Description

WPZ Investment Memo for Value Investor Club:

Despite having an irreplaceable asset based built around one of the single most valuable pipelines in North America (Transco which is a regulated gas pipeline connecting the Northeast with the Gulf Coast), WPZ is trading at ~.5x book value, 8x EBITDA (not a tax payer) and carrying a 14%+ dividend yield (that is classified as a return of capital and therefore pays no tax).  The stock is down 54% YTD and is trading at multi-year lows…despite EBITDA estimates for 2015 being revised less than 10% over the last year.  For perspective, EBITDA is growing 25-30% this year and for the next couple of years.

WPZ is trading here because:

1. it is an MLP and most MLP depend on capital markets to fund growth capex.  With equity yields where they are, public equity markets are effectively closed for funding.  As such, there is extreme focus on how WPZ will fund its capex; i.e. if the equity market is closed and the debt market is widening out, will it have to cut its dividend ala Kinder Morgan?

2. It has material CHK exposure via the acquisition it made of CHK’s captive midstream

3. It has oil exposure via its ethylene cracker (think LYB). Very limited oil exposure outside of this.

I will address these concerns through the thesis below.

But we think on virtually every metric, the stock is wildly mispriced and we believe offers 100% upside. 8x EBITDA for irreplaceable core natural gas infrastructure that earns solid returns in a non-tax paying entity? Comping to a tax paying entity at a 30% tax rate, overstates the 8x by ~ 2.5 turns. Further, the EV is burdened here by significant investment capital that is not earning yet as projects have a lead time from spending to earning. 

A 15% distribution yield that will grow over time while the balance sheet delevers as growth projects come into service? This should be more like 6-8% in today’s low interest rate world. Book value here is tricky given the payout model and some of the transactions but suffice to say that on any balance sheet/replacement value/invested capital metric, this doesn’t make much sense.  Staying power here will be highly rewarded in our view.

Business Description:

Williams Partners, LP (WPZ) is an MLP that operates regulated interstate gas pipelines, gas gathering pipelines and processing plants, NGL fractionation plants, and a petrochemical cracker (which consumes ethane and propane to produce ethylene and propylene)

WPZ is organized into 4 segments:

• 1) Northeast G&P:   gas gathering and processing operations in 1) Northeast PA, and 2) northern WV and eastern OH

  • This segment is a key driver of WPZ’s growth, on the back of growing natural gas production in the Marcellus and Utica

• 2) Atlantic-Gulf:  Transco gas pipeline (regulated, a key gas pipeline artery of the U.S., and the backbone of WPZ), Gulfstream gas pipeline, and various Gulf of Mexico gas gathering and processing operations

• 3) West:  Northwest gas pipeline (regulated) and Rockies gas gathering and processing operations

• 4) NGL and Petchem Services:  Geismar petrochemical cracker, Canada off-gas processing, and various other operations

In June of 2014, WPZ also completed the acquisition of Access Midstream which today is roughly 20% of WPZ EBITDA.  ACMP is an MLP that operates gas gathering and processing services in most major U.S. shale basins.  It is the former midstream business of Chesapeake Energy (CHK), and was spun-out in July 2010.  ACMP’s business is 100% fee-based, in an industry where ~30-40% of most peers’ revenue is commodity based and exposed to both gas and NGL prices.  When ACMP was spun-out of CHK, it had to set up service contracts with CHK because that’s who the majority of its business was done with. ACMP got extremely favorable contracts with CHK, which were either ‘cost-of-service’-based (i.e. guaranteed mid-teens return on invested capital), or fee-for-service (i.e. no direct commodity price exposure) with minimum volume commitments (i.e. minimal volume exposure).

The CHK risk is usually framed 2 ways. First, if CHK goes BK, WPZ will lose all this EBITDA. This is just patently false. The CHK issue is a balance sheet issue. Not an asset issue. If they go bust, those assets will run and they will run right through bankruptcy.  They are the senior most claims in the capital structure and rest “on the well head”.  In other words, the contacts have liens against the mineral rights.  The 2^nd concern is more valid: how over-market are those contract and what is the hit if those reset to market levels.  Our work (corroborated by ETE management and WPZ CFO) is that worst case scenario hit would be $200mm in 2018/19. That is ~3% of 2018 EBITDA.

