MELIORA CAPITAL MLP SECTOR REVIEW HOSTED BY … · MELIORA CAPITAL Meliora Capital is a boutique...
Transcript of MELIORA CAPITAL MLP SECTOR REVIEW HOSTED BY … · MELIORA CAPITAL Meliora Capital is a boutique...
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MELIORA CAPITALMLP SECTOR REVIEW
HOSTED BY COMMERCE BANKApril 8, 2016
www.melcapital.com
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DISCLAIMERMeliora Capital, its officers and employees may have an interest in some or all of the securitiesmentioned herein. The information set forth herein has been derived from sources believed to bereliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis ofthe securities, companies, or industries involved. In addition, many of the statements made hereinare opinions based on available information and cannot be guaranteed or construed as fact.
The information presented herein is provided for discussion purposes only and may not bereproduced. No offering of interests in Meliora Capital or any affiliated entities is made or implied asa result of the circulation hereof. The discussion herein is qualified in its entirety by reference to thedetailed information, including the substantial risks associated with investments.
The historical return data for investments set forth herein is for informational purposes only. It shouldnot be construed as representative of the returns that may be achieved in the future. There is noguarantee that any of the projections set forth herein will be obtained. Opinions and estimates setforth herein involve a number of assumptions which may not prove valid and may be changedwithout notice. The projections and forward-looking statements included herein are subject to risks,uncertainties and assumptions. Some important factors that could cause actual results to differmaterially from those in any forward-looking statement include the following: changes in interestrates and financial, market, economic or legal conditions, among others.
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MELIORA CAPITALMeliora Capital is a boutique investment management firm. We believe thatrigorous analysis and active portfolio management combined with excellentclient service will help our clients and firm succeed and grow.
Meliora {MEH-lee-OR-a} – 1) The pursuit of better. 2) To make better. 3) To Improve.
Meliora is not just a name, but an ethos for how we intend to run our businessand manage client capital. Never be satisfied. Always try to improve. It alsorepresents our promise to the clients we are honored to serve. Much like doctorsor attorneys, we think of our firm as a “practice.”MLP StrategyMeliora possesses a unique expertise and approach in the MLP sector.Multi-Cap Value StrategyFocused domestic stock strategy with flexibility to invest in most attractive areas.Truly a “multi-cap” strategy as the strategy currently owns companies currentlyranging from a micro-cap bank based in Defiance, OH to Apple, Inc.
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WHAT MAKES AN MLP AN MLP?Being an energy producer?...No.
Operating a pipeline?...No.
Paying out the majority of quarterly cash flows?...No.
Generating 90% qualifying Income?...Yes.
Qualifying Income - income and gains derived from the exploration,development, mining or production, processing, refining, transportation orthe marketing of any Mineral or Natural Resource...
as well as certain passive-type income including interest, dividends and realproperty rents.
Traditional MLPs – Midstream Energy (Meliora’s Focus Area)
Non-Traditional MLPs – Cemeteries, Amusement Parks, Fertilizer, etc.
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INVESTMENT & TAX ATTRIBUTES OF MLPS
Partnership units are publicly traded just like shares of stock
Pass-through structure offers single layer of taxation – The Key Advantage
Unitholders receive a K-1 for each MLP held during a tax year
Most MLPs pay out the majority of generated cash flows each quarter Tax shield provided by non-cash depreciation expense
70%-90% of cash distributions in early years are often tax deferred
Tax Complexity Potential need to file state tax returns
Passive losses held in suspense
Depreciation recapture upon sale
UBTI complicates ownership in IRAs and other tax exempt entities
Estate Planning Benefits of Holding Until Death (Basis Step-Up)
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WAYS TO OWN MLPS
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Passive Strategies Active StrategiesExchange
TradedNote
Exchange Traded Fund
Closed-End Mutual Fund
Open-End Mutual Fund
Limited Partnership
Fund
Separate Account
Liquidity Daily Daily Daily Daily Typically Quarterly
Daily
Tax Reporting
1099 1099 1099 1099 Consolidated K-1
Multiple K-1s
Investment Tax Status
Taxable Note
Taxable C-Corp
Taxable C-Corp
Taxable C-Corp
Partnership Tax Status
Partnership Tax Status
Additional Corporate Level Tax Drag
No Yes Yes Yes No No
Taxation of Distributions
Interest Income
Largely Return of Capital
Largely Return of Capital
Largely Return of Capital
Largely Return of Capital
Largely Return of Capital
Generates UBTI
No No No No Yes Yes
Bank Credit Risk
Yes No No No No No
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PASSIVE VS ACTIVE Passive management is predicated upon markets being close to
fully efficient. The friction created by the investment and tax attributes of MLPs makes
them difficult to passively replicate.
