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In the world of dropdowns, some top-flight midstream players are already soaring comfortably ahead of schedule on their chosen flight paths. Another group, including upstream players, has also made it off the runway and into the air. But the latter are gaining altitude less quickly, and have yet to enjoy the strong tailwinds that have propelled others.
In the current low interest rate environment, with growing apprehension of the inevitability of interest rate hikes, visibility of sustained distribution growth has been rewarded among MLPs. In many cases, a focus on visibility of distribution growth is associated with the depth of the parent’s inventory of assets that may be suitable for dropdown to the subsidiary MLP.
An oft-cited example is the inventory of assets that Phillips 66 has available to drop down to its MLP subsidiary, Phillips 66 Partners LP. The MLP made its debut on the New York Stock Exchange as PXSP in the summer of 2013. From an IPO price of $23 per unit, the MLP closed its first day of trading at $29.70, and ended 2013 at $37.93. Over the next six months, the MLP doubled to $75.56 as investors anticipated a series of dropdowns leading to gains in distributions. From its IPO, it has delivered four distribution increases through July of this year, raising the quarterly rate from 15.5 cents to 30 cents per unit.
While Phillips 66 Partners’ (NYSE: PSXP) doubling of its stock price is perhaps most notable, other dropdown stories have also put in remarkable year-to-date performances. EQT Midstream Partners (NYSE: EQM) and Tallgrass Energy Partners (NYSE: TEP) have both chalked up more than 65% in total returns through mid-July, while Valero Energy Partners (NYSE: VLP) and Marathon Petroleum Corp. (NYSE: MPC) subsidiary MPLX LP have returned 47% and 43%, respectively. Tesoro Logistics LP and Western Refining Logistics LP have topped 35% and 25%, respectively. This compares to the 15% total return of the Alerian MLP index over the same period.
Clearly, there has been no shortage of demand for these dropdown vehicles, which can offer distribution growth in the teens or better over a period of years. But have dropdowns come a little too far, too fast?
A study by Credit Suisse looked at seven top-tier dropdown stories that went public with a yield averaging 5.2% and had since traded up to an average yield of just 2.1%. The average target price for the seven MLPs offered only 4% upside, according to the report, which factored in a compound annual growth rate in distributions of 15.3% for the first five years and 6.5% for the next five years. “The lure of lower-risk, tax-deferred cash flows has fueled demand,” noted the report. “Investors have clearly paid for visible long-term growth.”
While these MLPs have offered impressive year-to-date performance, better opportunities are to be found elsewhere, according to the report. Other analysts similarly sound a note of caution.
“They’re priced to perfection,” said Ethan Bellamy, senior research analyst with Robert W. Baird & Co. “They’re high-quality, with very good growth visibility, and they are priced as such—to perfection.”
Underappreciated names
Bellamy has encouraged investors to focus on some of the lesser-known vehicles to play the dropdown theme. Two underappreciated stocks that are among Baird’s “best ideas,” said Bellamy, are Susser Petroleum Partners LP (NYSE: SUSP) and Legacy Reserves LP (NASDAQ: LGCY).
Both picks have noteworthy dropdown strategies. For Susser Petroleum, plans involve a synchronized series of dropdowns of the entire retail fuel business of Sunoco Inc., making up by far the greatest part of a dropdown program estimated to exceed $5 billion through 2017. For upstream MLP Legacy, a projected pipeline of dropdowns is now in sight, following its cementing of a strategic alliance with WPX Energy that involves newly minted incentive distribution rights (IDRs) for use in such transactions.
Enthusiasm for Susser Petroleum follows the agreement by its parent, Susser Holdings Corp. (NYSE: SUSS), to be acquired by Energy Transfer Partners (NYSE: ETP). Susser Holdings is a Texas-based, family-led business that owns and operates 630 convenience stores in Texas, New Mexico and Oklahoma. Under the Energy Transfer umbrella are some 553 retail fuel sites owned and operated by Sunoco. Adding in dealer-operated and distributor-operated sites, Susser Petroleum has a total of 1,246 locations, while Sunoco’s total jumps to 5,152 locations, concentrated across the eastern U.S.
With the addition of more than 5,000 Sunoco sites that can be dropped down into Susser Petroleum, which will remain a separately traded security, distributions are projected to rise as assets are identified for sale from parent to subsidiary. The combined Sunoco and Susser Holding assets available for dropdown through 2017, plus $150 million in third-party M&A, are valued by Baird at $5.4 billion. This represents a scaling up of the former SUSP dropdown strategy by a factor of eight times.
“Based on the potential for accelerated distribution growth and value creation, we think it is unlikely that ETP will dawdle in moving Sunoco and Susser Holding assets into SUSP as quickly as possible,” said Bellamy in raising his SUSP target price to $63 from an earlier—and quickly surpassed—target of $48.
Of course, the projected series of dropdowns necessitates periodic equity raises to finance the asset purchases, which are projected to begin in early 2015. Financing is assumed to be 70% equity/30% debt.
“The gating factor is raising the equity necessary to finance the dropdowns,” said Bellamy, describing the latter as “a fairly low hurdle given the creativity and aggression of SUSP’s new parent.” And given the outlook for distribution growth, it “likely warrants investors stepping into such a headwind.”
How much growth is possible?
