The market’s volatility is starting to make me feel like Bugs Bunny toward the end of “Falling Hare.”
That’s the classic WWII-era cartoon in which gremlins sabotage the bomber Bugs is piloting, ultimately sending it into a heart-stopping downward spiral that miraculously stops just before it hits the ground.
This week, for instance, Spectra Energy Partners LP (NYSE: SEP) plunged in an apparent reaction to TransCanada (NYSE: TRP, TSX TRP) subsidiary TC PipeLines LP’s 35% distribution cut.
That news also sparked an even bigger decline in units of Spectra’s fellow Enbridge (NYSE: ENB, TSX: ENB) subsidiary Enbridge Energy Partners LP (NYSE: EEP), which could now be at risk of another distribution cut fresh on the heels of last year’s 40% cut.
All of this action comes courtesy of the Federal Energy Regulatory Commission’s (FERC) recent decision to no longer include income-tax allowances in cost-of-service rates for interstate pipelines owned by master limited partnerships (MLPs).
Given that 55% of TCP’s revenues are derived from cost-of-service rates, the stock had already been marked down significantly as a result. But TCP’s distribution cut plus newfound orphan status–TransCanada does not plan to feed it any new assets–is a veritable one-two punch. So it’s considering strategic alternatives including the possibility of converting into a corporation.
It’s important to note that TCP has taken a conservative, proactive approach to the rule change as well as its orphan status.
We don’t know yet how Enbridge plans to respond.
But EEP expects that its distribution coverage could decline to 1.0 times again if the FERC rule is implemented as expected, which is disappointing given that last year’s distribution cut was intended to restore ample coverage of its payout. Now EEP is essentially back in the same situation it was earlier, which could portend a similar fate as TCP.
By contrast, SEP has stronger distribution coverage and lower leverage. And only about 27% of its revenues are exposed to the rule change. Additionally, even before the rule change, SEP noted that it had made a number of upgrades to its systems that have yet to be reflected in rates. With each new rate case, SEP will move to offset the loss of the income-tax allowance by seeking recovery on these improvements.
Nevertheless, there’s still the question of how the rule change has affected Enbridge’s strategy with regard to SEP longer term. We’ll learn more about that when the entire Enbridge complex reports earnings next week.
At minimum, SEP could decide to follow the lead of many of its peers and halt distribution growth. Beyond that, I would assume that Enbridge would still need SEP as a funding vehicle to help it de-lever following last year’s mega-merger with Spectra.
Absent another distribution cut, Enbridge won’t be able to use EEP for that purpose based on its current yield. But SEP should still be viable in that regard.
There are other possibilities as well, such as swapping cost-of-service assets with the parent for those with negotiated or market rates.
Lastly, a number of companies have filed for an expedited rehearing with the FERC and are also seeking clarification of a number of details relating to the rule change. While it’s probably too much to hope for an outright reversal from the agency, the industry’s aggressive pushback could end up winning some concessions.
This was a busy week in terms of earnings news. Let’s review a few.
Propane distributor AmeriGas Partners LP (NYSE: APU) reported that fiscal second-quarter adjusted EBITDA climbed 14% year over year, to $309.5 million, missing analyst estimates by 8.1%.
Although the weather was 14.2% colder than last year, uneven weather during the quarter caused lumpy month-to-month results, with February 10% warmer than average, for example.
But overall, colder weather helped push volumes up by 10%, while margins rose slightly despite the fact that propane prices were up 19% from a year ago. As a distributor, AmeriGas actually performs better when propane prices decline.
Propane distribution is a highly seasonal business. With the fuel primarily used for heating, the two quarters that overlap winter are when AmeriGas generates the vast majority of annual earnings.
With results for these two crucial quarters in hand, AmeriGas lowered its estimate for full-year adjusted EBITDA by 5.2% based on the midpoint of the new guidance range of $625 million to $645 million. The new guidance implies potential growth of 8.0% for the full fiscal year, though it still fell short of analyst estimates by 2.2%.
An earnings miss along with lowered guidance on a down day for the market was enough to push units of AmeriGas lower by more than 4% at one point.
