Examples In MLP Due Diligence - Spectra Energy Partners

| About: Spectra Energy (SEP)

Summary

This is the second in a series of 'due diligence example' articles on MLPs.

SEP is a large cap investment grade MLP with good safety attributes.

SEP has superior distribution coverage - another safety attribute.

SEP has distribution growth projected at close to 8% over the next three years.

This is the second in a series where I provide my answer the question "What is good due diligence for MLP (energy Master Limited Partnership investors?" Many investor have few clues as to what good due diligence is. I will provide examples of what most investors would call hyper due diligence. You can opt to weed out some of the hyper to arrive at the level that feels right to you. Prune prudently.

I will start with an update for 6-13-16 for the large capped midstream MLPs in my coverage universe:

Large Cap Midstream

Current Distrib/ Q2 Dist Dist/dcf Dist/dcf Year-to-Date Percent Change
Company name Price Quarter Yield 2016 2017 Price Pr+Dist EPS Target DCF Dist* CAGR
Buckeye Partners, L.P. (NYSE:BPL) 69.88 1.1875 6.80 89.79 86.84 5.94 9.54 0.24 -2.19 0.38 3.26 0.00
Enable Midstream Partners (NYSE:ENBL) 14.25 0.3180 8.93 102.58 100.16 54.89 61.80 -4.88 1.82 -10.79 1.76 -97.50
Enbridge Energy Partners, L.P. (NYSE:EEP) 22.15 0.5830 10.53 105.52 100.95 -3.99 1.07 -40.34 -28.99 -3.07 2.28 -86.84
Enterprise Products Partners L.P. (NYSE:EPD) 27.92 0.3950 5.66 77.83 74.18 9.15 12.24 -6.85 -5.09 -2.87 5.33 -3.64
Energy Transfer Partners, L.P. (NYSE:ETP) 37.71 1.0550 11.19 107.93 91.94 11.80 18.06 -62.76 -19.96 -18.71 3.94 -66.10
Kinder Morgan, Inc (NYSE:KMI) 17.38 0.1250 2.88 23.26 21.83 16.49 18.16 -6.67 -3.75 -5.70 -73.96 0.00
Magellan Midstream Partners LP (NYSE:MMP) 72.05 0.8025 4.46 80.05 72.46 6.05 8.41 -5.69 -0.88 1.01 11.85 -10.11
Oneok Partners, L.P. (NYSE:OKS) 37.44 0.7900 8.44 100.32 96.93 24.26 29.51 13.20 11.34 3.28 0.00 -20.00
Plains All American Pipeline, L.P. (NYSE:PAA) 26.68 0.7000 10.49 121.74 105.26 15.50 21.56 -31.67 -25.22 -14.50 2.19 -96.67
Spectra Energy Partners, LP (NYSE:SEP) 46.60 0.6338 5.44 81.00 74.56 -2.31 0.35 6.73 1.43 10.99 3.85 7.69
Sunoco Logistics Partners L.P. (NYSE:SXL) 27.36 0.4890 7.15 87.32 72.99 6.46 10.26 -23.26 37.98 -3.03 16.71 -2.11
Williams Partners L.P. (NYSE:WPZ) 32.55 0.8500 10.45 90.67 85.00 16.88 22.98 -48.65 0.00 -2.34 0.00 -33.33
Large Cap Average 7.70 89.00 81.93 13.43 17.83 -17.55 -2.79 -3.78
The Alerian MLP index ETN AMJ is 5.66% and with dividends is 7.51%.
The S&P500 index ETF SPY is 2.25% and with dividends is 2.76%.
The Russell 2000 index ETF IWM is 1.94% and with dividend is 2.23%.
Click to enlarge

Let's continue with an examination of Spectra Energy Partners, LP or SEP - and answer the questions all income investors ask: "is the dividend or (correctly) distribution safe?" and "can the distribution grow?"

