Description

Columbia Pipeline Partners LP (CPPL)

I think Columbia Pipeline Partners LP (CPPL) is an attractive opportunity because the market has confused uncertainty with risk. I think fair value is $18-22/share (25-55% upside from here). I think that downside is minimal and you should get a catalyst in the next two or so months when TRP communicates their MLP strategy. They hired a financial advisor to help them with this process. Their analyst day is typically in mid-November. The only way I can foresee a downside case is if TransCanada were to essentially steal from public unitholders. I think that today’s announced acquisition of Spectra Energy (SE) for 14.7x 2017 EV/EBITDA places a floor valuation multiple for CPPL, as CPPL is higher quality and growing 2.5x the rate. Applying this multiple gives you an $18 price.

Overview

CPPL owns 15.7% of CPG OpCo, LP or “Columbia OpCo”, which is the entity that owns and develops all of the natural gas assets and operations for Columbia Energy Group. Columbia Pipeline Group (CPGX, now owned by TransCanada) owns the other 84.3% of Columbia OpCo, as well as the General Partner of CPPL and 44% of CPPL’s limited partner units. This is different from pretty much every MLP limited partner that has ever existed and therefore has created confusion, which I believe has resulted in an overly discounted price. Instead of growing by discrete asset dropdowns, CPPL grows by participating in its pro rata share of organic growth capex that is being built at 5-7x EBITDA (when the assets are worth 12-14x) and by purchasing additional interests in the OpCo. This structure was put in place to avoid recognizing gain on assets that have a very low cost basis. Importantly, CPPL also has a ROFO for any sale of OpCo interests.

As far as the business goes, MLP assets don’t get any higher quality than these. Columbia’s existing asset footprint sits right on top of the best natural gas assets in the US and one of the lowest cost basins in the world. Cash flows from the current assets should be relatively flat, as they have an average remaining contract term of over 4 years, are largely demand-pull (meaning their customers consumer gas rather than produce it) and virtually all of their cash flows are supported by firm, fee-based cash flows. The cash flows even if the gas doesn’t. Here is a map:

Source: NiSource Pre-Separation Update, 5/14/2015

Their growth runway is massive and underpinned by long-term, firm contracted cash flows with strong counterparties. The majority of their customers are investment grade. Those that aren’t are well-capitalized (if you haven’t noticed, E&Ps have had free access to the capital markets). Even still, non-IG  customers are required to post 1-2 years of collateral for pipeline capacity.

Through the balance of the decade, Columbia expects to spend ~$9B in growth capex at an average EBITDA multiple of 5-7x. One interesting element here is that a decent chunk of their maintenance capex, which would typically earn zero return, has been included as part of a modernization effort from the FERC and will earn low double digit unlevered returns. In sum, this build-out should result in +20% annual EBITDA growth for the next five years, assuming that CPPL simply participates in its pro rata share of capex and does not acquire additional interests in OpCo.

Source: NiSource Pre-Separation Update, 5/14/2015

Situation Background

CPPL IPO’d at $23/unit (70% above current price) in February 2015 and quickly traded to $28/unit (+110% above current price). The partnership was formed to serve as the “dropdown” LP for Columbia Pipeline Group (CPGX), which was about to get spun off from NiSource (NI). At the time, LP’s with +20% parent-supported, long-term distribution growth were trading at ~2% yields and represented a very attractive source of financing for MLPs with large growth capex needs. Despite the fact that the underlying business was arguably the highest quality Northeast gas infrastructure build-out story in the sector, the complicated structure and limited liquidity of CPPL resulted weak share price performance (the stock declined +40% by September and the yield spiked to 4%). As a result, the prospect of issuing ~$1B of CPPL equity per year against a public float of $900MM became significantly less attractive for CPGX. This resulted in an un-virtuous cycle that eventually pushed the yield above 5% and depressed the price to the low teens.

