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Summary

  • Boardwalk Pipeline Partners is a large, non-diversified, highly levered, natural gas and gas liquids pipeline operator.
  • 95% of its revenues came from natural gas transportation and storage. Recently, many of its assets have become less profitable and rising natural gas prices have hurt margins.
  • Several of its long term contracts have come up for renewal and the partnership was forced to accept lower rates.
  • The result was a catastrophic decline in EBITDA, Distributable Cash Flow and a 81% distribution cut, which resulted in a 40% sell off.
  • Its dividend yield, now just 3%, and 0 likely distribution growth for the foreseeable future indicates that investors can expect 3.2% CAGR returns going forward.

As part of my ongoing research into building a real world high yielding portfolio I began analyzing Midstream MLPs. One of the largest headlines in this sector recently has been the catastrophic collapse of Boardwalk Pipeline Partner's (NYSE:BWP) distribution. As part of an effort to investigate a potential dirty value opportunity I will analyze Boardwalk's recent troubles, its future growth prospects and whether or not there is anything here for long-term investors to salvage.

What Happened:

  • Revenues down 4%.
  • Distribution cut of 81% from $2.14/share/year to $.40/share, resulting in 40% sell off.
  • Cut spurred by devastating 4th quarter results:

- Net Income down 78%

- Adjusted EBITDA down 34%

- Distributable Cash Flow down 4%

On the surface the small declines in revenues and DCF make the size of the distribution cut seem excessive, but there is good reason why management took such drastic action.

Walking Off A Contract Cliff:

Midstream pipeline partnerships such as Boardwalk are typically very stable and reliable sources of distributions because of long-term (typically 10 year) contracts that reduce exposure to commodity risk. This is because the partnership's contract states a guaranteed volume and payment for use of its pipes to transport oil and gas. The only risk is if commodity prices have greatly changed for the worse when the contract is up for renewal and renegotiation. At that point the partnership may have to lock themselves into a new 10 year contract that ensures far less cash flow. This is what recently began happening to Boardwalk.

The important thing to understand about Boardwalk is that it is incredibly non-diversified. 95% of its income comes from the transport and storage of natural gas and natural gas liquids.

BPW has numerous contracts coming up for renewal in 2014 and 2015. Compressed natural gas spreads, caused by rising prices, resulted in a $13 million decline in Q4 and is expected to result in 28% less DCF in 2014, from $560 million to $400 million. Why has the natural gas spread so affected the company?

Think of the pipeline and natural gas storage business like this:

Say I have natural gas that I'm producing in state A where the price of gas is $4/mcf. It costs me $3/mcf to produce and I make a 25% profit on it if I sell in the area. But lets say in State B natural gas is selling for $6/mcf. Then I can double my profit if I can just transport my gas over there. That's where Boardwalk comes in. I might sign a 10 year contract with the partnership to transport my gas from state A to state B at a cost of say $.5/mcf. It is a great deal for both sides. I get an extra $2.5/mcf of my gas and Boardwalk secures steady cash flow for a decade.

Now imagine that new gas fields are discovered close to state B and the price of gas there plunges to $4. Suddenly the spread on my gas is much compressed and I'm only making $.5/mcf of gas instead of $2.5. I am still locked into my contract but when that contract is up, I will be sure to either get Boardwalk to lower the price they charge me for transporting my gas, (such as to $.1/mcf) or I will just stop selling to state B.

Now imagine a second scenario involving gas storage. Again, I am a natural gas producer in state A where it costs me $3/mcf to produce gas and gas is selling for $4/mcf. Suddenly the fracking boom hits my area and gas prices drop to $3. I'm making no profit at these prices but my leases on the land I'm producing gas from are "use it or lose it." This means I either produce a certain amount of gas or I forfeit my right to drill at all. So I keep producing my gas at cost but I'm confident that the price of gas will have to increase in the future. So I sign a contract with Boardwalk to store my gas, expecting to be able to sell it at $5 or $6 later (perhaps during a very severe winter when natural gas prices spike). In that case, Boardwalk benefits from both storing and transporting my gas.

But what happens if the price of natural gas goes back up to say $4.5/mcf. Do I still think the price is likely to rise? Not so much. So why pay to store gas?

This is what happened to Boardwalk Pipeline Partners. They initially made very lucrative contracts during the early years of the fracking boom when natural gas prices dropped in some areas and not in others. This resulted in lucrative decade long contracts that ensured solid cash flow and high distributions. Later, the nationwide fracking boom drove natural gas prices to historical lows and demand for storage was very high. In fact, just in 2013 Boardwalk was able to sell some of its gas in storage at a profit resulting in $56 million in DCF. This is DCF that is not to be repeated in 2014.

The Picture Ahead:

The next few years look bleak for Boardwalk for several reasons.

