Investment Thesis
Plains All American Pipeline, L.P. (NASDAQ:PAA) units have fallen lower than warranted based on fundamentals. Unitholders have soured on management after having experienced five years of distribution cuts aimed at shoring up PAA’s balance sheet and maintaining its investment-grade rating. Units today are priced as if a recovery in distributions is a lost cause.
PAA’s asset portfolio is heavily weighted toward oil infrastructure in the Permian basin. An oil-market recovery will increase Permian midstream throughput and bring about positive operating leverage for PAA that is likely to increase its distributable cash flow.
Over the next two to three years, we believe PAA will generate enough free cash flow to increase its distribution by at least 50%, and as much as 100% amid a robust increase in oil production. Unit prices are likely to follow with 50%-to-100% appreciation. With PAA units currently yielding a safe 8.5%, we believe they should be bought and held over that timeframe.
PAA Operational Review
PAA is one of the largest midstream operators in the U.S. Its system provides transportation and logistical services of crude oil, natural gas, and natural gas liquids (NGLs) in the U.S. and Canada. Its transportation system is focused on crude oil, and to a lesser extent, NGLs. It also operates natural gas storage terminals. PAA’s operations are shown in the chart below.
Source: PAA 2019 10-K.
PAA’s general partner, Plains GP Holdings LP (PAGP), owns a non-economic controlling general partner interest. PAGP owns approximately 250 million units of PAA, amounting to 31.3% of PAA’s outstanding units. PAGP does not own incentive distribution rights in PAA, nor does it receive management fees from PAA, though it is reimbursed for the services it provides on PAA’s behalf.
PAA Unit Performance
PAA unitholders have had a rough ride over the past five years as its units have been nearly cut in half.
PAA cut quarterly distributions to unitholders in four of the past five years. Understandably, existing and prospective unitholders have become disenchanted with the company’s management and PAA’s investment prospects.
PAA units have lagged the S&P by a huge margin, though they traded in line with the Alerian MLP Index (AMZ), as shown below.
Over the past years, the units have fallen by 39%.
They have underperformed both the AMZ and S&P 500, evidence that they have fallen out of favor among midstream specialists and investors more broadly.
Financial Overview
PAA released its full-year 2020 results on Feb. 9, though it has yet to file its 10-K. Its earnings press release shows its poor financial results.
Source: PAA press release, “Plains All American Pipeline and Plains GP Holdings Report Fourth Quarter and Full-Year 2020 Results,” Feb. 9, 2021.
Management is focused on deleveraging and returning the company from today’s 3.7-times debt-to-adjusted EBITDA to its historical average of 3.0-to-3.5-times. Management is seeking to raise $750 million from asset sales and apply the proceeds toward paying down debt.
The final line item in the above chart shows PAA’s 50% distribution cut made in 2020. The cut hammered its unit prices, but it allowed the company to generate a cash flow surplus after distributions in some of the most challenging conditions in midstream history.
PAA’s cash-flow surplus over the last twelve months (LTM) ending Sept. 30, 2020, can be seen below.
The deterioration of PAA’s EBITDA during 2020 blew out its debt metrics, with its GAAP leverage ratio surging from 2.8-times in 2019 to 6.7-times over the last 12 months.
Note that the metrics shown in the following chart are based on GAAP, and have not been adjusted by management.
Source: HFI Research.
PAA’s asset value exceeds its liabilities by a healthy margin. Its negative returns on capital and equity over the last twelve months are attributable to a massive $2.5 billion goodwill impairment it took in the first quarter of 2020. The impairment was the result of the declines in oil prices and PAA’s market capitalization at the time.
PAA’s unit count has remained steady in recent years, so its per-unit metrics are in-line with its consolidated results.
Source: HFI Research.
As of year-end 2020, PAA had $2.5 billion in available liquidity, more than enough for its funding needs. It has no near-term debt maturities.
PAA’s Poor Capital Allocation Track Record
Since its IPO in 1998, PAA has completed and integrated more than 90 acquisitions for an aggregate purchase price of $13.3 billion, according to its securities filings. Since that time, the company has also implemented capital expansion projects in excess of $16.5 billion.
Despite the nearly $30 billion in acquisitions and capital spending, PAA has little to show in terms of unitholder value creation. Consider, for instance, that in PAA’s first year as a public company, it sported a book value of $9.23 per unit. Today, its book value stands at $12.32 per unit. That 33.5% gain in book value per unit is the end result of 23 years of PAA’s frenetic capital program. Its results indicate that management failed to use PAA’s retained earnings to meaningfully increase unitholder value.