Once the MLP equity markets hung up their “Closed for Remodeling” sign in Q4 2015, CPGX, who was already deep into discussions with multiple bidders, threw in the towel and elected to raise capital at the GP level. In early December 2015, CPGX raised $1.25B in equity, effectively pre-funding equity capex needs for all of 2016. While at the time we thought this was simply a knee-jerk response from an inexperienced MLP management team operating in a bad capital markets environment, in hindsight we now know this raise was completed to help CPGX eliminate any opportunity for a suitor to use funding needs to wield negotiating leverage. In mid-March CPGX announced that it would be acquired by TransCanada (TRP) for $25.50/share in cash.  In response to having its parent replaced by a Canadian infrastructure major who has a well-documented aversion to anything that looks like financial engineering, CPPL units declined 28% (3/9-3/18) to around $13/unit and they garnered the ill-reputed “orphaned MLP” status. Even after this drubbing, the stock proceeded to underperform the Alerian MLP Index by over 10% the following six months as the market continues to await TRP’s unveiling of their “MLP strategy” (or lack thereof).

Today, investors and sellside analysts seem paralyzed by the fact that we don't know what TRP is going to do with CPPL. However, at this price, I think that anything shy of stealing the business will result in a meaningfully positive return. CPGX was acquired by TransCanada (TRP) in July 2016 for $25.50/share in cash, which represented a 20x EBITDA multiple. The Alerian MLP Index has returned almost 20% since CPGX accepted TRP’s offer. TRP has gained 24%. Today, CPPL trades at 13x 2016 EBITDA, which is slightly cheap than slower growing, much lower quality peers (SEP is the best comp here, it trades at 14.5x 2016 EBITDA multiple and 5.8% yield) and a deep discount to assets with similar growth profiles (DM, PSXP, SHLX, AM, EQM all trade at 18-21x EV/EBITDA and 3.8-4.1% yields) . While I accept that one needs to apply a control/GP premium when comparing CPPL to CPGX, I think the current discount is simply too wide, especially when one considers the “downside case” for CPPL in which it receives no support from its new parent, and therefore does not produce meaningful IDR cash flows thus negating any premium one may have applied for GP cash flow.

One last wrinkle here - sellside analysts generally seem to give CPPL 100% of the $630MM in debt that sits at the OpCo level, instead of their 15.7% share. This is likely a hangover from when the market looked at the CPGX/CPPL capital structure on a consolidated basis and, at that time, it was levered nearly 5x. But today, CPPL is levered at less than 1x. Believe it or not, but incorrectly layering on +4.5 turns of debt has a pretty meaningful impact to both valuation and funding options.

Outcomes

In my opinion, the market is currently paralyzed by the uncertainty around what kind of MLP strategy TRP will pursue. While I too share the frustration of not being able to handicap one outcome over another, I think we are at a price where it doesn’t really matter. I expect a positive return in almost every scenario.

This is how I think about TRP’s decision tree and what it means for CPPL’s possible unit price and return from today:

-          Best Case: $25 price / 85% return

o   What happens: CPPL buys TC Pipelines, LP (TCP) which is TRP legacy MLP. In this best case scenario, the acquisition could be 20% accretive (I base this number on some work that Credit Suisse did in their 4/11/16 note) and TRP would communicates a mid-teens long-term distribution growth rate. In this scenario, the current distribution gets a 20% bump and the stock trades at a 4% yield (aided by some TRP drops) and the stock trades at 4.5% yield.

o    Why it makes sense: TRP has +$25B in total growth capex over the next five years. They want to maintain their Baa1/A- credit rating. In order to do this you are going to need to issue a ton of equity. Much of their projects are in the US, so having a robust, low-cost funding option in the US is quite valuable. TCP’s IDR splits top out at 25%. CPPL’s IDRs go to 50%. In the long-run, TRP would retain more ownership of the business by using CPPL.

o   Why it doesn’t make sense: TRP’s dislike of relying on financial engineering to create value is well-documented. This option would require an assumption that MLP capital markets will remain open. Also, this option preserves the unique ownership of OpCo at the LP which the market doesn’t understand and TRP almost certainly dislikes.

-          Good Case: $22 price /  63% return

o   What happens: TRP leaves CPPL as a stand-alone, pure-play Marcellus/Utica gas MLP and reiterates the 20% distribution growth that CPGX had previously communicated. In this scenario I think the current distribution would receive a 3.75% yield.

o   Why it makes sense: This option requires the least amount of work and provides the cleanest framework for establishing CPPL’s cost of capital in line with high growth MLP peers.

o   Why it doesn’t make sense: CPPL already traded at a discount because of its odd structure and limited liquidity. These issues are marginally better because TRP has a much better balance sheet than CPGX did, but TRP will likely not be any better at communicating a complex MLP strategy and therefore probably won’t be completely successful in eliminating the discount.

