Strong Prospects, Better Buys

By Roger Conrad • December 5, 2012 • Portfolio Update

Calendar 2012 third-quarter results confirmed that MLP Profits Portfolio Holdings remain in good health.

And the credit for solid numbers goes to our recommendations’ conservative financial and operating strategies as well as their ability to execute.

By contrast, the operating environment has become somewhat less favorable in recent months.

The sharp drop in North American natural gas prices in the first half of the year has led to an equally dramatic cut back in gas drilling.

Natural gas liquids (NGL) prices crashed as well, reducing the appeal of ramping up output in the near term.

Gas and NGLs have rebounded somewhat. But the negative reaction to an unexpected boost in inventories in late November is the latest sign that we’re probably close to an upward limit for prices, given what’s still a sizeable supply-demand imbalance.

Meanwhile, worries that a US fiscal cliff will further wreck the global economy have put downward pressure on oil prices. That in turn has called into question oil related projects, demonstrated by ONEOK Partners LP’s (NYSE: OKS) tabling of a planned oil pipeline connecting the reserve rich Bakken Shale region to major refineries.

Unfortunately, these conditions are unlikely to improve substantially in the near future. Demand for natural gas to generate electricity, fuel transportation and power-heavy industry is rising–but not fast enough to absorb the enormous new supplies from shale deposits.

In fact, until there are sufficient facilities for exporting the fuel from these shores the price of North American gas is likely to remain depressed by a supply glut. And that’s likely to be several years, even if financially shaky Cheniere Energy Partners LP (NYSE: CQP) successfully develops the Sabine Pass facility.

That puts all the pressure on oil to pick up the slack for producers’ earnings the next few years. And until there’s some clarity on the fiscal cliff and other issues affecting expectations for economic growth in 2013, black gold is unlikely to set any price records either.

The result is a cautious drilling environment at best for 2013. And that means new midstream development will at a minimum be less robust than it’s been the past few years. There will still be new projects. And until growth does flare up, borrowing costs will remain very low. But it’s going to take a lot of management skill to keep dividends growing, with no rising tide to raise all boats.

Fortunately, based on the most recent round of numbers, management guidance and what we’ve seen since on the transaction front, MLP Profits Portfolio Holdings are still proving up to the challenge. And prices are more reasonable than they’ve been in a while for new buyers.

A handful–including Growth Holding DCP Midstream Partners LP (NYSE: DPM) and Conservative Holdings Genesis Energy LP (NYSE: GEL), Magellan Midstream Partners LP (NYSE: MMP) and November addition Oiltanking Partners LP (NSDQ: OILT)–are still selling above buy targets.

Not surprisingly, all of the commodity-price sensitive Aggressive Holdings sell below their targets, reflecting fear of weaker energy prices.

I like all of these MLPs as long-term holdings. But I’m not inclined to raise targets for any of them at this time, particularly given many investors’ tendency to follow momentum in this market rather than value.

Each of these MLPs seems to have been put on a pedestal of elevated expectations that even blow-the-doors-off performance could disappoint.

Rather than chase them, the wise course is to wait for a dip, which, as we’ve seen repeatedly in recent years, can occur for reasons that have nothing whatsoever to do with underlying company health.

I am restoring Growth Holding Inergy Midstream LP (NYSE: NRGM) to a buy anytime it trades below USD24. The 26 percent jump in third-quarter cash flow demonstrates that recent acquisitions and expansion of energy midstream assets is paying off. And the 41 percent surge in distributable cash flow clearly indicates the long-term path for distributions is up.

Looking ahead, Inergy expects several new assets to keep cash flow growth going. Meanwhile, third-quarter transportation revenue more than doubled, while sales from “hub” services more than tripled, even as the company was able to cut costs. That offset flat results in energy storage.

Inergy’s purchase of Rangeland Energy LLC for USD425 million is another show of strength, as was its arrangement to raise USD225 million of equity capital to partially finance the deal.

The transaction adds crude oil rail, terminal, storage and pipeline facilities that will immediately boost cash flow after closing, which is expected to occur on Dec. 7. The company also priced USD400 million in eight-year notes at an interest rate of around 6 percent, reducing its traditional dependence on credit lines and hence exposure to interest rate swings. Inergy Midstream is a buy on dips below USD24.

Numbers to Know

Below I highlight the last three MLP Profits Portfolio members to report calendar 2012 third-quarter results, Energy Transfer Partners LP (NYSE: ETP), Genesis Energy and Regency Energy Partners LP (NYSE: RGP).

Here are links for finding analysis of the rest. Also check the table “Portfolio Facts.”

Energy Transfer Partners’ big question is still when distribution growth will resume. The most recent increase was way back in early 2008. Management has repeatedly promised a return to growth once it completes a raft of strategic moves that’s already transformed the MLP into a major gas and liquids midstream company.

The lack of distribution growth has arguably been a major drag on the MLP’s unit price the past several years. But Energy Transfer’s yield is still well over 8 percent, more than three percentage points higher than the payout of midstream rival Enterprise Products Partners LP (NYSE: EPD).

My contention is a return to dividend growth would narrow that yield gap considerably, with the result of robust unit price gains for Energy Transfer.

