Separating Turnaround Stories From The Value Traps In The MLP Space

Feb.20.14 | About: Boardwalk Pipeline (BWP)

Buckeye Partners LP (BPL) rewards investors with a 70 percent total return the year after it restores regular distribution growth; Boardwalk Pipeline Partners LP's (BWP) unit price falls by almost half after it guts its payout by more than 80 percent.

Both master limited partnerships (MLP) operate in industries with a history of stability, but had failed to earn their distributions for several quarters. And as a result, both had suspended long-held policies of regular quarterly distribution increases.

Both MLPs own and operate natural gas-related assets that have lost value and have bled revenue from expiring contracts. And both had underperformed other MLPs for months.

Buckeye Partners, however, found a way around its troubles. As a result, its shareholders are huge winners: The partnership's total return tripled a robust 2013 gain by the Alerian MLP Index.

Not so with Boardwalk Pipeline Partners. And its demise has fired up the chatter that other MLPs' high payout policies in general are unsustainable.

The bears' pronouncements aren't finding their mark as they did this past summer, when Hedgeye Risk Management, abetted by Barron's, spread ugly rumors about Linn Energy LLC (LINE) and Kinder Morgan Energy Partners LP (KMP). That's probably because of the thrashing short sellers have taken in Linn Energy over the past several months.

Boardwalk Pipeline Partners' blowup, however, will cause investors to shy away from some of the best opportunities for big gains in the now five-year-old bull market for MLPs.

The Next Buckeye Partners

Buckeye Partners wasn't the only MLP that scored big gains last year after restoring regular dividend growth. Energy Transfer Partners LP (ETP) and Regency Energy Partners LP (RGP) - MLPs that share the same general partner Energy Transfer Equity LP (ETE) - also topped the Alerian MLP Index's gains by doing the same.

These success stories notwithstanding, imploding high-yield stocks always get more headlines. And there's no shortage of commentary on why Boardwalk Pipelines Partners blew up-and how investors can avoid a repeat. Here's my take:

  • Distributable cash flow had repeatedly failed to cover distributions in recent quarters.
  • After raising distributions for 30 consecutive quarters, management suspended regular increases in July 2012.
  • The partnership faces a series of large debt maturities, starting in early 2015.
  • Expiring contracts on the MLP's long-haul gas pipelines and storage assets set the stage for a massive revenue crunch.

In When MLP Distribution Growth Starts and Stops, we cited each of these challenges as reasons why Boardwalk Pipeline Partners was unlikely to emerge as a legitimate turnaround story. This article, available exclusively to Energy & Income Advisor subscribers, handicapped the odds for 14 other MLPs to raise their distributions after extended fallow periods.

In our estimation, Boardwalk Pipeline Partners had one saving grace at the time: the ostensible backing of well-capitalized conglomerate Loews Corp (L), which owns 59 percent of the MLP. Loews, however, elected not to provide the necessary support for Boardwalk Pipeline Partners to pursue growth opportunities and maintain its distribution.

The biggest lesson from Boardwalk Pipeline Partners' experience: Every MLP in your portfolio should be able to stand on its own merits.

What doomed Boardwalk Pipeline Partners while other chronic underperformers such as Buckeye Partners were able to right the ship? You won't find the answers to these questions by resorting to the usual platitudes.

For example, several mass-produced investment newsletters tout the idea investors can separate "good" and "bad" MLPs by focusing on one or two numbers, usually the coverage ratio and the number of consecutive quarters of distribution growth.

Investors must put these metrics in the proper context for them to be useful.

An MLP may fail to cover its distribution in a given quarter because of temporary weakness. And MLPs sometimes raise their payouts despite a shortfall in cash flow, implying management that has confidence in the partnership's future growth.

In these instances, the coverage ratio may vastly overstate the risk to the MLP's distribution. Selling based on that number alone will take you out of solid positions for little reason, very likely with a tax liability. Conversely, a seemingly comfortable distribution coverage ratio can narrow in a hurry for a more cyclical business.

