Midstreams Going C-Corp, Should SEC Disallow The Measure Distributable Cash Flow?

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Includes: APA, APLP, EEP, ENB, EPD, ET, FANG, FB, KMI, KYN, MMP, MORN, RTLR, SEP, WPZ, XOM
by: Brian M. Nelson, CFA
Summary

It’s important to differentiate the concept of enterprise free cash flow valuation and the idea of capital market dependence.

The uncertainty of the MLP business model remains, as it is clear operators are shunning the MLP business model preferring C-Corps instead.

According to work from Global X Funds, now, 40% of the energy infrastructure market cap consists of C-Corps, up considerably from just 15% at the end of 2014.

Though many simplifications have come with implied distribution cuts, the primary reason for the rise in C-Corps across the midstream space has been the rationalizing of excess MLP valuations to enterprise free cash flow assessments.

We encourage the SEC to consider disallowing the use of distributable cash flow, as it is confusing to investors.

A version of this article first appeared on Valuentum's website here.

By Kris Rosemann and Brian Nelson, CFA

We think one of the more inspirational people in finance is Vanguard's Jack Bogle. His story about what he had to overcome to explain to the investment community the benefits of index funds is a great one. When Bogle launched the first index fund decades ago, it could probably be described as nothing short of a failure, at least in today's terms. Index funds, at the time, were called un-American, brokers and even Fidelity's Chairman Edward C. Johnson III argued that nobody would want just "average returns," and Vanguard in its early days didn't even have enough money to invest in all the stocks of the S&P 500 Index in their exact proportions. The initial index fund on the S&P 500 Index held just 280 stocks.

But that didn't stop Jack Bogle. The old guard is fierce to defeat any new idea because the status quo is so valuable to it. Creative destruction is often only welcomed when the incumbent is doing the innovation, as new ideas, particularly in the field of finance, face tremendous opposition from those that are resistance to change. "Bogle's folly" (i.e. the index fund) is now arguably among the most successful product idea launches in the history of the markets, with indexed assets accounting for ~30-40% of all fund assets today.

In corporate finance, the challenge for others to embrace new ideas is no different. Those that were in the finance business for 30 or 40 years or longer in the 1970s simply couldn't believe that such a product like an index fund would be successful, and this resistance to new ideas has been a staple to incumbents that have grown comfortable with the status quo, as for many years the lack of change made them wealthy. Wall Street is mighty, but the skeptics can be proven wrong, and Jack Bogle is but one instance.

At Valuentum, our financial publishing company, we've been commenting on master limited partnerships for as long as we can remember. Most investors follow price movements in the midstream space by tracking the Alerian MLP ETF (NYSEARCA:AMLP). Depending on an MLP's price, we can be either bullish or bearish on their investment opportunities, and we change our mind as a result. We believe that valuation should be the key determinant in assessing a company's investment merits. The question "What is a company worth?" should be the key question in anyone's thesis.

We can't expect our readers to have read all our work on MLPs during the past several years, which have spanned Seeking Alpha, our website, Tumblr and syndication providers including Barron's and even others we may not know about, but there is one thing that cuts through it all: enterprise discounted cash flow valuation. Valuing a company on a free-cash-flow-to-the-firm basis is as accepted method of valuation as any that I know. I would argue that it is even the standard by which any other valuation process is measured against.

In mid-2015, when we presented the idea that midstream equities should be valued the same way as any other company, the opposition to this very basic idea was tremendous. All companies generate operating cash flow and all companies have growth and maintenance capital spending, and capital raised in the marketplace is still shareholder capital regardless of the business model attached to it. Enterprise free cash flow valuation is a universal concept.

Most of the midstream MLPs in mid-2015, in our view, were being valued on the basis of distributable cash flow, which is merely a proxy for their distribution (yield), and many had been systematically assessed on a price-to-distributable cash flow (P/DCF) basis or dividend discount model on artificially-elevated payouts. Distributable cash flow is not to be confused with discounted cash flow, though both go by the acronym DCF. The marketplace, in applying distributed cash flow or distribution analysis, was ignoring the concept that growth capital associated with driving future distributable cash flow is also shareholder capital. Said differently, in the valuation context, MLPs were getting a free pass on new equity/debt issuance, and only through an enterprise free cash flow model could such a dynamic be exposed.

