Limited Partnerships sound like great investment vehicles for income investors. Until one finds out that these partnerships usually pay out 100% of their income. Then when there is no income, they still pay out at the same rate hoping that the market will not notice what is happening. Then what in effect is a partial liquidation is reversed by selling more partnership units. It is almost as though earnings don't matter to the market, just the ability to distribute that money no matter what fiscal gymnastics are required to make that distribution. So if the market conditions change at all and there is a need to re-invest earnings into the partnership, then look out below. The games begin to avoid such an outcome.
Source: William Companies, August, 2016, Investor Presentation
Let the games begin. One the one hand, Williams Partners L.P. (NYSE:WPZ) distributed $1.2 billion to the general partner and the limited partnership units in the first six months. On the other hand, the parent company, Williams Companies (NYSE:WMB) is going to cut its distributions so that the limited partnership can maintain its distributions as well as its growth objectives. Williams Companies is purchasing about 7 million partnership units at about a 2.5% discount to the calculated market price. This will net the partnership about $250 million. Williams companies has every intention to purchase more units in the partnership.
If all goes well these purchases should total somewhere near $1.3 billion or so in the next year. That is enough to pay the distributions for six months. If Mr. Market could see the big picture, a distribution cut, especially while no income is being reported would have been far more reasonable. The purpose of these investments is to maintain the investment grade rating of the limited partnership and the parent company's rating within a reasonable range of the partnership.
Like many other entities in the oil and gas industry, the pipelines have faced a changing perception among lenders. This changing perception has resulted in a need to deleverage the balance sheet and increase the rate of returns on projects that require borrowing. Even though the company reported some decent results, the lenders are now far more skittish about pipeline company debt than they were in the past. There have been enough examples (such as Kinder Morgan (NYSE:KMI) of Mr. Market's disdain for distribution cuts that this pipeline company thinks that there is a way around that using the cooperation of the parent company.
"In February 2015, we filed a shelf registration statement, as a well-known seasoned issuer and we also filed a shelf registration statement for the offer and sale from time to time of common units representing limited partner interests in us having an aggregate offering price of up to $1 billion."
The shelf registration in and of itself, does not require that a sale of stock will follow. However, the company management has now established a DRIP plan (distribution re-investment plan in this case). Plus the parent company's announcement above of the investment in more pipeline units leads one to believe that the pipeline clearly needs cash to keep the distribution and achieve all of its capital goals. Business as usual that included borrowing to pay for "everything" (capital budgets and distribution) is no longer an option.
On the other hand, the willingness of the parent company to purchase more units of the subsidiary is a vote of faith in the future of the limited partnership. Williams Companies is the ultimate insider that probably knows more than Mr. Market ever will. This parent company does not have to spend money on the limited partnership. The parent company had the option of spending the money elsewhere, requiring the limited partnership to sell more assets to fund its spending objectives, and allowing the partial liquidation to continue as needed. So even if the distribution will not increase for a while, clearly the parent company management sees a bright future for their investment in the limited partnership. Clearly, management is noting that this is a good time to invest in the partnership, observers have noted how the industry is out of favor, and therefore there could be some decent capital appreciation as well as the distribution "income" (or return of capital right now) for unit holders. That $1.7 billion noted in the slide above is not chump change.
The company noted several major projects that could require capital. Plus at least one challenge was highlighted:
"As of June 30, 2016, Property, plant, and equipment, at cost in our Consolidated Balance Sheet includes approximately $389 million of capitalized project costs for Constitution, for which we are the construction manager and own a 41 percent consolidated interest. In December 2014, we received approval from the FERC to construct and operate this jointly owned pipeline. However, in April 2016, the New York State Department of Environmental Conservation (NYSDEC) denied a necessary water quality certification for the New York portion of the Constitution pipeline. We remain steadfastly committed to the project, and in May 2016, Constitution appealed the NYSDEC's denial of the certification and filed an action in federal court seeking a declaration that the State of New York's authority to exercise permitting jurisdiction over certain other environmental matters is preempted by federal law.
