What Happened Last Week in MLPs: Consolidation and Simplification Highlights the Waning Importance of Dropdown Stories
DCP Midstream Partners (DPM) started the year off with a bang announcing a simplification transaction in which it would acquire all of its (private) sponsor’s assets, simplifying the corporate structure. The deal was not a true simplification in the sense that most MLP investors are familiar with, since the incentive distribution rights (IDRs) were not eliminated. Instead, the deal included a $100 million/year IDR waiver through 2019 to help DPM keep coverage ratios above 1.0×. Per the guidance they released, distributions will remain flat for 2017.
The market didn’t particularly support the deal as DPM fell 4.4% on the news. Industry analysts were overall neutral. While the simplification was welcomed, several analysts felt that the $100million/year IDR waiver did not go far enough—they (and the market) would have preferred to see the IDRs completely eliminated.
Unfortunately for DPM, their news was preceded by MPLX (MPLX)’s announcement that parent company Marathon Petroleum (MPC) would be dropping all MLP-eligible assets to MPLX in 2017 and it would be buying out the GP/IDR interest once that was completed.
While MPLX rose 1.7% on the news, analysts were significantly more bullish than the market, applauding the plan to remove the IDRs, lowering the cost of capital for future growth. On the other hand, John Fox built a dedicated website and published a public letter arguing for immediate IDR elimination instead and not dropping down assets at the accelerated rate.
The golden age of the MLP dropdown story appears to be fading (for now, at least). Last year, Shell Midstream Partners (SHLX) functioned as a pure dropdown story, raising its distribution by 28.7%, and yet its unit price fell 29.9% during the year. Only part of that can be blamed on equity overhang. Receiving assets from a parent is simple financial engineering, which can absolutely result in cash flow and distribution growth, but true value creation will be found in organic growth.
Future growth for the new DPM (which, by the way, will change its ticker to DCP on January 23rd) will be more dependent on the broader commodity story, as the recently acquired assets are more commodity sensitive. Concurrently, the company announced a handful of organic growth projects. Some investors will use this opportunity to use DPM as another way to access the Permian Basin and the SCOOP/STACK plays, but DPM management also cautioned against East Texas and Eagle Ford weakness. However, DPM still has IDR obligations which raise its cost of capital, resulting in growth headwinds.
MPLX, on the other hand, after these transactions, will be an MLP with peers like Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP). It will be one of the few MLPs with a market cap larger than $10 billion but without IDR obligations. With a lowered cost of capital, it will be able to pursue organic growth opportunities and be better positioned for M&A. The near-term headwind will be equity overhang as investors prepare for MPLX to issue units to pay for the final dropdowns.
[Recently, Williams Partners (WPZ) announced its own simplification transaction with parent Williams (WMB). The IDRs will be eliminated, the distribution (at WPZ) will be cut; however, WPZ is not a dropdown story, so we’ll leave discussion of this transaction for another day.]
It is no longer enough for an MLP to have a supportive sponsor with a large suite of dropdown assets, or to have no IDR burden, or to be advantageously positioned in a growth basin, or to have the vast majority of cash flows coming from fee-based contracts. As the asset class grows and matures, investors want to see near perfection before trading an MLP to sub-five percent yields.