for such a take-private transaction. This illustrates why private equity firms often outbid the large midstream public companies for assets, despite the latter’s enormous competitive advantages of linking to existing integrated systems, and the associated synergies of maximizing utilization across their assets.

We are invested in EPD, KMI, MMP and OKE. We are short AMLP

Many MLP management teams have pursued growth at the expense of honoring their promise of stable distributions. We think the sector’s persistently high yields need explaining. Last week’s blog post (Kinder Morgan: Still Paying for Broken Promises) drew thousands of pageviews and over a hundred comments on Seeking Alpha.

Although Kinder Morgan (KMI) got there through a series of steps, ultimately they redirected cashflows from distributions to new projects. From an NPV standpoint, financial theory holds that investors should be indifferent to how a company deploys its cash as they can always manufacture their own dividends by selling some shares.

Markets don’t work that way. Capital investments are not an expense, they’re a use of cash. But the dividend cuts required to fund them were treated as a drop in operating profit by investors. KMI should have understood this, because for many years prior to 2014 they sought investors who valued stable dividends. KMI then decided they no longer wished to appeal to those investors, and their valuation still reflects the betrayal. The bitterness of many investors is on full display via the comments on last Sunday’s blog.

KMI’s problem of an undervalued stock is self-inflicted – but what about other MLPs who have been faithful to their income-seeking investor base? Magellan Midstream (MMP) does all the right things:

• Grows Distributable Cash Flow (DCF) annually
• Raises its dividend (distribution), annually
• Finances its growth projects with internally generated cash, thereby avoiding dilutive secondary offerings of equity
• Maintains a strong balance sheet with Debt:EBITDA consistently below 4X

.avia-image-container.av-1jyt8lb-272876ee61c2ef80f8abd589ad0013d1 img.avia_image{ box-shadow:none; } .avia-image-container.av-1jyt8lb-272876ee61c2ef80f8abd589ad0013d1 .av-image-caption-overlay-center{ color:#ffffff; }

Such judicious capital management has probably caused MMP to pass on growth opportunities that others have chosen. Energy infrastructure analysts widely hold that the sector remain undervalued. Dozens of MLP distribution cuts are at least part of the reason – so a company that has remained steadfast should stand out.

But while MMP’s unwavering embrace of its principles has helped, it hasn’t been enough to truly separate them from their less reliable peers.

.avia-image-container.av-ufdj33-b565219255cdce45cf129cb130d19213 img.avia_image{ box-shadow:none; } .avia-image-container.av-ufdj33-b565219255cdce45cf129cb130d19213 .av-image-caption-overlay-center{ color:#ffffff; }

MLPs peaked in 2014. Since then, MMP has raised per unit EBITDA by 31%, per unit DCF by 25% and distributions are up 54%. Distribution coverage remains healthy at 1.25X.

MMP’s leverage has risen, from 2.8X to 3.5X, but will drop back next year as new projects come into production. Even at 3.5X it is comfortably below the 4X that most of their peers target.

Magellan’s management team hasn’t issued equity or made dilutive acquisitions.  They’ve done just what they promised by increasing cash flows & distributions while maintaining a strong balance sheet.  And yet, MMP’s stock price is 26% below where it ended 2014.

.avia-image-container.av-17fa3en-b931cd48f9221e8d86bdfae1499b7177 img.avia_image{ box-shadow:none; } .avia-image-container.av-17fa3en-b931cd48f9221e8d86bdfae1499b7177 .av-image-caption-overlay-center{ color:#ffffff; }

MMP’s yield is more than 2% below the AMZ, reflecting a valuation premium relative to the MLP index. But the entire sector is laboring under the history of dozens of distribution cuts, which have lowered the payout on the Alerian MLP ETF by 30%. MMP’s valuation has moved in the opposite direction from its steadily improving operating performance in recent years, reflecting that traditional MLP investors remain far less enthusiastic than in the past.

The most common question asked of investors is, given persistent undervaluation, what is the catalyst that will drive prices higher? We showed last week that an MLP’s DCF yield is analogous to the Funds From Operations measure used in real estate, since it represents cashflow generated after the cost of maintaining the assets but before investment in new projects.  On that basis, MMP’s 9.1% DCF yield (based on $5.54 per unit for 2019) is pretty attractive for a long term holder.

