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Reasons to Be Cautious on Midstream MLPs

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Matt Coffina. He is the editor of Morningstar StockInvestor newsletter. He recently sold Energy Transfer Equity (ETE) out of his portfolio. We're here to talk about why. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk about the sale. Why did you decide and what were some of the factors behind your decision to sell ETE?

Coffina: Energy Transfer has been a great holding for the Hare [portfolio]. We more than tripled our money. It was about a three-and-a-half-bagger if you include dividends, since we purchased the units in late 2010. So, it's been a very successful holding for us for a number of years, but what concerns me right now about Energy Transfer is just the valuation.

When we first bought the company, it had about a 5.5% yield. Now, the yield is below 2.7%, as of my sale. We don't often talk about price/earnings ratios when discussing master limited partnerships, but if we use distributable cash flow as our measure of earnings--and that's arguably an aggressive assumption already--but using distributable cash flow, ETE is trading at about 35 times current earnings. So, that's definitely a growth company kind of multiple. And investors, I think, are baking in some pretty optimistic assumptions for future growth.

On the one hand, we think that those are justified; our analyst expects ETE to be able to raise its distribution about 20% a year over the next five years. But we also need to look forward beyond that and say, "What is this company going to look like, say, five years from now?" And in that case, I think the growth is going to slow dramatically. There's no getting around it.

First of all, ETE will be a much larger company than it is now, and it's always harder to grow off a larger base. There are some temporary effects over the next five years. For example, they waived some of their incentive distribution rights from their limited partners, and those waivers will be rolling off over the next five years and that won't be continuing indefinitely. But perhaps most importantly, Energy Transfer is really benefiting from the domestic energy boom where the innovations in shale drilling have really changed the landscape for transporting oil and natural gas and related products around the country--natural gas and oil both coming from different areas than they had historically and they need to go to different areas.

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So, for example, pipes that used to bring natural gas from the Gulf Coast up to the Northeast are now being reversed to bring some of that gas that's being produced in the Marcellus Shale south, perhaps, in the future to the Gulf, where it can be exported as liquefied natural gas. Booming oil production in North Dakota creates a need to transport that oil to the Gulf Coast, where it can be refined. So, all of that requires basically replumbing the country. We need to move where the pipes are and to change the direction that they are flowing, and that has created a plethora of investment opportunities for master limited partnerships, but that won't last forever.

Sooner or later, domestic energy production is going to peak--probably sooner rather than later, within the next few years. And even besides that, a lot of the plumbing needs to be in place before the major production ramp-up can occur--which means that, five years from now, I think there will be much less need for new oil and gas infrastructure than there is today. Which means that Energy Transfer probably will be growing a lot slower beyond 2020, and that will require a significantly higher yield.

The question, then, becomes if Energy Transfer should yield, say, 5% plus five years from now, can they grow the distribution enough in the near term that it more than makes up for that deteriorating yield? And in a relatively bullish scenario, I think that that's the case and maybe investors could look forward to an 8% to 10% total return.

But on the other hand, some things could certainly go wrong with their current growth expectations. That could be regulatory delays to projects; maybe the recent decline in oil prices will cause some producers to cut back on production and make some projects not viable anymore, and so on. Commercial partners could pull out lot of projects. For example, they have this very large LNG project at Lake Charles, and that may be less economic now, especially with the decline in oil prices.

So, I think that there is maybe an 8% to 10% total return per year that's possible, but that's starting to look more and more like a bull case. And there are a few too many things that could go wrong--where if the yield were to rise sooner than five years from now, then investors could be looking at not much margin of safety, at least, in the current stock price.

Glaser: If valuation was a major driver here, it sounds like some of those other factors could impact all MLPs. Has this really made you rethink, or have you started to rethink, your position on all of these energy names that you own?

Coffina: Well, it's been interesting that MLPs, in general, had a huge sell-off in mid-October, in conjunction with the decline in oil prices. And we thought that wasn't really justified at the time. These companies tend to have much less commodity-price sensitivity than other parts of the energy value chain--say, services companies or exploration and production companies.

So, we didn't think that sell-off was deserved. But for the most part, these MLPs have bounced all the way back to where they were and then some. And I think that's the wrong view, too. I don't think you should say that the decline in oil prices is going to have no impact on MLPs. If it's sustained, it certainly could have implications, as they have to roll over their transportation contracts with shippers, as they pursue new organic growth projects that may not be as attractive as they were in a different commodity-price environment.

Other factors do carry over across MLPs: If interest rates rise over the next five years, that can certainly be a factor that makes investors a little less desperate for yield. And I have to wonder what role low interest rates have played in the very strong performance of MLPs over the last five years here.

So, there are a number of reasons to be concerned, I think, about midstream energy in general. Also, the fact that there aren't going to be as many growth projects five years from now as there are today, as the country will largely have the plumbing that it needs.

So, there is a reason to be cautious. I would say, for Energy Transfer, there were a lot more growth expectations baked into the unit price, a lower yield than some of our other holdings, very tight distribution coverage. ETE is only covering its distribution about 1.04 times on a year-to-date basis. And so, other companies like maybe Magellan Midstream Partners (MMP)--which we don't own, but that I've been considering--also trades at a low yield but not quite as low as Energy Transfer. Arguably, it has a much more sustainable long-term growth profile due to a favorable regulatory environment. And they also have significant excess distribution coverage, which again creates a margin of safety around the sustainability of the distributions.

Enterprise Products Partners (EPD) is a company that we do own in the Tortoise portfolio. There, the yield is materially higher than Energy Transfer. So, again, not baking in quite as much growth. Also, significant excess distribution coverage, which creates more margin of safety.

We own TransCanada (TRP), which also has a very large portfolio of growth projects, but a higher yield, better dividend coverage. It creates a little bit less risk. It's a little less dependent on future growth than Energy Transfer is.

And lastly, Kinder Morgan Management (KMR). There, the financial profile is also very aggressive, similar to Energy Transfer, which we think is a very aggressive financing and distribution strategy. But Kinder Morgan is trading at more than a 5% yield. So, again, it's much less reliant on future growth expectations that justify that valuation than Energy Transfer is.

So, I guess the main takeaway I would say is that I'm increasingly likely to favor more conservative master limited partnerships or C-corp midstream energy companies--companies that have excess distribution coverage, relatively higher yields, and that are less dependent on future growth to justify their current valuations.

Glaser: Matt, I certainly appreciate your update on the MLP space today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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