BOARDWALK PIPELINE PARTNERS, LP [BWP] operates an integrated gas pipeline and storage system. The natural gas is primarily drilled in the Gulf Coast Region, Oklahoma, Arkansas and goes up to Tennessee, Kentucky, Illinois, Indiana and Ohio. BWP’s network is located over most of the vast sources of unconventional natural gas in shale deposits. The company is structured as a Master Limited Partnership [MLP] and I suggest that you read my introduction to MLPs post to gain a better understanding of this type of security. BWP falls into the category of “Pipeline MLPs” which have more predictable income streams since most of their revenues are derived from long-term fee contracts. In the case of BWP, as of 2011, it derived 82% of revenues from “Firm Capacity Reservation Charges” which are contractual obligations regardless of the level of commodity actually transported. Transportation customers pay a pre-determined fee based on the capacity reserved plus a fuel charge on the actual gas transported. The storage part of the business works the same way.
The General Partner [GP] for BWP is Loews Corporation [L] which controls the BWP via its 2% interest as a GP and a 53% Limited Partner [LP] interest. As the GP, Loews receives what are called Incentive Distribution Rights [IDRs]. IDRs are essentially a “reward” to the GP for growing the business in such a way as to be able to increase dividends. The current quarterly BWP distribution is $0.5325, so as you can tell from the table below, BWP has reached the point where the available cash flow from operations over $0.525 is equally split between the GP and the LPs even though, the GP is only 2% equity owner of BWP. This is one of my biggest issues with the MLP structure, but the MLPs that do not pay IDRs are a few and far between.
1. Contract renewals – BWP has long-term contracts with its transportation and storage customers and a portion needs to be renegotiated in 2013. The new terms will probably be less favorable to BWP mostly because of the drop in natural gas prices. The current weighted average contract life is 6 years.
2. Lower commodity prices – a portion of BWP’s revenues are tied to natural gas prices which are already at depressed levels. The good part is that most of BWP’s revenues are from firm charges. Also, some natural gas exploration and production (E&P) companies are just not finding it economically to drill and have been postponing exploration plans.
3. Competition – with the boom of shale development, a lot of infrastructure was build out, so there are more transportation and storage options for BWP’s customers.
4. Interest rates – I already talked about the two main types of interest rate risk MLP investors deal with.
5. Debt level – Since MLPs are required to distribute almost all of their earnings, they are not able to build “cash chests” to fund expansion plans. MLPs including BWP, rely on issuing debt and equity and consequently tend to have higher debt levels compared to a regular company. BWP is leveraged almost 1x meaning that its total liabilities equal its total equity. BWP debt’s maturities are nicely staggered going all the way out to 2027 (median around 2017) with no significant maturities falling on the same year making repayment/refinancing easier. Its Current Ratio (current assets / current liabilities) is at 0.65. Like I explained in my post on GMXR preferred stock, a current ratio under 1 can be alarming, but unlike GMXR, BWP has a line of credit with plenty of available capacity which can used if need be.
With all that said, the risks listed are more industry-specific so every other MLP is having to deal with them or will do so in the future.
Reasons to be bullish on BWP
The revival of domestic manufacturing is on the lips of every politician. Barron’s cover story from last week was on that subject. The crux of it was that with the immense amount of natural gas produced in the US, manufacturing is getting cheaper and the untapped supply is still abundant to make the US a net energy exporter by 2025. I am not sure how close we are to a meaningful increase in domestic manufacturing, but I think that natural gas will only become a bigger contributor to energy generation in the USA.
BWP has been building out and buying assets fairly aggressively using both debt and equity offerings to finance its asset expansion. From the table below, you can see that the company was especially aggressive during the 2007-2009 period. BWP has amassed a network of pipelines and storage facilities over a geographic area which will see drilling activity for many years to come. Loews Corporation, BWP’s GP, has been providing financing capital in the past to fund acquisitions, and I don’t see a reason for this not to continue in the future.
When looking at the balance sheet of BWP, I noticed that the accumulated depreciation is fairly low compared to the gross Property, Plant and Equipment indicating that the assets are fairly new. Accumulated depreciation is the sum of all the depreciation expenses for the long term assets. Using, gross PP&E, accumulated depreciation and amortization, and depreciation and amortization expense, we can calculate 3 ratios which provide a more in-depth analytical look at BWP’s fixed assets.