However, many investors prefer immediately rising prices following a purchase to confirm their buy decision. Continued strong earnings should support increases in payouts. 3Q18 results for pipeline companies have been strong. Current forecasts are for 5-6% annual distribution growth for MLPs – slower than their growth in DCF as they build coverage for their distributions. Since many MLP managements continue to believe their stock undervalued, they prefer internally generated cash to issuing expensive equity. We agree.  We expect dividend growth for the broad American Energy Independence Index (80% corporations and 20% MLPs) of 10% next year.

Rising dividends should improve sentiment.

We are long MMP and KMI.

Broken promises aren’t quickly forgotten. That’s the hard lesson being learned by pipeline company managements, as the sector remains cheap yet out of favor.

Kinder Morgan (KMI) reported good earnings on October 17th. Volumes were up, and they sold their Trans Mountain Pipeline (TMX), including its expansion project, to the Canadian Federal government. TMX is Canada’s only domestic pipeline that can supply seaborne tankers. All other pipelines lead to the U.S.

Canada’s landlocked energy resources are becoming a political football. Alberta wants to get its oil and gas to export markets, but neighboring British Columbia opposes the new pipelines necessary for Albertan crude to reach the Pacific coast. Caught between the two provinces, KMI sensibly sought an exit. The transaction was well timed, closing before cost estimates for completing the expansion  were ratcheted up and a court ruled that a new environmental study was required (see Canada’s Failing Energy Strategy). Canada’s taxpayers were on the wrong end of the deal.

Nonetheless, Rich Kinder opened the earnings call lamenting KMI’s valuation. He said, “I’m puzzled and frustrated that our stock price does not reflect our progress and future outlook.” We do think KMI is cheap, but the explanation lies in recent history. Before the Shale Revolution created the need for substantial new pipeline investments, KMI’s investor presentation reminded “Promises Made, Promises Kept.”

.avia-image-container.av-70kb3l-cb44f06f3bcc4e69a57d7df763584a5c img.avia_image{ box-shadow:none; } .avia-image-container.av-70kb3l-cb44f06f3bcc4e69a57d7df763584a5c .av-image-caption-overlay-center{ color:#ffffff; }

This turned out to be true only until financing new projects conflicted with paying out almost all available operating cash flow in distributions. Investors in Kinder Morgan Partners (KMP), the original vehicle, were heavily abused. They suffered two distribution cuts and a realization of prior tax deferrals timed to suit KMI, not them (see What Kinder Morgan Tells Us About MLPs). Former KMP investors, who are numerous, retain deeply bitter memories of the events and have lost all trust in Rich Kinder.

.avia-image-container.av-1l3u04x-3710292e69a3b8632808509773179632 img.avia_image{ box-shadow:none; } .avia-image-container.av-1l3u04x-3710292e69a3b8632808509773179632 .av-image-caption-overlay-center{ color:#ffffff; }

KMI was only the first of many. Distributions on Alerian’s MLP index have been falling for three years. Their eponymous ETF has cut its payout by 30%. Alerian CEO Kenny Feng, normally a reliable cheerleader for the MLP model, recently turned more critical, citing,”…significant abuses of [distribution growth] in the past…” The irony is that until late last year Alerian’s own website showed reliable distribution growth, completely at odds with what investors in their products were experiencing. They only corrected it when mounting criticism from this blog (see MLP Distributions Through the Looking Glass), @MLPGuy and others forced a humbling revision.

.avia-image-container.av-15wdxe9-fbbb7f4567a47fc75db7bef6509afe19 img.avia_image{ box-shadow:none; } .avia-image-container.av-15wdxe9-fbbb7f4567a47fc75db7bef6509afe19 .av-image-caption-overlay-center{ color:#ffffff; }

Too few commentators acknowledge the poor treatment of MLP investors (see MLP Investors: The Great Betrayal). Pipeline stocks are attractively valued but have been that way for some time. The legacy of broken distribution promises continues to cast a pall. KMI’s objective in abandoning the MLP model was to be accessible to a far broader set of investors as a corporation. So far, it hasn’t helped their stock price.