As a result of the denial by the NYSDEC, we evaluated the capitalized project costs for impairment as of March 31, 2016, and determined that no impairment was necessary. Our evaluation considered probability-weighted scenarios of undiscounted future net cash flows, including a scenario assuming successful resolution with the NYSDEC and construction of the pipeline, as well as a scenario where the project does not proceed. We continue to monitor the capitalized project costs associated with Constitution for potential impairment."
Up until now, the major difference in earnings between this year and last year has been an impairment charge. The $396 million charge was related to the sale of some Canadian properties that should occur in the second half of the year. Without that charge, second quarter earnings were similar to the previous year earnings. As noted above there could be another significant, though hardly crippling one time charge on the way.
Interestingly, despite the charge, management was still distributed roughly the same amount of general partner priority income as the year before. So even though that impairment is an admission that (probably several) previous years of earnings were basically overstated by the amount of that impairment charge, management has reported impairments in such a way as to leave the management income to the parent company unaffected. This management definitely is taking care of itself first and outside shareholders later.
All of this financial dancing may have happened because the company probably had some major commitments to some customers and some growth projects underway before the commodity price downturn. So even though the lending community has changed the lending requirements, the capital requirements marched onward. Some capital projects cannot be "turned off" or stopped without some future payback or industry reputation impact. Therefore, the partnership units need to be kept at a non-dilutive level or minimal dilution level in case the sale of more units becomes a necessity should the debt markets become too restrictive. So the way to reverse the partial liquidation involves a massive investment of distributions by the parent company, a DRIP program, and an at the market sale of units as needed. That is a lot of game playing to get cash that could have been acquired by simply cutting the distribution temporarily. The idea that the market treats this behavior better than a distribution cut is appalling but not unexpected. So in the eyes of management a decrease in the parent company's distribution was seen as far less damaging under the circumstances.
So what does this mean to the investor?? Any distribution received when there are no earnings is basically a return of capital. The parent company, Williams Companies, is basically returning its distributions to the limited partnership by purchasing more units. Investors can follow the parent company by using the newly established DRIP program. Supposedly the DRIP program will also allow investors to purchase units at a discount along the same terms that the parent company had for its latest purchase. The DRIP program is probably a very competitive program for investing in this partnership. The parent company did not have to re-invest its distributions in the partnership, management chose that action above all others competing for capital. The amount potentially invested represents a giant vote of confidence in the future of the limited partnership from management.
The partnership is diversified, although it may find it will have to diversify away from some of the higher cost areas. The company has stated that it has "take or pay" contracts to protect its cash flow. However, there are quite a few troubled companies that could renegotiate the contracts should they enter bankruptcy. So in a business where small volume changes make a big difference due to the balance sheet leverage, the very rough industry conditions could affect the partnership more than anticipated. By now though, management should be able to anticipate the potential casualties and take corrective action to minimize the damage. There should be very few unpleasant surprises going forward. The market has been bearish on these units and therefore quite a bit of unfavorable outcomes are priced into the stock. The stock price reflects a very bearish future. As a result a change in market perception could add some capital appreciation of 20% to 50% over the next five years in addition to some generous distributions. "Buying straw hats in January" would result in a fairly safe but definitely above average return for the investor.
The proxy battle for board seats should enhance the chances for significant capital appreciation. Parties such as Corvex Management L.P. usually start these battles because they believe that there is substantial chances for 100% and a lot more appreciation. Corvex also needs those kinds of gains to cover the unsuccessful attempts and the attempts where Corvex gains control but finds that the undervaluation is not quite what they thought as an outsider. Williams Companies management make take some of those steps to increase the value in an attempt to fend off the attempted proxy fight for board seats. But if the battle heats up, the Williams Partners LP may become less of an income investment and more of a special situation or capital appreciation investment. In any event the proxy battle significantly lessens the chances that a long term investor will lose money.
So the partnership is probably a good candidate for an investment as part of a diversified group of pipelines carefully chosen to minimize risk. There is an industry shake-out going on among oil and gas companies, but the full effects on the various pipeline companies are not all that clear. So additional safety is called for, although some forecasting is currently being attempted.
Disclaimer: I am not an investment advisor and this article is not an investment recommendation. Investors are urged to read all of the company's filings and press releases to determine for themselves if this company fits their investment profile.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.