PAA’s unit performance suggests as much. The following chart compares PAA’s unit price performance with corporate America generally, as represented by the S&P 500.
PAA units have been flat since 2005.
Not only have PAA’s units underperformed since its IPO, but its quarterly distributions have fallen below where they stood at the time.
Clearly, in terms of management and asset quality, PAA is not nearly in the same class as EPD and MMP.
Leverage Reduction Plan
In August 2017, PAA launched a leverage reduction plan funded through retained cash flow and asset sales.
Since PAA launched the plan, its units have fallen by half. PAA’s distribution cuts were no doubt a contributor to the decline. Since its plan was announced, PAA’s quarterly distributions have fallen from $0.55 to $0.18.
In April 2019, management announced its debt reduction targets had been met, and it increased PAA’s distributions from $0.30 to $0.36. At the time, a $0.36 distribution appeared sustainable.
Then, in early 2020, the COVID-19 turmoil hit the oil market. In response, PAA slashed its distribution by half, from $0.36 to $0.18, where it stands today.
PAA Units Remain Out-of-Favor
While PAA’s management quality and financial returns are mediocre at best, we believe the selloff in its units has gone too far. This can be seen in investor sentiment toward PAA units.
From a stock market perspective, consider how PAA has lagged the AMZ, of which it is a larger holding. Its large-cap peers have not fared as badly.
PAA units currently trade at a discount to its large-cap peers. Its enterprise value (EV)-to-EBITDA is the lowest among them, further illustrating its relative undervaluation.
EV-to-EBITDA figures for PAA and its peers can be seen in the table below.
Source, Morgan Stanley, Feb. 5, 2021.
Relative undervaluation like PAA’s is usually brought about by a weak balance sheet or persistent operating obstacles. PAA faces neither. Its undervaluation is more likely a consequence of midstream investors’ lack of faith in management.
We believe if management can reduce debt and capital expenditures, it can once again find favor with investors. PAA units can then make their way toward the average EV-to-EBITDA multiple of its peers, which would significantly increase their unit price. For instance, if PAA traded to 9.0-times EB-to-EBITDA — in line with peers — its units would trade at $13.50.
PAA Will Outperform in a Permian Recovery
PAA’s undervaluation begs the question: Is it deserved?
It would appear so from a capital allocation perspective. It's entirely possible that PAA’s EV-to-EBITDA ratio remains depressed compared to its peers.
But management issues aside—as valid as they may be—we see PAA’s assets benefiting purely from increased throughput. If management can simply constrain capital spending as promised, it will be forced to halt its poor capital allocation decisions that have dogged its units for years.
Consider, for instance, that if PAA’s throughput begins to increase, its EBITDA is likely to rise, while its debt stays flat or falls. In such a scenario, PAA units can retain their relatively low multiple and still outperform peers if PAA’s financial improvement is large enough.
Permian Production Growth
We believe Permian growth will be more heavily weighted toward 2022. This is because—so far, at least—U.S. exploration and production (E&P) companies have been restrained in their growth-capital budgeting and production-growth forecasts. With few exceptions, companies are being cautious in adding incremental production, and are opting to spend their capital on repairing their balance sheets.
By and large, E&Ps will enter 2022 in better financial shape. If oil prices are sustained above $65 per barrel—as we believe is likely—these producers may begin to once again consider growth in their capital budgeting.
Consider, for instance, that since 2010, U.S. shale production growth has almost single-handedly risen to meet global demand growth, and since 2016, the Permian was the largest driver of that growth. According to the EIA, the Permian was responsible for 77% of total U.S. oil-production growth from January 2016 through year-end 2019, before COVID-19 decimated the global oil market in early 2020.
Of all the oil-producing basins in North America, the Permian will be the first to receive E&P capital aimed at growing production. In that scenario, PAA stands to benefit the most among large-cap midstream operators.
PAA in the Permian
If Permian production grows, how can we be sure that PAA will benefit from that growth?
We see three main reasons.
1. PAA’s Permian Position
First, PAA operates an extensive midstream asset portfolio in the basin. The map below shows PAA’s Permian pipelines. The red lines depict its gathering system, and the blue and gray lines show its long-haul pipelines that tie into various demand hubs.
Source: PAA Investor Presentation, Nov. 2020.
PAA’s Permian system is interconnected and contiguous, transporting oil from the wellhead to major demand hubs such as Cushing and Houston. Its Permian crude-oil gathering system moves approximately 1.4 million bpd, while its Permian transmission pipelines have 1.3 million bpd of takeaway capacity.
2. The Permian’s Heavy Weighting in PAA’s Results
Second, PAA’s operations are concentrated in the basin. In fact, the basin has such an outsized impact on PAA’s financial results that its units’ long-term return prospects hinge on future Permian oil throughput.
