A December to Remember

This could be a fateful month for income investors.

For one, the Federal Reserve is widely expected to raise short-term rates by another quarter-point at its meeting next week.

While the market has already priced in that outcome, the central bank could still surprise investors with a more hawkish outlook than expected.

To be sure, the Fed has promised to pursue a course of gradual monetary tightening. And, in general, we would expect the central bank to carefully manage market expectations regarding its next moves—even after Jerome Powell takes the helm in February.

Instead, the so-called Dot Plot, which gathers predictions from Fed policymakers, is where rumblings of dissent typically appear.

These forecasts are disseminated every other meeting. The last Dot Plot appeared in September, so another one is due next week.

One of the surprises in the September table was that the Fed’s long-run forecast for its federal funds rate actually declined by a quarter-point, to 2.75%. This is the central bank’s prediction of the neutral rate for the economy, where inflation is running neither too hot, nor too cold.

But such a muted expectation also suggests that dividend stocks won’t face quite the same level of competition from fixed-income securities as they have during past tightening cycles.

So I’ll be watching to see the extent to which the long-run forecast changes.

The other thing to watch out for is the number of times the Fed expects to raise rates next year.

On that score, right now there’s a big disconnect between traders and central bankers.

Action in the federal funds futures market implies two quarter-point rate hikes next year, which would take the upper bound of the benchmark rate to 2.0%.

But the Fed’s own policymakers expect to raise rates three times next year.

Of course, we’ve seen similar disconnects before. But in the expectations game, every quarter-point increment can have significant consequences.

Uncle Sam’s Bite Guard

While the House tax bill is a modest positive for MLPs, the Senate’s version is potentially worrisome.

That’s because its initial iteration did not fully preserve the relative tax advantage between corporations and pass-through entities, at least when it comes to ordinary income.  

Of course, this distinction may seem largely academic to retail investors, particularly those who buy and hold MLPs with an eye toward passing them along to their heirs.

In such cases, the proposed legislation probably wouldn’t affect unitholders until they decide to sell, since the vast majority of MLPs’ distributions are tax-deferred.

But it could affect demand for MLPs from other types of investors with different considerations, and it might also dampen the creation of new MLPs in the future.

The good news is that two senators stuck to their guns and won a key concession from their peers. Owners of pass-through entities will get a 23% deduction that would bring the net rate on ordinary income much closer to the one proposed by the House.

Of course, none of this is a done deal. Now that both houses of Congress have passed their own versions of the bill, the two chambers still have to hash out their differences via conference committee.

That negotiation will produce a single bill that will then be submitted for another vote in the House and the Senate.

One thing that could prove helpful is if Congress backs away from a 20% corporate tax rate by a percentage point or two.

For instance, a 22% rate would roughly preserve the status quo in the gap between the net effect of corporate and pass-through tax rates on income. That is, assuming there’s not a similar adjustment that reduces the proposed deduction on pass-through income.

There are other items that could see similar tweaks, thereby playing a role in whether the tax bill stays within the $1.5 trillion budgeted for it.

Congress is aiming to deliver a bill to the president by Christmas.

Portfolio Update

In company news, there are some interesting stats about which midstream players have the biggest share of takeaway capacity in the Permian Basin. The West Texas shale formation is the fastest-growing oil field in the U.S.

The Permian’s current production—around 2.7 million barrels per day—exceeds the region’s existing pipeline capacity. Consequently, midstream players are working to expand takeaway capacity by 36% this year, to around 3 million barrels per day.

Two new pipelines along with expansions of existing infrastructure will come on line by mid-2018, adding another 790,000 barrels per day of takeaway capacity. Our portfolio has exposure to both scenarios.

Enterprise Products Partners LP (NYSE: EPD) is building the 450,000 barrel per day Midland-to-Sealy line. Meanwhile, the Energy Transfer empire is adding another 100,000 barrels per day of capacity to its Permian Express 3 line.

Both Energy Transfer and EPD are among the leaders in terms of overall share of takeaway capacity in the Permian. The Energy Transfer complex owns 23% of capacity, while EPD will control 17% of capacity once its new pipe commences operations.

EPD and ETE remain Buys.

One of our concerns about Gaming and Leisure Properties Inc. (NYSE: GLPI) is that the real estate investment trust’s portfolio of properties is essentially split between two tenants—Penn National Gaming Inc. (NSDQ: PENN), from which it was spun off back in 2013 and Pinnacle Entertainment Inc. (NSDQ: PNK).

In early November, rumors began to circulate of a possible deal between Penn and Pinnacle. While one Pinnacle executive initially dismissed such speculation as “strange,” late last week the casino operator confirmed that it was negotiating to be acquired by Penn in a cash-and-stock deal.

This transaction would mean that GLPI will soon have only one main tenant.

That brings up another concern.

Both Penn and Pinnacle have significant leverage—just under 6.0 times on a net debt-to-EBITDA basis.

A cash-and-stock deal would limit the deal’s effect on leverage, as would $50 million in possible synergies. But leverage will still rise overall.

The good news is that GLPI gets paid rent before its tenants’ debt holders get paid principal and interest.

And regional casino operators face less competition and have lower exposure to the boom-and-bust cycle of their peers in Las Vegas and Atlantic City.

Also, the stocks of both tenants, which were already up strongly for the year, surged even further on news of a potential deal. Both are now up by more than 100%.

That makes Penn’s shares a powerful currency, though I don’t know if it’s powerful enough for a $2.6 billion company to absorb a $1.8 billion company in an all-stock deal. But an equity-for-equity transaction would go a long way toward allaying our debt concerns.

While GLPI has gained nearly 18% year to date, it hasn’t moved all that much since rumors of a deal first emerged. That’s okay. With a nearly 7% yield, the stock doesn’t need to rise all that much to stay in our favor anyway. GLPI remains a Buy.

Stock Talk

pipeline

pipeline

Ari

Today EPD lost over 2% must be something going on . There results reported today seemed very good. what do you think??

Ari Charney

Ari Charney

Hi,

I thought fourth-quarter results looked great–they beat Wall Street’s estimates by a wide margin on both revenue (up 30%, beating estimates by nearly 20%) and EBITDA (up 14%, beating estimates by nearly 7%).

Looking ahead, EPD plans to invest about $3 billion this year in growth capital, also well above analyst expectations.

Honestly, I’m not seeing much to worry about.

But two things came up during the analyst call that may have spooked some investors or disappointed others:

1) One analyst asked about whether the MLP structure remains optimal for EPD in light of tax reform.

Management said the MLP structure works for them as far as access to equity capital at a reasonable price is concerned.

But they did say they would continue to monitor how the market values midstream C corps vs. MLPs. However, they also noted that the prospect of conversion is not something “to be taken lightly.”

The market likes certainty, so a candid response where the company admits something that anyone would reasonably expect them to be doing probably wasn’t what it was looking for, especially given the potential tax implications of conversion for longtime unitholders.

But it sounds like conversion remains highly unlikely.

2) Another analyst asked about what their plans are for the excess cash flow they’ll be generating once they become fully self-funding on the equity side of their financing.

The market was probably looking for the company to say it would ramp up distribution growth back to its former levels, but management demurred by noting it was premature to speculate.

Best regards,
Ari

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