Here is a map of the WPZ footprint:

Three Components to the Thesis:

Quality of base business:

The fundamental pressure presumed to be on WPZ is vastly over-stated.  To be sure, there is a checkered history of hear of negative developments as the business used to be very levered to NGL prices; as the US became over-supplied with NGLs from wet gas, the company had to cycle through this pain.  We are through this and several other exogenous events that have plagued the company.  Here is a snapshot of what WPZ’s evolution looks like.

WMB owns one of the most valuable energy infrastructure footprints in North America, which will facilitate industry-leading growth investment through the end of the decade.

With 2015 ending,  all of the projects that WPZ pre-financed with equity over 2012-2013 are coming or have come online in H2’2014-2015, and will drive a meaningful increase in WPZ Standalone EBITDA.  Combined with the return of their ethylene cracker (Geismar), credit metrics, cash flow, and growth are set to inflect higher. Further, Williams’ quality of earnings is improving materially as shown in the pie charts above.

Legacy Williams is loaded with top tier assets and growth, with the most important being:

1) Transco Gas Pipeline, between the Gulf Coast and Northeast, which is regulated (so return is a guaranteed ROIC).
(~$830mm 2014 EBITDA growing to >$1.4bn in 2018E and further growth thereafter)

• WMB’s Transco pipeline used to ship gas from the Gulf Coast supply region to demand markets in the Northeast (e.g. NYC). Theoretical $100bn replacement value; in reality you couldn’t build the pipeline today if you wanted to.

• Shale gas have turned gas flows on their head, so WMB has reversed flows on Transco and is adding as much capacity as it can.  Transco’s flows now connect the Marcellus, the best gas reservoir in the U.S., to
          1) LNG on the East Coast
          2) the U.S. Southeast, the fastest growing region nationally for gas demand amidst a gas power plant buildout
                      - there are plenty more of these projects to be added to guidance, as high-return ‘singles and doubles’
          3) the U.S. Gulf Coast to supply LNG and a growing Petrochemical industry

• New Transco projects come at high returns on capital because they are brownfield. They’d be even higher if the asset wasn’t regulated

  • Most important approved growth project is Atlantic Sunrise, a $2.1bn growth capex opportunity (attributable to WPZ;  >$3bn project overall incl. minority interest contributions), which will ship gas from the Marcellus to Cove Point LNG in Chesapeake Bay and down to the Gulf Coast, and is anchored by Cabot Oil & Gas, the lowest-cost gas producer in the U.S.

• 2) Northeast Nat Gas Gathering/Processing in the Marcellus and Utica
  (~$300mm 2014E EBITDA growing to >$750mm in 2018E)

  • Comprised of 4 separate assets: 
    1) Susquehanna Gathering, for Cabot Oil & Gas (COG), the lowest-cost nat gas producer in the country
    2) Caiman Gathering/Processing, for ~10 different producers of varying sizes / commitments to the acreage
    3) 58% ownership Caiman Energy II, which owns 50% of the Blue Racer Midstream JV in the Utica (other 50% owned by Dominion Resources)
    4) 50% ownership in Laurel Mountain Midstream, a dry gas gathering JV with Chevron for their acreage

  • EBITDA to grow from ~$300mm in 2014 to >$750mm by ~2018E

  • Susquehanna is a terrific asset. COG will grow volumes on a ‘manufacturing-mode’ basis through 2020 and beyond

  • Blue Racer has a Tier 1 position and is an underappreciated piece of WMB’s growth story. WPZ will most likely buy out [private equity company] Caiman Energy’s remaining 42% interest in Caiman Energy II.

• 3) Geismar ethane/ethylene cracker in LA  (think LYB)
  (~We estimate $150mm EBITDA in 2016 which is already down massively from 2013/14 levels)

  • Generates ~$750mm of EBITDA/year at ~$90 crude… risk here is skewed massively to the upside

  • 1.1bn lbs / year cracker recently expanded to 1.6bn lbs / year

  • Cracker suffered an explosion and fire in June 2013 which resulted in 2 fatalities; the cracker had been out of operation for much longer than anyone thought but is now back online.