It's important to differentiate the concept of enterprise free cash flow valuation, as in the case of our view that most midstream MLPs were overvalued in mid-2015 (their prices were trading above what we thought was fair value), and the idea of capital-market dependence (their operating cash flow does not cover all capital spending and all distributions). During the Financial Crisis of late last decade, "10 Years Since the Fallout," one of the key lessons I learned was that the risk of capital-market dependence can be a wrecking ball to equity prices. When times get tough, the bottom simply falls out for those equities requiring new capital, and this fallout in capital-market dependent entities is what we got ahead of prior to the collapse in MLPs.

Energy resource prices had been plummeting in 2015, and while others were saying that midstream equities were immune to such price movements due to their volume-based contracts and other defenses, we had argued that the health of a midstream entity's customer base matters and therefore makes midstream equities significantly more tied to energy resource prices than what others thought at the time. Said differently, in the event credit market conditions were to deteriorate even further as a result of reduced credit quality across the energy space, MLP equity prices would get walloped… and they did, and we were right. But it's important to understand that MLP prices, in their fallout, have merely adjusted from systematic overvaluation (on the basis of distributable cash flow and the dividend discount model) to fair valuation with respect to enterprise free cash flow.

Image Source: Valuentum

For example, when we made our call on Kinder Morgan (KMI) in mid-2015, we had valued the shares at $29 each, and the company registered a 1 on the Valuentum Buying Index, one of the worst ratings (as shown in the image above). Shares converged to our fair value estimate later in the year, and we've held the line with our views on Kinder Morgan's intrinsic value being ~$20 per share for nearly 3 years now. What we believe that we witnessed in Kinder Morgan was a systematic correction in the market's valuation of the company. MLPs reacted the same way, converging to valuations that captured the real cost of growth capital spending. When we speak of enterprise discounted cash flow valuation, this dynamic of overvalued-versus-undervalued is what we're talking about.

Additionally, Kinder Morgan cut its dividend in late 2015. There were myriad factors that drove the dividend cut, but to us, getting ahead of the announcement rested primarily in free cash flow analysis, which while connected, remains distinct from enterprise free cash flow valuation (also a key component of our theses), the method to arrive at an intrinsic value. Where enterprise free cash flow analysis focuses on generating a fair value estimate for shares, capital-market dependence analysis focuses on evaluating how dependent a company is on external capital to keep funding its business model. We generally evaluate market dependence in assessing whether operating cash flow (from the cash flow statement) covers both capital spending (both growth and maintenance) and distributions/dividends paid.

When it came to Kinder Morgan and most MLPs in mid-2015, they were considerably capital-market dependent at a time when the energy complex was starting to feel the pain from falling energy resource prices. Not only were they exposed to deteriorating credit conditions in this regard, but their equity prices were also significantly overvalued on the basis of a tried-and-true enterprise discounted cash flow framework, which considers the concept that growth capital is shareholder capital and the timing of such capital deployment (outflows) matters. It was a perfect storm that led to the collapse of Kinder Morgan and MLPs.

How did we get ahead of this, and why was our thesis so unique? For starters, we apply an enterprise free cash flow model systematically across our coverage universe, so we think we have a better chance of identifying market outliers across industries and sectors than others focusing purely on one industry or a sector, or just a handful of them. Second, the lessons from the Financial Crisis with respect to banks were clear. Stocks that were capital-market dependent during the Financial Crisis were punished, and we believed that with energy resource prices falling, putting into question the health of independents, which were customers of MLPs, the writing was on the wall for a big fallout.

Since Barron's prominently published our work on Kinder Morgan and MLPs in mid-2015, more than 60 MLPs have cut their distributions and many of them have rolled up or simplified their business operations. The uncertainty of the MLP business model remains, as it is clear operators are shunning the MLP business model preferring C-Corps instead. In August 2014, Kinder Morgan set the trend in MLP rollups, and the number of rollups have only continued, "Master Limited Partnership Simplifications on the Rise," including Archrock Partners (APLP), Tallgrass, Williams (WPZ), Spectra (SEP), and Enbridge Energy (EEP). According to work from Global X Funds, now, 40% of the energy infrastructure market cap consists of C-Corps, up considerably from just 15% at the end of 2014.

