El Paso Remains A Must Sell

| About: El Paso (EPB)

After the bell on Wednesday, El Paso Pipeline Partners (NYSE:EPB) reported a weak quarter that sent units modestly lower (press release available here). In December, El Paso offered disappointing guidance that sent units down 10%, which is a reason why there was a muted reaction to this quarter. The bad news was already known in a sense, and as the following chart shows the pain has already been felt by investors. So is the quarter a sign the bottom is in, or should investors continue to avoid EPB?

EPB has struggled with lower contract rates, mainly in Wyoming. Pipelines are operated on multi-year contracts, but when they expire, producers put forth new bids, which can either be higher or lower depending on production levels and alternative transportation options. Unfortunately, EPB has gotten lower contract rates, which will be a major headwind for distributable cash flow for several quarters. As a consequence, EPB had to hold its distribution steady from last quarter at $0.65.

Further, El Paso confirmed its guidance for 2014, which includes an annual distribution of $2.60. This breaks down to $0.65 a quarter, so El Paso will not be able to grow its distribution at all in 2014 while virtually all other MLPs like Kinder Morgan Energy Partners (NYSE:KMP), Enterprise Products (NYSE:EPD), and Plains All American (NYSE:PAA) should be growing their distributions. Given the dramatic boom in U.S. energy production, it is deeply disappointing to see a pipeline MLP hold its distribution steady. The lack of distribution growth is the primary reason why EPB has a comparatively high yield (7.65%).

This yield may entice some investors to take a chance on EPB, and the question becomes whether EPB's business will turn around enough so that the company can boost the payout in 2015. If it can, units should perform very well, but if not, there may be continued downside. Looking through this quarter, I struggled to find signs of improvement.

First, even though the $0.65 distribution was up 7% from last year's report, distributable cash flow actually fell. DCF came in at $144 million, which was down 11% from last year's $163 million. DCF/unit also fell to $0.66 from $0.75. El Paso is able to maintain a higher year over year payout because it paid out far less than it generated in 2012. In the final quarter of 2013, its coverage ratio shrunk to 1.016x. As a consequence, core operations will have to show some improvement before the company is capable of growing its distribution.

Revenue of $391 million was flat year over year, but EPB faced higher costs, depreciation, and taxes, which cut net income by 10% to $159 million in the quarter. Further even though net income was lower, El Paso had to pay a higher incentive distribution to its General Partner, Kinder Morgan (NYSE:KMI). KMI gets paid a fee to manage El Paso's pipelines, and this quarter it totaled $51 million compared to $43 million last year. If the company starts to perform better, KMI will get paid even more, which is reasonable. From EPB's current perspective though, it certainly stings that KMI generated a higher fee even though EPB's numbers were worse.

These lower contract rates will have a prolonged negative impact on EPB's results, and EPB is only able to maintain its $0.65 distribution because of asset dropdowns from KMI that include 50% of the Ruby Pipeline and 50% of Gulf LNG. Without these transactions, El Paso would have a worse 2014 than 2013 and could have been faced with the prospect of a distribution cut.

Unfortunately, El Paso will have trouble growing out of its current problems. EPB carries long-term debt of $4.171 billion against $1.939 billion in equity for a debt to equity ratio of 2.15x. As a consequence, EPB will have to fund any acquisitions with more equity than debt to right-size its balance sheet. With a current yield of 7.5%, equity is relatively expensive, which will make it more difficult for EPB to find accretive projects and acquisitions. As a consequence, it will be a long and challenging effort to get the distribution higher than the current level. EPB's existing business is generating less cash while future projects will be extremely expensive, which is why I don't see EPB appreciably increasing its distribution.

With weaker contract rates, lower DCF, higher payments to the GP, and a deeply indebted balance sheet, 2014 will certainly be a challenging year for EPB. Unfortunately, these are not just immediate term headwinds and will bleed into 2015 when I expect an annual distribution of $2.60-$2.65, which would be flat to up 2%. While the current yield may be attractive, EPB's distribution growth will lag other MLPs. Given these headwinds, I would not buy EPB at current levels and don't see any catalyst that will send units higher. I wouldn't be interested in going long EPB unless shares reached $30; at $34, investors would be wise to sell.

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.