Source: Spectra Energy Partners
Over the past year, as the bottom has fallen out of nearly all energy stocks, even supposedly stable midstream MLP's whose cash flows are supposed to be immune from commodity prices, have suffered. This has served as a painful lesson that income investors need to be careful which pipeline operators they select for their diversified portfolios.
To help explain how to separate the wheat from the chaff when it comes to comparing midstream MLPs, let's use the example of Spectra Energy Partners (NYSE: SEP), and its general partner Spectra Energy Corp. (NYSE: SE), two of this industry's better names. Spectra Energy's latest earnings release is a perfect illustration of the four most important factors dividend lovers need to focus on to maximize the chances of boosting both their portfolios' yield, and long-term returns.
Tough market conditions for GP, record year for MLP
| Spectra Energy Corp. | 2014 | 2015 | Change |
| Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) | $3.146 billion | $2.746 billion | (12.7%) |
| Distributable Cash Flow (DCF) | $1.460 billion | $1.292 billion | (11.5%) |
| Annual Dividend | $1.48 | $1.62 | 9.5% |
| Dividend Coverage Ratio (DCR) | 1.3 | 1.6 | (18.7%) |
| Spectra Energy Partners | 2014 | 2015 | Change |
| Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) | $1.591 billion | $1.825 billion | 14.7% |
| Distributable Cash Flow (DCF) | $1.055 billion | $1.205 billion | 14.2% |
| Distribution | $2.36 | $2.56 | 8.5% |
| Distribution Coverage Ratio | 1.2 | 1.2 |
0% |
Source: Spectra Energy Q4 earnings presentation.
As you can see from Spectra Energy Corps.' and Spectra Energy Partners' respective full year results, the ongoing oil crash was a lot harder on the general partner than on the MLP. This is because Spectra Energy Partners benefited from completion of some major oil and gas transmission projects which resulted in record results where it matters most to income investors: the annual payout, and DCF growth to make it sustainable.
Spectra Energy Corps.' though suffering declining results, mainly due to weakness in its natural gas liquids or NGL business and a declining Canadian Dollar, still beat management's guidance for 2015 DCF (which is what funds the dividend) by 7%. This resulted in a coverage ratio 8.3% stronger than previously forecast.
More important for long-term investors is management's 2016-2018 guidance. Due to $6 billion in growth spending Spectra plans to complete over the next three years management is confident that it can achieve substantial DCF growth of 6% for the GP and 8.7% for the MLP, respectively.
Perhaps as impressively managements assumptions of an average gas, and oil price of $2.5 per MMBTU and $45 per barrel through 2018 seems not just reasonable, but may very prove conservative. Given that management believes it can maintain a sustainable DCR for Spectra Energy Corp. and Spectra Energy Partners of 1.1 and 1.2, respectively, over the next three years, a stronger energy price recovery could very well result in an even stronger payout profile. Which brings me to the most important factor income investors need to pay attention to.
Solid distribution growth profile compared to troubled peers
| Company/MLP | Yield | 2015 DCR | Payout Growth Guidance |
| Spectra Energy Corp. | 5.5% | 1.3 | 28.8% through 2018 |
| Spectra Energy Partners | 5.5% | 1.2 | 7.3% through 2018 |
| Kinder Morgan Inc. | 2.9% | 4.2 | NA |
Source: Q4 earnings presentation, management guidance
Spectra Energy Corp. and Spectra Energy Partners are among my favorite midstream operators due to some of the best distribution profiles in the industry. This means that, not just is the current yield generous, but more importantly it is more likely to survive, and even grow during this oil crash, especially compared to weaker competitors such as Kinder Morgan Inc. (NYSE: KMI).
However, while a midstream MLP's payout profile is certainly an important quality indicator, investors always need to be skeptical of management guidance and ask themselves whether forecasts of strong, sustainable distribution growth is realistic.
After all Kinder Morgan was formerly a dividend darling because of management projections of sustainable 10% annual dividend growth through 2020. Those projections died when America's largest midstream operator was forced to slash its dividend by 75%.
Massive backlog acts as a growth driver BUT...
A large medium-term backlog of growth projects is an important growth catalyst to maximize the chances that management's guidance turns out accurate. In Spectra's case over $8 billion in projects under construction, to be completed by the end of 2018, is a solid reason to believe Spectra's growth forecasts.
However, just as importantly as the size of the backlog is its safety. After all, just six months ago Kinder Morgan's backlog was a staggering $22 billion in size, but due to low oil prices forcing cancellations of several of these, today Kinder's growth backlog has shrunk to $18.2 billion. What's worse, management is expecting this to continue shrinking over the coming quarters.
Luckily 75% and 80% of Spectra Energy Corps.' and Spectra Energy Partners' projects are natural gas pipelines, whose demand is driven by consumer demand which is far more stable in a low energy price environment, making Spectra's backlog more resilient than Kinder's.
...Backlog without good access to growth capital is worthless
| Metric | Spectra Energy Corp. | Spectra Energy Partners | Kinder Morgan |
| Debt/EBITDA (Leverage) Ratio | 5.3 | 3.6 | 5.6 |
| Operating Income/Interest (Interest Coverage) Ratio | 2.25 | 5.33 | 1.28 |
| Average Debt Cost | 4.6% | 4.0% | 5.1% |
| Weighted Average Cost of Capital (WACC) | 5.36% | 6.39% | 2.87% |
| Return on Invested Capital (ROIC) | 5.74% | 7.41% | 2.09% |
| Net Return on New Investment (WACC-ROIC) | 0.38% | 1.02% | (0.78%) |
Sources: earnings presentations, Gurufocus, Morningstar
The final piece of the quality midstream MLP puzzle is adequate access to growth capital, which primarily depends on a strong balance sheet that results in low debt costs.
While Spectra Energy Corps. leverage ratio is nearly as high as Kinder's, fortunately for investors over the next three years about 70% of spending will be undertaken by the less levered (and more profitable) MLP.
Finally, Spectra Energy's higher valuation means that it has ongoing access to equity capital, to help ensure its DCF growth projections are met.
Bottom line
It can be hard deciding which high-yield midstream MLP's represent an undervalued high-yield opportunity and which are cheap for a reason. By focusing on the highest quality pipeline operators, those with: strong payout profiles, large growth runways, strong balance sheets, and strong access to cheap capital, you can maximize the chances of locking in both excellent income and market spanking total returns once energy prices finally recover.