Unfortunately, PAA doesn’t break out its revenues by geography. Instead, it reports results in three segments: Transportation, Facilities, and Supply & Logistics. During the first nine months of 2020, these segments accounted for 62%, 28%, and 10% of PAA’s EBITDA, respectively.
We can see how significant the Permian is to PAA’s overall results by examining each segment’s throughput volumes. Of the 6.8 million bpd flowing through PAA’s transportation segment, a full 4.7 million bpd—or 70.9%—resides in the Permian, as shown in the excerpt below from its 2019 10-K.
Source: PAA 2019 10-K.
Crude oil pipeline volumes account for 81.6% of PAA’s total volumes, so we can calculate that its Permian crude system accounts for 57.9% of PAA’s company-wide volumes.
Over the past few years, PAA has significantly increased its exposure to the Permian, which can be seen in its capital spending results below.
Source: PAA 2019 10-K
The chart shows that of the $4.4 billion PAA invested in non-maintenance capital expenditures from 2017 to 2019, $2.8 billion—or 63.5%—was directed at the Permian. These projects have increased PAA’s Permian volumes from 2.9 million bpd to 4.7 million bpd, or 40%, since 2017.
Source: PAA 2019 10-K.
Note, however, that this data represents year-end 2019. It therefore does not include Permian capacity increases stemming from PAA’s 2020 capital investments.
In April 2020, PAA reduced its capital budget for the year by 37%. Still, the lion’s share of its growth capital was directed toward the Permian, as can be seen in the following excerpt from PAA’s third quarter 2020 10-Q.
Source: PAA Q3 2020 10-Q.
This capital spending has made PAA’s performance far more dependent on the Permian than its peers.
3. PAA’s Permian Operating Leverage
The third reason why PAA will benefit from growing Permian production is its operating leverage.
PAA’s assets are currently underutilized, mainly for the following reasons, all of which permit for utilization increases amid Permian production growth.
Firstly, the recent reduction in oilfield activity in the wake of the COVID downturn has caused reduced the usage of PAA’s pipelines. Reduced completion activity in 2020 caused crude throughput to fall for all U.S. midstream operators.
Secondly, there has been massive overbuilding in Permian midstream infrastructure. This has caused the basin’s takeaway capacity to far exceed its production. However, PAA’s interconnected system in the Permian is fed by its extensive gathering network. This gives it a favorable competitive position, and keeps its throughput relatively high.
Thirdly, PAA’s assets are underutilized because the company has recently made billions of dollars’ worth of new capital investments in the Permian. Due to the unexpected downturn in early 2020, some of its newly built pipelines have not been fully contracted.
As PAA’s throughput increases with Permian production growth, free cash flow will grow at a higher rate than revenues, as higher fee revenue drops directly to the bottom line.
PAA’s Financial Outlook
The following factors underlie PAA’s operating leverage.
Firstly, its cash expenses are set to fall as growth-capital spending is likely to be restrained going forward. During PAA’s Q4 2020 earnings conference call on Feb. 9, management guided for total capital spending of $650 million in 2021, which falls to $450 million in 2022 and beyond. These amounts stand in stark contrast to the $1.7 billion PAA has spent on average per year from 2017 through 2019.
Also, management plans to pay down debt through proceeds from asset sales.
The following chart from PAA’s earnings conference call shows PAA’s recent capital spending and asset sales, as well as management’s estimates for 2021. It also shows management’s longer term plan to restrain capital spending in 2022 and beyond in a $55 per barrel oil price environment.
Source: PAA Q4 & Full-Year 2020 Earnings Conference Call Presentation, Feb. 9, 2021.
It's difficult for us to believe that PAA’s $14.6 billion asset base requires a mere $200 million of yearly maintenance, as management claims in the chart above. We believe a more conservative estimate would be $400 million-to-$500 million. Combined with $200 million-to-$300 million of growth-capital spending, we believe PAA’s total capital expenditures can fall to between $600 and $800 million on a sustained basis, from $1.2 billion over the past 12 months.
This estimate is before cash contributions from asset sales, which could be substantial. For instance, management is projecting $750 million in asset sales in 2021 alone.
In 2021, if PAA generates $2.0 billion in operating cash flow, while directing $700 million toward capital spending, and $200 million toward preferred distributions, it would generate $1.1 billion in cash flow before common distributions. Since it currently pays $700 million in common distributions, it would have $400 million left over to allocate toward paying down debt.
