Image Source: Roy Luck
By Kris Rosemann and Brian Nelson, CFA
Valuentum’s opinion of the significant capital-market dependence of the master limited partner (MLP) business model has not changed, and it appears the Williams’ family, Williams Companies (WMB) Williams Partners (WPZ), has become the latest illustration of this ongoing need. We maintain our view that there will be continued challenges to the MLP structure in the coming years, particularly in the event energy resource prices start to give back some of their recent gains and/or if high-yield spreads begin to expand (making borrowing more costly, irrespective of what the 10-year Treasury does). However, with energy resource pricing improving since the doldrums of January/February and the high-yield market warming up to issuers, equity prices of MLPs have started to “re-inflate,” but whether such a recovery is sustainable is something largely beyond their control, in our view.
Our initial take on the Williams news, announced January 9, is that both Williams Companies and Williams Partners (WPZ) will be issuing new equity, and from what we understand, Williams Companies will be buying the equity issuance from Williams Partners in a private-placement, effectively resulting in what we’d describe as a double-capital raise, with the parent using its own newly-raised proceeds to support the partner by buying its partner’s new issues. Essentially, from our perspective, Williams Companies has largely acted as the “market” for Williams Partners’ units in this transaction, and we wonder if capital-market access continues to be very difficult for highly-leveraged MLPs as the reason why. We’ll be monitoring unit prices of MLPs very closely to see if the market starts to get nervous again in light of this deal. Shares of Williams Companies sold off aggressively on the news.
Under this transaction, Williams Companies will be waiving its incentive distribution rights and exchanging its general partner economic interest for 289 million newly-issued common units of Williams Partners, which will increase its ownership stake in Williams Partners to ~72%. Williams Partners will issue the new units in a private placement, and Williams Companies will also raise capital for the purchase of the new units via its own equity issuance (a 65 million share public offering). Though the cost of capital is largely a subjective measurement, particularly in valuation, management expects such a move to improve Williams Partners’ cost of capital (generally an equity infusion reduces leverage metrics and shores up liquidity), and management hopes that it will now not require access to the public equity markets for the next several years. From where we stand, this huge, double equity-issuance is a tell-tale sign that the entities are raising capital now while the going is good (in case in the next few years, the capital markets are closed to them).
Though Williams Partners has eliminated the additional payments formerly required to its general partner, it will issue 289 million new units on which it will have to pay a distribution. In order to maintain coverage of its distribution, Williams Partners cut its quarterly payout by 29% to $0.60 per unit. Management indicated that such a move will translate into a distribution coverage ratio of ~1.2 times in 2017, but we emphasize that management’s coverage ratio is based on distributable cash flow projections for the year, which currently sit at $2.8 billion and do not take into account expectations for growth capex to be in a range of $2.1-$2.8 billion. Subtracting growth capex from distributable cash flow may not be an accurate comparison to traditional free cash flow, but the exercise remains useful in illustrating the massive amounts of capital that are ignored in the calculation of distribution coverage ratios from MLPs. Capital is not free – and especially in the context of valuation, both cash flow generated and cash flow used to generate cash flow must be considered. We continue to emphasize free cash flow (cash flow from operations less all capital spending) in our analysis, and such a measure is consistently applied across our coverage universe.
Williams Companies will up its dividend for the March quarter by 50%, to $0.30 per share, adding to its massive obligations that may inevitably come back to bite hard if times continue to be tough for the energy space. Long-term debt stood at $23.9 billion at Williams Companies at the end of September 2016 (see page 8 here), while free cash flow stood at $505 million through the first nine months of the year (see page 10 here). During the same nine months, Williams paid more than $1.1 billion in dividends, implying that traditional free cash flow measures were coming up short with respect to dividend coverage, even before the latest announcement of a dividend hike.
Though we are considering adding a diversified MLP ETF, in the form of the ALPS Alerian MLP ETF (AMLP) to the Dividend Growth Newsletter portfolio, solely in light of a potential capital-allocation decision to the recovering energy arena, we’re not ready to pull the trigger on this diversified ETF. If we ever do, our finger will be on the ‘remove’ button the whole way, as we’d only view such an addition as a short-term “trade.” We continue to include Kinder Morgan (KMI) in the Best Ideas Newsletter portfolio as our only exposure to the midstream space for now. We expect to update our reports shortly. Please be careful with these highly-leveraged, capital-market dependent, income-vehicles that are tied to the commodity-price cycle…
Pipelines – Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, OKS, PAA, SE, SEP, WES
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Now, what if we told you there was a master limited partnership whose distribution was covered several times over by traditional free cash flow and supported by a net cash position…
Want to find out what MLP this might be, along with other ideas each month, from Valuentum’s President of Investment Research Brian Nelson? Each monthly edition of The Nelson Exclusive includes three stock ideas from outside the Valuentum coverage universe (one for income, one for capital appreciation, and a “short” idea), fully-laid out in thesis form.
Learn more about The Nelson Exclusive here.