Will every current MLP convert to a C-Corp? It's possible. But as with anything, there will always be late movers, and many MLPs are still watching to see if the C-Corp conversions will be successful in generating better reception from the market community. Everything takes time, and our time horizon on our call is long term. What is telling, however, is that many new issues for midstream assets have chosen the C-Corp route. Diamondback Energy (FANG) announced an IPO for their midstream entity, Rattler Midstream (RTLR) that, while structured as an MLP, will be taxed as a C-Corp. Apache Corp (APA) and Kayne Anderson (KYN) announced that they are creating a brand new C-Corp entity Atlus Midstream, according to Global X.

On August 24, Enbridge (ENB) announced that it would buy Spectra Energy Partners. This followed the Energy Transfer Equity (ETE) and Energy Transfer Partners (ETP) tie up, "ETE-ETP Rollup and Implied Distribution Cut." Consolidations continue to slowly eliminate the MLP model. Though many simplifications have come with implied distribution cuts, the primary reason for the rise in C-Corps across the midstream space has been the rationalizing of excess MLP valuations to enterprise free cash flow assessments, eliminating distributable cash-flow (yield) based pricing, something we warned about in mid-2015 when we stated that growth capital was not being properly accounted for within the MLP valuation construct:

"In summarizing the reasoning behind the use of the C-Corp structure, Kevin McCarthy, an executive at Kayne Anderson stated, "MLPs are no longer getting a premium valuation compared to C-Corps. There's been a lot of C-Corp conversions in the space. And we think for this type of asset, the market will place a premium on something that's a C-Corp rather than something that's paying out all this cash flow and having to come to the market to fund growth." In other words, the MLP tax structure is no longer favored in today's dynamic environment, with preference being given to the more flexible and accessible C-Corp structure. Given the uncertainty that has plagued MLPs over the past few years and how much the business model has changed in such a short period of time, it's difficult to argue against that thinking." - Source: Global X

As summarized above, the story of the demise of the MLP model seems rather simple, in our eyes. From where we stand, the MLP model was used primarily as a financing mechanism that could raise equity for the corporate umbrella at a price that was reflective of a yield-based valuation, or one that is effectively priced on the concept of distributable cash flow (not on an enterprise discounted cash flow basis). Distributable cash flow is an industry specific term that ignores growth capital spending, but includes the net income within the measure that is driven by growth capital spending, "MLP Speak: A Critique of Distributable Cash Flow." This imbalance, in our view, translated into equity unit prices for MLPs of bubble proportions that eventually popped as the energy resource markets began to swoon in late 2015 and early 2016, and funding dried up.

Since then, many midstream companies have become more transparent, better explaining their capital-market dependency to shareholders. For example, in the ENB/SEP press release from August 24: "MLPs are dependent on consistent access to the capital markets at a reasonable cost of capital to grow their distributions." It seems there should be no further doubt that MLPs are funding their distributions in part from the external capital markets. Generally speaking (and absent the concept of negative yielding debt on corporates), the lowest cost form of capital is generated from internal funds (operating cash flow), and such funds are allocated to the highest-return projects (growth capital spending). Once operating cash flow is exhausted from all capital spending, including growth-related endeavors, external capital issuance, which is higher cost funding, is then allocated as support for the distributions of MLPs.

The concept of traditional free cash flow is a well-understood measure. It is generally defined as cash flow from operations less all capital spending. It's important to note that when it comes to valuation processes, all companies have maintenance and growth capital spending, and even some ultra-efficient technology companies could have lower maintenance spending profiles than midstream pipeline entities (so the maintenance-versus-growth capital spending ratio varies across sectors, but it is not different for MLPs in the eyes of valuation). There are myriad examples of companies that use free cash flow in reporting, as measured by cash from operations less all capital spending, including Facebook (FB) and even research provider Morningstar (MORN).

Image Source: Facebook

Image Source: Seeking Alpha

There are variants of free cash flow representation, too, and while we generally do not like situations where companies deviate from cash flow from operations less all capital spending as the measure of free cash flow in disclosures, the concept of cash flow from operations less all capital spending remains the key relationship in assessing free cash flow. For example, Exxon Mobil (XOM) includes 'Proceeds associated with Asset Sales' in the calculation of free cash flow, as shown in the image below, something that we'd prefer not to be in there. Though we have our preferences, the construct is the same in assessing operating cash flow less all capital spending in arriving at free cash flow.

