Don't Let Your Dividend Pipeline Run Dry

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors were caught by surprise when Boardwalk Pipeline Partners sharply cut their distribution. I'm here today with Josh Peters, editor of Morningstar DividendInvestor and also Morningstar's director of equity-income strategy, to see if investors and other master limited partnerships should be worried.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at Boardwalk. Why was management forced to have such a large distribution cut so rapidly? What happened here?

Peters: They had a lot of things that have been pressuring Boardwalk for a while now all of a sudden snowball into, frankly, a disaster. The biggest pressure that has emerged for Boardwalk's particular set of pipeline and storage assets is the rapid growth of natural gas production in the Marcellus Shale, which is in Pennsylvania and adjacent states.

Historically, the Northeast states and mid-Atlantic states can get pretty cold in the winter; they need that natural gas supply. They were importing gas over long-haul pipelines either from the Gulf of Mexico or western Canada. But now with the Marcellus accounting for a giant share of natural gas output and that's still rising, a pipeline that is taking gas from the Gulf of Mexico into areas kind of close to the Marcellus really might not have much left for customers.

Now, Boardwalk was able to sort of prevent this threat from harming the distribution up until now, but it seems that 2014 is really a tipping point where their key pipeline that runs from Texas and Louisiana up into Indiana and Ohio is seeing lower contract renewals and lower tariffs. Their storage business is not doing well either for some of the same big-picture industry reasons, and they're looking at distributable cash flow, the resource with which to pay those dividends falling close to 30% this year.

They went ahead and cut the distribution by 81%, and that highlights a couple of other risks associated with a partnership like this. They typically rely on the capital markets, especially the equity market for financing for new projects. If Boardwalk wants to dig itself out of its hole and have the opportunity to recover some of the lost cash flow with other expansion projects, it has to find some source of financing because it was paying out all of its cash before.

Now, having cut the distribution, raising equity and public equity offerings is really not a viable option. They just have to live within the means that they're generating internally. Now that distribution of only $0.10 a quarter per unit is only about a quarter of the cash flow that they're generating, so they should be able to deleverage, reduce some debt, and hopefully, bring some growth projects on line. But, this is definitely what you call permanent capital impairment. It's extremely unlikely that investors are going to be able to recover what they've lost here just in the last couple of weeks with this problem.

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Glaser: MLPs have been very popular over the last few years with investors looking for yields. Does this raise any red flags to some of the other partnerships out there? Should investors be worried that there could be some big cuts on the horizon for some other popular names?

Peters: Fortunately no. Boardwalk was uniquely vulnerable. Now, management hadn't done a good job of explaining how vulnerable it was; they were very, very tight in terms of giving forward guidance. We did not see this problem materializing as fast as it did, but Boardwalk as I mentioned earlier, the pipes that it operates run from Texas to Louisiana up into Ohio, Indiana, and Kentucky. It gets close to the Marcellus without actually getting into it. So, A, they don't have the opportunity to easily connect to new sources of gas production in the Marcellus, but B, they also have customers in that area that can now buy gas more cheaply from the Marcellus as opposed to the [from the Gulf Coast]. This was a set of assets [that were] highly concentrated; it was not a very well-diversified asset base. It was, we think, really uniquely vulnerable.

There are lots of other pipelines that run through the Marcellus, but in those cases, yes, the patterns of the gas flows may be changing. In some cases, the gas might be going south instead of north, but companies that have assets in those areas are in a position to take advantage of the new sources of supply, deploy new capital, and utilize existing assets to make sure that those are continuing to perform reasonably well.

At the same time, I think it's really easy for people to oversell the advantage of these assets. Just because you have a pipeline in the ground--you can maintain it, it may last for decades or for who knows, hundreds of years maybe--but that doesn't guarantee you're always going to have customers at either end of the pipe. I think you need diversity; you need good capital allocators at the top of the companies themselves, the partnerships themselves. You really want to look for financial strength and excess distribution coverage and hopefully a business that doesn't require continual infusions from the capital markets in order to just hold its distribution steady. That's something that we've seen from Boardwalk again with the benefit of hindsight issuing more units and not having those new unit issues turn into distribution growth.

One of the most important takeaways really in this story is that even though the distribution was just cut here recently, the distribution stopped growing in the middle of 2012. That was a pretty good tipoff at the time that at least this isn't a name that you would want to be buying.

Glaser: Looking across the MLP universe, who do you think is better positioned, who do you feel comfortable with now and who do you think kind of has some of those yellow flags that you just described?

Peters: One of my favorites is Magellan Midstream Partners, which is actually our largest holding [in the DividendInvestor portfolios] and has been for a number of years. It's a refined petroleum products and crude oil carrier. So, it's not seeing the same types of industry dynamics that you're feeling with the Marcellus and the natural gas side. It has great balance sheet. It has only had to issue equity once, I think, in the last nine years and that was to fund a large acquisition.

Just on their internally generated resources and internal growth, they've been able to put up very good distribution increases over time and are looking at 20% growth in distributions here this year. It's just a phenomenal record, one of the best out there. In my view they are the best; Magellan Midstream is the best. The yield's a little bit low, but I think they make up for it with a really conservative risk profile as well as lots of growth.

AmeriGas Partners is another name. It might sound a little more counterintuitive than what I really like. It's a propane distributor, which means it's dealing less with pipelines and more with just trucks and tanks. Now, propane is in secular decline. The national consumption of propane is dropping maybe 1% or 2% a year on average over the long run, but with AmeriGas they make up for it with pricing power and with scale. They're by far the biggest player in their industry with excess distribution coverage that provides plenty of room for variability in the weather from year to year without jeopardizing the distribution. And that also lets them make acquisitions. They're slowly rolling up the industry offsetting those secular volume declines with those small acquisitions. This partnership deal is close to 8% and yet is raising its distribution 5% a year. I don't always like secular-decline stories, but as long as cash flow is growing, I'm less worried about volume declining.

Then Spectra Energy Partners rounds out my favorites. That's a name that has a lot of assets running through the Marcellus, but they are in the position to take advantage of those new investment opportunities. We're looking at a yield here in the mid- to high-4% range. We think it has mid- to high-single-digit distribution growth over the long run. It has a very attractively positioned set of assets and is big enough and diverse enough to take advantage of these changing gas flows as opposed to being a victim of them.

A couple of names that I'd be a little bit more conservative on, Enbridge Energy Partners is one that comes to mind. It's another big MLP, but its coverage ratios have been very poor. They are not actually generating enough cash to maintain the distribution without raising more debt in equity capital. They do enjoy very strong support from their parent, the Canadian company Enbridge, but the distribution is not growing. The yield's high. A high yield sounds good to us, but for the companies it's bad because it means it's that much more expensive to raise new equity capital.

Another name I'd stay away from is NuStar Energy. I actually owned this for a couple of years and sold it. They've had assets that have not been performing well. In particular, they made a foray into asphalt that was just a disaster. They've been struggling to try to keep their distribution steady, and thus far they've managed to pull it off. But they're still making a lot of very risky and expensive bets with new investments to try to dig out of the hole that they've dug with some bad investments. It's not a management team I would have a whole lot of confidence in. So that's another name I'd stay away from.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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