Annual distributions could reach $4 per unit, according to Bellamy, although as of July, projections ramp slightly more conservatively through 2017, reaching a $4 annual run rate in the final quarter of the year. Since the announcement of Susser Holdings’ acquisition by Energy Transfer in late April, Bellamy has raised his 2015 distribution projections for SUSP twice—from $2.41 to $2.65, and then to $2.76 per unit—and has initiated 2016 and 2017 projections of $3.35 and $3.86 per unit. These compare to annual distributions of $1.84 in 2013 and around $2.16 unit in the current year.
From a strategic perspective, the attractiveness of the combination lies in Susser Petroleum’s well-regarded brand and marketing model, coupled with the strong economy and demographic trends in Texas, applied to Sunoco’s strong fuel management. On a combined basis, the fuel distribution network will comprise more than 6,000 sites making sales of 6.3 billion gallons of fuel per year. Management has set a goal of at least $70 million annually in cost synergies.
Bellamy excludes any such synergies in his projections. His modeling assumptions are that dropdowns start with a $600 million transaction in the first quarter of 2015, followed by an $800 million transaction in the third quarter, and then $1 billion dropdowns in each of the first and third quarters of both 2016 and 2017. Transaction values are assumed to be at 12 times EBITDA, and equity is issued at a 4.7% yield. Maintenance capex is estimated at 6% of 2015 EBITDA, rising to 7% and 8% in 2016 and 2017.
An upstream option
In the upstream sector, Legacy Reserves has been a name long favored by John Ragozzino, vice president with RBC Capital Markets, as well as Baird’s Bellamy.
What’s new of late is the upstream MLP’s creation of IDRs to incentivize third-party E&Ps to engage in periodic dropdowns within a defined timeframe. Coupled with an “escalator” feature designed to help offset natural production declines, Legacy’s recent strategic alliance with WPX Energy offers Legacy investors unprecedented visibility in distribution growth.
“With the use of the IDR currency,
they were able to establish a different degree of visibility that not a single one of their peers can offer,” commented RBC’s Ragozzino. “In a subsector accustomed to low- to mid-single-digit rates of annual distribution growth, Legacy’s alliance with WPX Energy provides material, sustainable competitive advantages to Legacy, including a clearly identifiable dropdown schedule and the likelihood of significantly accelerated distribution growth.”
Bellamy concurs. “The distribution growth in upstream MLPs has been stalled for a long time,” he said, “and this was a creative way to bring in a significant amount of accretive dropdowns by attracting WPX Energy with an incentive payout option. Certainly, it’s an inflection point in the distribution growth trajectory relative to the low-single-digit growth rates we’ve been seeing in upstream MLPs since natural gas prices cratered.
“The other thing is that it shows the market that it is aggressively pursuing growth in distributions for unit holders, and so there is option value to be had there. It’s a change in sentiment and a change in the way they’ve managed the business in the last couple of years,” he added.
Terms of the strategic alliance with WPX Energy include Legacy’s initial purchase of 276 billion cubic feet equivalent of reserves in the Piceance Basin of Colorado for $355 million in cash. Natural gas comprises 83% of the reserves, which are 100% proved developed producing. Production in the third quarter is estimated at 63 million cubic feet equivalent per day. The escalator provides for a 29% working interest at closing, rising to 37% on January 1, 2015, and 41% on January 1, 2016.
In addition, WPX receives an immediate 10% stake, or 100,000 units, of the 1 million IDRs recently created by Legacy. WPX can earn a further 20%, or 200,000 units, which will vest at a rate of 10,000 units per $35.5 million in assets sales to Legacy. However, this is subject to a specified timetable, and WPX Energy’s ability to earn future IDR will be forfeited—at a rate of 66,667 units at each of the next three anniversaries—if vesting has not been triggered by dropdowns by the target dates.
“It’s a linear use-it-or-lose-it schedule,” said Ragozzino, describing the IDR deal structure as providing a “clearly identifiable future dropdown inventory in the amount of $710 million of assets.” (Each transaction of $35.5 million earns 10,000 units, so $710 million in transactions earns the full 200,000 units.) And because the IDRs don’t kick in until quarterly distributions grow 15% over the 59 cents per unit base level, “there’s a significant motivation for WPX Energy to facilitate that growth by doing deals with Legacy.”
Moreover, because the use of IDRs as currency means reduced reliance on higher cost capital in the form of equity and long-term debt, there is greater scope for accretion in distributions as a result of the dropdown transactions. Whereas Ragozzino previously projected low- to mid-single-digit distribution growth for Legacy, he now foresees a compound annual growth rate of 10% over the next three years. He models increases of 5 cents and 2 cents in quarterly distributions in the final two quarters of 2014, for a full-year distribution of $2.55 per unit, and then a jump to $2.92 unit in 2015.
This is not to overlook the strong fundamentals of the transaction with WPX Energy, which Ragozzino said also played a role. “Legacy got a great price. The prices paid per flowing Mcf and per reserves in the ground were highly attractive.” RBC’s target price on Legacy is $36.
Ragozzino described the Legacy-WXP alliance as being a “game-changer” in its implications for the upstream sector.
“What’s the difference between MLPs that trade at a 2%, 3% or 4% yield and a 10% yield? At the end of the day, it all comes down to the visibility of the distribution growth. The upstream guys all lack any sort of visibility. January 1 comes around each year, and management teams are facing a blank drawing board.
“The fact that Legacy has settled on an inventory of assets that has to be sold in a specific time frame has changed the game pretty significantly. If I can identify three years of distribution growth, that’s pretty compelling.”
Are others likely to be fast followers?
“This is something that’s probably going to pick up steam,” said Ragozzino. “Visibility is king.”
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