One of the biggest advantages for companies that operate in the midstream space is the ability to create a master limited partnership subsidiary. By placing pipeline, storage and terminal assets into an MLP, the sponsoring firms are able to avoid taxes and receive generous distribution payments.

Those payouts get even juicer thanks to the continued relationship between sponsoring firm — called the general partner (GP) — and their publicly traded MLP subsidiaries. After acquiring new pipelines or gathering facilities, GPs often will pass along or “drop down” some of the prime assets into their MLPs.

These asset sales are priced at a level that guarantees cash flow accretion for the MLPs and enables the MLPs to raise distributions at a faster rate. The general partner benefits directly from increased distributions on the limited partner units it owns, as well as from increased incentive distributions — all while avoiding taxation on those assets. When it’s done right, it can be a thing of beauty for shareholders in both the MLP and GP.

For Spectra Energy (SE) and Spectra Energy Partners (SEP) shareholders, it’s a beautiful thing indeed.

‘All Our Pipelines’

Since its spin-off from electric utility Duke Energy (DUK) back in 2007, natural gas pipeline firm Spectra Energy has produced pretty steady and dependable returns for its shareholders. However, according to activist investors at Sandell Asset Management, the company has always traded at a discount to its intrinsic value.

Bowing to pressure from the hedge fund, Spectra is planning to boost returns for its shareholders … and its plan is a quite a doozy.

The company has agreed to drop down not one, not two, but all of its remaining U.S. transmission and storage assets to its master limited partnership — Spectra Energy Partners — by the end of the year. That will make SEP one of the largest MLPs and pipeline companies in the nation.

Spectra had initially resisted the idea because many of its primary pipelines are older — i.e. more depreciated on their balance sheet — and have a lower tax base, which would result in higher taxable gains on the drop-downs. However, the good news outweighs the potential bad tax implications.

The drop-down of assets into SEP will ultimately put  Spectra in a stronger financial position to carry out the additional pipeline projects it has recently began implementing. In attempts to diversify away from natural gas midstream infrastructure — which generated $5.1 billion in revenue last year — Spectra has started to break out its check-book and purchase some “oilier” assets.

Back in March, the company purchased its first oil pipeline from Kinder Morgan Energy Partners (KMP), The Ontario Teachers’ Pension Plan and Borealis Infrastructure Partners for $1.25 billion. The Express-Platte Pipeline System is one of three critical pipelines that transport crude oil from Western Canada to the U.S.

Analysts believe this is just the first of many moves, as Spectra announced at the time of the deal that it was looking for more bolt-on investments in oil and refined products pipelines, storage tanks and terminals.

Boosting Dividends

In the end, Spectra will be able to add capacity across its logistics empire and boost dividends and cash flows … and investors may not have to wait that long for that to happen.

See, one of the best things about drop-down transactions is that they are usually immediately accretive. Meaning, they start paying “dividends” and cash flows right away. The SE/SEP deal is no exception.

According to CEO Greg Ebel, shareholders will see a higher level of dividend grow at both firms. Investors in Spectra Energy will realize annual dividend growth of 12 cents per share vs. its previous commitment of only 8 cents, while Spectra Energy Partners unit holders can expect quarterly distribution rate growth of a penny versus the current three-quarters of a cent.

While that may not seem all that impressive, this is from one transaction and doesn’t include any potential increases from additional asset purchase or drop-downs, nor does it include potential increases due capacity upgrades.

This could be the tip of the iceberg in terms of rising distributions for the two share classes.

Time To Buy

While news of the drop-down sent shares of SE up as much as 11% on Wednesday and units of SEP up 6%, over the longer term the deal could propel the pair still higher. The chance for increasing distribution rates from both firms is exactly what investors should be looking for in MLPs and their respective general partners. The SE/SEP deal highlights this fact quite nicely.

Additionally, the shift in focus from being a strictly natural gas logistics player to being more diversified can only help shares as America’s shale revolution is taking many forms.  If we’re going to actually use all of this energy we are producing, transporting it from the remote places where it’s produced to the markets where it can be refined or consumed is a necessity. Spectra will be a forerunner in that process.

Analysts seem to agree. At least three firms — Morgan Stanley, Deutsche Bank, and Tudor Pickering Holt — upgraded the stock after the deal was publicized and publicized higher price targets for shares of SE and SEP.

Both share classes aren’t the cheapest on a P/E basis, but at current prices investors are the gaining exposure to some decent future dividend increases. Investors should take the plunge on Spectra. 

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.