The spreadsheet that follows summarizes key metrics in the income statement and balance sheet:

Spectra Energy Partners metrics

Q1-2016 Q4-2015 Q3-2015 Q2-2015 Q1-2015 Q4-2014 Q3-2014 Q2-2014 Q1-2014 Q4-2013 Q3-2013 Q2-2013 Q1-2013
Revenues 624 634 612 603 606 599 558 531 581 520 494 492 459
Costs 300 294 293 281 295 300 278 282 273 273 260 249 210
EBITDA 447 484 467 456 436 405 401 353 432 351 344 348 341
Total DCF dollars 371 260 270 321 354 245 247 239 324 120 66 56 73
GP's DCF dollars ** 69 65 66 61 57 52 48 45 42 45 14 13 11
Net DCF dollars 302 195 204 260 297 193 199 194 282 75 52 43 62
Units 291 291 307 296 295 294 288 286 284 227 113 108 104
DCF/unit $1.0378 $0.6701 $0.6645 $0.8784 $1.0068 $0.6565 $0.6909 $0.6783 $0.9929 $0.3304 $0.4602 $0.3981 $0.5961
Upcoming Distrib. $0.65125 $0.63875 $0.62625 $0.61375 $0.60125 $0.589 $0.57625 $0.56625 $0.55625 $0.54625 $0.51625 $0.50875 $0.50125
Calculated Coverage 1.594x 1.049x 1.061x 1.431x 1.6745x 1.1146x 1.2201x 1.1979x 1.7850x 0.6049x 0.8914x 1.7825x 1.1892x
Reported Coverage* 1.2x 1.3x 1.4x 1.5x 1.2x 1.3x 1.4x 1.6x
Broker1 DCF/unit $1.04 $0.69 $0.68 $0.88 $1.01 $0.66 $0.69 $0.68 $1.00
Broker2 DCF/unit $0.66 $0.85 $0.99 $0.64 $0.67 $0.66 $0.97
Broker3 DCF/unit $0.69 $0.67 $0.85 $0.99 $0.64 $0.68 $0.66 $0.97
* "Reported coverage" comes from the quarterly earnings presentation - and it is a year to date number
** From the "Statements of Operations" - the first spreadsheet in 10-Q - find "General partner's interest in net income"
Since most metrics have only 2 places of accuracy, the DCF calculation showing 4 places of accuracy are an incorrect data presentation. I'm just showing the math.
In Q3-13, SEP reported $5.8 million in transaction costs. Adjusting for that, DCF would have been $58 or $0.51/unit. Q4-13 also had transaction costs.
Due to game changing acquisitions in Q4-14, SEP produced pro forma EBITDA stats going back to 2013 - but not before. LTM EBITDA numbers for 2013 are useless.
SEP's EBITDA projections: 2016: 1965 -- 2017: 2235 -- 2018: 2335
SEP's DCF projections: 2016: 1310 -- 2017: 1515 -- 2018: 1750
LTM EBITDA 1,854 1,843 1,764 1,698 1,595 1,591 1,537 1,480 1,475 1,384
Long term debt 5,862 5,845 5,891 5,877 6,147 5,149 5,161 5,163 5,178 5,178 2,786.1 699.6 699.6
Debt/EBITDA 3.16x 3.17x 3.34x 3.46x 3.85x 3.24x 3.36x 3.49x 3.51x 3.74x

Short Term Debt 283 476 287 287 36 36 34 34 445 445 15.7 15.7 15.7
Total Debt 6,951 6,321 6,178 6,164 6,183 5,185 5,195 5,197 5,623 5,623
Total Debt/EBITDA 3.75x 3.43x 3.50x 3.63x 3.88x 3.26x 3.38x 3.51x 3.81x 4.06x
Interest Expense 56 60 59 63 57 55 54 62 67 84 105 100 94
Interest Coverage 7.98x 8.07x 7.91x 7.24x 7.65x 7.36x 7.43x 5.69x 6.45x 4.18x
On 9-16-13 SEP priced $500 million 2.95% senior notes due 2018, $1.0 billion 4.75% senior notes due 2024, and $400 million 5.95% senior notes due 2043 at 99.8%, 99.7%, and 99.9% of face value
Click to enlarge

Why should equity investors worry about debt metrics?

It is my perception that credit covenant issues have been the key reason for distribution cuts at American Midstream Partners (NYSE:AMID), Exterran/Archrock (NASDAQ:APLP), KMI, Teekay LNG Partners (NYSE:TGP) and Teekay Offshore Partners (NYSE:TOO). The red flag warnings about distribution cuts did not come from the distribution coverage numbers. Equity investors need to have credit metrics on their radar because this is where the red flags are found.

