GETTING CREATIVE
by Elliott H.
Gue
Editor, The Energy
Letter
February 16, 2007
My favorite long-term income play in the energy patch is a group of publicly traded partnerships organized either as master limited partnerships (MLPs) or limited liability companies (LLCs). These securities trade right on the major exchanges just like any other stock.
The beauty of MLPs and LLCs is that they pay no tax at the entity level--they pay no corporate tax. This allows firms organized in this manner to pass through the vast majority of their cash flows to unitholders--the partnership equivalent of shareholders--as dividend distributions. That's why your average publicly traded MLP yields in excess of 6 percent.
And if you think 6 percent might not seem all that high, think again. Some of the MLPs I cover are boosting their distributions at a rate in excess of 15 percent annualized. Few, if any, income-oriented investments can offer that combination of high and rapidly growing yields. I highlighted this important point in the November 10, 2006, issue of The Energy Letter, Growing Profits.
Better still, those distributions are tax-advantaged. On average for the energy-related MLPs I cover, 80 to 90 percent of distributions are actually considered a return of capital by the IRS. That means that you don't owe tax on the return of capital portion of your distribution until the MLPs are sold.
Finally, the MLP and LLC space has literally exploded in size in recent years. A decade ago, only a few pipeline companies were organized as publicly traded MLPs; nowadays, there are MLPs involved in everything from tankers to pipelines to the actual production of oil and gas. This has vastly improved and widened the sort of trends you can play with these high-income securities.
But my point this week isn't to extol the virtues of MLPs as an income investment. Rather, I've received numerous queries about one particular deal that recently closed involving an MLP--the spinoff of Duncan Energy Partners (NYSE: DEP) from Enterprise Products Partners (NYSE: EPD). I addressed this very issue in the most recent issue of my subscription based newsletter The Energy Strategist. Given the volume of questions I've received, I'd also like to cover the topic in this journal.
Enterprise is among the largest and oldest MLPs in the country and concentrates on midstream energy assets. Those assets include natural gas and natural gas liquids pipelines, deepwater production platforms, gathering pipelines and natural gas processing facilities.
Enterprise has been among the most consistent performers in the MLP universe. The partnership has a long history of growing its cash flows and boosting its distributions to shareholders; distributions are up a whopping 75 percent over the past six years alone.
Many smaller MLPs generate cash flow growth via acquisitions. Oil and natural gas exploration and production (E&P) companies often own gas storage facilities, pipelines and gas processing plants; these assets are key to the energy business.
Infrastructure assets tend to generate copious free cash flows but little in the way of revenue growth. They're highly profitable, slow-growing assets.
Slow-growing assets aren't desirable for E&P companies. Such firms are typically valued based on their ability to find new reserves and boost their production of hydrocarbons. Investors are looking for growth, not cash. Most of these firms pay little in the way of dividends; they keep most of their cash to fund growth projects.
But MLPs are ideally suited for holding highly cash-generative, slow-growing assets. That's because partnerships are valued on their ability to generate cash that can be distributed to unitholders.
This makes acquisitions a win-win situation. E&P companies can sell these slow-growing assets to an MLP; this generates an immediate cash infusion that can be used to fund further growth or new exploration activity. Meanwhile, the MLP acquiring the assets gets another reliable source of steady cash to back up distribution payments.
The problem is that an MLP the size of Enterprise has trouble moving the needle with acquisitions alone. There just aren't that many assets or companies out there large enough to generate a significant jump in cash flows.
Instead, Enterprise relies a great deal on so-called organic growth; the MLP actually builds new pipelines, storage facilities and offshore platforms. For 2007, Enterprise plans another $1.6 billion in organic growth projects that should power distributable cash flow growth in the 7 to 8 percent range.
The question, of course, is, �How does an MLP like Enterprise fund that type of spending year after year?� The answer is typically one of two techniques: issuing additional shares (called units in MLP parlance) or taking on more debt in the forms of newly issued bonds or a bank line of credit. While neither method is necessarily bad, taking on huge stocks of additional debt can be undesirable, particularly when the credit markets are weak. And issuing more units dilutes the value of existing unitholders.
