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A 10% Yield, 11 Straight Hikes, No K-1, IDR Swap Deal Coming In Q2, Goes Ex-Dividend Soon
April 14, 2018 6:07 pm|Comments (0)

Looking for a new deal? In MLP land, there have been a few GP/Yieldco consolidations over the past few months, and we just came across another one, which looks rather interesting for income investors.

Tallgrass Energy GP LP (TEGP) is the parent/GP of Tallgrass Energy Partners LP (TEP) and has interests in a group of energy-related entities. On 3/26/18, TEGP announced a merger with TEP, in which TEP unitholders will receive two TEGP units for each TEGP unit they own.

TEGP’s earnings are virtually synonymous with TEP’s, which stem from midstream operations in the western U.S.

(Source: TEGP site)

Tallgrass Energy GP LP, through its interests in Tallgrass Equity LLC, provides crude oil transportation services to customers in Wyoming, Colorado, and the surrounding regions of the United States. The company operates through three segments: Natural Gas Transportation; Crude Oil Transportation; and Gathering, Processing & Terminalling.

Tallgrass owns and operates more than 6,700 miles of natural gas pipeline and about 760 miles of crude pipeline across a broad portion of the U.S. It also has one of the industry’s leading water reclamation programs situated in close proximity to producers. (Source: TEGP site)

To say that the Tallgrass corporate setup was complex would be an understatement – trying to decipher this setup reminded us of those Franz Kafka novels we read in English Lit. 101:

(Source: TEGP site)

This is one of the reasons that management is doing this merger deal – to simplify the group’s structure for investors, in addition to reducing its cost of capital:

(Source: TEGP site)

As mentioned above, TEP unitholders will receive two TEGP units for each unit that they own. In addition, management raised TEGP’s quarterly distribution to be exactly half of TEP’s, so there will be no distribution loss to TEP unitholders.

Tallgrass Energy Partners LP will be merged into a new entity, Tallgrass Energy LP, which will trade on the NYSE under the ticker “TGE.”

The new entity will be taxed as a C-Corp, which eliminates K-1 hassles for investors, and can give the combined companies broader market exposure.

The deal has already been approved by the boards of both TEGP and TEP, in addition to the TEP conflicts committee.

(Source: TEGP site)

On the Q4 ’17 earnings call, management referenced the fact that there’s a potentially valuable tax shelter available for the company.

“TEGP has a deferred tax asset of $ 313.0 million which is the expected tax benefit of available future deductions that offset future taxable income. It is currently expected that no cash taxes will be paid by TEGP for a period estimated to exceed 10 years”.

However, it’s uncertain if regulators will allow the new entity to use this asset or not.

Distributions

Here’s how the upcoming May distributions look for TEGP and TEP.

TEGP increased its quarterly payout by 37%, from $ .3675 to $ .4875, and was currently yielding 9.87%, at a price/unit of $ 19.75, as of 4/12/18 intraday. TEP’s distribution is $ .975, (2x TEGP’s). Both payouts go ex-dividend on 4/27/18.

Both companies have good quarterly distribution hike streaks going – TEP has raised their payouts for 19 straight quarters, while TEP has an 11-quarter streak.

We’ve added these two tickers to our High Dividend Stocks By Sectors Tables, in the Basic Materials section.

Arbitrage anyone? Unlike many mergers, in which the acquiring company pays a fixed price/share for the target company, this one is based upon a 2X multiple of the buying company’s price, TEGP, which arbitrage players may want to try to profit from. As of 4/12/18 intraday, there was a -$ .30/unit variance between the two unit prices, including the effect of the upcoming distributions:

Earnings

The yieldco, TEP, had huge growth in 2017, as new assets kicked into earnings. EBITDA rose 57%; DCF grew 50%; and revenue grew a more modest 7%. Management continued raising the quarterly distributions, which grew 20% in 2017, while TEP’s distribution coverage improved by 16%.

You can see part of the reasoning for the merger in the GP Interest & IDR payout figures below. These payouts grew by 43% in 2017 and were ~24% of TEP’s DCF. The total distributions payout was ~$ 563M, which should decrease after the elimination of the GP and IDR payouts post-merger.

Looking back further, it’s clear that TEP has produced some outstanding results, with EBITDA growing by over 6X from 2014 to 2017:

(Source: TEGP site)

This filtered into the Tallgrass group’s earnings:

(Source: TEGP site)

This is what supported all of these distribution hikes for TEP, which had a CAGR of 31% since 2013:

(Source: TEGP site)

Analyzing the Deal

Here’s how the merger shakes out, if management leaves the new entity payout at $ .4875/quarter, ($ 1.95/year). There will be 152.2M publicly held units and 126.7M LLC equity exchanged units, which would receive a total of ~$ 546M in annual distributions:

Can they afford to pay $ 1.95/year to all of those units? Management guided to a range of $ 755-835M in adjusted EBITDA for the new entity, with a coverage ratio of 1.20x or better:

(Source: TEGP site)

They had slightly different guidance figures on the S-4 document for this deal – $ 807M for adjusted EBITDA, and a DCF figure of $ 662.00 for 2018.