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ETF/Index 2015 Return 9/30/10 – 12/31/15Alerian MLP ETF (25.7%) 9.5%Alerian Infrastructure Index (31.7%) 26.4%
ETF/Index 2015 Return 9/30/10 – 12/31/15S&P 500 ETF 1.3% 99.0%S&P 500 Index 1.4% 100.1%
Index replication via individual ownership would result in 25-30 K1s annually
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CURRENT ENVIRONMENT
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“Why the MLP Business Model May Be a Goner”
Barrons – September 2015
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“MLP Pain May Not Be Done, With Oil Hopes Still Too High”
Bloomberg – January 2016
“Turns Out MLPs Aren’t Immune to the Oil Market”
Bloomberg – February 2016
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ALERIAN MLP INDEX VS. S&P 500
Superior Long-Term Performance…12/31/95 – 3/31/16
Index Total Return AnnualizedAlerian MLP Index 957.7% 12.3%S&P 500 Index 388.0% 8.1%
Source: Bloomberg
Until Recently!9/30/14 – 3/31/16
Index Total Return AnnualizedAlerian MLP Index -43.3% -31.5%S&P 500 Index 7.8% 5.1%
Source: Bloomberg
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GREATEST STRENGTH OF MIDSTREAM MLPS LEADS DIRECTLY TO THEIR ACHILLES HEEL
MLPs depend on cooperative capital markets to fund incremental growth capital projects and to refinance maturing debt
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Cash Flow Stability
Ability to Pay Out Most Cash
Flow
Dependence on External
Capital Markets
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$2,000,000,000
$4,000,000,000
$6,000,000,000
$8,000,000,000
$10,000,000,000
$12,000,000,000
Pipeline - High Yield Issuance - Trailing 4 Qtrs
Chart Data: Bloomberg
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THE TIDE HAS GONE OUT
Challenged midstream business fundamentals Midstream is bearing its share of the entire energy value chain’s stress
Macro level volumes in decline
Margins pressured due to over-capacity
Counter-party risk uncertainty
Financial markets responding to fundamentals and magnifying problems at times Feedback Loops
Lower unit prices = higher cost of capital
Higher cost of capital = less accretion for growth projects
Less accretion for growth projects = lower distribution growth
Lower distribution growth = further reduced unit prices
Even lower unit prices = distribution sustainability?
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13IT’S NOT THE STRUCTURE, IT’S HOW YOU USE IT
IS THE MLP STRUCTURE FLAWED?
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5 KEY ATTRIBUTES TO MLP SUSTAINABILITY
Market Power
Asset quality
Competitive environment
Cash Flow Stability
Commodity price exposure
Contract terms/tenor
Scale/Diversity
Operational flexibility
Balance Sheet
Debt/EBITDA
Distribution Coverage
Distributable CF/
Distributions Paid
EMES, HCLP(Frac Sand)
LINE, BBEP, VNR(Upstream)
AZUR, SXE(Small G&P) KMI, CEQP KMI
Examples of MLPs under financial distress (distribution cuts, restructurings)
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In recent years, a large wave of management teams and their all too obliging investment bankers “went rafting” with fresh IPO capital from yield-hungry investors. This included a historic amount of non-traditional MLPs, many lacking in market power,
scale and cash flow stability (e.g. frac sand, refiners, petchem, minerals and shipping) in the 3 years ended June 30, 2015:
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MLP Type # of IPOs IPO Proceeds ($ mil) Avg Offering Size ($ mil) Avg Price Chg to Date
Non-Traditional 23 $5,519 $240 -24.0%Traditional 25 $11,338 $450 -3.9%
More seasoned MLPs also found themselves in a tight spot as they struggled to keep pace with infrastructure needs from rapidly growing domestic hydrocarbon production.
Source: Bloomberg
Source: Credit Suisse
The resulting capital strain pressured distribution coverage and leverage in many cases.
