El Paso Severely Disappoints

Dec. 4.13 | About: El Paso (EPB)

Units of El Paso Pipeline Partners (NYSE:EPB) are getting slammed today after an extremely disappointing guidance release (available here). Shares are down 9% today and have now turned negative on the year. In response to guidance, Morgan Stanley has downgraded EPB to underweight, and unfortunately for longs, I believe Morgan Stanley is right.

There are two key things MLP investors are looking for: absolute yield and distribution growth. Right now, EPB is yielding 7%, which makes it attractive on the first count; however, growth is lacking. The company anticipates paying out $2.60 per unit in 2014, up 2% year over year, which is far from spectacular. More troublesome, that distribution breaks down to a $0.65 quarterly payout. In its most recent quarter, EPB declared a $0.65 distribution, so investors will not get any distribution growth during calendar 2014 in my estimation. Many analysts had been looking for a 5% bump in 2014, similar to the increase in Kinder Morgan Energy Partners (NYSE:KMP), which shares the same general partner, Kinder Morgan Inc. (NYSE:KMI).

It is never good news for an MLP when its distribution growth comes to screeching halt, and within the guidance, there is reason to be concerned that lackluster growth could be the norm beyond 2014. There are two ways pipeline companies can increase distributions: expand the network and increasing rates for pipeline usage when contracts come up. Unfortunately, El Paso expects a lower rate at its Wyoming system. Lower rates will be a cash flow headwind for the company for the length of the contract, and if we see deteriorating pricing power spread to the rest of El Paso's networks, the company could even struggle to maintain the $2.60 annual distribution in 2015 and beyond. Without distribution growth, EPB units will not be going any higher while cuts would send shares quite a bit lower. Lower contract rates are a major red flag as to the health of the firm's cash flows, and investors must carefully watch for weakness at EPB.

El Paso is only able to maintain the $0.65 quarterly pace next year thanks to dropdowns (purchases) from the general partner of the Ruby Pipeline, Gulf LNG, and Young Gas Storage. These purchases will buoy 2014 results but will be unable to make up for any further rate decreases in the network. EPB only has $1 billion in growth projects or 15% of assets, which is below growth projects planned at KMP. Without expanding its network, EPB's distribution growth will lag the sector. EPB also has $4.25 billion in debt against $2 billion in equity, which means future purchases will likely have to be funded mainly through equity offerings, limiting the potential increase to the distribution. With limited expansion plans outside of general partner dropdowns and pricing pressure occurring in the Wyoming pipeline, there is a relatively cloudy picture for distribution growth going forward. EPB has one of the weaker stories in the pipeline sector.

Based on El Paso's guidance, increases in the distribution from the current $0.65 level are unlikely in 2014, and with rate decreases, I believe the company will be unable to meaningfully increase the distribution in 2015. While the 7% yield may be appealing, investors should recognize there are no growth prospects. As a consequence, I would rather own KMP, which yields less (6.75%) but is still growing the distribution by 5-6%. Over the next 3-5 years, KMP's effective yield will be higher than EPB's. After this guidance, EPB is dead money with no real upside until it can show some distribution growth. I agree with Morgan Stanley and believe investors should rotate out of EPB and into other MLPs with good yields and better growth potential.

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.