-          Base Case: $19 price / 40% return

o   What happens: TRP decides to acquire CPPL, and consolidate its ownership of the Columbia assets. I would expect that anything less than a $19 share price (16x 2017 EBITDA) would have a very difficult time getting a fairness opinion and/or public unitholder support. Since each incremental dollar paid for publicly held CPPL units only costs TRP $54MM, which pales in comparison to their $13B acquisition of CPGX and any value they place on being seen as good corporate actors who need to access the markets to fund a $25B growth capex program, I don’t think it makes sense for TRP to try and put the screws to CPPL public unitholders. Besides, that just wouldn’t be a Canadian thing to do.

o   Why it makes sense: TRP bought CPGX because they viewed the purchase as a once in a lifetime opportunity to control one of the best NE natural gas footprints. They likely want to have complete flexibility financing their growth projects and buying in CPPL affords them that opportunity. Also, buying CPPL at $19 is arguably a discount to its fair value.

o   Why it doesn’t make sense: TRP would benefit from having a lower cost equity source of capital in the US. TCP is not likely liquid or high quality enough to fund a meaningful amount of growth capex.

-          Bad Case: $16 price / 19% return

o   What happens: TRP has TCP buy CPPL for a small premium and communicates a mid-single digit distribution growth rate. In this scenario I think your return would equal the premium that TCP paid, plus however much TCP went up due to the fact that its assets just got a lot better and its growth rate is going to be higher and more visible.

o   Why it makes sense: TRP was very intentional in setting a top IDR tier of 25% for TCP and they are farther into the high splits. Also, TCP is roughly 3x larger than CPPL.

o   Why it doesn’t make sense: In any scenario where TRP does not buy-in CPPL, TRP is going to have to fund organic growth at the MLP level. Through 2020, this capex burden will likely exceed $1.5B. TCP’s ten-year debt trades at a 4.2% YTM, which is +150 bps higher than TRP’s ten year debt. TCP’s distribution yield is 7.2%, versus TRP’s dividend yield of 3.7%. If a TCP/CPPL combination is still viewed as a low-growth MLP with an uncommitted parent then MLP funding will be much more expensive than alternative options.

-           Really Bad Case: $17 price / 26% return

o   What happens: TRP offers no support or distribution outlook for CPPL and leaves it to fend for itself funding its own portion of the growth capex. In truth, I have no idea where the stock would initially go in this scenario. Since this is the worst case (outside of TRP somehow stealing assets from OpCo), I suppose the stock would go down. If that happened I would just buy more. I saw one sellside shop that says they think the stock hits $11 in this scenario. That seems punitive, but it also would be an excellent opportunity.  In this scenario, I’d look at valuation more on the basis of a discounted future EV/EBITDA basis. The five year distribution growth could be in the mid-teens ballpark, but it would be backend loaded and would assume all of the capex is debt funded. This is my back of the napkin framework. A $17 current stock price would give you a 15% annualized return, which is probably reasonable given how unlikeable this story will be for most MLP investors.

o   Why it makes sense: TRP may think that this would depress the stock even further and give them an opportunity to buy it in at a lower price.

o   Why it doesn’t make sense: Similar to the prior scenario, TRP would be foolishly ensuring that a large portion of their capital is going to be financed at an unnecessarily high cost of capital. Also, I still think that a fairness opinion is going to say that a proportionate share of a company that just traded at 20x EBITDA is worth more than 13x. Thus a “kill the stock to buy it in cheaper” option seems ill-advised.

Risks

The most credible risk scenario is that the MLP sector sells off materially between now and November and your loss between now and then exceeds whatever gain you might earn following TransCanada’s unveiling of their MLP strategy. I happen to like the MLP asset class a lot right now, particularly natural gas assets, and am happy to own this business until it is fairly valued.

The ideas expressed in this posting are the views and opinions of the author of this posting (Author).  Author has no obligation to update any of the information contained herein and has no obligation to update the posting to reflect any changes in the Author’s opinion on any of the companies or topics contained herein. Do not rely upon the information contained in this posting for making investment decisions; prepare your own analysis or contact your financial advisor. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  Past performance is not necessarily indicative of future results, and there can be no assurance that targeted or projected returns will be achieved.

Catalyst

TRP makes a decision on its MLP strategy