Image Source: Exxon Mobil

The SEC, too, has commented specifically on free cash flow, a measure that deducts for all capital spending, not just maintenance capital spending. In the SEC's May 2016 guidelines for free cash flow, it reads (Question 102.07) in response to a question that defines free cash flow as cash flow from operations… less capital expenditures: "Companies should also avoid inappropriate or potentially misleading inferences about its usefulness. For example, "free cash flow" should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures, since many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure." The guidelines make a lot of sense to us.

However, when we think about the SEC's guidelines for free cash flow, a punitive metric that deducts for all capital spending, it becomes questionable whether distributable cash flow, because it does not deduct for growth capital spending, is a useful measure at all. After all, the general partner determines a discretionary reserve with respect to distributions, distribution coverage ratios vary quarter-to-quarter and are not fixed at 1, more than 60 MLPs have opted to cut their distributions since we warned about their business models in mid-2015, and many have chosen to pursue business-model simplification initiatives, rolling up subsidiaries and adjusting their payouts along the way. Yet, distributable cash flow continues to set MLP distribution policy, enabling "yield," which then may drive equity "valuations," something that we believe contributed to the bubble in early 2015 (see here on how traditional enterprise valuation can be used to value MLPs).

Critically, if traditional free cash flow should not be viewed as a measure representing "the residual cash flow available for discretionary expenditures," including dividend policy (which is discretionary), some may reason that distributable cash flow should probably not be used either to set MLP distribution policy, itself discretionary to a large degree. We applaud the SEC's move to caution companies on how they present free cash flow, and we're hoping that we may eventually see a systematic measure of free cash flow as a mandatory release for all companies--hopefully one as simple and straightforward as cash flow from operations less all gross capital spending (companies sometimes like to use net capital spending). The transparency and consistency that this one move would make across the financial markets would be phenomenal, and we hope one day we will see this. One thing is clear though: if free cash flow, which deducts for all growth spending, is not a good measure of residual cash flow, distributable cash flow should probably not be allowed at all.

Why now does enterprise free cash flow valuation make sense for MLPs? There are a number of ways to account for business performance across various business structures, whether an entity is a corporate, REIT, or master limited partnership, but cash flow will always be cash flow. In finance (and in valuation), a business, for example, cannot be worth more or less than the present value of its future enterprise free cash flows, adjusted for its net balance sheet (a net debt or a net cash position), as well as any other "hidden" factors (e.g. an overfunded pension) - no matter if the entity is structured as a corporate, a real estate investment trust (REIT) or a master limited partnership. The prices of these entities may become disconnected from their intrinsic value, if for example, "yield-based pricing" (systematic valuation on distributable cash flow) is pursued in an ultra-low interest rate environment, but value will always be value, distinct from price. A dollar of free cash flow generated by a retailer is a dollar generated by a software company is a dollar generated by a midstream entity. The present value of dollars coming in versus dollars going out forms the basis of any valuation context.

As mentioned previously, every company has both growth and maintenance spending, and the drivers behind the composition of any entity's value are the same, differentiated only with respect to magnitude and duration. In this respect, all midstream MLPs are similar, even if the magnitude and duration behind the composition of their value drivers are different. Said plainly, many pipeline companies may have relatively low maintenance capital spending, all else equal, but so do many software companies and other asset light entities, too. Many capital-light operations do not have tremendous growth capital spending, as fixed cost investment is not a core driver behind the earnings stream, but midstream entities do. The midstream space almost encourages analytical thinking on a project-by-project basis, which is great with respect to NPV (net present value) considerations, but all projects roll up into a cumulative forward trajectory of net free cash flow (cash flow from operations less all capital spending) for each and every entity and form the basis of a value estimate for each and every entity.

