It’s no secret that master limited partnerships (MLPs) — when done right — could be gifts from the market gods. The pass-through structure allows for some hefty tax-advantaged distributions to sponsoring firms and holders of the general partner.
For investors in MLPs, you’re treated to similar high dividends and a long-term total return that beats just about every other asset class out there.
The unfortunate thing is that even MLPs have their limits.
And for natural gas midstream giant Williams Companies Inc (NYSE:WMB), we may have reached that limit. That’s why it decided to eat its MLP subsidiary and move the unit back into WMB.
While some may think that’s a a bad move on the part of WMB, it actually is the right decision — and investors of WMB stock should benefit over the long term.
WMB Follows Kinder Morgan’s Lead
Over the last few years or so, energy firms of all stripes have begun to seriously take a look at spinning off midstream assets as MLPs in order to drive profits and boost returns for their investors. So it may seem odd that WMB is deciding to swallow Williams Partners LP (NYSE:WPZ) its MLP and potentially leave tax savings on the table.
But for Williams Companies, the structure doesn’t work because Williams is just too big.
Since buying Access Midstream last summer, WMB owns nearly 34,000 miles worth of interstate pipelines, terminals and numerous processing and chemicals refining facilities. Williams at some point touches 30% of all the natural gas produced in the United States. That’s pretty darn impressive.
But when operating at that scale, it takes huge joint ventures, expansion projects or buyouts to make a real dent in profits and cash flows. This is exactly what’s going on at many of the major integrated energy firms.
Spending $2 billion on some smaller energy firm isn’t going to do it at Exxon Mobil Corporation (NYSE:XOM). It had to spend $35 billion to buy XTO Energy in 2010.
For a midstream firm the size of Williams, it also takes a deal that large to move the needle for profit and cash flow.
Also, the MLP structure benefits from “drop-down” transactions with its parent. Basically, WMB will sell its MLP assets on the cheap and collect the dividends/cash flows back from WPZ. But as a pass-through structure, MLPs generally don’t carry a lot of cash. Most of their cash flows are kicked back as these distributions and IDRs to investors and the general partners.
As such, MLPs are constantly raising money via new debt and additional rights offerings of new units.
The problem is when you need to raise a ton of capital to do these drop-downs from your parent firm. That’s the issue at WMB/WPZ. And it was the issue at venerable midstream superstar Kinder Morgan Inc. (NYSE:KMI). Last summer, KMI ate its two MLPs in a surprise move.
The idea is that as a straight C corporation, Kinder Morgan would be able to reduce its cost of capital — because the MLP wouldn’t need to issue and debt — and use KMI shares as acquisition currency. Over the longer term, that will grow dividends at KMI faster. Cash flow and dividend growth at KMI and KMP had slowed in recent years.
The same thing should happen at WMB — perhaps even moreso, considering WPZ’s already high debt load.
Why WMB Stock Is A Big Buy For Investors
For investors in Williams, the deal is going to be a long term slam-dunk.
Initially, WMB estimates that its earnings should hit $5.4 billion in 2016 and $6.8 billion in 2018. Those earnings along with the simplified cost of capital should help increase cash flows pretty meaningfully.
Williams already announced that its third quarter dividend will amount to 64 cents per share — $2.56 per share annualized. That’s 6.7% over Williams’ previously guided third-quarter dividend.
More impressively, WMB estimates that 2016’s total payout will be about 20% what it pays out this year. Longer term, Williams should be able to grow its payout 10% to 15% from now until 2020.
Additionally, that payout is stronger than ever before. Based on increased cash flows, the new Williams as a C corporation will increase its dividend coverage ratio to 1.1 in 2016 and 1.2 in 2018. And as for the roughly $22.5 billion debt that WPZ and WMB had, it’s now considered investment grade — with Fitch removing any negative points based on the increasing cash flows and lower costs.
The only negative is the hefty tax bill awaiting WPZ unit holders. The buyout is a taxable event. The MLP structure allows investors to defer tax payments on distributions until the holder sells or the cost basis hits zero. Under the proposed buyout, WPZ investors will get tax bill for all those accumulated deferred distributions.
The positive is that longer term, your dividend is going to grow by a lot more than what WPZ was doing. The 14.5% premium that WMB is paying for WPZ should help cushion the tax bill as well.
The Bottom Line
WMB’s move to buy out its MLP WPZ is huge win for shareholders in the long term. Overall, WMB should become a dividend machine.
And that machine will deserve a place in your portfolio.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.
