Pieces in Place for Potential MLP Rebound

Transcription

1 Pieces in Place for Potential MLP Rebound Key Takeaways ffmlp stocks have traded down recently, but fundamentals are strong. The long-term trend in U.S. energy production growth has been powerful and enduring. ffat ClearBridge, we believe cash flows are poised to inflect higher as capital expenditures recede and new projects come online. ffmlps have been successfully pursuing alternative sources of capital and becoming more self-financing. ffmlp valuations are the most attractive they have been in decades. The combination of robust fundamentals and attractive valuations highlights MLP potential in 2018 and Despite gains in December and January, the Alerian MLP Index is down almost 4% in 2018, as of April 30. With the equity market near all-time highs, and with oil prices firming, MLP performance has been frustrating. There are, however, several developments in the MLP area not reflected in this performance, and we see a potential turning point for MLPs this year and into U.S. Energy Production Has Been Growing First and foremost: MLP fundamentals are in place. The fundamental driver for MLPs is the volume of oil and gas produced. MLPs suffered in 2015 and 2016 when oil production modestly declined, but the long-term trend in U.S. production growth has been powerful and enduring (Exhibit 1). Production rebounded in 2017 and we expect further growth in 2018 and At ClearBridge, we believe a continuation of the long-term positive trend in U.S. production growth can provide a supportive backdrop for MLPs as increased volumes drive increased cash flows. Cash flows should get a further boost as the industry exits a period of above-average capital expenditures. At the same time, the projects the capital expenditures funded are beginning to come online and generate cash flows (Exhibit 2).

2 PIECES IN PLACE FOR POTENTIAL MLP REBOUND MLPs Self-Financing Via Alternative Equity As cash flows from new projects ramp up and capex ramps downs, MLPs have been reaching an important inflection. MLPs should be able to improve distribution coverage ratios, delever their balance sheets and become increasingly selffinancing. In fact, this shift toward self-financing has already begun. In addition to targeting benefits from reduced capex and higher retained earnings, MLPs have been tapping the preferred equity market to raise low-cost capital. This is an important development for MLP unit holders, as it eliminates dilution and improves the returns on MLP growth projects. Between August and December 2017, MLPs raised nearly $5 billion in alternative equity instruments at very favorable costs (Exhibit 3). Exhibit 1: Shale Has Driven Significant Growth in U.S. Oil and Gas Production Quadrillion BTU U.S. Oil and Gas Production E As of March 31, Source: Department of Energy. Past performance is no guarantee of future results. Exhibit 2: Potential Inflection Point in 2018 as Capex Declines and Cash Flows Increase Industry Capex (Left Axis) MLP EBITDA (Right Axis) $ in Billions E 2019E 2020E $ Per Share As of November 27, Source: Partnership reports and Wells Fargo Securities estimates (organic capex estimates include MLP and C-corp); Bloomberg Finance L.P.For illustrative purposes only. Estimates are inherently limited and should not be relied upon as indicators of future performance or forecast of actual future events. Capital expenditures (capex), also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period. EBITDA measures earnings before interest, tax, depreciation and amortization. 2 Distribution Cuts Have Silver Lining In late 2017, portfolio holding Genesis Energy announced a distribution cut, joining Enbridge, Williams and Plains All American in the list of midstream MLPs that have cut since the rout in energy prices. It s hard not to see some negative near-term optics with this move, but we also see the longer-term benefits. With a healthy distribution coverage ratio of 1.2x before the cut, there was no question that Genesis had the cash flows to pay the distribution. While Genesis could afford to pay the distribution, it does not make economic sense to pay an 11% distribution rate to bearish equity investors when a slight cut in the distribution growth rate could fund new projects and, more importantly, drive such a balance sheet improvement that Genesis would not need to access equity capital markets in the future. Similarly, Enterprise recently reduced its distribution growth rate by $ per unit. This is a de minimus change that on the surface reinforces equity investor skepticism, yet Enterprise finds that even this moderation would enable it to be self-funding by as early as Both Genesis and Enterprise linked the measures to the possibility of common unit buybacks in the future. Source: Company press releases, October 12, 2017.