What can we learn from these numbers?
1. First off, I have verified by DCF/unit (or Distributable Cash Flow per unit) calculations with the DCF numbers from three different brokerage analysts. The SEP DCF calculation is relatively simple - there is an adjustment to subtract DCF dollars owed to the General Partner. Those dollars include the IDR's or Incentive Distribution Rights. Most MLPs require adjustments for 'normalization' of the DCF metric for items like mark to market hedge gains and gains from one time sales of assets. I can arrive at reasonably good numbers without going to that degree of complexity.
2. I can have a decent level of confidence in my DCF calculation because my numbers are in the same neighborhood as those done by the professional analysts.
3. DCF/unit change since 2014 has been strong. Most MLPs have faced headwinds due to commodity price falls.
Let's move on to some attributes I know due to producing similar spreadsheets for many other MLPs. As you absorb the data from future articles in this series, you will have the data in which to arrive at similar assessments.
4. DCF/unit numbers by quarter are relatively volatile. Seasonality in demand causes first quarter's to be very strong - and summer months with lower numbers.
5. The 'annual' distribution coverage is relatively strong. That is both a safety and growth attribute.
6. The debt metrics are relatively strong. That produces a relatively low cost of debt capital - which is a good thing. Strong balance sheets also result in high valuations for the equity.
7. In a low inertia environment, a good forward DCF projection will be close to the LTM (last twelve month) DCF number. For SEP, LTM DCF is (1.04 + .67 + .66 + .88) $3.25/unit.

The LTM numbers that existed before Q1-16 was (.67 + .66 + .88 + 1.01) $3.22 - and the beginning of the year 2016 consensus DCF projection was $2.82. The analysts did not have the expectation that Q1-16 would repeat Q1-15 in having such strong numbers.

I have 10 2016 DCF projections from the 11 brokerages I use to create a consensus number. The projections range from $2.77 to $3.44. The average for the projections is $3.13 - and only one projection is within ten cents of the average.

As a general rule of thumb - I hate it when I see this large of a range in projections. (This attribute may explain why SEP is rated BBB and not BBB+.) But, while SEP scores poorly on the 'range in projections' attribute - SEP scores high on 'historical earnings projection accuracy' when one compares the average beginning of the year projection to the ending actual DCF. Put in different words, the typical brokerage DCF projection for SEP is a bad projection. But the average of all projections produces a reasonable earnings expectation.

Now that I have a good DCF - let's move on the CAGRs - or a five year forward "Compound Annual Growth Rate" projection of the distribution.

Middle term metric trends
The average calculation for DCF growth is for five years - for 2017 through 2012
The first average is the sum of changes for each individual year over five year period - with that result divided by 5
The 2nd average is the difference between the current and beginning number, divided by the beginning number - with that result divided by 5
The distributions shown are annualized first quarter distributions

Co. 2012 2013 2014 2015 2016 2017 average average CAGRs PI-CAGRs
SEP DCF 2.08 2.08 2.83 3.06 3.13 3.40 My 7.00% RRR-yield 4.56%
Growth 1.46 0.00 36.06 8.13 2.29 8.63 11.02% 12.69% Last 5 11.02% P/DCF Ratio 4.77%
Dist. 1.90 1.98 2.19 2.35 2.54 Broker 1 7.20% Broker 2 8.40%
Growth 5.56 4.21 10.36 7.76 7.66 7.11% 8.17% Broker 3 6.90% Broker 4 7.30%
Dist/DCF 91% 95% 77% 77% 81% 84.34% Next 4 8.44%
Click to enlarge

The average distribution growth has been right at 7% while the distribution/DCF ratio has been 84%. Given that the current ratio is 81%, forward distribution growth should be slightly above average growth. Last 5 year DCF (ending with the 2017 projection) has averaged (+8.6 +2.3 +8.1 +36.1 +0.0) 11.02% - with one year skewing that average. I usually want my distribution growth number to be in alignment with the average DCF growth number. Because the average is skewed, I want my CAGR to be much lower.
I show four CAGR projections from the major brokerages - and I want a personal projection that is in alignment with a conservative consensus. There are two PI-CAGRs or "price implied CAGRs". I want the price implied CAGRs to be high enough to show the market is (mostly) pricing in projections in the same neighborhood - while at the same time I want the price implied CAGRs to be under the fundamentally derived projection to indicate that the degree of goodness expected in EPD is not fully priced in. (Those are frequently mutually exclusive attributes.)
For SEP, I believe my CAGR projection is the right amount lower than the brokerage projections - but my CAGR projection for SEP is well above the price-implied CAGRs - which would indicate SEP is under valued.

