The first part of every conference call is typically a review of quarterly or annual performance. In general, it is a rehashing of data released earlier that day, or perhaps the night before, and unless something has gone terribly right, or terribly wrong, it can be terribly boring. Until, that is, we reach the question and answer period. This section can unlock a tremendous amount of value for investors, not just on a company-specific level either.
Earlier this week, I spent some time highlighting three key takeaways from CEO Greg Armstrong on the Plains All American Pipeline, L.P. (NYSE:PAA) fourth-quarter conference call that I’d like to reiterate today. Though the issues discussed affect Plains, they are ultimately valuable for all energy investors.
1. Incentive distribution rights
Many of the most popular midstream companies are structured as master limited partnerships, or MLPs. With the notable exception of Enterprise Products Partners L.P. (NYSE:EPD), this structure requires MLPs to make payments to a general partner if and when their performance exceeds a certain level. These payments are known as incentive distribution rights, or IDRs. Many investors know little about them, other than that they exist. Armstrong sheds some light on the subject:
Clearly, the IDR burden increases our cost of capital. That’s really not an issue at all with respect to organic growth, because there’s a huge spread between our returns on our projects and our current cost of capital, even including the GP IDR. But where it really challenges you is on the initial transaction, big transactions. Because acquisition transactions, typically you’re having to pay a higher multiple. And it takes time to feather in the synergies or have the commercial benefits that you’re forecasting.
The main factor in Enterprise’s decision to absorb its general partner was in fact to lower its cost of capital. It is not a common practice, however. You can read more about incentive distribution rights here.
2. Consolidation of the midstream industry
MLPs are hot right now. These cash cows offer high yields and investors are flocking to them. It seems like there is an announcement about a new MLP spinoff every other week. But what about mergers? We’ve seen a few of those, and some of them have been quite significant. Armstrong gives his take here:
I think … we’re up to 90 plus MLPs today. My understanding is that there [are] probably 10 to 15 more in the hopper. It would surprise me if the answer is that number just gradually goes up and doesn’t contract at all with respect to some consolidation … And there’s fundamental industrial logic as to why some of that consolidation should happen. It’s easier to do when the markets aren’t as robust as they are right now because quite candidly people – you know capital is abundant and it’s relatively cheap. And people would rather do their own MLP than they would consolidate.
For now, perhaps we can expect to see many more spinoffs and IPOs than mergers. You can read more about midstream spinoffs and buyouts here.