Like many of its MLP peers, AmeriGas is halting distribution growth to improve coverage of its payout while lowering leverage.
The two significantly warmer-than-average winters in 2016 and 2017 have led to falling distribution coverage. While the partnership expects to finish the fiscal year with coverage above 1.0 times, it’s looking to restore coverage to a more comfortable 1.1 times to 1.2 times. AmeriGas is now a buy below $45.
Midstream master limited partnership Enterprise Products Partners LP (NYSE: EPD) reported first-quarter distributable cash flow per unit jumped 20.8% year over year, to $0.64, beating analyst estimates by 16.4%.
Revenues surged 27%, to $9.3 billion, beating estimates by 14.7%.
Management attributes these results to record volumes on its liquids and natural gas pipelines, as well as the fact that the first quarter is typically its seasonally strongest quarter of the year.
In terms of individual segment performance, the big winner was the petrochemical division, which saw earnings surge 50%, to $272 million, thanks largely to EPD’s propylene business.
The petrochemicals business is more cyclical than typical midstream operations, but EPD appears to have timed its entry right to benefit from the resurgence of this industry.
Well, that is, except for one thing. EPD’s customers for these products may have exposure to the potential trade war between the U.S. and China.
I am not alone in this concern. EPD’s units got hit hard in early April after China revealed its proposed tariffs would target the U.S. chemicals and plastics industries.
Surprisingly, only one analyst brought this matter up during the earnings call, but he was focused on propane exports, not petrochemicals. To that, CEO James Teague joked that he got “out of the fetal position in the corner of [his] office” because the global demand for the commodity is there regardless of where the flows go.
Also surprisingly, there was only one FERC-related question during the call–the recurring question of whether it’s time to convert to a C-corp. It sounds like management is still fine with operating as an MLP.
As the largest MLP, EPD has helped lead the way toward the sector’s shift to more of a self-funding model. During the quarter, the partnership retained $458 million in excess distributable cash flow, which it used to fund nearly half of the quarter’s growth spending.
Management expects to invest between $3.2 billion and 3.4 billion in growth capital this year.
EPD also remains one of the MLP sector’s more conservative players on the borrowing front, with leverage at 4.1 times at the end of the quarter.
Looking ahead, two important growth projects are entering full service during the second quarter.
The Midland-to-ECHO pipeline will extend a system that allows producers in the prolific Permian Basin to move multiple grades of crude oil to the Gulf Coast.
And EPD’s PDH plant has begun producing propylene while operating at an 84% average utilization rate. EPD is a Hold.
The consumer packaged goods industry has been getting pummeled by the market.
Case in point, Mondelez International (NSDQ: MDLZ) reported earnings that beat analyst estimates for the top and bottom lines by 1.7% and 1.1%, respectively, management reaffirmed full-year guidance, and its shares still sold off.
When the entire industry is facing margin pressure from rising freight costs, it seems silly to punish a company for not boosting its guidance.
With about six weeks to go until the contract we sold expires, there’s still time for the stock to recover back above our strike price.
Also, the earnings call revealed the one potential headwind I was worried about, namely the new CEO’s completion of his strategic review of the company, isn’t expected to be completed until the end of the summer.
FNF Group’s (NYSE: FNF) first-quarter earnings gave the stock a nice boost, with results beating estimates on both the top and bottom lines for what is typically a seasonally weak quarter.
As a result, the share price of the underlying stock is back around where it was when we opened the trade.
Despite Wall Street’s modest expectations for the quarter, I had been somewhat concerned that the housing market, particularly for existing homes, had recently been trending weaker.
But I wasn’t thinking about FNF’s business in the commercial real estate market, which saw an increase in activity during the quarter.
Wall Street wasn’t expecting all that much from Buckeye Partners LP’s (NYSE: BPL) first quarter.
With the partnership still in the midst of repurposing about 5% of tank capacity at its largest marine terminal in the Caribbean, the market was looking for a flat result year over year.
Further, management had previously said that distribution coverage would drop below 1.0 times at varying times during the year, but that full-year coverage should come in around 1.0 times.