Now that I have arrived at a growth projection with which I can have a fair amount of confidence - it is time to make a numeric risk assessment.

When it comes to historical DCF projection accuracy - SEP is as good as it gets. When it comes to credit ratings - it is just below as good as it gets. When it comes to credit metrics - they are almost as good as it gets (MMP does better). When it comes to distribution coverage - it too is as good as it gets in this sub-sector. Because of these attributes, I assess SEP as tied for the second lowest Required Rate of Return (or risk assessment) in this grouping. This assessment lightly weights the negative attributes of (1) the DCF projection spreads and (2) the higher than average DCF seasonality.

And with that - you should be sufficiently prepped for the ending spreadsheet that compared valuations:

Yield + CAGR Total Return Expectations

Company Q2-16 Consensus Total Bonds DCF My Total Rtn Consensus Price Implied CAGR Distrib Price
Yield CAGR Return Ratings Accr RRRs - RRR Ratings RRR-Yld P/DCF / DCF / DCF
Buckeye Partners, L.P. BPL 6.80% 4.40% 11.20% BBB- 2.50 11.00 0.20 2.1 4.20 4.09% 89.79 13.21
Enable Midstream Partners ENBL 8.93% 0.10% 9.03% BB+ 3.00 12.50 -3.47 2.6 3.57 1.84% 102.58 11.49
Enbridge Energy Partners, L.P. EEP 10.53% 0.50% 11.03% BBB 2.00 12.00 -0.97 2.9 1.47 0.04% 105.52 10.02
Enterprise Products Partners L.P. EPD 5.66% 5.30% 10.96% BBB+ 1.30 10.00 0.96 1.7 4.34 3.24% 77.83 13.75
Energy Transfer Partners, L.P. ETP 11.19% 2.00% 13.19% BBB- 3.00 12.50 0.69 2.2 1.31 0.27% 107.93 9.64
Kinder Morgan, Inc KMI 2.88% 6.00% 8.88% BBB- 1.30 11.00 -2.12 2.4 8.12 -5.40% 23.26 8.08
Magellan Midstream Partners LP MMP 4.46% 8.00% 12.46% BBB+ 1.00 10.30 2.16 2.1 5.84 11.60% 80.05 17.97
Oneok Partners, L.P. OKS 8.44% 0.80% 9.24% BBB 3.00 12.50 -3.26 2.9 4.06 4.41% 100.32 11.89
Plains All American Pipeline, L.P. PAA 10.49% 0.10% 10.59% BBB 3.00 12.50 -1.91 2.7 2.01 3.89% 121.74 11.60
Spectra Energy Partners, LP SEP 5.44% 7.00% 12.44% BBB 1.00 10.30 2.14 2.2 4.86 5.90% 81.00 14.89
Sunoco Logistics Partners L.P. SXL 7.15% 9.30% 16.45% BBB 1.10 12.00 4.45 2.1 4.85 4.10% 87.32 12.21
Average 7.45% 3.95% 11.41% 2.35 4.06% 3.09% 12.25
Click to enlarge

"Total Return minus RRR" is my the buy, hold or sell number. Positive is buy - the stock is selling below what the valuation assessments suggest. Negative is sell - the stock is selling above what the valuation assessment suggest. Close to zero means the stock is correctly priced. In most sectors there is superior metric transparency compared to MLPs - and I produce TR - RRR numbers that are close to zero. Total Return or "TR" = Yield + CAGR.

What does all of this math mean?

SEP is a relative buy based on current valuations. It is a much safer or predictable MLP than average. This is a time where such MLPs have relatively high valuations. One should expect some short to mid term under performance due to those valuations. At the same time, retail investors will be well served to reach and stick with a heavy weighting in the investment grade MLPs with strong distribution coverage and superior debt metrics.

This conclusion echoes the one I published on EPD earlier this week. And it will be echoed when I produce an update on MMP. Does this mean that you should potentially own EPD, MMP and SEP? I own two of the three - and I am moderately conservative. Given the degree that conservatism has been rewarded in this sector, my moderate degree of conservatism may be suboptimal.

Disclosure: I am/we are long EPD, MMP.

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.