TPYP - TPYP: Lean Into The Midstream Sector's Higher Estimates Yields And Buybacks

2023-08-28 14:26:14 ET

Summary

• Midstream ETFs have performed well this summer due to strong earnings and guidance from industry players.
• Resilient pricing, high yields, and cheap valuations make the midstream sector attractive even in a risk-off environment.
• The Tortoise North American Pipeline Fund ETF offers a relatively cheap and diversified way to gain midstream exposure.
• TPYP's low expense ratio, low P/E, strong yield, and RIC-compliant fund structure make this under-the-radar ETF worth scrutinizing.

Strong earnings reports and guidance have sent the midstream ETFs higher this summer. These funds could be a good trade for the remainder of the year, as resilient pricing, high yields, and cheap valuations make the sector attractive even in a risk-off environment.

Three of the big players in the industry – Williams ( WMB ), Cheniere Energy ( LNG ) and Magellan Midstream Partners ( MMP ) – reported earlier this month, beating the Street’s expectations. Magellan had an adjusted 2Q EBITDA of $385.9 million , outpacing consensus by 8.6%, and Cheniere outperformed by an impressive 13.6%. Williams offered up a 2Q net income of $547 million, up 36% year-over year. Making analysts even happier: Magellan and Cheniere both raised their FY 2023 guidance and Williams reaffirmed its $6.4 billion to $6.8 billion full year based on record volumes.

While renewable power gets the lion’s share of new investment, future energy demand is expected to increase by 50% over the next 30 years and natural gas-fired power generation will remain the dominant “peak energy” fuel source for the next two decades. The Energy Information Administration sees natural gas power generation potentially up as high as 87% by 2050. Pipelines are not going away, and the steady consolidation of the industry -- exemplified by Oneok’s $18.8 billion acquisition bid for Magellan – can only provide better pricing power in my view.

With an expense ratio of .40, the Tortoise North American Pipeline Fund ETF ( TPYP ) offers a relatively cheap way to gain midstream exposure. It follows its own Tortoise North American Pipeline Index, a float-adjusted, capitalization weighted index of pipeline companies headquartered in the United States and Canada.

The ETF exhibits low turnover and low volatility for the sector, and its dividend of 4.81% provides investors with a decent yield for a RIC-compliant ETF (more on this later). Its tiny $494.34M AUM is best explained by its dilutive exposure to utilities, and its competition with a sector dominated by bigger more established firms (Global X and Alerian) who offer more concentrated bets on the sector. With a fund P/E of 13.03, TPYP is also the least expensive RIC-compliant midstream ETF available.

In an ETF sector notorious for its highly concentrated holdings, TPYP distinguishes itself by being one of the most diversified midstream ETF available. It currently invests in 49 different midstream energy companies, with its top ten holdings constituting nearly 60% of the total portfolio. Only the First Trust North American Energy Infrastructure Fund ETF ( EMLP ) has more, with 65 total holdings.

This diversification can even be seen in the portfolio’s breakdown via pipeline product.

Still, the heavyweights are well-represented. Williams, Cheniere, and Kinder Morgan ( KMI ), Enbridge ( ENB:CA ) (ENB), TC Energy Corp ( TRP ), and Oneok ( OKE ) are its top holdings and make up nearly 40% of the portfolio. All have extensive pipeline systems delivering oil and natural gas across most of North America.

The Midstreams' Value Proposition

The midstream companies have always enjoyed a more stable, fee-based business model than other players in the energy patch, but there has been real valuation compression in recent years. Today high-quality midstream companies can be found at below 8.5x EV/EBITDA. This is a far cry from ten years ago, when it wasn't uncommon to see the big names trade at over 15x.

Now, with resilient energy pricing and the years of big capital spending that followed the fracking boom behind them, they are seeing a lot more free cash flow generation. With these operating cash flows, they are expanding their payouts and executing buybacks.

Enterprise Products Partners (EPD), a Houston-based MLP with 50,000 miles of pipeline, is indicative of this newfound muscle. It recently raised its dividend an additional 2% (50 cents per share), taking its yield to 7.6%, while also highlighting 2Q equity repurchases of nearly $75 million.

