Seeking Alpha
Research analyst, dividend investing, oil & gas, master limited partnerships
Profile| Send Message|
( followers)  

Summary

  • Individual investors often focus on distribution yield, but yield compression has accounted for much of the return posted by the best-performing MLPs.
  • Three of the 10 top-performing MLPs in 2013 were beaten-down names that surged after a private-equity outfit stepped in, creating a visible pipeline of growth opportunities.
  • Investors should focus on potential takeover targets that have other upside drivers to provide a degree of protection if the expected transaction never comes to fruition.
  • NSH could be a potential takeover target and, even if a deal doesn't materialize, the firm's turnaround story should continue to gain traction.

Despite the dramatic changes that have occurred in the universe of publicly trade partnerships since the 1980s, the basic appeal of this security class to investors has remained the same: above-average yields and significant tax advantages.

In a March 1987 article published in the Wall Street Journal, Barbara Donnelly wrote: "Investment bankers specializing in [master limited] partnerships say that in order to be competitive an issue must offer a current return of 9 percent to 10 percent."

Twenty-five years later, it's still all about the yield for many investors, especially as retiring baby boomers shift their focus from accruing assets to transforming accumulated savings into a reliable income stream.

This "strategy" of focusing on high-yielding names worked wonders in the aftermath of Lehman Brothers declaring bankruptcy; with fear running rampant, investors could lock in double-digit yields on Enterprise Products Partners LP (NYSE: EPD) and other high-quality names.

Publicly traded partnerships with exposure to commodity prices-producers such as Vanguard Natural Resources LLC (NSDQ: VNR) and gathering-and-processing outfits such as MarkWest Energy Partners LP (NYSE: MWE)-suffered the biggest hit during the 2008-09 panic and offered truly gargantuan yields.

In the subsequent recovery rally, the Alerian MLP Index-a capitalization-weighted basket of 59 prominent partnerships-delivered a record 75 percent return in 2009, while MarkWest Energy Partners and other hard-hit names generated total returns in excess of 250 percent.

Much of this upside came from price appreciation, or yield compression. And the same goes for the top-performing MLPs in subsequent years.

(click to enlarge)

From 2011 to 2013, price appreciation accounted for an average of 87 percent of the total return posted by the top-performing MLPs from each year. Thus far in 2014, climbing unit prices have contributed about 93 percent of the total return posted by the top 10 publicly traded partnerships.

A surging unit price also benefits the MLP, which enjoys a lower cost of equity capital relative to higher-yielding peers.

In the June 16 issue of Energy & Income Advisor, we covered three characteristics that tend to drive yield compression and explored our top picks based on these strategies. Here, we explore recent trends in mergers and acquisitions.

M&A Mania

Whereas some MLPs can unlock shareholder value with the assistance of their sponsor or self-help measures, three formerly out-of-favor names last year delivered total returns in excess of 100 percent after a third party acquired their general partner:

  • EnLink Midstream Partners LP (NYSE: ENLK)-102.9 Percent Return;
  • Constellation Energy Partners LLC (NYSE: CEP)-103.4 Percent Return; and
  • American Midstream Partners LP (NYSE: AMID)-117.4 Percent Return.

These transactions reflect the confluence of several trends.

First and foremost, many smaller MLPs find their opportunities for organic growth constrained by relatively limited asset bases that leave them exposed to supply and demand conditions in specific basins or industries. Meanwhile, competition for infrastructure and upstream assets that generate MLP-qualifying income has intensified considerably in recent years.

While smaller operators seek greater scale and cash flow diversification, the higher multiples that energy assets command when housed in publicly traded partnerships have made MLPs the preferred vehicle for private-equity concerns and producers to monetize their midstream (pipelines and processing) and mature upstream (oil and gas fields). (See MLPs Remain Popular Way to Monetize Midstream Assets.)

And because these struggling MLPs often commanded undemanding valuations before their general partner changed hands, these transformative deals-which provide a visible queue of potential drop-down transactions to fuel distribution growth-drive significant price appreciation.

Deal History: Past as Precursor

American Midstream Partners LP

American Midstream Partners LP had struggled to bridge the gap between its cash flow and its quarterly distribution ever since its initial public offering.

But thanks to the intervention of High Point Infrastructure Partners LLC, a portfolio company of private-equity outfit ArcLight Capital Partners LLC, the hapless partnership's future appears brighter.