That an industry has designated the term distributable cash flow to mean one thing does not change the theoretical view that, hypothetically, distributable cash flow, in a more encompassing non-MLP-specific context, could even be further up the income statement, as in revenue (a rather extreme hypothetical, but one that illustrates the subjective nature of the industry's term). As by definition, the industry's measure of distributable cash flow backs out growth capital spending, but doing so may be no logically different in substance than revenue, for example, being perhaps an even more aggressive form of "distributable cash flow," if one backs out all costs. In both cases, any traditional free cash flow shortfalls, as measured by cash flow from operations less all capital spending, would be made up by floating new debt or equity to keep paying an outsize distribution/dividend, as is already the case with respect to the master limited partnership model, in our view. Cash flow from operations less all capital spending is often less than cash dividends paid each year for MLPs, and the shortfall is made up in the financing section of the cash flow statement as new debt or new equity.

We've used the rather extreme concept of labeling 'revenue' as some unrealistic measure of distributable cash flow to illustrate a point. Not only must growth capital spending and costs be considered in the valuation context, but it becomes clear that there is a tremendous amount of subjectivity involved in the industry's term, distributable cash flow (especially with respect to capital market access). In the eyes of an enterprise free cash flow model (FCFF, free cash flow to the firm), however, business entities of all types are treated similarly, and the enterprise free cash flow generated by the business, in aggregate, is considered, on a net basis (inclusive of outflows related to growth spending). The timing of cash flows matters in the enterprise free cash flow process, and so does the balance sheet (net debt is not a good thing). For those focused on value-contributions of each individual project of a pipeline operator as only being incremental, what may be helpful is to consider an MLP as one big project, one big NPV calculation, and therefore, one enterprise free cash flow model, where the timing of net enterprise cash flows matters, in aggregate. In the image below, we show the link between the industry-specific metric distributable cash flow and the basic construct of an enterprise free cash flow model.

Image Source: Valuentum

The numerator is a short-form construct of an enterprise free cash flow model, which takes the present value of a company's earnings before interest, after taxes, less net new investment (or enterprise free cash flow) and divides that by units outstanding. The denominator is the industry specific term distributable cash flow for next year. The formula above therefore derives the value that should be placed on the business via the enterprise free cash flow construct, and then this value estimate helps to inform what multiple of forward expected distributable cash flow should be applied to units. In short, the enterprise free cash flow derives the distributable cash flow multiple that should be placed on the business, which differs from the price-observed distributable cash flow multiple that is taken by dividing a unit's price by its future distributable cash flow, for example. The reason why using an enterprise free cash flow model in valuation is so important for MLPs is that, if one applies only a distributable cash-flow relative analysis or pursues "yield-based" pricing considerations, one is opening the door to systematic overvaluation tendencies, as which occurred during the middle of 2015 when we made our call.

Discussing 5 Top Energy Stocks

An estimate of intrinsic value is as important as a view that shares of a company are undervalued or overvalued, and we think an application of a fair value estimate range is most helpful. The question, "What is a company worth?", remains paramount to any investment thesis. The fair value estimate is the outcome of any research and analysis. We'd view the company as undervalued across prices on green line and overvalued across prices on the red line.

Kinder Morgan - Fair Value Estimate: $20 per share

Image Source: Valuentum

Kinder Morgan is one of the largest midstream energy companies in North America, and its operations are conducted through the following business segments: Natural Gas Pipelines (56% of EBDA), CO2, Products Pipelines, Terminals, and Kinder Morgan Canada. We applaud management's recent efforts to reduce its lofty financial leverage, and it is targeting a net debt-to-adjusted EBITDA ratio of around 4.5x by the end of 2018--assuming it is able to de-lever with the proceeds from the sale of the Trans Mountain Pipeline--while funding all investment needs with internally-generated free cash flow in 2018.

Through the first six months of 2018, Kinder Morgan has generated cash flow from operations of $2.47 billion with total capital spending of $1.47 billion, good enough for roughly $1 billion in free cash flow generation. This is fantastic. The measure is also far in excess of its cash dividends paid on common shares of $719 million over the same time period. Kinder Morgan's dividend is now in excellent shape, after cutting it in late 2015.

Furthermore, Kinder Morgan expects to be considered for a credit ratings upgrade in the near future, though investors should note that it has debt maturities of $2.18+ billion each year from 2019-2022 ($2.8 billion in 2019, $2.18 billion in 2020, $2.4 billion in 2021, and $2.45 billion in 2022), all of which we expect it to be able to roll over easily given its strong free cash flow generation. Things are moving in the right direction at Kinder Morgan, and we like what we see.