1. Wrong assets in the wrong places:

Boardwalk has relatively few pipelines servicing the newly hot Marcellus and Utica Shale areas. They are currently investing in new pipelines to fix the problem but that takes cash flow (which is dropping quickly).

2. Highly levered balance sheet:

Currently Boardwalk's debt is $3.3 billion and its Debt/EBITDA is 4.6x. Anything above 4.5 is alarmingly high and management is both guiding for lower EBITDA in 2014 and has stated a long term goal of debt/EBITDA of 4. The reason for the necessity of the debt decrease is Fitch cutting Boardwalk's credit rating to BBB- which is the lowest that is still investment grade. In addition, the credit rating agency predicted that "the partnership will be shut out of capital markets for a prolonged period of time."

According to the most recent earnings call, management is targeting $90 million of 2014's guided $400 DCF towards the new lower distribution. The remainder will go towards cap-ex projects designed to increase EBITDA and counter the decreased revenues from the upcoming contractual roll offs. This is management's long term plan to lower its Debt/EBITDA ratio from 4.6x to 4x.

3. Continued contractual roll offs and weakness in 2014-2015:

The partnership is anticipating being forced to lock in lower rates for transport and storage for when they come up for renewal. In 2018 and 2019, the partnership has its largest number of highly lucrative contracts roll off, which threatens long-term cash flows.

4. Cap-ex investments are unlikely to offset lower contractual rates:

According to the most recent earnings call:

The company's largest cap-ex program is the Bluegrass project which will build pipelines for natural gas liquids from Marcellus and Utica shale fields to the Gulf Coast Petrochemical complexes.

The partnership is also working on a SouthEast Market expansion which will increase gas transportation to utilities in Mississippi, Alabama and Florida. The partnership states that they have just signed a new 10 year contract at favorable rates.

Texas Gas Interstate pipeline project will cost $150 million and a new 10 year contract will begin in mid 2016.

Unfortunately, these new projects won't be able to make up the lost revenues from the 2014, 2015, and much less the 2018-2019 contract roll offs.

5. Distribution growth is 0 for the foreseeable future.

With Boardwalk facing a continued contractual roll off cliff in 2014, 2015 and worst of all in 2018-2019 revenues, EBITDA and DCF will likely be unable to grow for the foreseeable future. What's worse is that according to management Marcellus and Utica shale production is expected to double by 2020. This indicates that the conditions that resulted in the recent weakness are here to stay for the long-term.

Given that the entire reason for owning an MLP is for high yield and consistent distribution growth, the current state of Boardwalk Pipelines Partners is nothing less than disastrous.

This is because the long-term total return of high yielding investments such as MLPs, REITs and BDCs is (yield+CAGR of dividend/distribution)*average yield. This takes into account the income, capital gains and dividend/distribution reinvestment.

For Boardwalk's yield to drop to 3% and no distribution growth likely anytime soon long-term investors can expect about 3.2% CAGR with distributions reinvested.

Now compare that to Boardwalk's competitors: Kinder Morgan Energy Partners (NYSE:KMP), Enbridge Energy Partners (NYSE:EEP), Energy Transfer Partners (NYSE:ETP), Plains All American Pipeline (NYSE:PAA), Magellan Midstream Partners (NYSE:MMP).

Company

Yield

Dividend CAGR (7 year)

Dividend CAGR (5 year)

Predicted 5 year Total Return CAGR

MMP

3.38

10.96

10.51

14.57

KMP

7.23

7.68

5.31

13.33

PAA

4.6

8.22

6.33

11.54

EEP

7.88

2.33

1.89

10.46

EPD

4.17

6.69

5.24

9.92

ETP

6.68

4.63

0.58

7.78

BWP

3.07

-19.6

-17.41

3.16

As one can see, Boardwalk cannot hold a candle to its more successful competitors - most of whom are not having the kinds of company specific issues like Boardwalk .

Conclusion:

With its yield slashed and its prospects of future distribution increases all but eliminated, in the short-medium term the investment thesis for Boardwalk Pipeline Partners has completely collapsed. The continued weakness in revenues, EBITDA and DCF from ongoing contract roll offs (which will extend into 2019) ensures weak financial results for the short to medium term. The long-term growth in Marcellus and Utica shale threatens even the partnership's long-term ability to restart the growth in its distribution. In other words, there is nothing to salvage from the corpse of Boardwalk's distribution.

Meanwhile, Boardwalk's competitors Magellan Midstream, Kinder Morgan and Plains All American continue to execute well, cover distributions and grow consistently. The end result is that these 3 excellent Midstream MLPs are likely to outperform the market's 1871-2013 CAGR of 11.1% (with dividend reinvestment). Therefore yield hungry investors searching for quality yield and distribution growth should turn to these MLPs.

Source: Boardwalk Pipeline Partners: Is There Anything To Be Salvaged From This Fiasco?