(Source: TEGP S-4 2018)

We looked at it three ways, using low, high, and S-4 guidance figures. Since there wasn’t a DCF figure given in the deal presentation, we used a 90% multiple of EBITDA guidance, (which is the same as 2017’s ratio), in the low-end and high end columns.

As the merger presentation stated, the new entity should have solid distribution coverage:

On the low end, using a $ 1.95/unit annual payout, the new entity would have coverage of ~1.24X. The high end coverage would be ~1.20X, if management raised the distribution to $ 2.24/year (which they haven’t stated as of yet).

If they hit the high end of their EBITDA target, and DCF is 90% of it, and they leave the payout at $ 1.95/year, their coverage would be a very robust 1.38X.

Using the S-4 doc’s guidance figures of $ 807M in EBITDA, and $ 662M in DCF, we inferred that coverage would be ~1.21X, if the distribution was $ 1.95/year for the new entity:

A good part of TEP’s EBITDA stems from unconsolidated investments. In 2017, TEP received $ 306.6M from these sources, which include the Rockies Express and the Pony Express Pipelines:

(Source: TEGP site)

Here’s a look at the 2015-2017 income statements for Rockies Express Pipeline LLC, often referred to as “REX” in the company docs. After a revenue and operating income dip in 2016, REX came roaring back in 2017, with revenues up 18.7% vs. 2016, and up 8.7% vs. 2015. Operating income also bounced back, rising 36% in 2017 vs. 2016, and 10.8% vs. 2015:

(Source: TEGP 2017 10K)

Risks

Deal Execution

TEP unitholders must approve the deal. However, Tallgrass Equity owns ~35% of the TEP units, so the deal should go through. The TEP and TEGP boards, and the conflict committee also already approved the deal. The other holdup might be regulators, but as of yet, we’ve heard no negative news about this.

New Entity Debt Load

The new entity would own 75% of Rockies/REX, so we took a look at how the combined debt loads of TEP, TEGP, and REX would affect the new entity’s debt leverage and interest coverage.

Both TEP and REX had good interest coverage in 2017, at 8.12X and 5.48X, respectively. The new entity would have ~3.6X interest coverage, based upon 2017 figures, which, of course, will change. It’ll be lower coverage, but still reasonable.

They also had reasonable debt leverage of 3.17X and 2.76X, respectively, which is roughly in line with other midstream companies we follow. (See Financials section for more on this.)

The new entity’s Net Debt/EBITDA leverage looks like it’ll range from ~5X to 5.6X. The company’s 10-K mentioned that there’s an upper end limit of 5.5X leverage. Timing is often tricky in these deals – the new entity may experience higher levels of leverage initially for 1-2 quarters, depending upon when the deal is finalized. However, it doesn’t appear that operations management will be changing, so that’s an advantage.

Management also mentioned on the earnings call that,

“REX’s board has agreed to repay the July 2018 maturity of $ 550 million. At TEP and Tallgrass equities current ownership that will amount to approximately $ 275 million and $ 137.5 million, respectively. This debt reduction will further strengthen REX’s balance sheet for the long-term and should be the next step towards returning REX to an investment grade pipeline. The less interest at REX is paid at the entity, the more cash there is to distribute.”

Other Developments

On the earnings call, management detailed several new growth projects:

On January 3, we announced an agreement to buy 51% interest in the Pawnee Terminal from Zenith Energy from $ 31 million and also announced the acquisition of a 38% interest in Deeprock North for $ 19.5 million. This past week TEP announced the acquisition of water infrastructure assets in the Bakken for $ 95 million, a prime customer there being XTO with an additional $ 45 million of capital expenditures expected.

We also announced the formation of a joint venture in the Powder River basin with Silver Creek midstream for the development of the Iron Horse crude oil pipeline. Iron Horse will transport crude oil from the PRB to Guernsey and then on into Pony Express. We expect to invest approximately $ 150 million into the joint venture and its associated Guernsey terminal.

Analysts’ Estimates And Price Targets

TEGP has received some upward earnings estimate revisions over the past month, as details of the deal were digested. 2018 estimates rose from $ 1.30 to $ 1.44, while 2019 estimates rose from $ 1.25 to $ 1.61.

