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.