This week has been no friend to the long-term unit-holders of Boardwalk Pipelines (BWP) who were greeted with a cash distribution reduction of 81% from $0.5325 to $0.10. And because the appeal of midstream natural gas MLPs is generally the immediate income that they provide, the price of the stock fell almost 50% in reaction to the news, from the mid-$20s to just below $13 per share.
With the double whammy of a dividend cut and share price decrease like that, the only way to remain sensible is to channel your inner St. Lawrence, who reportedly said “Turn me over! I’m done on this side!” when the prefects burned him on the coal gridiron. You might as well accept the pain if you want to act intelligently going forward.
As we get ready to analyze what led Boardwalk to this predicament in which it saw wisdom in substantially eliminating the annual cash payout, it is worth stopping to inventory the moment to understand what led Boardwalk to this position in the first place.
The roots of Boardwalk’s current dilemma can be traced to the first quarter of 2006, when the management team decided to raise the quarterly cash payout from $0.179 per unit to $0.36. At the time, the decision seemed reasonable. With the doubled payout, the pipeline firm was only committing to paying $1.44 of its cash flow per share of $2.53, seemingly giving the management ample room to address its debt, fund some long-term growth using internally generated funds, and even have some margin of safety room to hike the payout ratio in the event that adverse conditions materialized.
Of course, as we now know with the benefit of hindsight, a rapidly growing cash distribution turned out to be a noose rather than a blessing when the financial crisis arrived in 2008 and 2009. This put the Boardwalk team in a tricky position: investors had grown accustomed to a distribution that increased every quarter without fail, but the firm found itself in a true crisis situation in 2009 when the cash payout exceeded the cash flow generated; unit-holders were receiving $1.95 per unit in cash distributions, but the pipelines were only generating $1.90 per unit.
Suddenly, all the options going forward had a Faustian quality: if you slash the payout in the middle of the worst economic situation since The Great Depression, then the already skittish investors will dump the stock, potentially creating a death-spiral in which case it would be impossible to access the credit markets to take on debt or issue additional shares because of a plummeting price.
With the price already depressed in the mid and upper teens, the management team acted intelligently (in my opinion) by holding the share count steady 192.6 million in both 2009 and 2010 as it would have been punitively dilutive to issue additional shares during a period of artificially low prices. With the share count holding steady, and the dividend exceeding the cash flow generated, the company found itself continuing on the path to taking on debt that now stands at north of $3 billion.
Because of the tradition of raising the cash distribution quarterly, and because of the painful commitment (in hindsight) created by the doubling of the cash payout in 2006, Boardwalk Pipelines needed high cash flow per share growth coming out of the financial crisis to re-establish the firm’s footing.
That didn’t happen.
Instead, Boardwalk faced three temporary, but ultimately debilitating, set of circumstances that led to this recent distribution cut. First, the pipelines were steadily generating less cash-in 2010, each unit was producing around $2.63 worth of cash flow. By the end of 2013, that figure had reduced $2.50 per share, which meant that the old $2.13 per share in cash distributions only gave the management team $0.37 per unit to put to use without increasing its already substantial debt load or having a share offering simply to use the capital to address the hemorrhaging.
The last two debilitating factors related to the claims on Boardwalk’s cash: the general partner, Loews (L), had converted its B shares into A shares, which had the net effect of diluting the share count by 10% and entitling them to the payout of $0.5325 instead of the A share payout of $0.30. In short, even though Boardwalk’s distribution had remained steady, the Loews conversion increased the amount of cash necessarily simply to maintain the cash payout at the status quo.
The other problem, of course, is the firm’s debt: total debt crossed the $3.3 billion mark (about half of which is due in the next five years). Within the next year, Boardwalk has debt maturities of $275 and $250 million coming due (Gulf South, and Texas Gas, respectively). If not for the fact that Loews has been willing to step in as Daddy Warbucks and provide Boardwalk with $300 million if needed, it is unlikely that Boardwalk would even be an investment-grade company.
Ultimately, the cash payout cut happened because the debt was overwhelming and the business was unable to achieve near term growth due to the unfavorable headwind of “repricing”. In a nutshell, Boardwalk recently lost $40 million in contract renewals because the oversupply in the natural gas industry in the past three years has led to a narrowing of the forward natural gas pricing curve (which has a detrimental effect on Boardwalk’s bargaining power).
The combination of those factors is what led to Boardwalk to cut the payout.
Looking forward, though, the terms of a Boardwalk investment are much more attractive today than they were a few days ago.
Boardwalk expects to generate $400 million in distributable cash flow this year, with the negative re-pricing factors included. Boardwalk has always been a cash generating machine-even in 2009, possibly the worst environment we’ll see in our lifetimes (knock on wood), Boardwalk still pumped out net profit of $162 million. It’s not that the underlying company is bad-the cash generated has always been impressive since the company went public in 2005, it’s just that the dividend had become a straightjacket for management, and the debt load had been quite high.
The terms going forward are quite different: before the cut, Boardwalk was set to generate $400 million in distributable cash flow while paying out over $500 million to unit-holders. You can see the problem there. Now, the cash payout commitment is only a shade above $100 million, which gives the company huge breathing room to lower its debt burden and use that internally generated cash to fund growth projects without being entirely at the mercy of the credit markets to fund growth.
The current cash payout is not indicative of Boardwalk’s earnings power. My guess is that Boardwalk cut the dividend much more than necessary so that it could follow the “General Electric model” of dividend cuts. You make the cut one-time and draconian, and thereafter, you create a huge gap that allows you to change the storyline by giving lofty dividend increases going forward.
It shows a preference for sharp, quick pain over a drawn-out, moderate pain. From a management perspective, it is more enjoyable to spend the next 5-10 years announcing quarterly cash payout raises rather than freezes and moderate cuts.
For those of you looking to take a page out of the Graham playbook, this is your chance. The profits that Boardwalk generates are real and substantial. But now the cash payout only accounts for $100 million out of the $400 million in distributable cash flow. The spread can tackle debt and fund growth, making the company’s balance sheet healthier, and earnings power stronger.
If the Bluegrass plans materialize, you could realistically find yourself in the situation ten years from now in which the company is generating $4 per unit in cash flow and paying out over $3 per unit in cash distributions. The volatility risk is high-with the distribution yield support temporarily out of whack, there is nothing to stop the share price from falling to $5-but the long-term earnings power potential is great. There aren’t a whole lot of situations out there in which you can make an investment today that has a realistic shot of paying you an annual cash yield of over 23% in 2024 in relation to the cash you set aside in 2014. To earn those lucrative returns, you will have to tolerate severe volatility in the near term, and cash flow per unit figures that may take two or three years before showing meaningful growth.