But even with these diminished expectations, Buckeye still managed to disappoint. Adjusted EBITDA (earnings before interest, taxation, depreciation, and amortization) came in at $261.7 million, down 5.7% year over year, while missing analyst estimates by 5.3%.
Additionally, Buckeye’s distributable cash flow fell 11.3% year over year, to $169.2 million, falling short of estimates by 6.2%.
Consequently, cash distribution coverage dropped to 0.91 times for the quarter. For the full year, management expects distribution coverage to come in between 0.90 times and 0.95 times.
Nevertheless, management reiterated their (and the board’s) commitment to maintaining the distribution at the current level while working through this period of weakness. They see a distribution cut as an absolute last resort.
And they’re using every tool available to them to uphold their covenant with unitholders. That includes the private placement earlier this year that raised all their equity growth capital for the next two years, and it also means refinancing maturing debt with junior subordinated notes.
These moves were made with an eye toward maintaining its payout while keeping an investment-grade credit rating by pacifying credit raters.
At this point, the value in the MLP is entirely embodied by its distribution. Meaningful unit-price appreciation probably won’t happen until the company demonstrates that it has successfully managed through this rough patch.
The main culprit for this performance continues to be the loss of Venezuelan oil giant PDVSA. Buckeye booted the company from its Bahamas terminal about a year ago, and now they’re someone else’s problem.
But that decision also temporarily sidelined a portion of Buckeye’s terminal capacity until it finishes repurposing the storage for lighter grades of crude than the heavier stuff Venezuela produces. This process takes about nine months, and it sounds like some of that tankage will finally hit the market again this quarter.
The other problem is that the oil market is currently in backwardation–spot prices are higher than futures prices.
Storage performs best in terms of both rates and utilization during periods of contango. When futures prices are higher than spot prices, producers and commodity traders are willing to pay up to store more barrels now with hopes of selling them at a better price in the future.
Obviously, Buckeye has operated during both periods. And while storage demand during contango can still lead to capacity utilization of around 92% to 94%, rates for storage are lower and contracts are shorter.
During the quarter, Buckeye did announce some promising growth initiatives. These include the expansion of its Chicago Complex thanks to a long-term contract with BP, as well as a joint venture with Phillips 66 Partners LP and Andeavor to construct a new marine terminal in South Texas.
However, I was surprised to learn that Buckeye has also agreed to acquire joint-venture partner Trafigura’s 20% stake of Buckeye Texas. At the same time, it sounds like that helped tee things up for the joint venture with Phillips and Andeavor. Still, given the tight situation, I would prefer not to see any quasi-acquisitions during this period.
Although the repurposed tank capacity is expected to hit the market during the second and third quarters, these quarters tend to be seasonally weaker for Buckeye. Accordingly, management does not expect a meaningful rebound in business performance until the fourth quarter.
Where does that leave us?
I’m pretty disappointed by these results, as well as management’s forward guidance.
With the private placement earlier this year and apparent access to other forms of private capital, Buckeye has bought itself two years to return to ample distribution coverage, though at the cost of diluting existing unitholders.
But a lot of things have to go right, and there’s not much room for things to go wrong.
Our sister service Utility Forecaster has held Buckeye through multiple downturns, including the last energy crash.
However, in many ways, the current situation is more challenged than it was two years ago. Last time around, the oil market was in deep contango just as Buckeye just happened to be completing a major storage project.
It’s reassuring that management understands investors are mainly here for the distribution. But you can’t sustain a distribution indefinitely without growth.
In the near term, I’m willing to give Buckeye a bit more time.
But I no longer see this name as a long-term holding. In particular, I’m concerned about what happens two years hence, when the holders of Buckeye’s private placement start collecting a cash distribution instead of the payment-in-kind units they’re currently accruing.
Now, a lot can happen in two years. But with 2018 perhaps even more of a transition year for the partnership than investors anticipated, it’s starting to feel like two years may not be quite long enough.
If Buckeye’s fundamentals were stronger, I would be more comfortable having the stock put to us when the option expires in two weeks, and then selling covered calls against it. However, I’m considering rolling instead.