Since High Point Infrastructure Partners acquired a 90 percent interest in American Midstream Partners' general partner, the new sponsor has made a number of changes that improved the small-cap MLP's growth prospects.

First, this transaction involved the contribution of High Point Infrastructure Partners' operating assets, which include approximately 700 miles of onshore and offshore gathering and transmission assets that serve producers on the Gulf Coast.

Management expects these assets to add $10 million to $12 million in annual earnings before interest, taxes, depreciation and amortization (EBITDA) and estimates that the combination in 2014 will produce $1 million to $2 million in cost synergies.

Equally important, American Midstream Partners and ArcLight Capital Partners reached an agreement whereby the outstanding subordinated units and incentive distribution rights were restructured, effectively removing a persistent shortage of cash flow and providing a margin of safety to the distribution.

This new structure also incentivizes ArcLight Capital Partners and High Point Infrastructure Partners to drive distribution growth through additional drop-down transactions.

After ArcLight Capital Partners took over as American Midstream Partners LP's sponsor, the MLP has raised its distribution and covers this higher payout by a comfortable margin.

We expect organic growth opportunities in the Eagle Ford Shale, bolt-on acquisitions from third parties and drop-down transactions from its sponsor to drive future distribution growth.

Constellation Energy Partners LLC

Constellation Energy Partners has reduced its debt load substantially since 2009 and refocused its drilling activity on oil-bearing plays within its existing asset base.

Despite this halting progress, the MLP hasn't paid a distribution mid-2009 and briefly considered converting to a C-corp to lighten unitholders' tax bills.

In the second quarter of 2013, Constellation Energy Partners acquired an interest in 67 producing wells in Texas and Louisiana from privately held Sanchez Oil & Gas for $20 million in cash and about $10 million in equity.

After this deal, Sanchez Energy owned about 70 percent of Constellation Energy Partners' Class A units and about 16 percent of its outstanding Class B units, setting the stage for additional collaboration between the two outfits.

Constellation Energy Partners' sponsor, PostRock Energy Corp (NSDQ: PSTR), sued to block the transaction. The sides agreed to a settlement in March 2014 that will give Sanchez Oil & Gas all of the MLP's Class A units and give PostRock Energy an opportunity to exit its remaining ownership.

This deal is an incremental positive for Constellation Energy Partners, removing the sole hurdle blocking the MLP from pursuing a transformative relationship with Sanchez Oil & Gas that likely will involve a name change, a series of drop-down transactions and the potential initiation of a quarterly distribution.

This event-driven upside potential could make Constellation Energy Partners LLC an interesting speculation for aggressive investors.

EnLink Midstream Partners LP

The former Crosstex Energy LP was ahead of many peers in its effort to offset declining volumes at its legacy operations in the Barnett Shale and Fayetteville Shale with organic-growth projects that will provide NGL (natural gas liquids) handling and fractionation to producers in the Eagle Ford Shale.

Independent oil and gas producer Devon Energy Corp (NYSE: DVN) contributed $4.8 billion in midstream assets to EnLink Midstream Partners' general partner; this infrastructure complements the MLP's existing asset base. EnLink Midstream Partners stands to benefit from drop-down transactions from the general partner, as well as its new sponsor, Devon Energy.

Meanwhile, the MLP also has an opportunity to support Devon Energy's aggressive drilling campaigns in the Eagle Ford Shale, Permian Basin and Niobrara Shale.

The stock's valuation doesn't fully reflect these growth opportunities; as drop-down transactions ramp up later this year, look for the units to outperform. A secondary offering to finance the first deal could give patient investors a buying opportunity.

Strategy

Within the universe of energy-focused publicly traded partnerships, the hapless Eagle Rock Energy Partners LP (NSDQ: EROC) could be a candidate for a transformative takeover offer after selling its midstream assets to Regency Energy Partners LP.

According to the proxy filing related to the aforementioned transaction, Eagle Rock Energy Partners had explored establishing a long-term relationship with a private-equity firm that would contribute upstream assets to the MLP in exchange for an equity stake and other considerations.

Eagle Rock Energy Partners' management team also instructed its advisers to explore the possibility of a companion transaction that would involve the MLP's remaining assets.