We currently value shares at $20 each, but the high end of our fair value estimate is $27 (and we would not be surprised to see a bounce in shares). Kinder Morgan's adjusted Dividend Cushion ratio sits at parity (1), mostly because of its large net debt position. We think the company will be successful delivering on its 25% dividend growth in 2019 and 2020 ($1.00 in 2019 and $1.25 in 2020). Our expectations for Kinder Morgan's dividend growth are provided below.

Image Source: Valuentum

Note: An MLP's adjusted Dividend Cushion ratio gives it credit for continued access to the capital markets and may not be the most appropriate estimate of risk in the payout if such access becomes challenged.

Energy Transfer Partners (ETP) - Fair Value Estimate: $23 per share

Image Source: Valuentum

On August 1, Energy Transfer Equity announced that it would roll up Energy Transfer Partners in a unit-for-unit merger exchange. Energy Transfer Equity's incentive distribution rights (IDRs) in Energy Transfer Partners will be eliminated, and the deal is scheduled to close in the fourth quarter of 2018. The executive team expects to maintain the ETE distribution per unit, but we note that such a distribution remains a function of the availability of outside capital from the debt and equity markets. The company expects to fund the majority of growth capital spending with retained cash flow, but while this may sound great on the surface, it also implies that the combined entity still cannot fund both the distribution and maintenance/growth capital spending with operating cash flow.

Here's what we mean. During the first six months of 2018, for example, Energy Transfer Equity generated $3.16 billion in cash flow from operations, but it spent $3.54 billion in capital spending, revealing negative free cash flow during the period. The company still paid out $1.79 billion in distributions to non-controlling interests and another $532 million in distributions to partners, despite the free cash flow shortfall. We continue to believe that internal operating cash flow is the lowest cost form of internal funding, and therefore, applied to the highest-return growth projects, meaning that in aggregate, the distribution is being financed in part by external market activity and/or asset sales (i.e. inorganic measures) because free cash flow is negative.

Furthermore, in many MLP rollups that we have witnessed of late, there have been implied distribution cuts in the combined entity, and this looks to be the case at ETE-ETP. By scooping up Energy Transfer Partners units, it swaps a $2.26 per unit distribution obligation for a $1.22 dividend obligation at Energy Transfer Equity, while Energy Transfer Partners' unitholders only receive 28% more units. By our back-of-the-envelope math, that means the dividend/distribution equivalent of the swap for Energy Transfer Partners unitholders is a reduction from the $2.26 distribution to a $1.56 dividend ($1.22 x 1.28). Income investors can't be too pleased by this. Our fair value estimate for Energy Transfer Partners is $23 per share.

Note: An MLP's adjusted Dividend Cushion ratio gives it credit for continued access to the capital markets and may not be the most appropriate estimate of risk in the payout if such access becomes challenged.

Enterprise Products Partners (EPD) - Fair Value Estimate: $28 per share

Image Source: Valuentum

Enterprise Product Partners boasts one of the most integrated midstream energy systems in the US, with pipelines connecting to more than 90% of refining capacity east of the Rockies. This integrated system allows the MLP to reduce the impact commodity price swings have on its business, and we like its simplified ownership structure that has no general partner incentive distribution rights, allowing for long-term durability and flexibility. The entity continues to invest billions in new natural gas, NGLs and crude oil infrastructure, including in the Eagle Ford, Rockies, and Permian Basin, and it expects to play a meaningful role in the US' continued growth as the largest exporter of liquefied petroleum gas (LPG).

Management has set a goal of self-funding growth capital spending through 2019, a target of which we are quite fond. However, it is important to note that free cash flow ($777 million = $2.7 billion less $1.92 billion) still did not cover cash distributions paid ($1.85 billion) during the first six months of 2018, per its most recent 10-Q. The MLP has raised its distribution for 56 consecutive quarters as of the second quarter of 2018, and its adjusted Dividend Cushion ratio currently sits at 1.9. Our current fair value estimate for Enterprise Product Partners is $28 per unit, about in line with where shares are currently trading.

Note: An MLP's adjusted Dividend Cushion ratio gives it credit for continued access to the capital markets and may not be the most appropriate estimate of risk in the payout if such access becomes challenged.