  • Plant consumes ethane as feedstock, ‘cracks’ it by putting it into a furnace, and it spits out ethylene, the building block for plastics. Geismar is near the bottom of the global cost curve, along with the rest of the US ethane-based crackers and Middle East Crackers. Their feedstock, ethane, will be massively oversupplied through the latter part of the decade at least. Their end product, ethylene, has its price set by naphtha-based crackers in Asia and Europe, where ethylene is ~2x as costly to produce at $40 crude and 4x as expensive at $90 crude. Simplistically, global ethylene prices are set by the price of crude oil (of which naphtha, their feedstock, is a by-product). In reality, U.S. ethylene prices are set by local supply/demand dynamics and should trade at  a premium to global ethylene because it is higher quality and there are logistical/relationship challenges with importing ethylene.

  • It is unlikely, but there’s an outside chance Williams announces a ‘Geismar II’ ethylene cracker on a fee-based basis. Whether such a project is good/bad for WPZ depends on the contract terms (particularly protection from capital cost inflation and commodity price exposure), because a new world-scale cracker in the Gulf Coast will most likely come in over-budget and late.

• 4) Canadian Oil Sands Off-Gas Processing
  (~$300mm 2014 EBITDA, to be flattish with upside from crude prices)

  • Williams is the only company in the world with the technology to process oil sands ‘off-gas’ (by-product of oil) into propylene and NGLs.  The technology both adds value and reduces oil sands emissions.

  • There are 3 oil sands upgraders in Alberta… Williams has a plant at Suncor already, is building one at CNRL now, and is in advanced negotiations to build one at Syncrude (which is not in guidance but will inevitably be built)

• 5) Northwest Pipeline and Rockies Gathering
  (~$900mm 2014 EBITDA to stay flattish, but new projects likely to be approved and drive upside)

  • Northwest Pipeline transports gas from the Rockies to markets in the Pacific Northwest, generating ~$340mm/year of fully-regulated EBITDA (i.e. guaranteed return on capital). 

    • Upside potential here for projects not-in-guidance, including the Pacific Connector JV with Veresen (>$2bn capex for WPZ’s 50% share) to take gas to Veresen’s planned Jordan Cove LNG plant in Washington, which has non-FTA approval and is anticipating FERC approval in ~Q2’2015

  • Leading gas gathering/processing position in the Rockies, primarily for WPX among other customers. This business is in decline at LSD% but still generates ~$500mm of EBITDA/year.  West G&P EBITDA has been exceeding budget for 2013-2014’YTD.

• 6) Offshore Gulf of Mexico Gas Gathering
  ($160mm 2014 EBITDA growing to ~$600mm in 2018E)

  • Williams and ENB are the industry leaders in GoM offshore pipelines (in addition to Majors)

  • 2 projects offshore GoM starting up in H2’2014:  Gulfstar (~$200mm of annual EBITDA) and Keathley Canyon (~$60mm of annual EBITDA)

  • New ‘Gulfstars’ highly likely in the GoM and ~$1bn capex each - Gulfstar is a Floating Production System (FPS) for which WMB took a standard design approach so it could be easily replicable for future projects. This is the likely FPS choice for future GoM development wells in the U.S., as well as for PEMEX as it develops its offshore reserves in ~2017-2020

• WMB has had more than its share of issues over the past 3 years, but THESE ISSUES ARE AT AN INFLECTION POINT
  A brief history of Williams key issues in recent years and putting them in context:

  • In general, the old management’s execution track record is very mediocre. They have made 2 material mistakes (at Caiman and Geismar, more below), which for casual observers overshadow the company’s strong execution history in the company’s core businesses of interstate pipelines and offshore Gulf of Mexico oil/gas gathering, both businesses in which Williams is best-in-class. They have also hit several ‘home runs’, in particular their acquisition of ACMP (their initial investment of $2.5bn was worth $5bn after just 1 year) and of Cabot’s gathering business (their entry cost here was just $150mm).

    1) Oversupply of NGLs caused structural deterioration of NGL prices, severely impacting WPZ’s NGL extraction business over 2011-2013.

    • In the Rockies and Gulf of Mexico, WPZ processes ‘wet gas’ (a stream of nat gas and NGLs), which it separates into dry gas and NGLs at gas processing plants. This business was traditionally structured on ‘keep whole’ contracts, where WPZ would pay its customers for the gas energy value of the NGLs, then sell them as NGLs at higher prices, capturing the spread between the price of NGLs and cost of gas (“Frac Spread”).

