Chesapeake Midstream: Problems With Potential

Includes: ACMP, BHP, CHK
by: Mike Maher

Chesapeake Midstream Partners (CHKM) is a midstream MLP company formed last year by Chesapeake Energy (NYSE:CHK) and Global infrastructure Partners. CHKM owns and operates 2,800 miles of pipelines and moving 1.5 bcf/d, gathering natural gas from producing wells so it can be taken out of the field and towards processing facilities and consumers. CHKM's growth prospects are tied to the growth of CHK's assets, as well as CHK's attempts to unlock shareholder value, which I have previously discussed here. However, CHK's sale of its Fayetteville assets brings up concerns for CHKM's longer term strategy, making the units' valuation worth a second look.

MLPs are formed as tax shelters for assets that produce strong, steady returns. Companies like CHK place the assets into a subsidiary company, then spin off a minority stake in the company in the form of an IPO. In this case CHK and Global Infrastructure Partners both own 42% of CHKM, with the rest open to the public. CHK is the manager of CHKM, and should be looking to "drop-down" assets to CHKM, increasing the midstream company's size and distribution.

CHK wins by receiving cash for the assets, and still being able to benefit from the asset's cash flow by distributions paid to CHKM unit holders. CHKM wins by getting great assets at good prices, and public unit holders benefit from a larger distribution. In a February analyst presentation, CHKM cites Chesapeake's assets in the Haynesville Shale (460 mmcf/d), Fayetteville Shale (350), Marcellus Shale (220), Eagle Ford Shale (5), as well as other compression systems as potential drop-downs. Assets are listed in descending order of their throughput measured by mmcf/d, which is the number after each asset. A drop-down of all these assets, over time of course, would increase CHKM's daily volumes by two-thirds, providing for the prospects of significant distribution increases and unit appreciation.

Unfortunately, CHKM's management's ability to predict the future was dealt a blow yesterday, when CHK agreed to sell its assets in the Fayetteville Shale, including its midstream assets, to BHP Billiton (NYSE:BHP). While great for CHK shareholders, this loss of a potential drop-down is a setback for CHKM. The Fayetteville assets were the second-largest potential drop-down in terms of volume, and represented about one-third of all potential dropdown volume cited by management.

That isn't to say BHP won't put the assets up for sale and CHKM will not own them, but the odds of CHKM getting the assets are now much lower. The timing of both the presentation to analysts by CHKM, and the sale of the assets to BHP, is also a cause for concern, seeing as barely three weeks passed between CHKM management citing Fayetteville as a potential drop-down, and CHK selling the assets to BHP. If CHKM does not have as strong of a sponsor in CHK as investors once thought, that is a large negative for CHKM's model as well as valuation.

Speaking of valuation, CHKM's recent dividend of $0.3375 represents a $1.35 dividend on an annualized basis, and with shares falling through $27 today, that amounts to about a 5% yield. Now compare that to more established players like Enterprise Products (NYSE:EPD) at 5.4%, Energy Transfer Partners (NYSE:ETP) at 6.6%, Williams Partners (NYSE:WPZ) at 5.6%, TC Pipelines (TCLP) at 5.7%, Market West (NYSE:MWE) at 5.9%, and Oneok (NYSE:OKS) at 5.5%. All these companies have longer operating histories and more experienced management teams, yet investors are affording CHKM a higher price per unit, resulting in a lower yield. While that may have made sense when it seemed as if CHK would be dropping-down assets on a regular basis, investors should be re-evaluating that premium in light of yesterday's events.

Given the uncertainty over how many of CHK's assets will pass down to CHKM, the units should not command a premium to other established MLPs. Enterprise, which I discuss here, is the best in class in the MLP space, so riskier partnerships should have a higher yield than EPD, not a lower one. Assuming CHKM's $1.35 distribution stays flat, the units would need to fall $22.50 for a 6% yield. That equates to a fall of $4.30, or 16% from here. At that level the risk/reward will be more aligned in unit holders' favor, in my opinion. CHKM has strong potential to benefit from CHK's continued drilling program and drop-down acquisitions, but as the company has shown us this month, potential doesn't always come through.

Disclosure: I am long EPD.