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MIDSTREAM MLPS ARE RESILIENT
The post-Thanksgiving 2014 (OPEC non-cut) world has put remarkable stress on U.S. Energy Cash flows are stressed, common equity is uneconomic & bond markets are fractious at best
We’ve seen this play out before the last time capital markets seized up, in 2008-09
MLPs and their management teams continue to demonstrate financial flexibility & creativity Creative Financing Solutions
Preferred EquityPlains All American – Raised $1.6 bil in 8% PIK Preferred when common equity yielded 12.8% Targa Resources – Raised $1.0 bil in 9.5% Preferred (with warrants) when common equity yielded 15.8%
Asset SalesNGL Energy Partners – Sold GP of Transmontaigne for $350 mil., and increased EBITDA by $20 mil.
Joint VenturesHaven’t seen much yet, but saw a lot of this in 2008-09
Can cut distributions if necessary Bankruptcy risk for most MLPs very remote. Bonds look very cheap.
Market power of midstream seems underappreciated at times
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IDRS: WRONGLY ACCUSED OF BEING NO GOOD, VERY BAD
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Incentive Distribution Rights (IDRs) are typically presentwith the General Partners for most traditional MLPs.
Pros: Reward management teams for maintaining and growing
partnership distributions Great form of results-based incentive compensation
Cons: As IDR payments grow, they can become a significant part
of an MLP’s cost of equity. Can create a conflict of interest between GP & LP
Source: Wells Fargo
Tier Range LP/GP Split1st Target $0.00 $1.61 98% 2%2nd Target $1.61 $1.75 85% 15%3rd Target $1.75 $2.10 75% 25%High Splits $2.10 Thereafter 50% 50%
Example IDR Tiering Structure
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Vocal MLP bears of late like to cite negative free cash flow and accuse MLPs of borrowingfunds to pay their distributions This is intellectually dishonest
Free Cash Flow (FCF) – A flawed metric to measure an MLP’s ability to fund an existingdistribution because Growth CapEx is discretionary, at least in the intermediate run. FCF = Operating Cash Flow – Capital Expenditures
MLPs use a non-GAAP metric to measure cash available for distribution The key distinction from FCF is that CapEx is bifurcated
Maintenance CapEx: Funds to maintain existing assets and cash flow
Growth CapEx: Funds invested in new assets which will result in incremental cash flow DCF = EBITDA – Interest – Taxes – Maintenance CapEx
But can’t management teams play games with “maintenance” vs. “growth” CapEx to inflateDCF? Yes, but they can’t hide for long because any cheating will show up via rising leverage ratios
DCF > FCF WHEN ANALYZING MLPS
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OUTLOOK
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CURRENT VALUATIONS VS HISTORYMetric Current 10 Year Average
Average MLP Yield 8.8% 7.1%Average Price/DCF 9.5x 11.9x
Spread to 10 Year Tsy 7.0% 3.4%Spread to High Yield 0.4% (0.8%)
Source: Wells Fargo, Bloomberg and Company Filings
Commodity prices matter At the macro level, midstream MLPs need volumes to stabilize and an eventual return to growth
would be most welcome Current commodity prices are not sufficient for volume stability
Counterparty risk issues will continue to arise Sabine Oil & Gas Ruling Williams / Chesapeake
More distribution cuts likely Quantity and magnitude depend on commodity price and capital markets
Most important factor in successfully investing in any asset is almost always the price paid Our view is that current MLP valuations discount all of the above and more
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The trauma of the last year and a half will have positive implications for long-term MLP model sustainability Markets have rewarded MLPs with lower leverage & higher coverage (e.g. EPD, MMP)
Rest of the sector is likely to follow that path, with less focus on growth for growth’s sake
Constrained capital markets will lower near term capex which will eventually alleviate concerns of “overbuild” and tight margins
Feedback loops work both ways
Recovering bond market and MLP unit prices will have a positive self-reinforcing effect
Best cure for low prices is low prices
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CHAS CRAIG, CFA, CPAPRESIDENT
MELIORA CAPITALP: (918) 619-6752
[email protected] S. MAIN ST., STE. 500
TULSA, OK 74119
Contact
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J.P. SZAFRANSKI, CFACHIEF EXECUTIVE OFFICER
MELIORA CAPITALP: (918) 619-6710
[email protected] S. MAIN ST., STE. 500
TULSA, OK 74119