Wide-Moat Plains GP Offers Growth as Well as Income

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Plains' strategy centers on addressing regional supply and demand imbalances for crude oil and natural gas liquids in the United States and Canada by combining its diverse, strategically located assets with its deep logistics expertise. Plains has achieved growth in earnings and cash flows by optimizing its existing asset network and focusing on realizing cost efficiencies. In doing so, Plains is able to drive increases in cash flow from inefficiencies in energy markets by using its asset base to address physical imbalances in the market.

Plains has a long history of driving growth across a variety of commodity price environments. Approximately 77% of PAA's earnings are generated from fee-based activities, while the remaining 23% is from margin-based businesses, predominantly in the supply and logistics segment. PAA's supply and logistics segment profits from volatility in crude and NGL markets as PAA is able to trade around market structure, including contango and backwardation, time spreads, and basis differentials stemming from regional bottlenecks, regional crude quality imbalances, and changes in world supply and demand balances. Management estimates this business generates a base level of earnings with opportunities for incremental margin above this base level depending on market conditions.

Our fair value estimate of $30 is based on a standard discounted cash flow model. We check this estimate by using a distribution discount method, which also gives us a fair value estimate of $30 per share. Given PAGP's estimated distribution of $0.93 per share for 2015 and its current yield of 3.5%, the 12-month total return proposition is 15%.

Portfolio's Efficient Scale Results in Wide Moat Since the cash flows at the PAGP level are derived from business activities at the PAA level, our moat recommendation is wide, similar to PAA's moat rating. The foundation for the wide moat rating, also similar to PAA, rests on the efficient scale of the portfolio. PAGP's returns have proved to be consistently above its cost of capital in a variety of commodity price environments. The transportation and facilities segments, which produce 70% of PAA's earnings, include traditional pipeline and storage assets that generate stable cash flows supported by Federal Energy Regulatory Commission-indexed annual tariff increases, long-term customer contracts/minimum volume commitments, and minimal direct commodity price exposure.

PAA faces light-handed regulation from FERC on its liquids pipeline and storage/terminal assets. Annual rate increases on PAA's pipelines are tied to the producer price index plus a productivity escalator for five-year periods. This adds inflation protection and provides a multiyear line of sight on rates, which makes returns on capital more stable.

Approximately 50%-60% of PAA's pipelines are underpinned by long-term contracts or minimum volume commitments while the remaining 40%-50% is available for spot shipments. Long-term contracts and/or minimum volume commitments help to insulate PAA's core transportation segment earnings from fluctuations in commodity prices. Furthermore, new projects are typically secured by anchor shippers before project construction even begins. If there is insufficient interest, the project often does not move forward. This procedure ensures that capital is being prudently allocated.

In general, PAA does not take title to the hydrocarbon being transported in its pipelines and storages facilities; it simply charges a fee to the shipper for handling the volumes. These fee-based margins help maintain stability of earnings during periods of declining commodity prices. Furthermore, approximately 99% of PAA's growth capital is being invested in fee-based assets with a majority of these backed by long-term contracts with third parties. Returns on these projects vary, but broadly speaking, they range from low to high teens and handily exceed the company's cost of capital. Over the long term, management expects fee-based earnings to approach 80%.

The remaining 30% of earnings are from PAA's supply and logistics segment, which profits from the sale of crude oil and NGL marketing. While this segment incurs risk by taking title to liquids, PAA is not engaged in financial speculation in this segment but instead is focused on the physical sales of hydrocarbons in an effort to optimize its assets. The firm mitigates some of its commodity price risk by keeping a relatively balanced book at all times since it is simultaneously purchasing and selling forward commodities and locking in margins.

Management has indicated that the supply and logistics segment has a baseline level of earnings of approximately $550 million as of 2015. Incremental margins achieved above this base level are not used to support cash distributions. Instead, these profits are reinvested in long-term fee-based growth projects. When combined, these factors make PAA's deserving of a wide moat rating.

PAGP has consistently achieved steady returns on invested capital, which have handily exceeded its weighted average cost of capital. The distributions from PAA are generated by fee-based transportation and facilities businesses and the base level of margin in its higher-risk supply and logistics segment and have supported ROICs in the midteens. Plains has a long and successful record of completing smaller projects rather than larger-scale ones that can sometimes derail returns. Plains lowers its overall risk profile by employing this strategy, since growth doesn't depend on the success of a single project but rather is spread across many different projects. Its broad network of midstream assets lends itself to smaller-scale tuck-in organic growth projects as well as bolt-on acquisitions, which combined help boost volumes across its network and ultimately drive margin growth. We expect Plains to continue using this approach.

Management Restraint Mitigates Risk Plains faces risk resulting from commodity market volatility, which can lead to profits during good times and losses during bad times. Sustained low oil prices also reduce margins and could threaten system volumes. Regulatory changes regarding tariff structures or pipeline safety could also affect Plains' business model. Operational risks include the possibility of leaks, fires, or explosions. Refinery turnarounds can reduce the amount of crude and petroleum products Plains moves through its pipes and terminals. Also, Plains requires functioning financial markets to access growth capital.

Management has proved adept at allocating capital wisely, as demonstrated through its habit of reinvesting excess cash flow in organic growth projects or acquisitions. The company maintains strict target returns for new investments, and we've seen the results reflected in Plains' consistently growing asset base, cash flows, and distributions. We've also seen management exercise restraint in its decisions to form joint ventures at times rather than overbuild in a basin. On the whole, we view Plains' stewardship as exemplary.

The board of directors has deep energy and finance expertise and is elected by Plains' general partner. We like that a portion of directors' pay is tied to long-term unit prices and that management provides detailed data with its quarterly reports. Management's communication efforts and transparency are helpful for investors, as they provide additional visibility into future profitability and distribution growth.