Underlying business results are already strong enough to support such a move. The MLP earned a record USD339.5 million in distributable cash flow for the three months ended Sept. 30. That was a 27.6 percent boost over last year’s tally, and it covered the current payout by a solid 1.26-to-1 margin.

Moreover, the revenue mix is considerably more secure than it was last year. The sale of propane distribution assets to AmeriGas Partners LP (NYSE: APU) in return for equity has converted what was a seasonal enterprise with huge weather-related variations in income into a steady cash provider based on the buyer’s reliable dividend.

And the MLP has acquired numerous fee-generating assets as drop downs from its general partner Energy Transfer Equity LP’s (NYSE: ETE) purchase of the former Southern Union Group as well as from its own acquisition of Sunoco Inc.

Energy Transfer Partners is now generating the vast majority of its cash from fees that fluctuate little, if at all, with energy prices. And it’s now using its vastly increased scale to pursue new opportunities, such as the USD1.5 billion conversion of its Trunkline natural gas system to carry oil by mid-2014.

The Lone Star partnership with fellow MLP Profits Portfolio Growth Holding Regency Energy Partners continues to progress as well, expanding assets in the liquids rich Eagle Ford Shale.

For its part, Regency reported a slight increase in third-quarter cash flow as well as a small drop in distributable cash flow. It again failed to cover the distribution, which will likely once again discourage an increase when the next payment is announced in January. But management nonetheless stuck with its projection for volume and profit growth in 2013, as a series of new midstream projects come on stream.

Lone Star posted flat results from the year-earlier quarter. That was largely because of Hurricane Isaac-related downtime, however, and should be reversed as new assets start producing income. Regency anticipates spending USD380 million on the venture for all of 2012 and an additional USD120 million next year to complete projects now under development.

The rest of the USD400 million planned capital spending for next year will focus on Regency’s core gathering and processing and contract compression services. Gathering and processing (G&P) revenues are more sensitive to how energy prices affect drilling volumes than, say, income from fee-for-service pipelines. And weaker conditions are one reason for Regency’s shortfall in the third quarter.

The partnership’s nine-month cash available for distribution did cover the payout, however. Moreover, only 9 percent of cash flow is subject to commodity-price risk, Regency enjoyed a 13 percent boost in G&P volumes during the quarter and bookings for contract compression rose.

That’s pretty solid confirmation that the current distribution level is headed higher over time.

Regency’s third-quarter conference call featured one other interesting bit of information: management’s assertion that a merger between the MLP and Energy Transfer Partners is “inevitable.” The two currently share the same general partner, Energy Transfer Equity, so the most important consideration will almost certainly be the price offered Regency unitholders to complete the combination.

Management was unwilling to speculate during the call on what that price might be. But with Energy Transfer selling at a much higher price-to-book value, it’s likely that Regency will fetch at least some premium to its current price. Energy Transfer Equity currently holds 15.4 percent of Regency’s common units, in addition to the general partner interest.

Given the broad hints dropped by management about the need to “simplify” structure in the near future, a deal could take place as soon as next year. That’s enough reason to stick around Regency Energy Partners, which rates a buy up to USD29 for those who don’t already own it, at least until merger terms are announced.

Energy Transfer Partners is also cheap and is a buy up to USD50. General partner Energy Transfer Equity is a buy up to USD45.

Genesis Energy, by contrast, is actually a bit high priced as of this writing, selling well above my recently raised target of USD33. The reason is simple: This owner and operator of liquids-focused energy midstream assets continues to deliver reliably growing cash flow and distributions, and investors are willing to pay up for that in this fearful market.

The boost to 47.25 cents per unit announced in mid-October marked the 29th consecutive quarter Genesis has raised its distribution.

And it was the 24th time over that period that the annualized rate of increase was better than 10 percent, this time a rate of 10.5 percent.

Genesis’ third-quarter “available cash before reserves”–its primary measure of profits–rose 23.8 percent to a new record of USD45.9 million.

The company benefitted from its lack of exposure to commodity prices, the return of development drilling in the offshore Gulf of Mexico and the contribution from several new projects.

Pipeline transportation was the primary driver, with margin surging 45.3 percent. Supply and Logistics operations enjoyed a 25.1 percent margin increase, and even Refinery Services were up 5.5 percent. Pipeline margins were enlarged by this year’s acquisition of Gulf of Mexico pipelines. Margin is defined as revenue plus equity from investments, less all cash expenses.

As a smaller MLP focused on projects in fast-growing regions, Genesis has plenty of options to keep moving the profit meter forward at a rapid clip. And as crude oil production continues to grow throughout North America, so will its opportunities.

The MLP enjoys strong volume growth in the Permian Basin and Eagle Ford Shale areas, both prime areas of low risk output growth. And management expertise now extends to terminals serving both rail and water traffic. Sodium hydrosulfide (NaHS) volumes also continue to grow, as the company extends its reach into the pulp and paper and mining industries.

Geographically, Genesis’ list of opportunities spans Texas, Florida, Mississippi, the Rockies and the deepwater Gulf of Mexico. And Keystone XL pipeline or no, it will begin receiving Western Canadian crude oil over its system beginning in the first quarter of 2013.

That adds up to a hard-to-beat combination of safety and long-term growth prospects, though tempered by the fact that it trades a bit above my buy target. Buy Genesis Energy on any dip to USD33 or lower.

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