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This MLP Is Downturn-Ready

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy. We're going to take a closer look at Spectra Energy Partners (SEP) and Spectra Energy Corporation (SE).

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: In a previous video, we talked about midstream energy, particularly in light of the big declines there. We talked about how you like companies that are a little bit closer to the consumer versus the producers. When you think about Spectra Energy Partners, where does it really fall on that consumer/producer line?

Peters: I still think you have to be extremely selective, and we're continuing to see the drop in these midstream names. A good index, if you like to monitor it, is ticker symbol AMZ--the Alerian MLP Index. Even as the rest of the market has rebounded and stabilized a little bit, it's continuing to make new lows. Oil is not making new lows anymore, but the midstream names are, and you've got a lot of things feeding into it. Energy, as the much larger sector surrounding the MLP group, remains under pressure. In addition to that, you've got leverage holders as well as perhaps less sophisticated investors who didn't really realize that what they were buying had anything other than a yield--that there was also a risk there. You have people panicking.

A lot of these are owned through tax-shield type vehicles, whether they are ETFs or open-end funds or closed-end funds. And if you get into indiscriminant selling, these funds, in turn, have to sell MLPs, even some of the C-corps in the business. You've got a real rout going on. I'm too smart, I'd like think--or too chicken anyway--to call a bottom. There will be one at some point. But I think before this is over, you're also going to see dividend distribution cuts from some of the weaker names in the sector. So, I think you've got to be very selective. A good rule of thumb is get closer to the customers--get closer to the consumers of energy who will actually benefit from lower prices; if anything, volumes will be stimulated by lower prices, as opposed to being out there in the producing basins where drilling activity slows down. That means lower volumes on which you charge your fees, perhaps lower commodity-sensitive earnings as well as prices are low. So, sticking closer to consumers, I think, is where you want to be.

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Glaser: So, you own Spectra Energy Partners. Where are they in terms of that consumers-to-producers chain?

Peters: Spectra Energy Partners has a very, very attractive set of assets for any type of environment, but I think particularly right now. They are one of the leading long-haul carriers of natural gas. They have storage assets as well that are really oriented around the pull of demand for natural gas from customers. In the northeast, they've got a network that has lots of extension opportunities to connect new natural gas-fired power plants as they open and chemical plants as they open--all taking advantage of these low gas prices. The overwhelming majority--well over 90%--of their annual revenues are contracted out years in advance. So, you've got a great deal of visibility into the cash flow stream that's going to be coming for this network of assets.

It's much more like a utility than, say, a gathering-and-processing operation where you're running pipes out to individual wells--which is great if people are drilling wells, but not so great if the wells are not being drilled and the old ones are running dry. So, in that context, you've got a well-covered distribution--not a huge coverage ratio but sufficient, considering that those cash flows are so steady.

Glaser: Can you just explain the difference between Spectra Energy Partners and Spectra Energy Corporation, which is also publicly traded?

Peters: The key difference between the two is literally in the names. Spectra Energy Partners is a master limited partnership, so you've got to be aware of some of the tax consequences associated with that. Spectra Energy Corporation serves as a general partner and owns most of the limited partner units of SEP. About 60% of SE's value is their stake in SEP. These are really the crown-jewel assets for Spectra that provide these very steady cash flows as well as very good, profitable expansion opportunities in a long runway of expansion projects through the end of the decade and likely beyond, benefiting from low natural gas prices.

The problem with SE is that in exchange for being a traditional corporation that pays qualified dividends--you don't get a K-1, you just get a 1099, so it's very easy to own--is that you have some other assets that they own that aren't as attractive. The regular jewels, as opposed to the crown jewels, you might say. There's Union Gas, a local gas-distribution utility in Canada; it's an OK business, but it doesn't have the same level of profitability that the SEP assets here in the United States do. You've got their gas-gathering-and-processing operation up in Western Canada. Business has gotten better. They've taken a lot of the commodity-price sensitivity out of that business, but still not nearly as attractive as long-haul transportation.

Then, they have a stake in a joint venture called DCP Midstream. This is just plain-old natural gas gathering and processing. This is the volatile end of the business. Phillips 66 (PSX), which is a refiner--plenty of volatility there--owns the other half of it. For Spectra's three-year financial plan, they literally just zeroed out the contribution from DCP Midstream. They don't see themselves in a position to take any cash out to help fund their dividend. That said, if you have a very conservative forecast and you still expect to be able to grow your dividend at an 8% or 9% type of clip, that's--to me--better than an aggressive forecast that assumes that energy prices are going to rebound, things are going to get much better very quickly, and then you need a big margin of safety on top of that in order to hit your dividend objective.

So, what I'd say is SE is a little bit lower quality, a little higher risk. There's also some more leverage on the balance sheet. The yield is somewhat lower than SEP. SEP is closer to 6% lately; SE is closer to 5%. The growth rates are pretty similar, in the 8% or 9% range. If you can own the master limited partnership, I'd rather own SEP. But if you can't own partnerships directly, SE stands up very well as a substitute. That's, in fact, how I've used it; I own SEP in our Dividend Select model portfolio in the newsletter. SE is the automatic designated stand-in for people who can't own SEP.

Glaser: Recently, there was a transaction between SE and SEP that I know raised some concerns with you and our analysts. Can you talk a little bit about that?

Peters: Yeah, this was not really characteristic of the way Spectra has operated historically. This is what you see in the energy-transfer family--constantly shuffling assets between different entities and you don't really have a good insight into who is getting what. But Spectra Energy Corporation, SE, had to contribute some value--some additional capital--to its stake in DCP Midstream. Its balance sheet has struggled a little bit, and they decided to transfer ownership stakes in two natural gas liquids pipelines from SEP to SE and then pass those along to DCP Midstream.

They have moved that valued out of SEP, but they haven't been real clear on how SEP is going to be compensated. So, we took a pretty cautious view, brought our fair value estimate down by $5, from $55 to $50. But even with that, I don't expect this to become a pattern. I do think that there is a very good chance that when the transaction is actually settled here over the next month or two, we'll find that SEP is being compensated fairly. That's certainly what I hope for as an outcome.

With the units trading in the low $40s, yielding close to 6%, and having that really secure base of cash flow with which to fund their distributions even in tough times and continue to grow it, I really like the valuation right now. The reputation has been a little bit tarnished--I think that's worse than even the value potentially being lost here--but this is still a name that I think is very well positioned for this downturn. It's one of the few that I still have confidence in through this downturn and beyond.

Glaser: Josh, thanks for your take on Spectra today.

Peters: Thank you, too, Jeremy.

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