Master Limited Partnerships (MLPs) such as ONEOK Partners (OKS) have long been a favorite among high-yield income investors.
MLPs have appeal thanks to their generally steady cash flows (courtesy of long-term, fixed fee contracts) and business model that involves paying out the majority of distributable cash flow (MLP equivalent of free cash flow) to yield-hungry unit holders.
However, thanks to the worst oil crash in over 50 years, many MLPs have disappointed investors by proving to be less safe than initially thought.
In fact, many pipeline operators, such as Kinder Morgan (KMI), fell victim to liquidity traps and dangerous debt levels that resulted in large payout cuts.
While our Dividend Safety Scores caught these dividend cuts ahead of time for investors (view our real-time track record here), one way of getting out of trouble for an MLP is to combine with its general partner.
In this case, ONEOK Inc (OKE) could buyout its MLP ONEOK Partners, which is exactly what the company announced it’s doing on February 1st.
Let’s take a closer look at this $17.2 billion deal to see just what it means for dividend investors in both stocks.
More importantly, find out if this merger means that ONEOK is now a dividend stock that deserves a spot in your diversified dividend portfolio.
What ONEOK Does
ONEOK is one of America’s largest pipeline operators, specializing in natural gas gathering, processing, storage, and transportation. It is also a major player in natural gas liquids (NGLs), which are byproducts of natural gas production.
As you can see, the company’s midstream assets serve nearly all of America’s largest shale oil and gas formations, including the prolific Bakken, Permian, Marcellus and Utica regions.
ONEOK Inc is the general partner, sponsor, and manager of ONEOK Partners’ asset, meaning that, prior to the buyout, it owned 41% of the MLP’s limited partner units, a 2% general partner interest, and the valuable incentive distribution rights (IDRs).
ONEOK essentially served as the financier of its MLP, setting up the financing to pay for the $9 billion in growth projects ONEOK Partners benefitted from over the last decade.
ONEOK would raise the funds (in the form of debt and equity), and then “drop down” (i.e. sell) the assets to its MLP in exchange for cash, taking on debt or additional units of ONEOK Partners.
All told, ONEOK’s combined stake in its MLP meant that 70% of the marginal EBITDA earned by ONEOK Partners flowed back to the parent company, resulting in solid distribution growth over the years.
However, while the IDRs give ONEOK Inc 32% of ONEOK Partners’ marginal DCF, ONEOK Inc’s beneficial financial arrangement with its MLP also results in some major negative effects for unitholders.
Most strikingly is the much slower rate of distribution (a tax-deferred form of dividend) growth experienced by ONEOK Partners.
Terms of the OKE-OKS Deal
ONEOK will be buying the remaining 60% of ONEOK Partners’ units for $9.3 billion, as well as assuming the MLP’s $7.9 billion in debt.
The deal, which is expected to close in the second quarter, is a 100% stock swap, in which ONEOK Partners unitholders get 0.985 shares of ONEOK Inc for each unit of OKS they own.
The deal values the MLP at a 22% premium, and it will unfortunately create a taxable event for investors in OKS.
However, the question that many investors may have is, if ONEOK Inc was getting such a sweet deal from its MLP, then why buyout its MLP at all? The answer is simple.
The IDRs that ONEOK Inc owned meant that only 68% of marginal DCF went to OKS unitholders, greatly raising its cost of capital and making further profitable growth harder to come by.
That’s especially true given the tightening commodity margins ONEOK Partners was getting from its NGL business.
While management has done a great job of shifting the business model away from commodity-sensitive forms of cash flow in recent years, ONEOK Partners’ 15% exposure to commodity prices resulted in its sales and DCF taking a major hit over the past few years.
What’s more, as ONEOK Partners brings more growth projects online, its distribution was set to rise high enough to hit the highest 50% IDR tier, which would have sent even more DCF to its sponsor at the expense of the MLP’s investors.
By acquiring ONEOK Partners, ONEOK Inc eliminates the IDRs and thus greatly lowers the combined company’s cost of capital.
That in turn will make it easier to continue growing into the future. However, that is just one major benefit of many from this highly shareholder friendly deal.
Why This Deal Looks Good For Dividend Investors
The biggest reason to like this deal is that it will help secure the dividend, which has been under higher risk from falling DCF in recent years.
Specifically, the crashing of energy prices resulted in ONEOK Partners’ 2015 distribution coverage ratio falling to an unsustainable 0.80 (through the first 9 months of the year).