Western Midstream Partners ( WES ) also announced a 12.5% dividend increase, and Hess Midstream clicked up its distribution by 2.7%. Kinder Morgan, Targa Resources ( TRGP ), and Williams are all buying back shares, though Cheniere Energy probably made the biggest waves last September with its $4 billion equity repurchase authorization.

The result: in terms of weighted holdings, several of the midstream ETFs have seen an 80% to 90% increase in their payout this quarter. This makes sense as the industry is concentrated: Enterprise Products Partners alone is 4.02% of TPYP’s holdings, so its 2% dividend increase has heft.

MLPs, K-1s, UBTI, RICs: the Midstream's Alphabet Soup of Tax Liability

For most investors, trading in this sector is best done via ETF because of the tax liabilities of directly owning master limited partnerships (MLPs), a specific legal entity quite common in the natural resource sector that avoids corporate income tax by distributing income directly to its partners. In this case, though the “general partners” manage the actual business, any individual investors, however small, who is a unitholder is also legally proscribed as a “limited partner.”

Owning an individual MLP even in a tax-exempt account can result in the dreaded K-1 tax form, state-level income taxes, and “unrelated business taxable income” (though only income above $1000 annually is considered UBTI in a Roth or traditional IRA). In contrast, MLP ETFs held in taxable accounts do not trigger K-1s, will not generate UBTI, though investors will receive the more user-friendly Form 1099.

However, to add to the anagram parlance of this sector, it is important to register that there are two distinct types of MLP ETF –the C-Corp and the RIC-compliant.

Those funds that hold more than 25% MLPs in their portfolio will trigger the fund being taxed as a corporation, triggering double taxation. Alerian MLP ETF ( AMLP ), Global X MLP ETF ( MLPA ), InfraCap MLP ETF ( AMZA ) are C-Corp MLP ETFs. They are best suited for tax-savvy investors who lean into higher income and tax-deferred distributions.

TPYP is specifically structured as a “Regulated Investment Company” or RIC (under Subchapter M of the Internal Revenue Code of 1986 ). It avoids C-Corp status and functions as a pass-through, avoiding taxes at the fund level. To qualify as a RIC, they have structured their portfolios to avoid too much MLP exposure, even if that reduces the yield (by on average 210 basis points).

RICs provide a lower yield than the C-Corp MLP-only ETFs but do provide other advantages –lower tracking error and a wider range of investment opportunities. TPYP, for example, is RIC-compliant, caps its MLP exposure (currently at 19%), and thus does not pay taxes at the fund level. The other 81% of the portfolio is Canadian and US energy infrastructure corporations, and MLP affiliates. Lay investors may even prefer a RIC-compliant ETF that casts a wider net of possible midstream companies, like Oneok or Kinder Morgan which are not available to the MLP-only funds.

The issue of designated holdings takes on an added layer of complexity when you consider that individual MLPs that legally shift to C-Corp status or are bought out by C-Corps, cease to be eligible for inclusion in the MLP-only ETFs.

Growing consolidation in the industry usually means one thing -- more MLPs being absorbed by the larger C-Corp mega caps. Indeed, the raging industry debate this summer is Oneok’s $18.8 billion acquisition bid for Magellan Midstream Partners. Since Oneok is not a MLP, if the deal goes through, the MLP-only ETFs –AMLP, MLPA, AMZA-- will be forced to sell their MMP shares and experience a major tax event. Many long-term investors don’t like the tie-up strategically or the tax consequences, and the deal will be voted upon in September.

Conclusion

Having come into existence during the lean years, that post-2014 period of the oil industry, TPYP (and the midstream more generally) might finally be seeing a benign environment, maybe even a proverbial sweet spot.

The Saudis are no longer pushing oil prices. The much-heralded recession might be quite shallow given the Biden administration’s massive IRA / Chips / Jobs Act stimulus, US reshoring, and the now critical munitions replenishment.

The midstream sector is seeing resilient energy pricing and a hostile regulatory milieu in North America will only restrict future competition.

The renewable energy efforts in the US, however worthwhile, will not satisfy its industrial and consumer usage demands for the foreseeable future. And with the big capital spending years that followed the fracking boom behind them, the midstreams are finally seeing better operating cash flows, expanded payouts, and executing buybacks.

TPYP –long under the radar—might offer a constructive new aspect to your portfolio.

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