Over-Loved MarkWest Under-Delivers

| About: MarkWest Energy (MWE)

Many income oriented investors have flocked to MarkWest Energy Partners (NYSE:MWE) for its 4.5% distribution with units up 47% in the past year. This rally has been in part due to the company's pipelines in the Marcellus and Utica regions, which should power distribution growth for years to come. However, there is no way to categorize their results after the bell as anything but a disappointment.

In the quarter, the company had distributable cash flow of $118 million, giving it a coverage ratio of 0.92, which means that the company paid out more to unitholders than it brought in. Such practice is unsustainable in the long run, though it is okay for a quarter or two if there are specific operating issues. Moreover, DCF fell sequentially by 8% from $128 million in the second quarter. Despite this, management increased the distribution by a penny to $0.85. This has become a growing trend in the MLP space where management continues to raise the payout even when results don't justify the increase. With a sequential decline in DCF and coverage ratio of 0.92, there was no economic justification for a payout increase, and MarkWest has to increase its net debt position by $10 million to pay the distribution. The company is simply borrowing from future growth.

While the company does have significant growth prospects with Marcellus volume up 25% year over year, this is not appreciably helping the per-unit bottom line as Northeast volume fell by 6%. MWE is now forecasting 2013 DCF of $475-$485 million. Just last quarter, management was expecting $500-$540 million for 2013, which suggests a significantly weaker fourth quarter than previously anticipated. Based on guidance, the 4th quarter will have DCF of roughly $125 million, giving it another quarter with a coverage ratio of less than one.

This quarter, MWE also released 2014 guidance with DCF forecasted to be $600-$690 million. After being forced to cut guidance for 2013, I approach this guidance with a bet of skepticism as it would require significant reacceleration. I think an optimistic take would be for MWE to generate $600 million in DCF next year. Assuming a coverage ratio of 1x, this DCF would translate to a quarterly payout of $1.05 assuming the current number of outstanding units (142 million). At first glance, that seems like fantastic growth from the current $0.85 payout, but there is a caveat.

In 2014, MWE expects growth cap-ex of $1.8-$2.3 billion. Now, growth cap-ex is not deducted from distributable cash flow, but it does have to be paid for somehow. MWE typically issues a combination of debt and equity to pay for these programs. This year, the company is spending about $2-$2.3 billion in cap-ex. Over the first nine months, it increased debt by $500 million while issuing $1 billion in equity (a 2:1 equity to debt ratio). With significant spending on growth-cap-ex, the unit count will continue to increase in 2014. The best case for MWE holders would be a 50/50 split between debt and equity. Assuming realized equity pricing is the current unit price of $75, an additional 13 million units will be issued. In this scenario, the company would be able to pay $0.95 quarterly as a best case payout.

In reality, I expect the company to have DCF closer to $575 million and that it will fund closer to 2/3 of cap-ex with equity as it has in 2013. In this scenario, another 18 million units would be issued and a sustainable quarterly payout would be $0.85-$0.89, indicating no better than 5% growth. It is also worth noting that on its $7 billion in PP&E, MWE expects maintenance cap-ex to total $20 million. In other words, it will cost the firm 0.27% of asset cost to maintain their production. I will leave it up to you to decide whether or not this is a dubious assertion. The distinction between maintenance and growth cap-ex is important because growth cap-ex is not subtracted from DCF while maintenance is. If you believed maintenance requirements were 1% of assets, the sustainable distribution would be 9.2% lower or $0.79, indicating a year-over-year decline in the sustainable payout.

With 13 buy ratings, 0 holds, and 0 sells among analysts polled by Bloomberg, MWE is arguably the most beloved MLP on Wall Street, and after its big run up this year, I believe MWE is relatively expensive especially after it was forced to cut guidance. While the company will grow next year, much of that growth will not flow through to unitholders because of the dilution with distribution growth unlikely to be more than 50% of DCF growth. This leaves investors with 5% distribution growth potential even if you take maintenance cap-ex without hesitation, which is a reasonable (though not certain) assertion. With a 4.5% yield that is good but not great, I would not buy MWE on this disappointing quarter unless there was a 10% pullback. I believe investors will be much happier with Kinder Morgan Energy Partners (NYSE:KMP), which trades at a discount (6.7% yield) and should grow its quarterly payout as fast, if not faster, than MWE. MarkWest simply under-delivered.

Disclosure: I am long KMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.