A record of consistent distribution growth is usually a good thing. But it's also hardly a guarantee of safety and stability. Just ask unitholders of EV Energy Partners LP (EVEP). The natural gas-focused producer has raised its distribution every quarter since its initial public offering in September 2006.

The MLP's last 21 increases, however, have been for $0.001 per unit-an annualized growth rate of barely half a percentage point. Meanwhile, the stock has given up about 38 percent of its value over the past 12 months, hit by weak prices of natural gas liquids and disappointing results in the Utica Shale.

Debt levels are another important consideration for any dividend-paying stock, particularly when there's the possibility of an imminent increase in capital costs that revenue may or may not support. But again, there's no magic number to warn investors of impending disaster.

Always in Context

The factors that ultimately sank Boardwalk Pipeline Partners and fueled Buckeye Partners' comeback lie behind the numbers.

In Boardwalk Pipeline Partners' case, management could have cut distributions less drastically and spared investors such a bloodbath. But the root cause of the partnership's demise is its failure to diversify its operations away from long-haul pipelines made obsolete by surging production from the Marcellus Shale and other unconventional plays.

Boardwalk Pipeline Partners' long-term capacity reservation agreements with customers insulated the MLP from these headwinds for a time. But even long-term contracts (one of the most imprecise, overused terms in the MLP space) come to an end eventually. And the MLP and its sponsor never moved to replace this lost cash flow with new projects.

Fitch Ratings acknowledged these headwinds when the agency slashed Boardwalk Pipeline Partners' rating to BBB- and forecast that the MLP would be shut out of capital markets "for a prolonged period of time."

Similarly, Buckeye Partners stopped raising its distribution in 2012 because of weak results from newly acquired assets and the bleak outlook for its natural-gas storage assets in California.

But unlike Boardwalk Pipeline Partners, Buckeye Partners moved aggressively to diversify its operations and cash flow, adding a number of liquids storage and transportation assets via acquisitions and organic-growth projects.

This month, Buckeye Partners took a $169 million charge to eliminate its remaining financial exposure to its ailing storage business and will divest these assets fully by year-end.

The difference between Buckeye Partners and Boardwalk Pipeline Partners, in other words, boiled down to management understanding its market and executing its strategy. Buckeye Partners worked hard and succeeded.

Boardwalk Pipeline Partners' management sat on its hands until it was too late. The MLP's new strategic course may eventually result in a stronger company-but any potential turnaround is difficult to envision at this point.

Here are three keys to spotting the next Buckeye Partners (and avoiding the next Boardwalk Pipeline Partners:

  1. Find out the lay of the land. What are the headwinds facing an MLP's various assets?
  2. Evaluate management's strategy for dealing with these challenges. Is it being proactive like Buckeye Partners or reactive like Boardwalk Pipeline Partners?
  3. Regularly assess management's progress in the MLP's quarterly results.

Looking at distribution coverage and other financial metrics comes into play in the third step. But the most important thing isn't necessarily the bottom line figure; it's whether a broad set of facts are in line with the guidance management has given for progress.

If they are, recovery is on track and we have a potential Buckeye Partners. If not, odds are tilting toward a possible Boardwalk Pipeline Partners and it's time to get out.

Real investing success is never easy. It wasn't easy to be bullish on Buckeye Partners in 2012. And after the distribution cut at Boardwalk Pipeline Partners, it's going to be more difficult than ever to bet on the next Buckeye Partners.

But rest assured, these winning turnaround stories are out there and ready to reward the intrepid with market-beating gains. And what's more, today's top candidates are cheaper than ever compared to the average MLP.

The next Buckeye Partners is there for the taking -- but only for investors willing to delve a little deeper than the average bear.

Learn more about our favorite energy-related MLPs in Two Under-the-Radar Master Limited Partnerships.

Disclosure: I am long ETP, LINE, RGP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.