I was certainly wrong about this one. When I wrote about the Plains All American Pipelines LP (NYSE:PAA) annual Analyst Day, I expressed to opinion that the Plains leadership was not that serious about a quick change to the LP/GP relationship with Plains GP Holdings LP (NYSE:PAGP). Yesterday the companies announced an agreement to eliminate IDR payments to the general partner. Also, released was an announcement of a reduction in the distributions paid by both companies.
PAA and PAGP will be the same distributions on August 12 as was paid for the previous quarter. PAA unit holders will receive $0.70 and PAGP units earn $0.231 per share. For the next, Q3 distributions and going forward, the PAA payout will be reduced 21% to $0.55 per unit and the PAGP payout will drop 11% to $0.2065 per share per quarter.
The simplification -which I will cover below- along with the distribution reductions are forecast to provide full year 2016 DCF coverage of 1.05 times. Without these changes, coverage had been forecast at just 0.86 times. Also, without the elimination of the GP IDRs, the PAGP dividend would have declined by 39%, based on the new PAA distribution rate.
Simplifying Away the GP Incentives
Plains All American Pipelines will obtain the 2% GP interests and the Incentive Distribution Rights in exchange for the new issue of 245.5 PAA common units and the assumption of $593 million of debt at the general partner company. Total value of the transaction is $7.2 billion. On completion, the current owners of the GP interest and IDRs will own 34.8% of PAA. A proxy filing on the transaction is expected in August, with the transaction closing in the fourth quarter. A majority of PAGP shareholders have already entered into voting agreements in support of the transaction.
When the transaction closes, PAGP will initiate a reverse split so that the number of outstanding PAGP shares will match the 100.3 million PAA common units that PAGP will receive in exchange for the GP and IDR interests owned by PAGP. (PAGP currently owns 42% of the GP interests in PAA). As a result, each PAGP share will be backed by one PAA unit.
At the end of the transaction, Plains All American Pipelines will be an MLP without any incentive distribution rights or GP payment obligations. The PAGP shares will just be an alternate way of owning PAA with Form 1099 tax reporting instead of a Schedule K-1.
At the now near $30 unit price PAA is trading at a 7.3% forward yield based on the lower distribution rate. PAGP investors can view their shares as having the same forward yield. PAGP dividends will be classified as "return of capital" until the company works off a $1.9 billion deferred tax asset. That is forecast to take at least 8 years.
PAA management has turned more conservative concerning future distribution growth. The first goal is to get the debt/EBITDA ratio down to a range of 3.5 to 4.0. Currently the ratio is at about 4.5 times, including the general partner debt assumption. A new target of 1.15 DCF coverage was also put out with the new announcements. As noted above, the 2016 coverage is expected to be 1.05 times with the higher distribution rate paid for the first half of the year. It is possible that coverage will already be at the new target when we get quarterly results for Q3 or Q4.
As I covered in my previous article on Plains, the company has the potential to grow annual EBITDA by 46% just by completing the remainder of its capex products, filling its existing capacity and growing profits in its Supply and Logistics business back up to more normal levels. Plains is very well positioned to leverage cash flow growth when production activity in the major U.S. plays starts to pick up. With a bit of good news, the PAA distribution could start to grow again by the second half of next year. I think that will actually happen when management believes it can again support continued high single digit annual growth rates.
Investors now need to decide if earning 7% from an investment grade MLP is a high enough wage to earn while waiting for distribution growth to resume, possibly in a year, possibly even further out.
Disclosure: I am/we are long PAGP.
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.