Description

Disclosure: Either the author, his family, or funds the author manages and/or is associated with has a position in the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The analysis presented is the author’s own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation and as such, should not be used in isolation to make an investment decision. The author undertakes no obligation to update this report based on any future events or information. Estimates are subject to numerous assumptions, risks and uncertainties which change over time. 

BWP is a midstream MLP that slashed its distribution over 80% in an effort to deleverage and fund growth capex from distributable cash flow (DCF). This is unusual for MLPs, including BWP, which usually fund growth capex through new debt and unit issuance.

This announcement coincided with the announcement that decreased basis differentials and a weak Parking and Lending (PAL) business will impact 2014 DCF more than anticipated.  That being said, DCF is still significant at a current DCF (14e) / P yield of 13.20%  (Morgan Stanley universe est. average of 6.45%) as investors are too focused on the current distribution, rather than the cash generation of the equity.  

The ultimate catalyst will be when the distribution is raised from the current level of roughly 25% of DCF to something closer to 100%. To be clear, based on the internally generated cash, deleveraging goals (4x EBITDA) and growth projects that will also be a draw on DCF, this catalyst is unlikely prior to the 2017/2018 time frame, at the earliest. This is going to take some time, and I would argue this is why the opportunity exists.

Potential positive developments:

Distribution is raised in the future to a more typical 1.0x coverage level, which would provide very significant upside in the unit price even if distributable cash flow doesn’t significantly grow from the current level.

Existing and future growth projects more than compensate for the drag that has been created from compressed natural gas basis spreads.

Prudent financial support and long time horizon from parent company Loews (L) keep BWP on the right trajectory without unnecessarily diluting unit holders.

Parking and lending (PAL) recovery from current trough levels.

Potential negative developments:

Long term contracts that roll off each year to lower rates overwhelm any new growth initiatives.

Parking and lending (PAL) business does not recover.

New units are issued to speed deleveraging (BWP has said they don’t anticipate selling units in 2014).

BWP is the flip side of the MLP “virtuous cycle”, which I would simplify as when a MLP pays out operating cash flow (less maintenance capex) as distributions and almost exclusively funds growth capex by issuing new debt and equity. A high multiple for the issued units is required for the cycle to continue. I will leave aside the complex question of whether or not this is indeed virtuous for the unit holder.

In the situation that I present, growth falters, the partnership slashes the distribution, and rather than issuing new equity, the partnership funds deleveraging and growth capex from organically generated cash flow and a newly established line of credit from its parent company (Loews).

If growth headwinds have proven to be stronger than previously expected, then it certainly reasons that the unit value would go down. Separate from that, as a thought experiment, would the equity of a MLP be less valuable if it funded growth from DCF, rather than issuing new equity (breaking the virtuous cycle)? If so, how much less valuable? 

The MLP investors’ myopia for yield drowns out the fact that for the year 2014 BWP’s distribution coverage is estimated to be 4x (company guidance). The average distribution coverage out of roughly 50 companies in the Morgan Stanley midstream universe is 1.24 with a median of 1.13 (both 2014e, includes BWP). Clearly BWP’s coverage estimate of 4x sticks out like a sore thumb.

Pipeline & Storage

BWP owns a network of pipeline and storage assets across the southeast. The long term outlook for natural gas demand growth is very favorable in this area due to demographics, increased industrial demand, retirement of coal fired generation and potential natural gas export facilities.

In the near term however, significant volume of shale gas production has narrowed basis differentials, which negatively impacts the price BWP can charge to transport gas through its pipelines. BWP has long term contracts with an average life of about 6 years. For the year ending 2013, approximately 81% of revenues were from capacity reservation fees under firm contracts (fees owed regardless of actual pipeline utilization) and approximately 12% of revenues were from fees based on utilization under firm contracts (firm pricing, but only on actual utilization). Gas transportation revenues were just over $1b in 2013 and management has guided that roughly $100mm per year of fixed contracts roll off for recontracting. This has been the main source of the recent underperformance.

In order to counter this, BWP is taking a number of actions including existing pipeline expansion projects, repurposing some existing pipelines, diversifying into NGL storage and transportation, proposed Bluegrass pipeline, growth of BWP field services, and plans to directly connect to more end use markets. BWP has spent, or plans to spend a total of $1.8b on announced projects (including acquisitions) since the fall of 2011.

Existing pipeline expansion projects / connect to more end use markets

BWP has been connecting to new power plants as part of an effort to increase direct connection to customers who are less sensitive to basis spread contraction. Also, the Southeast Market Expansion Project ($300mm in capex) provides 550 MMcf/d of capacity, is fully contracted with 10 year firm agreements and is in service in q4, 2014 (for context, BWP currently has 13.2 Bcf/d of peak-day delivery capacity and 6.6 Bcf/d of average daily throughput). Since BWP has only provided guidance through the end of 2014, I believe this project has been largely not included in future guidance.

Reversing Pipeline flow

BWP will reverse the flow to South from North on one of its existing pipes in the Texas gas system to transport gas from the Marcellus/Utica to Louisiana. The project has firm transportation contracts of 600 MMcf/d of capacity with a weighted average contract life of 13 years. Expected cost is $115m and expected to be in service in the first half of 2016.

Acquisitions

Recent acquisitions include Petal Gas storage (closed dec 2011, $550mm), Boardwalk Louisiana Midstream (NGL storage and transport, closed oct 2012, $620mm), Boardwalk field services (gathering and processing, closed june 2013, $180mm).

Bluegrass Pipeline and related projects:

Bluegrass is a JV with Williams to develop transportation that would transport NGLs from the Marcellus/Utica to Lake Charles, Louisiana and related processing and export facilities. This project would utilize an existing portion of the BWP’s Texas Gas system to enable it to transport NGLs. BWP has contributed $11.9mm to this project and further funding will be done via a JV between BWP and Loews. Currently, the parties are in discussions with potential customers regarding various commitments as well as working on the various approvals.

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While these growth projects are in motion, it will take a year or two in order for them to really start impacting DCF. Therefore, I would expect 2015 to continue to trough (from a DCF basis).

The attached numbers are heavily drawn on from Morgan Stanley (“underweight” rating, “attractive” industry, $14.00 price target). I would expect that anyone looking at estimates that stretch years into the future has a healthy dose of skepticism as to the specificity of the numbers. I don’t believe a high degree of specificity is required in this case. Long term contracts give some foundation. Personally, I wouldn’t believe anyone who tells me what they think basis differentials are going to be in 2016 or, for that matter, what the seasonal spread will look like in 2017. Therefore, trying to determine whether recontracting will be above, below, or the same as current rates when they expire years in the future is not really possible.

I think the bull case rests on the opinion that the need to transport natural gas in the U.S. is a multi year secular growth story, and that between the company and the parent (Loews / Tisch family), BWP will invest in growing their business in a way that will create value. Many of these sensible growth initiatives are well underway.

I’ve input this idea as a simple long equity idea, but a strategy of buying half a position in the units and selling at the money puts for the other half could also be interesting. This would generate additional income in the scenario where the price goes sideways for the next year or two.

**This row (below) is for illusterative purposes. Obviously if BWP paid out 100% of DCF and didn't otherwise fund growth capex then that would negatively impact future levels of DCF and would therefore require a higher assumed yield.

Catalyst