(Source: Yahoo Finance)

At $ 19.75, TEGP is ~23% below analysts’ average price target, and ~42% below the $ 28.00 highest price target:
Performance

TEGP (candlesticks) and TEP (lavender line) are both down in 2018 but have moved higher since the March 26th merger announcement.

Options

Two other strategies to potentially profit from the merger deal, on a short-term basis, are selling covered calls and/or cash secured puts.

If you want to be aggressive but still get a lower breakeven, this in the money May put trade offers a $ 1.25 bid premium, roughly 2.5X TEGP’s $ .4875 quarterly payout, with a breakeven of $ 18.75.

Our Cash Secured Puts Table can give you more details for this put trade and over 25 other put-selling trades.

Conversely, you could hedge your bet by buying TEGP and selling covered calls against your units.

We’ve added this July trade to our Covered Calls Table, which tracks over 25 covered call trades on a daily basis. With the heightened volatility in 2018, we’re finding higher option premiums, which help to hedge vs. price declines.

The July at the money $ 20.00 call strike pays $ 1.20/unit, for an annualized yield of ~22%.

Here are the 3 main profitable scenarios for this trade:

  1. Static, in which TEGP doesn’t rise to or above $ 20.00 near the ex-dividend date or the expiration date, and you keep your TEGP units. In this instance, you’d collect $ 1.69/unit, the combination of the option $ and the distribution.
  2. Assigned pre- ex-dividend date. You’d collect the $ 1.20 option premium, and $ .25, the difference between TEGP’s $ 19.75 price/unit and the $ 20.00 strike, but no distribution.
  3. Assigned after the ex-dividend date. You’d collect all three profit streams, for a yield of 9.81% in this 100-day trade, or ~35% annualized.

You may be wondering why we didn’t detail selling options for TEP. The problem is that, since TEP’s eventual buyout price is tied to 2X TEGP’s price, you could end up with a downdraft once you buy TEGP. We’ve been down that road before, and it wasn’t pretty.

Since you’ll end up with TEP’s assets anyway, we prefer to own TEGP. Although the conventional wisdom is often to short the acquiring stock, and buy the target stock, we don’t feel that this will work in this case.

Valuations

Since it’s TEP’s earnings and operations that are mainly driving the Tallgrass group, we compared TEP’s valuations and yield to those of other midstream high-yield stocks we’ve covered in other articles. These include DKL Logistics Partners LP (DKL), Summit Midstream Partners (SMLP), Holly Energy Partners, L.P. (HEP), MPLX LP (MPLX), PBF Logistics LP (PBFX), Martin Midstream Partners L.P. (MMLP), and Green Plains Partners LP (GPP), Energy Transfer Partners LP (ETP), and Williams Partners LP (WPZ).

in 2017, TEP had far and away the best distribution coverage, at 1.47X. As detailed above, the new entity, TGE, will probably have coverage of ~1.20X, which is in line with this group’s average. TEP’s Price/DCF of 7.41X is lower than the group’s 8.82X average, as are its Price/Book of 1.97X, and its EV/EBITDA of 7.54X:

Financials

TEP’s Net Debt/EBITDA of 3.17X is the second lowest in this group, and its ROE and Operating Margin are above average. Its Debt/Equity leverage is also better than the group average.

Debt And Liquidity

On the Q4 earnings call in February (which was prior to the merger deal announcement), management detailed TEP’s liquidity status, as of 12/31/17:

At the end of the fourth quarter, TEP had nearly $ 1.1 billion of liquidity available on its revolver. TEP’s leverage as of quarter end was approximately 3x based on the trailing 12-month adjusted EBITDA as calculated according to our credit agreement provisions. As you know, this continues to be on the low end of our 3x to 4x long-term leverage target indicating ample leverage capacity at TEP to fund third-party acquisitions, organic growth projects, and TEP’s share of REX’s July 2018 debt maturity of $ 550 million.

Summary

We rate TEGP a buy, based upon its attractive, well-covered and improved yield, its sound management, and the oncoming merger deal, which will lower the cost of equity, and its ultimate overall organizational simplification – it’ll remain a C-Corp as the new combined entity, with no K-1 hassles for income investors.

All tables furnished by DoubleDividendStocks.com, unless otherwise noted.

Disclaimer: This article was written for informational purposes only, and is not intended as personal investment advice. Please practice due diligence before investing in any investment vehicle mentioned in this article.

CLARIFICATION: We have two investing services. Our independent, legacy site, DoubleDividendStocks.com, has been specializing in increasing yields via selling options on quality high dividend stocks since 2009. Option yields have improved a great deal in 2018, due to higher market volatility.

Disclosure: I am/we are long DKL, TEGP, MMLP, PBFX, ETP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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