Against this backdrop, we wouldn't be surprised if Eagle Rock Energy Partners were to either be acquired or secure an arrangement with a private-equity firm or upstream C-corp seeking to monetize assets.

However, we live by a hard and fast rule when it comes to investing in potential takeover targets: The stock in question must have other upside drivers to provide a degree of protection if the expected transaction never comes to fruition.

Potential Takeover and More: NuStar GP Holdings LLC (NYSE:NSH)

After an extended period of weakness and some dubious investment decisions by its former management team, NuStar Energy LP (NYSE: NS) posted first-quarter results that rekindled our interest in the MLP's turnaround story.

The ailing partnership generated distributable cash flow of about $1.00 per unit, exceeding management's guidance for between $0.85 and $0.95 per unit and covering 91 percent of the payout. Management reiterated its near-term goal of generating enough cash flow to fund the distribution by year-end.

As part of its strategic shift, NuStar Energy has divested its interest in cyclical businesses in favor of organic expansion projects at its South Texas pipeline system, which supports customers in the prolific Eagle Ford Shale.

This turnaround effort involved the divestment of the MLP's ownership interest in the San Antonio refinery and its exit from the much-maligned asphalt business.

In late 2012, NuStar Energy accelerated its growth opportunities in the Eagle Ford Shale with the $325 million acquisition of crude-oil and NGL pipelines and related storage and gathering assets from privately held TexStar Midstream Services LP.

The MLP in the second quarter completed its first expansion to its South Texas pipeline system, bringing the capacity to 135,000 barrels per day. Management expects to complete the second phase, which will increase the capacity to 200,000 barrels per day, in the first quarter of 2015.

NuStar Energy also more than tripled the capacity of its docks in Corpus Christi, enabling customers to move crude-oil volumes across the Gulf of Mexico to refineries in Louisiana. This expansion also positions the MLP to benefit from recent private-letter rulings from the US Commerce Dept that could reduce the barriers to exporting condensate, an ultralight hydrocarbon that predominates in the Eagle Ford Shale. (See Condensate Conundrum.)

We also like the MLP's recently announced agreement with Occidental Petroleum Corp (NYSE: OXY) to reactivate and reverse an idled pipeline that will transport NGLs to the oil and gas company's propane export facility in Ingleside, Texas. NuStar Energy expects this project to come onstream in the second quarter of 2015.

At the National Association of Publicly Traded Partnership's (NAPTP) annual MLP investor conference, management indicated that it would continue to focus on organic growth opportunities afforded by its existing asset base while eyeing complementary acquisitions in the Eagle Ford Shale. (See MLP Mania: Takeaways from the NAPTP's Annual Investor Conference.)

CEO Bradley Barron mentioned the Niobrara Shale in the Rockies as a basin that the MLP would consider entering.

But the progress in NuStar Energy's pipeline segment must overcome near-term weakness in its terminal segment, where a crude-oil market in contango-spot prices are lower than volumes for future delivery-has weighed on demand from traders.

In particular, management highlighted weakness at its West Coast facilities and reduced profit sharing at its terminals in St. James, La., because of the tightening spread between Light Louisiana Sweet crude oil and West Texas Intermediate.

Management's forecast calls for its storage segment to generate flat adjusted operating earnings relative to year-ago levels. Thus far, the MLP hasn't encountered problems renewing expiring storage contracts, though rate increases have been harder to come by.

The Verdict

NuStar GP Holdings LLC (NYSE: NSH), which owns a 2 percent general partner interest in NuStar Energy and 12.9 percent of the MLP's outstanding common units, sports a distribution yield of about 5.3 percent-easily the highest among pure-play general partners. (Read about the relative advantages and disadvantages of investing in general partners in Profit from General Knowledge.)

Buying the general partner gives us exposure to NuStar Energy's turnaround story-and any premium in a potential takeover.

Plains All American Pipeline LP (NYSE: PAA) is on the hunt for an acquisition after its general partner, Plains GP Holdings LLC (NYSE: PAGP), went public.

At the same time, an activist investor used NuStar Energy's third-quarter earnings call last year to press for a combination with Kinder Morgan Inc. (NYSE: KMI) or one of the other large MLPs.

Looking for more on my favorite energy-focused MLPs? Check out this free video presentation on my favorite general partner.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Source: The Search For Yield Compression: MLP Takeover Targets