MLP & Energy Infrastructure Team
St. Louis, Missouri
MLP Equity Review Q2’16: MLPs, as represented by the Alerian MLP Index gained 19.7% during the quarter ended June 30, 2016; this compares to a 2.5% return for the S&P 500 Index over the same period.
The quarter produced the second-highest quarterly return for MLPs in the past 20 years, continuing the significant rally that started in February. Through the first six months of 2016, the MLP index is up 14.7% vs. the S&P 500 return of 3.8%. For the one-year period, the MLP index declined -13.1% vs. the S&P 500 return of 4.0%.
Outlook: The second quarter was very productive for the MLP market. The “green shoots” that we outlined in our first quarter letter became more prominent in the second quarter, and MLP prices reacted positively to the improving conditions.
Specifically, MLP earnings held up in the quarter, capital-market activity accelerated, general partners continued to show support to their MLPs, and the fundamental outlook for oil & natural gas supply and demand improved.
We believe that the recent strong returns were driven by growing investor confidence as MLP prices moved up from the February bottom, worst-case scenarios for MLP fundamentals began to subside, and the “green shoots” took hold.
We expect the rest of the year to be more challenging for MLP investors, with our main rationale being that we have come very far, very quickly. In fact, the MLP index had rebounded 56% on a price basis since the February bottom, as of quarter end. At 14.7%, the 2016 year-to-date MLP index return has already reached the double-digit levels, which we projected for full-year 2016 in our last two letters.
While we expect that the MLP index will finish the year higher than it is today, we anticipate volatility will remain elevated as the recovery continues to take hold. We are maintaining our high-single-digit to low-double-digit total return outlook over the long term and believe that the returns and volatility levels of MLPs will stack up favorably against many similar asset classes that investors are comparing to MLPs.
The issues for MLP investors to focus on have not changed materially over the past six months. The prominent drivers of performance continue to be correlation with energy-related commodities, slowing distribution growth and attractive valuation levels.
Although valuation levels remain attractive, the recent move back to the low end of fair value leads to our expectation that the remainder of the year may be more challenging for investors. We think that there could be further weakness over the short term in commodity prices as the U.S. dollar strengthens. Furthermore, as the industry continues to respond to the lower-price environment, North American production volumes will likely bottom in the second half of 2016.
A counterpoint to this cautious outlook may be that many MLPs look very attractively valued in comparison to many other income-generating asset classes. This could lead to MLP valuations expanding even in a scenario where commodity prices and fundamentals are neutral.
There is positive news to report around MLP distributions. We projected in 2014 that MLP distribution growth, as measured by the Alerian Index, would come down from an 8% annualized rate, to a 4 to 6% annualized rate over the long term.
In the most recent quarter, distribution growth for the MLP index came in at 0.6% sequentially, indicating to us that contraction in distribution growth is occurring and that we should expect future quarter-over-quarter growth to be positive but modest as MLP management teams de-risk their distribution by building coverage.
Pedro Manfredini, CNPI
We are upgrading Cemig (CIG) to market perform (from underperform) and raising our year-end 2016 target price to BRL 10 [in the Brazilian currency, the real] or $3.10 [in U.S. dollars] per share from BRL 8.0 ($2.40).
While the upward revision of our target price was driven by the 190-basis-point reduction in our cost of equity (Cemig has one of the longest durations within our coverage universe), we are also less skeptical about the company’s ability to deleverage in the medium term. We believe that management now realizes that it could use a more favorable window of opportunities to sell some of its non-core assets (Santo Antonio, Telco, Gasmig and Taesa’s non-controlling shares), even if at a discount to the fair equity value.
Much-needed deleveraging is more likely now. Cemig’s recent outperformance was likely driven by some news flow linking the company to potential asset sales, more specifically, to the sale of Santo Antonio, Telco, Gasmig and Taesa’s non-controlling shares. We believe that Cemig could raise BRL 4.1 billion ($1.3 billion) by selling these assets at fair equity value, thereby reducing its consolidated net debt/EBITDA (including pension fund liabilities) to 1.6x by 2018, vs. 3.0x if it keeps the assets. We note that even if the company were to sell these assets at a 20% discount to fair equity value, the deleveraging would be significant, to 1.8x net debt/EBITDA by 2018. However, the impact on our target price would be limited (a decrease of BRL 0.9/share or $0.28/share).
Vinicius Canheu, CFA
55 11 3701 6310
We went to Cemig’s annual investor day (on May 24), held in Belo Horizonte, Brazil. At the event, the company discussed the main themes regarding its operations and provided its basic guidance for 2016 and 2017. Management estimates a consolidated EBITDA (including equity income) of between 3,235 million BRL to 3,997 million BRL ($1,003 million to $1,239 million) for 2016, and 3,404 million BRL to 4,205 million BRL ($1,055 million to $1,304 million) for 2017.
This consolidated guidance was reasonable with consensus up to the middle of the range. Overall, it was more aggressive in distribution and more reasonable in generation. Moreover, the company also reiterated its intentions to sell non-core assets in which it holds a non-controlling stake in order to deal with its high leverage ratios and refinancing needs. However, we expected more clear targets in relation to size and timing.