Magellan Midstream (MMP) - Fair Value Estimate: $69 per share

Image Source: Valuentum

Magellan Midstream Partners is an MLP that holds investment grade credit ratings (BBB+/Baa1) with no incentive distribution rights, the latter of which provides the MLP with a more simple organizational structure and a relatively lower cost of capital relative to peers. It has a history of maintaining sector-leading credit metrics, and it continues to target a leverage ratio (consolidated debt-to-EBITDA) of less than or equal to 4x.

Magellan boasts the longest refined products pipeline system in the US, primarily transporting gasoline and diesel fuel (refined products account for ~55% of its operating margin), and the breadth of its system (it can access nearly 50% of US refining capacity) gives it competitive advantages and a stable business model. Management expects fee-based, low risk operations to account for 85%+ of its operating margin, and the MLP is targeting 5%-8% distribution growth in 2019 and 2020 on top of 8% growth in 2018.

We currently value units at $69 each, and its adjusted Dividend Cushion ratio sits at 1.2. During the first six months of 2018, Magellan generated operating cash flow of $564.1 million and spent $219.4 million in capital spending, good enough for ~$344.7 million in free cash flow. Though this falls short of the $423.9 million in distributions paid over the same time period, Magellan is one of the better free cash flow generators within the midstream space.

Note: An MLP's adjusted Dividend Cushion ratio gives it credit for continued access to the capital markets and may not be the most appropriate estimate of risk in the payout if such access becomes challenged.

Exxon Mobil (XOM) - Fair Value Estimate: $83 per share

Image Source: Valuentum

Though Exxon Mobil lost its pristine AAA credit rating, its financial health is still solid, and it held more than 21 BOEB of total proved reserves at the end of 2017. Management believes its current upstream next-generation assets represent is strongest portfolio of opportunities since the merger of Exxon and Mobil around the turn of the century, while the shifting of its downstream operations, in which it is heavily investing, to higher-value products is expected to improve profitability. It estimates proprietary technology will help downstream margins expand by 20%, which will only benefit from the company's expectations for global energy demand to rise by ~25% through 2040.

Exxon is competitively positioned across the value chain, which helps mitigate sector risk and adds flexibility to capture new opportunities. Its integrated operations add synergy and optionality potential while maximizing value in dynamic markets. The firm estimates that cash flow from operations could nearly double by 2025 assuming 2017 prices hold. 2018 marked the 36th consecutive year in which the company has raised its annual dividend, and its Dividend Cushion ratio currently sits at 1.2. We value shares at $83 each, and the company yields ~4%. Our forecasts for Exxon Mobil's dividend growth are provided in the image below, and the company remains one of our favorite ideas in the energy space.

Image Source: Valuentum

Conclusion

From where we stand, the MLP-specific term distributable cash flow is an arbitrary one, and all entities, whether they are a corporate, REIT, or MLP have both growth and maintenance spending, the magnitude the only difference. In an extreme case to illustrate the point of how subjective distributable cash flow as a metric is, revenue could even be considered a form of distributable cash flow, with any cash shortfalls relative to any dividend/distribution made up by external capital market issuance. An enterprise discounted cash flow model derives the price-to-distributable cash flow metric that should be placed on each MLP's units, and systematic mispricings could occur if investors solely rely on relative distributable cash flow analysis or "yield-based" pricing considerations. We encourage the SEC to consider disallowing the use of distributable cash flow, as it is confusing to investors.

When we released these ideas in mid-2015 more broadly, we didn't expect everybody to agree with us, similar to what Jack Bogle encountered when he first introduced the index fund to the investment community. Energy investors have been using distributable cash flow arguably for decades, but enterprise free cash flow valuation remains a tried-and-true method that considers all the cash inflows and outflows of the business, unlike distributable cash flow (and yield) which is rather arbitrary and excludes key growth capital spending. Within an enterprise discounted cash flow valuation model, the dividend is a symptom not a driver of value, and by extension, so is distributable cash flow and yield, both symptoms of value (not drivers). We continue to believe that investors should cast a cautious eye on the MLP business model, if only because of its considerable capital-market dependency risk, which could pose challenges in the event of tightening external capital market conditions.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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. I have no business relationship with any company whose stock is mentioned in this article.