To help combat these issues, Enterprise Products has consistently come up with new, innovative ways to raise the capital it needs cheaply to carry on its organic growth investments. Last year, for example, the company issued an unusual long-term convertible bond that was well received by investors. And Enterprise was also the first to cut its top incentive distribution payment to 25 percent from 50 percent.
It's useful to review briefly the concept of an incentive distribution. MLPs consist of two basic entities: LPs and a general partner (GP). As an LP unitholder, this entitles you to cash distributions that come from the basic operation of the partnership business--basically, the cash flows received from running the business. But LPs don't actively manage or control the assets of the partnership.
The actual day-to-day management of an MLP is a task performed by the GP. GPs typically are compensated for their services in two ways.
First, most GPs also own LP units and receive cash flows just like any other unitholder. Second, GPs earn an incentive distribution--a sort of management fee that escalates based on a pre-set performance formula. Incentive distributions are typically based on the quarterly distribution paid to LP unitholders. The exact formula differs from MLP to MLP.
By cutting its top distribution to 25 percent, Enterprise freed up more of the company's cash flow to fund distributions and service debt. Because its cash flows became instantly more secure, the company pays a lower interest rate on its bonds and debt than other large MLPs; this move lowered its cost of capital and made it cheaper to fund growth.
Enterprise's latest innovation is even more unique: The partnership actually spun off Duncan Energy Partners. This deal is the first of its kind. Let's review the salient features:
- Duncan Energy Partners was formed out of Enterprise Products Partners� LP, not its GP. Enterprise retains a stake of roughly 35 percent and is, therefore, entitled to the same distributions from Duncan as any other LP unitholder.
- Duncan's GP is a wholly owned and controlled subsidiary of Enterprise Product Partners LP. So, the LP effectively has control over Duncan Partners.
- Duncan Energy Partners raised some $225 million in its initial public offering that will be paid to Enterprise Products.
- Duncan Energy has established a credit line of $300 million. The partnership is taking an advance of slightly under $200 million that will also be paid to Enterprise.
- In exchange for these considerations, Enterprise is contributing a 67 percent stake in a number of assets to Duncan. The list includes a series of onshore US pipelines and storage facilities.
- Duncan Energy Partners plans to initiate a distribution of roughly $0.40 per quarter, equivalent to an annualized yield of roughly 6.9 percent.
- Unlike any other MLP, Duncan will pay only a flat 2 percent distribution to its GP (controlled by Enterprise); it will pay no incentive distribution rights.
Bottom line: Enterprise really isn't giving up much in the way of assets or control. Enterprise even has right of first refusal to buy these assets back if Duncan ever decides to sell them.
Meanwhile, Enterprise is getting more than $400 million in cash that it needs to help fund its $1.6 billion 2007 organic growth plans. In fact, given the proceeds raised by this offering and last year's convertible bonds, Enterprise doesn't feel it will need to tap the debt or equity markets until sometime in 2008. Simply put, Enterprise has all the cash it needs to fund growth.
Enterprise has managed to raise equity and debt capital without directly issuing new debt or units. It's raised money without having to significantly dilute existing unitholders or weight down its balance sheet.
The only downside of the deal is that it complicates the MLP's organizational structure. The Enterprise family of companies now consists of two publicly traded LPs (Duncan and Enterprise) plus a publicly traded GP, Enterprise GP Holdings (NYSE: EPE).
There are a variety of relatively complex cross-shareholdings among different companies in this family. And Texas oilman Dan Duncan has a huge chunk of stock in Enterprise Products and its general partner; he effectively controls the management of all these companies.
Complexity is never a great thing; however, in this case, it doesn't worry me a great deal. Duncan has been running Enterprise for years with the benefit of unitholders in mind; with his huge stake in Enterprise Products, his interests are aligned with that of the other unitholders. I see this latest deal as yet another innovative, low-cost way to raise expansion capital.
One more point is worth noting. Since last week's issue of The Energy Strategist, the underwriters of the Duncan deal--led by Lehman Brothers and UBS-- exercised their so-called over allotment option. Basically, that option gave them the right to sell additional shares of Duncan. The final result of the over allotment is that Enterprise Product's stake in Duncan has been reduced to 26.4 percent; in exchange for the additional 1.95 million units sold under this over allotment, Enterprise receives roughly another $41 million.
© 2007 Elliott H. Gue
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