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Stock Strategist Industry Reports

Midstream Values Still Exist

With challenging industry fundamentals, investors will need to play defense.

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We continue to recommend that midstream investors play defense, as industry fundamentals are looking challenged. As we have listened to management teams discuss recent performance this earnings season, as well as their near- to medium-term outlooks for their firms, several themes have recurred.

First, balance sheets are getting stretched, with net debt/EBITDA at many midstream firms picking up. Cash distribution coverage levels are getting tighter, with some firms unable to reach 1.0 times coverage, including  Plains All American Pipeline (PAA),  Kinder Morgan (KMI), and  ONEOK Partners (OKS). Cash distribution growth rates are likewise coming down, most recently for Kinder Morgan. Several firms have cut capital expenditure plans for next year, and we believe this is only the beginning as management teams begin working on 2016 budgets. Some discussed potential noncore asset divestitures as a means to shore up balance sheets, while those who had expected growth to come from acquisitions have been disappointed as bid and ask prices remain far apart in most cases. As a result of these challenges, many firms--including Kinder Morgan and Plains All American--are now considering alternative financing to underpin growth plans.

We believe playing defense is the way to go because we are far from confident that the worst is behind the oil and gas industry just yet. While there is a tendency to throw the baby out with the bathwater, there are still a handful of names in decent shape despite the challenging backdrop. Top of these, in our opinion, are  Magellan Midstream Partners (MMP),  Spectra Energy Partners (SEP), and  Enterprise Products Partners (EPD). Each of these firms has a solid balance sheet, decent coverage of cash distributions, and stellar management.

Midstream Top Picks
With its portfolio of great assets and attractive valuation, we continue to view Magellan Midstream as one of the more attractive names in the midstream sector. The firm benefits from a conservative business run by a stellar management team. Magellan Midstream also possesses a strong balance sheet and is positioned to increase cash distributions 15% in 2015 and a minimum of 10% in 2016. Its solid coverage levels provide a cushion during periods of commodity and economic volatility. The firm is primarily a fee-based business with margins generated by low-risk transportation and storage-related activities, which constitute 85% of total operating profits. Below-average commodity exposure insulates the firm somewhat from volatile swings in commodity prices. Magellan has an investor-friendly partnership structure with one of the lowest costs of capital among energy partnerships, since its general partner does not receive the 2% GP interest nor incentive distributions. Furthermore, with management guidance that is based on a crude price of $50 per barrel, we believe Magellan units are well positioned to surprise to the upside when oil prices recover.

Wide-moat Spectra Energy Partners is one of the most defensive names in energy because it is entirely a tollbooth-based business model, with earnings generated by low-risk transportation and storage-related activities making up 100% of total margin. Spectra Energy does not incur direct commodity exposure and has minimal volumetric risk, since 80% of EBITDA is generated by demand charges that are paid regardless of usage levels. In the next five years, we expect an EBITDA compound annual growth rate of 9%, with projects in the U.S. Transmission segment the main driver of growth. Given our growth outlook, we expect distribution increases of 7%-8% annually through 2017, with coverage of 1.15 times in 2015 and 1.0 times in 2016.

Enterprise Products Partners has one of the best management teams in the master limited partnership/midstream sector and best-in-class assets that are positioned to monetize every link of the midstream value chain. While negative natural gas liquids fundamentals affect the partnership's commodity-sensitive gas processing and NGL marketing, longer term we expect Enterprise Products' tightly integrated network of assets along with management's conservatism will allow the firm to continue to expand the business during the commodity price downturn. We forecast cash distributions will grow at approximately 6% annually, with the firm also being able to maintain strong coverage ratios. As is its habit, management retains a large portion of distributable cash flow to offset future capital expenditure needs. Enterprise Products is in a very strong position to benefit from the growing supply of domestic NGLs, whether it exports them international markets, converts them to higher-value-added olefins in its own facilities, or transports them to domestic petrochemical firms as raw materials for use in manufacturing. Near-monopoly status for many of its pipelines coupled with a fully integrated system (which connects multiple sources of supply with multiple end-user markets) is a key driver of its long-term returns above the weighted average cost of capital.

Peggy Connerty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.