Plains All American Pipeline (NYSE: PAA) has gotten pummeled during the oil market downturn. Units are down more than 60% in the last three years, including losing a third of their value this year alone. The culprit is that the oil pipeline company had too much direct exposure to commodity prices, which has cut into its cash flow and weakened its balance sheet. While the company has attempted several stop-gap measures to address its issues, it recently ripped off the Band-Aid by significantly reducing its distribution to investors, which will leave it with more cash flow for debt reduction.
This deleveraging has the potential to lift the weight of debt that has been holding down the company's valuation. However, that's only part of the story because its earnings have significant upside potential once the oil market gets back on its feet. Consequently, Plains All American Pipeline could be a gold mine for value investors given that it's selling for a dirt-cheap valuation when considering its earnings capacity.
An unsurprising bargain
With Plains All American Pipeline's units tumbling, its valuation has followed suit, dropping from 15 times its enterprise value to EBITDA three years ago to less than 13 times at current prices. While that's not a screaming value for a master limited partnership, it's cheaper than most rivals:
One of the reasons Plains has a lower valuation is due to its weaker financial situation. As the following chart shows, the company has higher leverage and lower distribution coverage than those four rival MLPs:
Distribution Coverage Ratio
Enterprise Products Partners (NYSE: EPD)
Magellan Midstream Partners (NYSE: MMP)
MPLX (NYSE: MPLX)
Plains All American Pipeline
Williams Partners (NYSE: WPZ)
Data source: Plains All American Pipeline, Enterprise Products Partners, Williams Partners, Magellan Midstream Partners, and MPLX.
Because of its weaker financial metrics, Plains recently decided to slash its distribution from $2.20 per unit on an annual basis to just $1.20 per unit each year. That decision not only improves distribution coverage but will provide the company with a significant amount of excess cash that it plans to use along with some select asset sales to reduce debt so that it can reach its leverage target of 3.5 to 4.0 times debt to EBITDA within six quarters.
An expanding margin of safety
While Plains All American Pipeline already trades at a cheaper valuation than most peers, it's on pace to get even less expensive. That's because the company has several in-flight growth projects that should expand its fee-based earnings by 15% next year. That puts the company on pace to generate $2.3 billion of adjusted EBITDA in 2018 just from its fee-based transportation and facilities segment, which implies that it's only trading at 11.7 times forward earnings. That's cheaper than the rivals listed on the earlier chart save MPLX, which only trades at 10.2 times forward earnings thanks to the boatload of growth initiatives it has underway.
However, in addition to the predictable fee-based income of its transportation and facilities segment, Plains also earns a commodity-based margin from activities within its supply and logistics segment. The company initially expected to pull in $300 million of EBITDA from these pursuits this year but weaker market conditions will likely result in it only earning about $100 million from that segment. That's well off the peak of $893 million it generated from supply and logistics in 2013 when commodity margins were much higher. While it's unlikely that the company will top that peak anytime soon, it does have considerable earnings upside and could generate several hundred million dollars in EBITDA on an annual basis once margins improve as a result of a stronger oil market.
Meanwhile, there's further upside in the company's transportation and facilities segment when volumes recover. In fact, Plains All American Pipeline estimates that it can generate $650 million of incremental earnings from its current asset base by operating at full capacity when production and drilling activities fully recovery. The company also believes it has more than $150 million of additional upside potential if it were to invest a minimal amount of growth-focused capital to expand certain systems so they can handle increased volumes. Add it up and Plains All American Pipeline believes its existing asset base can generate more than $3 billion of annual EBITDA. At its current enterprise value, it implies that the company sells for less than nine times this earnings potential. While reaching its full earnings capacity would take time and an improvement in the oil market, it's upside that value investors won't want to overlook.
A cheap turnaround story
Plains All American Pipeline currently trades at a lower valuation than most of its closest peers because of its weaker financial situation. However, the company is working to address that problem, which should eventually fix the valuation gap. That said, Plains also has visible earnings growth in the near term due to expansion projects underway as well as tremendous upside potential within its current asset base as a recovering oil market drives margins and volumes higher. As a result, investors have the opportunity to buy the company for an excellent value just as it appears to be turning the corner.
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