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Stock Strategist

This MLP Is Positioned to Shine

A recent transaction shifts this MLP from a marginal investment vehicle into a major player in natural gas transportation.

Spectra Energy's move to drop down all of its gas transmission assets and its interests in oil and natural gas liquid pipelines fundamentally transformed  Spectra Energy Partners into a first-tier master limited partnership. The transaction, which closed in November 2013, shifts SEP from a marginal investment vehicle for Spectra to house interests in slow-growth pipelines into a major player in natural gas transportation with strong exposure to the Marcellus Shale, the nation's most prolific gas play.

In our view, this transaction creates one of the more attractive, low-risk business models in the MLP space while bolstering Spectra Energy's growth outlook. SEP provides Spectra with a more tax-efficient way to fund its growth, an important consideration because Spectra has approximately $25 billion in identified growth projects underway, it has just completed the $1.2 billion New Jersey-New York Expansion, and it recently received approval to build the $3.2 billion Sabal Trail pipeline into Florida.

The core of SEP's gas pipeline system is Texas Eastern Transmission, a massive pipeline able to move 10% of U.S. gas consumption, which runs from the Gulf Coast to New York, directly through the heart of the Marcellus. SEP also owns Algonquin Gas and the Maritimes and Northeast Pipeline, providing gas to New England; 50% of Gulfstream, one of the major gas pipes into Florida; and several other interstate gas lines. The key feature of this pipeline system is that all of Spectra's gas pipelines are connected, tying Texas Eastern into multiple sources of supply and demand. Utilization on the pipes is high, and all pipelines generate fixed-fee cash flow from long-term contracts, making SEP one of the most stable cash generators we cover.

Additionally, SEP now owns Spectra's interests in the Express-Platte crude oil line and the Sand Hills and Southern Hills NGL pipelines, providing a platform for additional liquids transportation investment.

SEP Has Impressive Scale and Experience
We give SEP a Wide Morningstar Economic Moat Rating. The core of the partnership's moat is its natural gas pipeline system, which consists of long-haul interstate pipelines that run from the Gulf Coast to Midwest, Northeast, and Southeast markets and provide needed market access for Marcellus Shale production. As one of the largest natural gas transportation companies in North America, SEP can bring its impressive scale and experience to bear across multiple markets. Its core strategy is to own and operate natural gas assets with local monopolies, effectively maximizing switching costs and yielding consistently attractive returns on invested capital. SEP only buys or builds assets in geographies where it expects market supply and demand to sustain volume for the long term, which allows it to lock in future streams of cash flow via capacity reservation fees with attractive regulated or market-based rates. As SEP continues to devote most of its growth capital to new pipeline and storage projects, we think it can achieve economies of scale by flowing incremental volumes through its existing system, connecting North America's major natural gas resource plays with its prominent demand centers.

Capital Access and Operational Risks Exist
Access to reasonably priced growth capital is always a risk for MLPs, including SEP, though a strong balance sheet and continued support from Spectra Energy mitigate this concern. Rising interest rates could convince investors to look elsewhere for yield. Other risks include legislation that could change MLPs' favorable tax treatment and agency issues that could result in transactions favoring the parent company over the MLP. Finally, as with all pipeline operators, operational risks include ruptures, explosions, fires, and environmental damages. Because of its contract structure, SEP does not face commodity price risks.

SEP is a controlled company, and its management team and most of its board members have worked or currently work for parent Spectra Energy. Investors should be aware that SEP, as a master limited partnership, affords fewer unitholder rights than shareholders of traditional companies typically receive. As a majority unitholder and owner of the general partner, Spectra calls the shots. Even though we don't like this arrangement from a stewardship perspective, we think SEP's management has allocated capital wisely over its history and expect more of the same, given SEP's attractive footprint and strong sponsor.