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Tuesday, March 29, 2016

The Great MLP Crash
Plunging oil prices threaten to trim historic multiples and dampen M&A market

Source: CSP Magazine
By Samantha Oller, Senior Editor/Special Projects Coordinator

What goes up must come down.

Investors’ great rush toward master limited partnerships (MLP) is now in reverse. And for good reason: One of the major draws that heated up the MLP market—the North American energy production boom—has come crashing back to earth, and crude prices are plummeting.

How much have MLPs dropped? Consider the direction of the Alerian MLP index, which tracks 50 large- and midcap energy MLPs, including downstream-focused entities such as Sunoco LP (SUN) and Global Partners LP (GLP). It fell 38% in 2015. The S&P 500, in comparison, slipped less than 1%.

“The woeful performance of MLPs and their perceived correlation to oil prices has triggered the great unwind of all of the capital that was put into them over the last five years,” says Hinds Howard, principal and an associate portfolio manager specializing in MLPs for CBRE Clarion Securities, Radnor, Pa.

How much capital was removed? “Tens of billions” of dollars, he estimates. While the MLP sell-off is real, it is also indiscriminating, punishing all entities regardless of the level of their exposure to falling oil prices.

“We’ve definitely seen investor sentiment play a huge role,” says Maria Halmo, director of research for Dallas-based Alerian, a provider of MLP analytics and benchmarks, including the Alerian MLP index. Many investors over the past decade have gotten into MLPs without understanding exactly how they operate, she says, or the level of their exposure to commodity prices.

“When they saw oil prices falling,” Halmo says, “they got rid of all of their energy exposure in total, which included their MLP exposure, even though it’s a different business model.”

Investors are punishing supply-driven, gathering/processing MLPs the most, because they are closest to the wellhead and production cuts. In fact, under pressure from falling stock prices, every upstream MLP has cut, suspended or eliminated its distributions—the profit paid back to unit holders—over the past year, says Halmo.

This is dramatic. When this tax-advantaged vehicle was launched during the Reagan administration, it sought to extricate America’s energy dependence from the stranglehold of OPEC. One of the boons of MLPs is its high-yield structure and the handsome returns it promised investors, who are called “unit holders.”

Many midstream and downstream MLPs that operate on still-healthy demand-driven volumes have had a somewhat easier go because they are “downstream of all of the pain,” says Howard of CBRE Clarion. And until recently, despite relatively lower stock prices, they had been able to increase their distributions consistently.

But in January, the first of the downstream MLPs buckled. GLP, which owns terminals and owns or supplies more than 1,000 gas stations in the Northeast, cut its distribution for the first time since its 2005 IPO filing.

Management cited “severe headwinds in the crude-oil market,” while analysts pointed to a challenging capital market for MLPs. The truth may be somewhere in between.

“With stock prices dropping, you’ve got a Catch-22 where your [investors] are looking for steadier increasing dividends, but most of your qualifying income is relatively stagnant,” says one executive experienced on the finance side of MLPs, who requested anonymity. “You’re predominantly going to be growing that through acquisitions. But if your stock prices are dropping because they’re driven by oil prices, then obviously your cost of capital is going up.” An MLP may still be able to raise capital, but it is more costly and dilutive to its members.

Meanwhile, the MLPs connected to some of the industry’s most active acquirers—MPLX LP (Marathon Petroleum Corp.), CrossAmerica Partners LP (CAPL) (CST Brands), and Energy Transfer Partners LP (ETP) (Sunoco and Stripes)—all have seen their values erode over the past year.

That makes the general outlook for c-store M&A in 2016 somewhat muted, compared to the massive deals and multiples of the past two years.

“Most of the MLPs’ stock prices are getting hammered pretty good,” says Dennis Ruben, executive managing director of NRC Realty & Capital Advisors LLC, Scottsdale, Ariz. “That’s going to put pressure on them because obviously they don’t want to do things that are not accretive to their earnings or bottom line. So that will make them more focused on whether they bid on deals and which deals they bid on.

“What it means is slightly fewer people in the marketplace bidding, and those who are bidding will be more conservative on prices they offer,” he says.

Downstream of the Pain?

MLPs have a money problem.

“Back when the MLP prices were so high and capital was relatively easy and less costly, those guys were making tons of acquisitions because they could pay much higher multiples because of the tax benefits—they weren’t subject to the double taxation,” the financing expert says. The cost of capital was lower because of the tax advantages, enabling MLPs to pay multiples of two turns or higher than their traditional competition.

NRC’s own research looked at the biggest deals of the past 24 months, or those involving 50 stores or more. “All but four or five of 28 were bought by MLPs or affiliates,” Ruben says. “That’s just amazing—MLPs wanted to buy about everything.”

But today’s bearish market has short-circuited the growth engine.