Fortunately, new projects being put into service boosted that to a secure 1.11. The new ONEOK Inc will be able to increase that distribution coverage ratio to above 1.2 thanks to the deal’s doubling of OKE’s annual DCF.
In other words, dividend safety should improve as a result of the merger.
Meanwhile, management expects that the company’s new projects coming online in 2017, which are all fixed-rate fee based, will lower the company’s commodity exposure to just 10% of earnings.
This is largely why ONEOK Inc plans to raise its dividend 21% as soon as the deal closes.
Better yet? ONEOK Inc thinks it will be able to maintain at least a coverage ratio of 1.2 while still growing the dividend at an annual rate of 9% to 11%.
Thus, even though ONEOK Partners’ investors are facing a decreased yield on an absolute basis (4.6% yield instead of 6.1%), their overall dividend growth and potential total return has increased.
Meanwhile, the deal is also expected to help ONEOK continue its impressive track record of strengthening its balance sheet.
For example, after the deal, ONEOK Inc will have a much stronger balance sheet.
|Pipeline Operator||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
|ONEOK Inc Post Merger||6.4||3.26||74%||0.54||BBB-|
Sources: Fastgraphs, Morningstar
The combined company’s debt levels will still be high, as seen by the higher than average debt/capital and below average current ratios.
However, management is confident that the merger will result in a credit rating increase for the new C-corp and larger access to cheaper debt.
In addition, ONEOK Partners’ investor will no longer own an MLP. That means they’ll get a 1099 tax form rather than a K-1, which means simpler tax preparation.
Furthermore, not being an MLP will mean that former ONEOK Partners investors will now be able to hold the stock in a tax-deferred account such as an IRA or 401K.
However, due to the beneficial effects of “step up” accounting, in which ONEOK Inc will be able to reset the value of OKS’s assets to the purchase price, it will be able to take much larger depreciation charges that should allow the new C-corp to avoid paying corporate income taxes through at least 2021.
In other words, the merger seems to be a win/win for investors in both ONEOK Inc and ONEOK Partners, resulting in lower costs of capital, more access to cheap debt (and thus better long-term growth opportunities), and a better dividend profile.
While the majority of ONEOK’s cash flow will be far less sensitive to volatile commodity prices than it once was (thanks in part to renegotiation of existing contracts), investors need to remember that ultimately ONEOK’s long-term growth prospects are still tied to a highly cyclical commodity business.
While oil and gas prices have bounced back nicely in the past year, there is no way to tell whether, or how high, they might recover.
That’s in large part due to the oil crash causing shale energy producers to become incredibly more efficient through the use of state-of-the-art fracking techniques that vastly lowered their breakeven prices.
Combined with high debt loads and desperation for cash flow to service their debts, this has resulted in the number of drilling rigs soaring in recent months.
For example, back in May the number of active wells in the U.S. was just 404. However, today that number has risen by 87% to 754.
Part of the reason that U.S. shale activity has increased so quickly is because, prior to the recovery in energy prices, shale producers had continued to drill with already contracted rigs.
This means there are approximately 4,000 or so drilled but uncompleted (DUC) wells in the US right now. All that’s required is the final fracking stage to bring new and relatively cheap production online.
Thus, despite OPEC’s 10% production cut, the global energy glut seems likely to continue for some time yet.
Add to this the record amounts of oil in global storage and the supply/demand imbalance will take several more years to work off.
Given the new, lower production costs of U.S. shale oil and gas, it’s possible that any declines from OPEC production might be made up by rising U.S. production.
As a result, oil and gas prices may remain suppressed for a long time, putting a squeeze on management’s optimistic growth projections. This is one of the key risks faced by many MLPs.
Since ONEOK Inc will still be paying out the vast majority of DCF as dividends, any shortfall in cash flow and dividend growth could result in a lower for longer share price (as well as slower dividend growth).
This could result in the company having a tougher time raising affordable capital, especially with interest rates on new and refinanced debt set to rise over the next few years.
Closing Thoughts on OKE-OKS Merger
While it’s still far too early to call an end to the oil crash, ONEOK Inc’s acquisition of its MLP seems like a win for dividend investors in both the parent company and its MLP.
The larger, more profitable ONEOK Inc will see a boost to DCF, which will likely result in a credit upgrade and thus help it maintain access to cheap credit in the years to come.
In this highly capital-intensive industry, and during a time of rising interest rates, that’s an important competitive advantage.
More importantly, the deal should result in a safer and faster-growing dividend, making ONEOK Inc a more appealing stock for income investors living off dividends in retirement.