Plains All American: A Compelling Income Investment

| About: Plains All (PAA)
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Plains All American Pipeline (NYSE:PAA) reported quarterly earnings that were mixed, and units were trading mildly lower after hours (press release available here). While PAA has been aggressively moving into the Permian Basin and Eagle Ford to grow its distribution, units are actually lower than they were 12 months ago. Sentiment has been turning against midstream MLPs as rising interest rates have made these companies less attractive. Most investors own MLPs for their yield, so rising interest rates can lead to a rotation out of MLPs and into bonds. Currently, PAA is yielding 4.9%, and it makes sense as an income investment at current levels.

In the quarter, PAA earned $0.76 on revenue of $10.63 billion. While EPS beat by $0.05, revenue was short by $600 million. Adjusted EBITDA came in at $595 million, which was down about 2% from last year's $609 million figure. Distributable cash flow ("DCF") came in at $429 million against $455 million last year. Now given the drop in DCF, investors may question whether the 9% hike to the distribution is sustainable. The answer is actually yes. DCF per unit totaled $1.24 in the quarter, so PAA covers its $0.615 payout twice over. In a sense, PAA has been underpaying, so it can grow its distribution without growing results. While this policy can be frustrating to investors looking to maximize current income, PAA can use some of its excess cash to fund growth projects that will increase DCF several years from now.

Now, this quarter was not perfect. On the positive side, the transportation and facilities segments grew profits by 12%, and this growth should accelerate to 15% in 2014. Conversely, supply and logistics saw a 22% decline in profitability. PAA is focused on building out its pipeline network, which function like toll roads, in high growth areas like the Permian Basin, which will benefit all of its segments going forward. Supply and logistic actually grew average daily volumes of crude by 2.5% and natural gas by 5%. Transportation activities also increased by 5.5% year over year.

In order to propel growth going forward, Plains All American needs to continue to invest in its network, which will translate to increased volumes and higher cash flow. The company sees so much opportunity it has increased its growth cap-ex budget by $300 million to $1.7 billion this year. PAA maintains a strong balance sheet to fund these additional projects. Debt-to-book capitalization stands at 50%, so I expect PAA to continue to use a combination of excess cash, debt, and equity to fund these projects. Given the strength of its balance sheet, PAA could raise $2.5-$3 billion in debt before feeling compelled to issue equity. Given the low price of units, I do hope PAA focuses more on debt than equity to fund upcoming projects.

Importantly, PAA is focusing its expansionary projects in the right area. It is spending up to $500 million on four projects in the Permian Basin, which is one of the primary regions in the U.S. energy boom. These expansion plans will add 890,000 barrels per day in capacity to PAA's system. As a consequence, PAA will be the pre-eminent pipeline play on the Permian. With continued production growth in the area, these expansion projects should add incremental cash flow for many years, beginning in 2015 when they should be fully operational. The total expansionary budget has the capacity to increase DCF by 11%, which will be very beneficial for units.

In 2014, PAA should produce DCF of roughly $1.65 billion, which will be flat year over year. Investors should note that more growth projects will be coming online in 2015. In this year, we should see appreciable DCF growth. In the immediate term, growth projects are a bit of a headwind because the partnership issues some equity to fund them; the average unit count was up 9 million year over year. However, these projects don't produce cash until they become operational. In the build-out phase, they drag on results, but once operational, results will improve dramatically. 2014-2015 will be an inflection point. Nonetheless, PAA is on track to raise its distribution by 10% during the course of the year as it moves to a more appropriate payout ratio. Assuming a similar level of dilution this year, a 10% higher payout would still leave PAA with a payout ratio above 1.4x.

With a current yield of roughly 4.9%, PAA is an attractive MLP investment. While results were mixed and a decline in DCF is never a positive, PAA remains well positioned. In 2014, results should be roughly flat, though the payout should increase, and in 2015, PAA will justify that increase with better results as the expansion budget proves wise. At about $50, PAA is extremely attractive. I would be willing to pay at least 12-13x DCF or $57-$61. Long term income-oriented investors would be wise to buy PAA on its current weakness.

Disclosure: I 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.