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September 29, 2015

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MLP Business Model Will Survive

We are compelled to respond to the sky-is-falling scenario outlined a few days ago by Valuentum Securities.  The market may or may not be responding to the “MLPs may not survive” sensationalism.  Hard to pin 5%+ consecutive down days on one article.  But maybe because he starts it with “Warren Buffet…”  If Warren said it, it must be true, right?  We think not, and want to point out what is and is not true.
Midstream MLP Business Model Will Endure
At CBRE Clarion, we have a long history in real asset investing and this is not the first time we have heard such “wisdom” from market participants (mostly hedge funds).  There was a time when the retail mall was going to end as internet retailing would take over the world.  Many a stock owner is glad they didn’t sell their Simon Property Group shares at $26/share in 2009 (now $182).  No Simon didn’t go out of business, despite the much heralded loss of capital access (sound familiar!) and of course death of demand due to internet sales taking mall demand.  Malls thrived in the new world and capital markets opened for real estate companies allowing them to grow their businesses.
MLPs own real, tangible assets, just like REITs.  The business is capital intensive, and to grow, you do need access to capital.  Capital market are not always open, and currently the equity markets are closed for MLPs.  And debt may be more expensive than it was 6 months ago.  But, capital markets do not close indefinitely, either.  MLPs, like regional malls, are not going out of business because they own irreplaceable assets, supported by long-term contracts and the U.S. is the lowest cost energy producer in the world (take that internet shopping!).
MLPs Can Fund Existing Dividends!
The MLP model has been one of a positive relationship between its investors and the company.  Investors buy MLPs in the expectation of a return of that investment in the form of distributions and future growth in that distribution.  MLPs are not required to make ANY distributions to their investors, unlike REITs which are mandated by the IRS to pay out a fixed percentage of net income.  The distribution by MLPs is an elective.  But, it also benefits the GP of the MLP as they typically have IDRs (Incentive Distribution Rights) tied to the level of the distribution.  Growing the distribution above certain targets creates incentive cash flow for the GP.
We estimate that the current coverage ratio of dividends across our midstream MLP universe is 1.18x.  Moreover, the universe of midstream MLP carries a distribution yield of 8.3% (yes, that starts with an EIGHT!).  The current distribution is covered by cash flow.  Cash flow that is adjusted (meaning deductions) for IDR payments to the GP and maintenance capital expenditures.  So, in fact, MLPs cover their dividend with cash flow, and have cash available for capital investments.
The author confuses the capital requirements that will generate future cash flow generation with on-going free cash flow.  Capital spending for growth projects is optional and companies can choose not to invest in uncommitted projects.  Moreover, projects that are committed are typically contracted out at a level that more than adequately covers the cost of capital.  In any event, an assumption of no capital access would mean no future capital spending.  But in that scenario, MLPs would still cover their current distributions and an investor would collect a very healthy yield!
Upstream MLPs are the Exception, not the Norm
MLPs can be formed to serve a wide variety of services along the value chain in energy resources.  The majority of MLPs are midstream-focused, providing transportation, storage and processing services.  The universe of MLPs is 94% midstream.  Midstream MLPs own tangible assets (pipelines, storage facilities, processing plants) with contracts based on fees for the services these assets provide.
A much smaller subset of the universe (Upstream MLPs) is exposed to exploration and production.  These MLPs are severely challenged in this sustained low oil price environment as their cash flows are directly tied to the price of oil.  The author attempts to link an Upstream MLP that has suspended its dividend to all MLPs.  He should have pointed to the fact that all Upstream MLPs have severely cut or suspended their dividends.  But, his generalization of all MLPs being potentially subject to dividend cuts is way off the mark.
Warren Buffet has a solid legacy for a reason.  Perhaps we should consider one of his other famous quotes: “Be fearful when others are greedy and greedy only when others are fearful”.  MLPs are down over 43% the past 12 months and yield over 8%.  We see tremendous fear and, while we know it is hard, recommend investors to think of being greedy and not succumb to the panic.
Claim Checks
As to the specific claims of the blog post referenced above, let’s run through a few of them.
Claim: MLPs are reliant on the capital markets to support ongoing distributions at current levels
MLPs are reliant on the capital markets for growth of distributions, but not ongoing distributions.  In some cases, MLPs may choose to borrow to pay distributions in a seasonally low quarter, or may choose to ride out a period before growth projects come online with less than 1.0x coverage, but those are meant to be temporary, and in any event are not representative of the 1.0x+ coverage universe of MLPs currently.
Claim: Free cash flow less all capital spending is the appropriate way to evaluate ongoing operations of MLPs.  When looked at through that lens, MLPs are not sustainable.
Not true, as mentioned above, if capital programs were put on hold, MLPs would be able to sustain existing distributions.  See 2008-2009.
Claim: “Most midstream MLPs will have to make difficult decision to either cut distributions or suspend growth plans altogether.  This would completely negate forever the distribution-based equity pricing framework that brokerage houses use.”
If MLPs are forced to suspend growth of distributions, how would that “negate forever the distribution-based equity pricing framework”?  The market will just back up the yield to reflect no growth.  That no-growth MLP yield has generally been between 7-10% over the last 10 years.  Many MLPs are now trading much higher on this recent over-correction.  But just because the market slaps a 15% yield on you, that doesn’t mean you have to cut the distribution so you are only yielding 10%.  At 12/31/2008, MarkWest (MWE) yielded 32.1% and Targa Resources (NGLS) yielded 26.7%.  Neither one reduced distributions through 2009, and each were up more than 200% over the next 12 months.  MWE recently felt it would be better able to fund its backlog of growth with a strong sponsor like Marathon.  Other MLPs may choose the consolidation path as well, but that’s to fund ongoing growth more easily and to protect valuable franchises and footprints, not to sustain current distributions.
Claim: ETE and WMB deal at much lower valuation that previously means that if the environment continues to deteriorate, leading participants to become desperate in the face of adverse conditions.
In the current environment, certain MLPs will have trouble living up to distribution growth targets set prior to the commodity collapse, this is true.  And some may seek to consolidate to be able to better defend market share in key regions.  But, there are real commercial synergies in this deal and there is real value to being bigger in the current environment, and that’s driving these deals.  WPZ was not going to have to reduce distributions, but it was going to have trouble growing as fast as previously guided.  WMB management saw the opportunity to get some value for the GP IDRs, which earlier this year it was willing to collapse entirely.

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