“The biggest problem for MLPs in this environment is capital market access,” says Halmo of Alerian. “If they had a project they were in the process of building, they will need to continue to fund that project. And getting capital to continue to build these projects has been difficult.”

As MLPs’ EBITDA (earnings before interest, taxes, depreciation and amortization) declines and debt levels grow to fund already-committed-to projects, it calls into question their ability to continue to spend money on growth projects that will increase EBITDA, especially when the cost of that debt is rising as well.

“It gets to be a cyclical process,” says Halmo. “As investors trade their unit prices down, the cost of equity gets higher, which makes it more difficult to grow because MLPs have historically paid out the majority of their cash flow in the form of distributions.”

Third-quarter 2015 was when it became clear that MLPs could not issue equity in the capital markets, Howard says: “They can’t de-lever, and that’s a problem, so that really started to play into their second-half performance for MLPs.”

Downstream MLPs are much more insulated from lower crude prices, and the purer their focus on wholesale, the better they have weathered the storm.

“Downstream has contracts in place, and the ability to pass on cost to the end user, so it’s really not an issue,” the financing expert says. “They are being lumped in with the broader group, and the investors market really hasn’t focused on: How do these guys make money, what’s the stability in that revenue stream, and what does that mean? Oil’s dropping, this is an oil/gas related business, so it must be suffering too.”

“Clearly, it is easy to throw out the baby with the bath water in a down market,” concurs Jeff Kramer, a Chicago-based managing director for NRC Realty & Capital Advisors LLC, via email. He points out, however, that downstream MLPs do have some exposure to weak crude prices.

“Retail margins have been very strong the last two years, and lower oil prices directly reduce the value of the 1% discount impacting the wholesale component, which is the key portion for many downstream MLPs,” says Kramer. Also, some downstream” MLPs have other components such as crude-oil transportation, pipelines and terminal throughputs that may be affected by lower crude oil prices.

For example, GLP has rail terminal assets that handle crude, in addition to its wholesale distribution business. With falling oil prices—and a narrowing discount of West Texas Intermediate to Brent—making rail shipments less profitable, GLP is focusing an Oregon rail terminal on shipping ethanol only. It also is trying to improve its bottom line by reducing costs—partly through an 8% cut in its non-c-store workforce—and maintaining a distribution increase, even if it was 34% smaller than the previous one.

While the distribution cut would save GLP more than $42 million, at least one investment firm—Mitsubishi UFJ—was unhappy with the move and downgraded the MLP. Its stock price fell more than 20% on the day of the cut announcement.

An Uncertain Market

Other industry MLPs have not yet cut distributions but are still showing signs of stress:

CrossAmerica Partners LP (CAPL): This fuel distributor to 1,200 sites, and owner or lessee of more than 800 sites across 25 states, has seen its stock price fall nearly 50% from its January 2015 peak. CAPL’s general partner, CrossAmerica GP LLC, is a subsidiary of San Antonio-based CST Brands Inc., which includes the former retail sites spun off from independent refiner Valero Corp.

Despite CAPL’s wholesale focus and consistent distribution increases, its performance has partly been tied to what some consider CST Brands’ mismanagement of the MLP. One source, who requested anonymity, told CSP that CST was essentially overcharging CAPL in its drop-downs, partly to pad the finances of the parent at the expense of the MLP investors. The pummeled stock price is a sign, he says, that the market saw through this maneuver.

“We were kind of disappointed it didn’t perform better in 2015 because they are a downstream MLP that would benefit from volumes,” Howard says. “I don’t think they had good earnings results relative to expectations through the year.”

But at least one analyst considers CAPL more of a victim of the equity markets than mismanagement.

“For CrossAmerica … it’s definitely more of the MLP general equity market being challenged,” says Ben Brownlow, equity research analyst for St. Petersburg, Fla.-based Raymond James. He does not believe its falling stocks in 2015 were reflective of fundamentals, noting it has successfully executed through drop-downs from its publicly traded sponsors, grown cash flow 30% year over year, and geographically diversified its assets, which creates a more stable cash flow.

Sunoco LP (SUN): This downstream MLP includes more than 850 c-stores and gas stations and distributes fuel in 30 states to about 6,800 sites, directly and through a 31.58% interest in Sunoco LLC, in partnership with an affiliate of Energy Transfer Partners LP (ETP). Energy Transfer Equity LP (ETE) owns SUN’s general partner. It has increased its distribution for the past 11 consecutive quarters but is still more than 42% off its August 2014 peak.

Brownlow says SUN is another MLP with solid fundamentals, and similar to CAPL, a victim of “low-energy investor sentiment.”

ETP, meanwhile, is wrangling with low sentiment of its own, considering it’s off nearly 55% from its November 2014 peak. Howard says this is tied to investor uncertainty about its growth path, and its efforts to at first acquire and then combine businesses with MLP The Williams Cos. Inc. (WMB).

