Master limited partnerships (or MLPs) differ from regular stocks in that interests in them are referred to as units and unitholders (not shareholders) are partners in the business. Importantly, these hybrid entities bring together the tax benefits of a limited partnership with the liquidity of publicly traded securities. The assets that these partnerships own typically are oil and natural gas pipelines and storage facilities.
A sub-sector of this business model, refining and marketing MLPs, operates refined products terminals, storage facilities and transportation services. They are involved in selling refined products (including heating oil, gasoline, residual oil, etc.) and a plethora of non-energy materials (like asphalt, road salt, clay, and gypsum).
Over the course of 2017 and early 2018, capital market access has remained tough and credit metrics stretched, making it difficult for the downstream (or the refining and marketing) MLPs to execute on their growth projects. As a result, the cash dividend (distribution) outlook became ambiguous, with a number of MLPs left with no choice but to trim their expected payouts.
Apart from payout shocks, the MLPs have also been bogged down by the Trump administration's 25% tariff on imported steel. Worse, the partnerships found themselves entangled in a FERC tax ruling, making them bleed even further.
Investors Have Largely Shunned This Industry
Looking at shareholder returns over the past year, it is quiteapparent that investors are not too confident about the industry’s prospects. Despite improving commodity prices and the subsequent surge in product volumes for midstream entities, the space still has a lot of uncertainty surrounding their cash flow generation abilities, while the tax policy change has gripped the sector with wide-ranging concerns and uncertainty.
The Zacks Oil and Gas - Refining & Marketing MLPs, part of the broader Zacks Oil and Energy Sector, has underperformed both the S&P 500 and its own sector over the past year. While the stocks in this industry have collectively gained a meager 3.4%, the Zacks S&P 500 Composite and the Zacks Oil and Energy Sector have rallied 16.2% and 9.4%, respectively.
One-Year Price Performance
The Group Remains Pricey for Investors
Since midstream-focused oil and gas partnerships use fixed rate debt for the majority of their borrowings, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.
Despite the massive industry underperformance over the past year, the valuation picture appears a little lofty, in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 12.84, at a premium to the S&P 500’s EV/EBITDA ratio 11.78. Moreover, the group’s valuation leaves little room for upside when compared with its median level of 13.12 over the 12-month period.
Enterprise Value/EBITDA Ratio (TTM)
As the industry’s valuation multiple is closely corelated with crude prices, comparing the group’s EV/EBITDA ratio with that of its border sector may make better sense to many investors.
The parameter shows that the group’s EV/EBITDA ratio — at 12.84 — is significantly above that of its broader sector’s 5.93. While this asset class has always commanded a premium valuation based on its relative immunity to commodity price fluctuations, investors should note that the industry is currently facing the drag of rising crude prices on refined product margins.
Enterprise Value/EBITDA Ratio (TTM)
Prospects Look Dim on Bleak Earnings Outlook
Agreed, the sporadic resumption of distribution growth is good news for investors. But the cyclicality of the business, levered balance sheets and relatively weak demand for refined product fuels (gasoline and distillate) during the peak summer driving season continue to impact the partnerships’ bottom lines.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. Despite the relatively poor performance of the downstream MLPs over a year, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences its stock performance.
While one can get a good understanding of a company's earnings outlook by comparing the consensus earnings expectation for the current financial year with the previous year’s reported number, an effective measure could be the magnitude and direction of the recent change in earnings estimates.
The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks Oil and Gas – Refining & Marketing MLP Industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $1.25 EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks Oil and Gas – Refining & Marketing industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for 2018 but how this estimate has evolved recently.
Current Fiscal Year EPS Estimate Revisions
As you can see here, the EPS estimate for 2018 is down from $1.28 at the end of June and $1.31 this time last year. In other words, the sell-side analysts covering the companies in the Zacks Oil and Gas – Refining & Marketing industry have lowered their estimates.
Zacks Industry Rank Confirms Bearish Sentiment
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, paints a pessimistic picture for the near term.
The Zacks Oil and Gas – Refining & Marketing MLP Industry currently carries a Zacks Industry Rank #199, placing it at the bottom 22% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
Long-Term Growth Prospects Look Dim
The long-term (3-5 years) EPS growth estimate for the Zacks Oil and Gas – Refining & Marketing MLP industry appears downbeat. Except for two minor uptrends in November 2017 and June 2018, the group’s mean estimate of long-term EPS growth rate has been on a slippery slope to reach the current level of 6.2%. This compares to 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of this dull long-term EPS growth outlook could be could be the deterioration in the group’s free cash flow, which is a key metric for evaluating oil and gas related stocks. It’s quite clear that the partnerships are not generating enough cash to pay off debt along with funding capex and distribution payments since the beginning of 2016.
Free Cash Flow: Zacks Oil and Gas – Refining & Marketing MLP industry
The traditional fuels refining operation — where crude is turned into products ranging from gasoline and diesel to jet fuel and asphalt — is heavily dependent on commodity price fluctuations. A rising oil price generally results in the collapse of crack spreads —difference between the price of oil and refined products.
Therefore, given the current strength and stability in oil (the input for refiners), product demand is expected to be tepid due to high product prices. This, in turn, will weigh on cash flow generation at the partnerships with downstream exposure. Already, some of them had to cut back on distribution growth over the last few years.
As it is, sentiment among pipeline investors remains cautious following the FERC policy revision that signaled significant future changes on how the pipeline partnerships will go about treating income taxes in their books of accounts.
Partnerships charging cost-based rates for interstate transportation service would have to lower customer tariffs to move oil, gas and refined products around the country by the amount of their income tax allowances — substantial in certain cases. A reduction in cost recovery would likely cut into their cash flows.
Though a number of MLPs came up with press releases claiming negligible or no material impact from the FERC ruling, the tax policy change has gripped the sector with wide-ranging concerns and uncertainty. With the new rule expected to be adopted only by 2020, the issue may remain a thorn in the flesh for the foreseeable future.
Finally, at a time when the cost of equity and debt capital is rising, the near-to-medium term growth prospect for this highly levered industry is anything but encouraging. So, it would be prudent to stay away from some weak refining and marketing partnerships for now. Stocks carrying an unfavorable Zacks Rank are particularly expected to underperform.
CrossAmerica Partners LP (CAPL) is an MLP focused on the wholesale motor fuel distribution business through approximately 1,300 locations.The units of this Allentown, PA-based downstream player has lost 31.1% over the past year. The Zacks Consensus Estimate for the current-year EPU has been revised 304.2% downward over the last 60 days. CrossAmerica carries a Zacks Rank #5 (Strong Sell).
Price and Consensus: CAPL
Genesis Energy, L.P. (GEL) is an MLP engaged in pipeline transportation, refinery services and supply and logistics.The units of this Houston, TX-based downstream player has lost 10.2% over the past year. The Zacks Consensus Estimate for the current-year EPU has been revised 47.6% downward over the last 60 days. Genesis Energy carries a Zacks Rank of 5.
Price and Consensus: GEL
However, investors may consider buying onto the following stock which has been seeing positive earnings estimate revision. The stock carries a Zacks Rank #2 (Buy).
You can see the complete list of today’s Zacks #1 Rank stocks here.
Targa Resources Corp. (TRGP) is a provider of an array of oil and gas related midstream services — gathering, processing, logistics and marketing — in North America.The stock of this downstream player, also based in Houston, TX, has gained 18.8% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised significantly upward (from a loss of 13 cents to a profit of 27 cents) over the last 60 days.
Price and Consensus: TRGP
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