3 Exhibit 3: MLPs Issuing Attractively Priced Hybrids to Fund Growth Investments 1 MLP Amount Raised ($M) Type of Financing Coupon Common Share Dist Rate at Pricing Date Genesis Energy (GEL) $750 Convertible preferred share 8.75% 9.6% DCP Midstream (DCP) $500 Fixed-to-floating preferred share 7.375% 9.3% Energy Transfer Partners (ETP) $1,500 Fixed-to-floating preferred share 6.39% % Summit Midstream Partners (SMLP) $300 Fixed-to-floating preferred share 9.50% 11.9% EnLink Midstream Partners (ENLK) $400 Preferred share 6.00% 9.5% Enterprise Products Partners (EPD) $700 Preferred share 4.875% 6.3% Plains All American (PAA) $800 Preferred share 6.125% 5.7% As of November 14, Source: Bloomberg Finance L.P. Company releases: GEL Aug. 12, 2017, DCP and ETP Nov. 13, 2017, SMLP Nov. 9, 2017, ENLK Sept. 14, 2017, EPD Aug 7, 2017, PAA Oct. 4, MLP distributions are not guaranteed and are subject to change based on market or other conditions. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. Credit Markets Could Lead the Way The new financing instruments also reveal a disconnect between how equity and fixed income investors value the prospects of MLPs. While equity investors are demanding high distribution rates from MLPs, the preferred share and credit markets have been willing to lend money to MLPs on very favorable terms. In the case of convertible preferreds, for example, institutional investors have been willing to buy instruments with lower coupons and higher conversion prices than they could get by purchasing MLP common equity units. The traditional credit markets are also very bullish on MLP credits. Interest rates for MLPs are as low as they have ever been, while MLP equity yields are relatively high. Indeed, the yield spread between MLP equities and MLP bonds is now 313 basis points (bps; one onehundredth of one percent), compared to the threeyear average of 217 bps (Exhibit 4). The spread between the distributions on MLP common units and these alternative equity sources stands in stark contrast to the equivalent spread in other traditional income sectors, such as REITs. REITs preferred shares are yielding 5.73%, 200 bps higher than the 3.73% yield on common shares. 3 The average MLP preferred share coupon is 7.00%, more than 200 bps lower than the 9.41% average yield on common shares at the time the preferred shares were issued. 4 At the same time, MLP distributions are more than 1.3x higher than their average in the past seven years (Exhibit 5). Exhibit 4: MLP Bonds Have Recovered but MLP Stocks Remain Cheap MLP Bond Yield Alerian MLP Index Distribution Yield Basis Points 1, bps vs. 217 bps historical As of April 30, The MLP bond yield composite reflects the yield of three long-term MLP corporate bonds: EPD 6.125%, MMP 5.15% and ETP 7.50% with yield data starting on 10/1/2014, 5/19/2015 and 10/1/2014, respectively. These MLPs used for comparison are among the largest debt issuers in the limited MLP universe; the bonds have been outstanding for several years and offer sufficient liquidity. Source: ClearBridge Investments, Alerian MLP Index. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. 3

4 PIECES IN PLACE FOR POTENTIAL MLP REBOUND Exhibit 5: Current MLP Distributions Well Above Historical Average 10% MLP Distributions Average 9% 8% 7% 6% 5% As of March 29, Source: ClearBridge Investments, Alerian MLP Index. Yields and dividends represent past performance and there is no guarantee they will continue to be paid. Credit markets often lead equity markets as bond investors grow comfortable with a company s earnings and cash flow prospects. In the case of MLPs, the two buyer profiles might also explain the gap between credit and equity distributions. The buyers of MLP equities are predominantly retail investors, whereas it is institutional investors buying MLP bonds, preferreds and hybrids. We believe it is this bifurcation, more than anything else, that explains the contrast in valuations. Institutional ownership of MLPs has been steadily increasing, from 23% in 2009 to roughly 40% in 2017, but the shares are still predominantly held by retail investors. 5 Exhibit 6: MLP EV/EBITDA Multiples Two Points Lower than Average 18 EV/EBITDA Average Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 As of March 30, Source: Partnership reports, FactSet, and Wells Fargo Securities estimates. 4

5 Exhibit 7: MLP Distributions and Spreads Are High 10 MLP v. Treasury MLP v. Corporate IG MLP v. HY 8 6 Yield (%) As of April 30, MLP measures the distribution rate of the Alerian MLP Index; Treasury, the yield of U.S. 3-Month Treasury Bills; Corporate IG, the Bloomberg Barclays US Corporate Total Return Index; HY, Bloomberg Barclays US Corporate High Yield Total Return Index. Source: ClearBridge Investments, Bloomberg Finance L.P. Valuations Attractive by Several Measures Except for the depths of the financial crisis and the worst of the energy selloff in early 2016, MLP valuations are the most attractive they have ever been. Whether we look at distribution rates, EV/EBITDA or spreads to other asset classes, MLPs appear cheap. These discount valuations seem aberrant to us, given the strong fundamentals and our MLP outlook: growing energy volumes, growing cash flows and improving financials. In a world where nearly every sector is trading at historically high valuations, MLPs are trading at historic lows (Exhibits 6 and 7). Since May 2017, we have noted MLP stocks are at attractive levels on both absolute and relative bases. Subsequently, strong fundamentals and an inflection point in free cash flows have been two signals we believe confirm our view. MLP equities, while attractive along several measures, still have not reflected these signals yet, but we believe that the credit markets will once again lead the equity markets and that there is a buying opportunity in MLP equities. Despite selling pressure we think MLPs are well-positioned for 2018 and 2019: energy production volumes are strong, cash flows appear poised to step up, MLPs are becoming self-financing and we believe the selling pressure will dissipate. 1 GEL s conversion strike price is $33.71, notably above the $30.05 stock price before issue. 2 Coupon is a weighted average of Series A ($950 million at 6.25%) and Series B ($550 million at 6.625%) preferred units. 3 As of May 14, Source: ClearBridge Investments, Bloomberg Finance L.P. REITs preferred shares based on InfraCap REIT Preferred ETF; common yield based on ishares US Real Estate ETF. 4 As of November 14, Calculated using data from Exhibit 3, including Energy Transfer Partners s weighted average coupon. 5 Source: PricewaterhouseCoopers LLP, Partnership reports, and Wells Fargo Securities, LLC. 5

6 About the Authors Michael Clarfeld, CFA Managing Director, Portfolio Manager 18 years of investment industry experience Joined ClearBridge in 2006 Member of the CFA Institute Member of the CFA Society of New York BA in History from Duke University Chris Eades Managing Director, Portfolio Manager 26 years of investment industry experience Joined ClearBridge in 2007 BA in Economics from Vanderbilt University ClearBridge Investments 620 Eighth Avenue, New York, NY ClearBridge.com Past performance is no guarantee of future results. Copyright 2018 ClearBridge Investments. All opinions and data included in this paper are as of May and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Standard & Poor s. Neither ClearBridge Investments LLC nor its information providers are responsible for any damages or losses arising from any use of this information.