“We believe the market is currently pricing in a lot of uncertainty around the future of their business, and whether they go forward with the Williams transaction at the parent level, and whether ETP can get the support and get their financing in order,” he says. In addition, given how complex the web of MLPs is within the ETE structure, it is tough to get a handle on ETP’s debt leverage, especially considering its $1 billion in capital expenditure budgeted for the next year.

“How do they get it?” Howard says. “The market is waiting for them to do some kind of deal to solve their funding needs.”

Growth for Growth’s Sake

This year is going to be one of reflection for MLPs, weighing whether it is better to reward their unit holders or engage in some self-love.

“For one of the first times, you’re seeing MLP management teams look at their cash flows coming in, which historically have gone right back out to investors in the form of distributions, and saying, ‘Do we need to retain these cash flows to fund growth internally? Can we continue to return them to investors?’” says Halmo.

“It’s a combination of slow down your growth and stop spending money, because you’re destroying capital when you’re spending money at these price levels,” says Howard. “After that, it’s trying to find sponsor support or get outside capital that’s not common equity.

“[This year] is the year when the market distinguishes a bit further between MLPs that are in good shape and those really failing on all levels.”

For MLPs that have historically driven the M&A market in the c-store industry for the past couple of years, it means being more discriminating about deals. Brownlow expects CST Brands and Sunoco to continue to be “very active” consolidators in 2016, although the higher cost of equity capital will be somewhat inhibitive.

“There’s going to more scrutiny placed on deals,” says Ruben of NRC. “You’re going to see lower multiples, or certainly fewer people bidding on deals because of that.” For example, the rumored multiple that CST Brands paid in its November 2015 acquisition of Flash Foods—14X—is going to be increasingly difficult to replicate.

And don’t be surprised if MLPs decide to rationalize their assets, Ruben says, pointing out that some may have had to buy an entire market to acquire a company, so they may begin shedding assets that are not strategically desirable.

“There continues to be a relatively strong level of M&A activity,” the financing expert says, “but it’s now being driven more by the independents, the guys getting knocked out of these deals before.”

There also might be fewer sellers as those who can decide to wait it out until oil prices and the MLP market recover, and sky-high multiples return.

Master Limited Partnerships—At a Glance

  Crossamerica Partners LP Global Partners LP Sunoco LP (SUN) Western Refining Logistics Delek Logistics Partners LP MPLX LP
Last Distribution Paid Per LP Unit $0.5925 $0.4625 $0.8013 $0.3825 $0.59 $0.50
Distribution Increase From Prior Quarter +2.6% -33.7% +7.5% +5% +3.5% +6.4%
Distribution Coverage Ratio 1.35x 1.6x 2.0x 1.22x 1.45x 1.27x
Stock Move From Peak -49% -64% -42% -36% -43% -65%
Latest Growth Move Acquired 31 franchise Holiday stores in Wisconsin and Minnesota from SSG Corp. for $48.5 million Acquired 97 owned or leased gas stations and seven dealer supply contracts from Capitol Petroleum Group (CPG) Acquired the wholesale motor-fuel distribution of Alta East Inc. for about $57 million plus the value of inventory Reached deal to buy the remaining shares of Northern Tier Energy LP (NTI) in a $2.43 billion transaction Delek U.S., which owns approximately 62% of DKL, acquired 48% of Alon USA Energy Inc. common stock Acquired natural-gas processor MarkWest, including more than 5,000 miles of pipelines
Leader Jeremy Bergerson, presiden Eric Slifka, president & CEO Robert W. Owens, president & CEO Jeff Stevens, president & CEO Ezra Uzi Yemin, CEO Gary R. Heminger, CEO
Source: Company reports, latest financial quarter
* Percent change from stock’s historical peak to price on Feb. 1, 2016

The Best of the Worst

MLPs performing best in this bear oil market have a few things in common.

  • Assets on the demand side of the production stream. “With a refinery or utility parent, someone who’s very stable and investment-grade rating, you’re probably going to be in good shape,” says Hinds Howard of CBRE Clarion Securities, pointing out that many of those MLPs have demand-pull assets—pipelines feeding a refinery with crude and pushing finished product out to the market. “Those assets are flowing full right now because refineries are running pretty hard,” he says. One example is Valero Energy Partners LP (VLP), which has crude and refined products pipeline and terminal assets connected to Valero Energy Corp. refineries, and was one of the best-performing MLPs of 2015, Howard says.
  • The ability to grow with internally funded cash flows. These MLPs have not had to raise equity capital.
  • A distribution coverage ratio (how much cash it brings in vs. how much it pays out in distributions) of 1.3 times or higher. A higher number shows the MLP is hanging onto more cash to reinvest for growth.
  • A supportive general partner. A parent company willing to forgo some of its own cash flow and drop down an asset at an attractive multiple to the MLP is a bonus, says Maria Halmo of Alerian.