Estimated relative age of PP&E shows the asset’s age as a percent of depreciable life and is calculated by dividing the accumulated depreciation by the ending PP&E. Average depreciable life of PP&E is calculated by dividing the ending PP&E by the depreciation expense. The higher that number, the longer the assets will stay in exploration and do not need to be replaced. The average age of PP&E is calculated by dividing the accumulated depreciation by the depreciation expense. All three ratios are estimates, and changes in depreciation methods and large asset purchases or sales will impact them, but all three clearly show that BWP’s assets are fairly new and are expected to remain in exploitation for a long period of time. BWP uses the straight line depreciation method meaning that long-term assets are depreciated by the same amount each year. The useful life of the depreciable assets ranges from 3 to 35 years, with the pipelines which make up almost 90% of total gross Property, Plant and Equipment (PP&E) having a weighted-average useful life of 38 years.
I spent a lot of time on BWP’s assets, because after all MLPs are extremely dependent on the amount and quality of their long-term assets. Buying a MLP is essentially buying the income stream provided by the firm’s assets. I like to see currently existing fixed assets providing a good return and expansion plans hopefully leading to increased future distributions. BWP has slowed down expansions in recent years in light of the ill-timed glut of infrastructure expansion in the industry just prior to the recession and the big drop in natural gas prices. On the positive side, BWP has been able to increase the average daily throughput.
MLPs in general have high fixed costs associated with the buildup of the pipelines, so the more natural gas flows through the pipes, the higher the profit margins will be and vice versa. Because of pricing pressures, BWP’s operating margins have gone down from 44% in 2008 to 33% in 2011 with an average of 39% over the last 8 years. This is something we need to keep an eye on especially with the upcoming renewals of the contracts expiring in 2013.
BWP Dividend Checklist
1. How does the dividend yield of the stock compare to the yield of its sector – The current dividend yield of BWP is 7.8% and dividend yield of the Alerian MLP Index which “is a composite of the 50 most prominent energy MLPs” is 6.1%.
2. What is the company’s payout ratio, and how does it compare to the competition – MLPs are required to distribute almost all of their earnings to shareholders. A problem might arise if a company is distributing too much in order to keep dividend constant or increasing while generating flat or lower earnings. This is currently not an issue for Boardwalk Partners.
3. For how long has the dividend been in place – BWP started paying a dividend at its formation in Q4 2005, and since then it has increased it by an average of 5.5%, albeit at a much smaller rate in recent years. With the current 50-50% split between LPs and the GP for quarterly distributions over $0.525 it will be more challenging for BWP to deliver higher distributions to the LPs.
I decided to include a valuation model for BWP in this post. I used the Gordon Growth Model which is a relatively simple way to estimate an intrinsic value for a company paying consistent dividends and having a relatively small growth rate. The basic premise of any valuation model is that the intrinsic value of an asset is equal to the present value of its future cash flows (dividends). The specific inputs, input sources, and calculations are as follows:
For the expected growth rate of BWP, I used the expected nominal GDP growth rate. To calculate the cost of equity I used the Capital Asset Pricing Model (CAPM). I want to insert a big red flag, before you rush to buy BWP seeing that the intrinsic value calculated this way is $111 or almost 300% over the current price. The two biggest variables in this model are the expected growth rate and the cost of equity. In reality, I expect BWP to grow slower than the aggregate economy over the long run and the cost of equity of only 6.3% appears too low to me. To see the impact of the two variables, I did a quick scenario analysis showing various intrinsic values for given expected growth rates and cost of equity. The shaded area reflects my opinion for the range of fair value of BWP from $27.16 to $39.70 using a 2-2.5% expected growth rate and 8-10% cost of equity.
I think that Boardwalk Pipeline Partners offers a great yield more than twice what the S&P 500 is paying right now. BWP will have more challenging time raising future distributions, but its relatively new assets are positioned to generate predictable cash flows. In my opinion the stock is not expensive, and if natural gas prices don’t plummet further and/or interest rates increase significantly, then BWP is a good addition to a diversified yield portfolio.