MLP Bottom Fishing 5: JP Energy Partners LP's Capital Structure Protects Investors

| About: JP Energy (JPEP)

Summary

JPEP is an MLP which engages in crude oil and refined products logistics as well as natural gas liquids logistics and distribution.

JPEP is now selling at a distribution yield of 25%.

JPEP has low leverage and growing cash flow; it should be able to cover its distribution in the intermediate future.

JPEP's capital structure protects unit investors because it's sponsor has a strong incentive to maintain distributions at the current level.

JPEP's leverage is relatively low for the MLP sector with debt at considerably less than 4 times adjusted EBITDA.

This article focuses on JP Energy Partners LP (NYSE:JPEP) which closed Monday at $5.20. This series of articles covers master limited partnerships (NYSEARCA:MLPS) whose prices have been driven down to levels producing very high distribution yields and the potential for substantial appreciation going forward. The first article in the series dealt with compression companies, the second with Azure Midstream (NYSE:AZUR), the third with Capital Products Partners (NASDAQ:CPLP) and the fourth with Crestwood Equity (NYSE:CEQP). All of the stocks covered in this series involve some risk and investors should approach the sector with caution.

JPEP (all data and information about JPEP is based upon its filings with the SEC) has been paying a $1.30 per year distribution which - at the current price - produces a distribution yield of 25%, not the highest in the sector but certainly among the highest. JPEP has three lines of business - crude oil transportation and storage, refined products terminals and storage and natural gas liquids logistics and distribution. Most of its business is priced on a throughput basis and a significant part of its revenue is covered by fixed fees. Normally, I would pass up JPEP because of its emphasis on petroleum. When looking at the big energy picture, it appears that U.S. domestic petroleum production will decline and put pressure on MLPs oriented to petroleum. On the other hand, U.S. domestic natural gas production should increase over time providing a tailwind for gas oriented MLPs. As is so often the case, other factors trump "big picture" analysis here.

Financial Performance - JPEP put down solid numbers in 2015. While it lost money on a GAAP basis, it generated adjusted EBITDA of $46.9 million (including some $5.5 million in overhead support from its very supportive sponsor - ArcLight). It projects adjusted EBITDA of $50-56 million for calendar 2016 without any sponsor support. Since interest expense was only $5.4 million in 2015, JPEP is generating substantial distributable cash flow.

Leverage - One feature of JPEP I am very happy about is leverage. JPEP had net debt of $161 million at the close of 2015. Based on 2015 results, the debt/adjusted EBITDA ratio (which is becoming one of the most important metrics for MLPs) was 3.4. Using JPEP's 2016 projections, the debt/adjusted EBITDA ratio will be between 2.9 and 3.2. This is well below the level we have seen for other discounted MLPs and provides JPEP with considerable flexibility and durability. We are unlikely to see the kind of "covenant problem" which is devastating AZUR.

Capital Structure - As with many MLP's, the capital structure is complex. I think that the best way to think about this is to look at a martini glass. The bottom is narrow but the glass gets wider as you move up to the top. MLP capital structures generally provide that the first distributions go to ordinary units. Then, after ordinary units receive a certain "guaranteed" distribution, subordinated units share in additional distributions. Finally, as distributions rise even higher, incentive distribution rights (IDRs) entitle the general partner to increasing shares. As a result, more and more dollars have to be paid out for each penny that the distributions rise above certain levels. This tends to limit the upside for ordinary unit holders. JPEP has 18.5 million ordinary units and 18.1 million subordinated units. It also has IDR's which kick in when distributions reach an annual rate of $1.495 per unit. In the case of JPEP, a distribution of $1.30 costs $47.6 million while a distribution of $1.29 costs only $23.9 million because the subordinated units don't participate.

The important thing for investors to be aware of is JPEP's subordinated unit structure. The subordinated units can convert to ordinary units after the end of the "subordination period." As long as the units continue to be subordinated, they can be paid distributions only if the common units receive an annual distribution of $1.30. The subordination period is defined in such a way that conversion to common units can occur only if existing common unit holders are paid the distribution of $1.30 per year through the end of 2017. At that point conversion can occur and we will wind up with a total of over 36 million common units.

For several reasons, the sponsor would like to get through the conversion period and have the subordinated units (largely held by the sponsor) convert to common units. First of all, it will enhance the value of the subordinated units. More importantly, it will give management the flexibility to manage distributions and, if necessary reduce the distribution level. Until conversion occurs, any reduction in distributions to common units will simply extend the subordination period and push back the date of conversion.

This may be the real reason behind the generous sponsor support of overhead for JPEP. It enables JPEP to maintain distributions at the level of $1.30 per year and to pay distributions on subordinated units. It hastens the day of conversion when management will not have to worry about the risk of an extension of the subordination period.

Most Likely Scenarios - If all goes reasonably well, JPEP will likely distribute at the rate of $1.30 per year for the next two years. At that point conversion will occur and it is possible that there will be a reduction although it will depend on the partnership's performance. Unless the economics of the partnership turn very, very ugly, however, I think that the sponsor with move heaven and earth to maintain the $1.30 distribution for the next two years so as to bring the subordination period to an end. That means that investors at this price will get half of their money back over the next two years.

If the partnership runs into trouble, and distributions have to be reduced in the next two years, then the martini glass structure comes into play. If the distribution goes below $1.30, then fewer units share and it becomes easier to manage. For example, a distribution of $1.06 (for a 20% yield on the current price) would cost JPEP only $19.6 million - well below adjusted EBITDA and therefore leaving room for some really bad news on the operational front.

While I would not pay $20 a share of JPEP, at the current price (or even up to $13 a share), it is attractive. At the current price, an investor gets either the repayment of half his outlay in the next two years or an extended period in which he does not have to share distributable cash flow with the subordinated units. I think that the former is the more likely scenario as ArcLight is very highly motivated to maintain the distribution.

JPEP seems to be well run and it does have upside. Its oil pipeline is underutilized (utilization is roughly 25%) meaning that lots of revenue can be added without any significant increase in costs. At this price, it is one of my favorite plays in the sector. As always, the distribution yield would not be this high if there weren't risks and investors should approach this whole sector (beaten down MLPs) by investing in a diverse group of these entities and tip toeing in.

Disclosure: I am/we are long JPEP, AZUR, CEQP, CPLP.

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.