Distribution: The company expects 2016 EBITDA for its distribution segment of between $1,173 million to 1,448 million BRL ($364 million to $449 million), and 2017 figures of between 1,277 million BRL to 1,578 million BRL ($396 million to $489 million). We note that the company estimates flattish year-over-year captive market volumes in 2016, which surprised us given the -5.5% year over year drop in the first quarter.
On the topic of excess contracting, the company states that it would be 105.4% contracted throughout the year given their demand estimates. However, Cemig mentioned that the new possibility to renegotiate contracts with delayed generation projects already solves their issue. Finally, the company also expects to reduce its operating expense per client from $334 BRL ($104) in 2015 to $293 BRL ($91) in 2017 (flattish thereafter). This would follow a sharp decrease in personnel costs, with a reformed profit-sharing program and voluntary layoffs.
Generation & transmission: The company expects the segment to yield an EBITDA between 1,333million BRL and 1,646 million BRL ($413 million to $510 million) for 2016, and $1,568 million BRL to 1,937million BRL ($486 million to $600 million) for 2017.
Moreover, the company mentioned that it is already seeing recovering net prices at around $130 BRL per megawatt hour ($40 per megawatt hour) for five-year contracts starting in 2017. Given spot price (or PLD in Brazil) predictions, the company adopted an allocation strategy in which it heavily allocated its energy for the second semester in lieu of the first (when the spot price reached its legal minimum). This could boost the segment’s results later in the year with a higher PLD. We note that Cemig has basically no available energy until 2020, meaning that renewing some expiring contracts would put them in a short position.
Finally, regarding the legal disputes [involving] its three big expiring plants, Cemig mentioned that it is still waiting to sit with the new government and restart negotiations.
EQT Midstream Partners (EQM) reported Q2’16 earnings with adjusted earnings before interest, taxes, depreciation and amortization (or EBITDA) of $138.1 million, beating both consensus at $135.7 million (+2%) as well as guidance (slightly at $133 million to $138 million). Distributable cash flow (or DCF) of $129.7 million remains solid with coverage at 1.49x, and management increased both current-year 2016 EBITDA and DCF guidance. Overall, we see this as another impressive release from one of our top picks.
EQGP Holdings (EQGP) announced net income attributable to the partnership of $51.2 million, above our estimate, due to the strong underlying EQM beat (no DCF given in the release).
Key takeaways: The partnership raised CY16 EBITDA guidance to $555 million to $565 million (+2% at the midpoint), as well as CY16 DCF guidance to $495 million to $505 million (+4% at the midpoint). We note that this is before the last drop-down, which we still expect later this year. Capital expenditures of $695 million to $725 million plus $25 million in maintenance was reiterated.
Projects moving forward: The three largest projects are on track to meet their targets — Ohio Valley Connector, year-end 2016; Range Resources Header, first half of 2017, and Mountain Valley Pipeline, year-end 2018. We note the reiterated message on Mountain Valley Pipeline was key given the Federal Energy Regulatory Commission timing delay.
Volumes solid: Firm transmission reservations were up +2% year over year, and though actual volumes fell slightly (-1%), the gain in interruptible/spot volumes of approximately 150% year over year was notable. Gathering was up an impressive +29% year over year.
Distributions-per-unit growth on track: As reported earlier, EQM reported +22% year-over-year DPU growth for the quarter, with guidance of 20% through 2017 reiterated. EQGP came in at +63% year over year, with guidance of 40%-plus through 2017 also reiterated.
Brian J. Brungardt Jr., CFA
Two key takeaways on EQT Midstream Partners: One, the partnership completed $217 million of equity issuance during the quarter through its ATM [for “At the Market” common-unit offering program]. In turn, the partnership has approximately $830 million in liquidity including an untapped revolver. We estimate the partnership exited 2Q16 with total leverage of approximately 1.0x — well below management’s long-term targeted 3.5x.
Two, following the Q2 results, management modestly raised its fiscal-year 2016 guidance. Adjusted EBITDA increased $10 million to $560 million, and DCF guidance by $20 million to $500 million.
Unique balance sheet: Relative to the MLP space at large, we continue to view EQM as having a relatively rare balance sheet with total leverage of approximately 1.0x. We previously viewed the partnership as having sufficient liquidity to fund any free-cash-flow shortfall through FY17 with incremental borrowings under revolver.
Our view is reinforced following the partnership’s disclosure [that] it raised $217 million under its ATM program during the quarter and, in turn, has approximately $830 million in available liquidity.
Operational update: The partnership reported strong Q2’16 results which benefited from higher contracted-firm-gathering capacity and increased transmission fees from EQT.
The partnership reported adjusted EBITDA of $138.1 million (vs. our estimate of $133.8 million and Q1’16 of $141.6 million), which drove the DCF beat of $129.1 million (versus our estimate of $118.0 million and Q1’16 of $133.3 million). The partnership declared a DPU of $0.78/unit — payable on August 12 to those on record on August 5 — and a strong DPU coverage of 1.5x.