One explanation might lie in how they present their financial results. Distributable Cash Flow (DCF) is a term widely used by MLPs and retained by KMI even after it became a corporation. MLPs calculate their distribution coverage ratio, which is the amount by which DCF exceeds distributions. It’s somewhat analogous to a dividend payout ratio, albeit based on DCF not earnings. Kenny Feng notes that generalist investors aren’t familiar with DCF or its coverage ratio. It may be why KMI’s stock is languishing.

DCF is Free Cash Flow (FCF) before growth capex. MLPs have long separated capex into (1) maintenance, required to maintain their existing infrastructure, and (2) growth, for new projects. FCF, a GAAP term, is indifferent to the two types of capex and deducts them both. DCF (not a GAAP term) treats them differently by excluding growth capex, and is always higher.

.avia-image-container.av-kjeggh-d478b2fcdb4dbfba2f2b88e1f0a5e4f2 img.avia_image{ box-shadow:none; } .avia-image-container.av-kjeggh-d478b2fcdb4dbfba2f2b88e1f0a5e4f2 .av-image-caption-overlay-center{ color:#ffffff; }

Unsurprisingly, KMI regularly promotes its 11% DCF yield, which is higher than its energy infrastructure peer group. However, FCF is the more familiar metric, and is lowered by the subtraction of growth capex. Because KMI spent over 70% of its $4.5BN DCF on new projects, the remaining $1.4BN in FCF results in just a 3.3% FCF yield. This is still higher than the energy sector and certainly better than utilities (which are often negative because of their ongoing capex requirements). But it doesn’t stand out versus other sectors, and probably causes analysts to overlook the high DCF yield.

As a corporation, KMI continues to promote a DCF valuation metric used by MLPs, Using the more common FCF yield, it isn’t compelling. However, DCF seems reasonable to us given their business model.

To see why, consider yourself owning an office building. After all cash expenses, including maintenance and setting aside money annually to replace HVAC and other equipment, it generates $1 million in cash, annually. In real estate this is called Funds From Operations (FFO). Because you’re already deducting the expenses required to keep the building operating, and it’s most likely appreciating in value, it’s reasonable to value it based on the $1million recurring cashflow. A cap rate of 5% means you’d require at least $20 million before agreeing to sell it.

Now suppose you decided to redirect $700K of your $1 million annual cashflow towards buying a second building that you also plan to rent out. You still own a $20 million asset, and reinvesting some of that annual cashflow in a new building doesn’t affect the value of what you already own.

In this example the $1million in FFO is analogous to KMI’s DCF. It’s why they believe their stock is undervalued, because 11% is a high DCF yield. Their FCF is so much lower because they’re investing most of their DCF in new assets that will generate a return.

GAAP FCF doesn’t differentiate between capex to maintain an asset and capex to acquire a new one, which is why pipeline companies don’t dwell much on FCF. Moreover, properly maintained pipeline assets generally appreciate. As climate activists slow new pipeline construction in some states, it simply raises the value of nearby infrastructure that can serve the same need.

Critics may believe that DCF doesn’t reflect all the necessary maintenance capex that’s really required, or that the underlying assets are depreciating in value even while properly maintained, although there’s little if any evidence to support either claim. So KMI remains misunderstood.

The dividend might offer a more compelling story. Yielding 4.7%, it’s below the 5.8% of the broad American Energy Independence Index. Because of history, investors are understandably cautious in buying for the yield. But today’s $0.80 annual payout is expected to jump to $1 next year and $1.25 in 2020. This 25% annual growth will push the yield to 7.4% in two years, assuming no upward adjustment in the stock price. A rising dividend might finally vanquish the unpleasant memories of prior cuts, and draw in new buyers.

In spite of its attractive valuation, MLP ETFs and mutual funds don’t own KMI, because it’s not an MLP, providing another good reason to seek broad energy infrastructure exposure that includes corporations.

We are long KMI and short AMLP.