    • In 2011, WPZ made $982mm of NGL margin, when Frac Spreads were $0.89/gal. Frac Spreads for 2013 were cut in half to $0.45/gal (2014E is similar at ~$0.40-45/gal), which cut WPZ’s NGL margin to $448mm. WPZ (ex-Canada) Segment EBITDA fell from $2,667 in 2011 to $2,494mm (-6%), with the decline driven by the $534mm NGL margin headwind (-20% of 2011 EBITDA). Excluding this NGL commodity price headwind, Segment EBITDA grew from $1,685mm to $2,046mm in 2013 (+20%).

    • NGLs are a much less meaningful part of Williams’ business today. In 2011, they were 37% of Segment EBITDA.  In 2013, they were 18%. Pro forma for the ACMP merger, NGLs will be 7% of 2015E Segment EBITDA, falling to ~5% in 2017-2018.

    • Not only are frac spreads less meaningful to Williams today, they are also on their a**. There is not much room for them to fall further, and if they do it doesn’t matter. This risk to the Williams story is now behind it.

      2) Caiman acquisition has been a massive disappointment and capital destructive.

    • WPZ acquired the Caiman gathering system in West Virginia, targeting the SW Marcellus and Utica shales, for $2.5bn in March 2012, and they have since invested another ~$2.5bn capex. The business is only expected to generate ~$50mm of EBITDA in 2014, well below the company’s underwriting expectations.

    • Upshot here is WPZ owns a $5bn asset that is significantly under-earning, offering upside growth potential with minimal incremental capital requirements.

    • My view of the situation is that WPZ overpaid for assets that were inadequately diligence, were poorly constructed to withstand the harsh Appalachian weather and mountainous topography, and were untested for those conditions. In the winter of 2012-2013, the gathering pipelines suffered several ruptures and disruption from landslides, and also clogged up due to liquids dropping out of the gas stream. This discouraged Caiman’s producer customers from investing capital in the basin until the infrastructure demonstrated reliability, and in the case of what were supposed to be the 2 biggest customers (Statoil and Chevron), these delays were crippling because they lost momentum to invest in the basin.  Over the summer 2013, Williams made significant improvements to the infrastructure and the systems demonstrated reliability over the extremely harsh winter of 2013-2014.

      3) The aforementioned headwinds coincided with WPZ deploying record amounts of growth capex, which required material equity financing , resulted in a ‘perfect storm’ to hit WPZ’s “distribution coverage” ratio. This is MLP speak for how much of your dividend is covered by cash earnings using maintenance capex.

    • WPZ’s distribution coverage ratio was 1.41x in 2011. It fell to 0.95x in 2012 and 0.90x in 2013.

    • The NGL margin headwind was a major driver of the coverage deterioration.

    • The other major driver was that WPZ’s growth capex was pre-financed with equity.

      • WPZ spent growth capex of $2.8bn, $3.0bn, $3.3bn, $3.5bn over 2011-2014E, as well as $2.4bn for Caiman in April 2014

      • Capex was financed at ~50/50 debt/equity. WPZ was faced with the requirement to pay distributions to incremental LP units, even though the cash flow that the equity was raised to generate was still years away. This created a transitory under-covered situation at WPZ which the market was very penal for (in 2013 the market clearly differentiated its favor of MLPs with 1x)

    • This issue of pre-financing WPZ capex with equity is now largely behind us. Meanwhile, the growth that equity was financing will grow EBITDA and DCF meaningfully in 2016.

      4) Williams Geismar ethylene cracker exploded in June 2013, killing 2 people, and taking out the driver of ~20-25% of WPZ’s EBITDA. This issue is now fully behind the company.

      5) Soroban and Corvex (‘the Activists’) filed a 13D in December 2013, pushing for board seats and better management of Williams’ business. Eric Mandelblatt of Soroban and Keith Meister of Corvex were added to the Williams board in February 2014.

      6) In September of 2015, ETE (a major MLP competitor) announced the agreement to buy WMB which is the GP that controls WPZ.  I will avoid this soap opera here as the real implication for WPZ is that ETE believes there are at least $400mm of operational synergies that it will be drive out of WPZ.  Here is there justification for this:

Quality of backlog:

This chart shows where a majority of their capital is being invested as well which drives lots of growth in 2016-2018.  These are typically 15 year contracts with regulated returns

Summary Financials:

Catalyst

Q3 started a trend of what we believe solid, consensus beating results

ETE/WMB deal close will setoff the synergy realization

These results will show very manageable capital markets needs