The Coming Pipeline Cash Gusher

Pipeline company earnings are being scrutinized for capital investment plans. The energy sector’s pursuit of growth has been well covered. Investors would prefer less excitement and more return on capital through dividends and buybacks. Company management teams are for the most part grudgingly co-operating. Targa (TRGP) CEO Joe Bob Perkins defiantly described growth projects as “capital blessings”. TRGP promptly dropped 5%. Owners want more cash returned.

Distributable Cash Flow (DCF) is the cash return from existing assets. REIT investors know it as Funds From Operations (FFO), an equivalent measure. Because DCF excludes spending on new projects, it reflects steady-state cash earned before growth initiatives. This is why DCF or FFO are commonly used in evaluating businesses whose returns come from large fixed assets, such as infrastructure and real estate.

Free Cash Flow (FCF) is the net cash generated (or spent) after considering DCF, growth projects and any financings and asset sales (i.e. after everything). It’s common for companies that are investing heavily to have little or negative FCF. Investors in such stocks ultimately expect FCF commensurate with sums invested.

Exploiting the Shale Revolution has boosted growth capex by billions of dollars, both for upstream companies as well as the midstream infrastructure sector. It’s why FCF has substantially lagged DCF in recent years. Although today’s income statements don’t show it, a combination of slowing growth capex and rising DCF will cause pipeline companies to produce vastly more FCF.

We examined all the names in the American Energy Independence Index (AEITR), which provides broad exposure to North American midstream corporations along with a few MLPs. On a bottom up basis, FCF was just over $1 billion last year, a paltry figure given the industry’s $514BN market cap.

The need for growth capital broke the MLP model (see It’s the Distributions, Stupid!). Their narrow set of income-seeking investors wasn’t willing to support the growing secondary offerings of equity without higher yields. Companies needed to find the cash somewhere, so four years of distribution cuts followed – for example, the Alerian MLP ETF (AMLP) has cut its payout by 36% since 2014, reflecting reduced distributions by the names in its index.

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Disclosure: We are invested in TRGP and TRP. We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund. To learn more about the Fund, please click more

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