In this scenario, cash flow of $1.1 billion would equate to $1.38 per unit. PAA currently distributes $0.72 per unit. In this scenario, the company could easily afford to hike its distributions by 50%, to $1.08.
This is the scenario we believe would be likely if the pickup in Permian production is more muted.
If the pickup is more robust, however, we believe PAA’s operating cash flow would increase from our normalized estimate of $2.0 billion in 2021, to $2.3 billion in 2022 and beyond. If management can keep PAA’s total capital spending at $700 million each year, the company could generate $1.4 billion of distributable cash flow, or $1.75 per unit.
PAA's operating leverage is evident in this scenario, as a 15% increase in operating cash flow drives a 27% increase in distributable cash flow.
If PAA generates $1.75 per unit, it could easily distribute $1.44 per unit annually, or double its current rate. In fact, such an outcome for unitholders would not be unprecedented. PAA distributed $2.80 per unit in the year beginning in the fourth quarter of 2015, and $2.20 in the four quarters thereafter.
This is why we are confident that PAA can conservatively increase its common distributions by at least 50%—to $1.08 per unit—amid growing Permian production. We believe this can happen over the next two-to-three years, once PAA achieves management’s targeted leverage ratio of 3.0-to-3.5 times.
Discounted Cash Flow Scenario
In our discounted cash flow analysis, we assume that PAA generates $1.1 billion annually, with no growth from 2021 onward. We believe this assumption to be conservative. Keep in mind that PAA generated $1.1 billion of free cash flow over the twelve months ending Sept. 30, in extremely difficult operating conditions.
In our first scenario, PAA units feature 62% upside from today’s price of $8.50. This can be seen in the following graphic.
This analysis indicates that at the very least, PAA’s current distribution is safe. But it also shows that at best, its distributions and unit price can increase substantially—even in the absence of a material change in cash-flow generation. If cash flow improves from a Permian recovery, so much the better.
Potential Accelerants to Positive Operating Leverage
Certain outcomes are likely to further increase PAA’s operating leverage if a Permian production growth scenario pans out.
Contract Cliffs in 2024 and 2025
PAA has several large Permian midstream contracts up for renewal in 2024 and 2025. If Permian production is sustained into 2024, demand for PAA’s midstream services will increase. PAA will then be able to negotiate favorable long-term rates for the use of its Permian system.
Operating Leverage from a Supply-and-Logistics Segment Recovery
Significant operating leverage also exists in PAA’s Supply & Logistics segment. The segment only accounted for 10% of PAA’s total EBITDA during the first nine months of 2020. However, the segment’s EBITDA had fallen by 64% from year-ago levels. This compares with a 3% decline for PAA’s Transportation segment and a 6% increase in its Facilities segment.
A Supply & Logistics segment recovery to pre-COVID levels would be good for an additional $165 million of EBITDA. The Facilities segment had a banner year in 2020 that is unlikely to be repeated in 2021. Assuming both segments’ performance reverts to 2019 levels, while the Transportation segment’s results remain flat, their total EBITDA contribution would amount to $130 million. This equates to $0.49 per unit, given PAA’s current EBITDA-to-market cap multiple.
However, if management also achieves its debt reduction target of $750 million in 2021, and if we assume that value was transferred on a one-to-one basis from debt to market capitalization, PAA’s units would receive a boost of $1.43. Since $750 million in debt reduction is likely to solidify PAA’s investment-grade credit rating, its unit’s price response could be even greater.
Bear Case
The bear case for PAA is simple: Oil prices stay low and U.S. well-completion activity remains subdued. Lower production would translate to lower midstream throughput and lower cash flows for even the best-positioned Permian-based midstream operators.
The main factor that bears watching in the PAA bull thesis is the Biden administration’s recently announced oil-and-gas drilling lease moratorium on federal lands. In the Permian, a significant portion of New Mexico acreage is federally owned, and a significant portion of PAA’s gathering system is in New Mexico.
At the moment, E&Ps in New Mexico own enough leases to satisfy their drilling programs for 2.5 to five years, depending on the producer. More importantly for PAA, however, its customers have massive drilling inventories on the Texas side of the Permian, which has minimal federal lands. As New Mexico leases expire, PAA will be able to offset much, though not all, of its New Mexico throughput losses from increased throughput in its Texas Permian system.
Conclusion
Of all the large-cap, diversified midstream operators, PAA is best positioned to benefit from a Permian recovery. We expect the basin’s production to grow as the world’s need for Permian oil increases. PAA will be one of the main beneficiaries with its established network of gathering, trunk lines, and mainline takeaway routes. Investors looking for a safe and high current yield coupled with the prospect for a 50%-to-100% increase in both distribution and unit price should buy PAA units.
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