What: Shares of both Plains All American Pipeline (NASDAQ:PAA) and Plains GP Holdings (NASDAQ:PAGP) are up 10% as of 10:45 a.m. EDT following the announcement yesterday after the market closed that the two entities will be cutting their dividends effective in the third quarter this year. Also, the two companies announced that, in exchange for eliminating Plains GP Holdings' incentive distribution rights on Plains All American, Plains All American will issue 245 million shares to Plains GP Holdings and will assume $593 million in debt from another subsidiary of Plains GP Holdings.
So What: Despite all the talk from the company's management at the end of last year and the beginning of this year that the dividend was safe, Plains has made the right decision as far as its long-term viability. Cutting its dividend will help the company reduce the amount of cash going out the door and allow it to focus on dedicating that cash either toward its ongoing investments or toward reducing its onerous debt levels. At the time of the announcement, Plains All American and Plains GP Holdings had net debt-to-EBITDA levels of 5.7 and 6.1, respectively. These are levels that just aren't conducive to long-term growth.
Also, there was the announcement that the deal will remove Plains GP Holdings' incentive distribution rights. The reason this is important is that incentive distribution rights entitle the holder to a certain percentage of the distributable cash flow each quarter before payouts to shareholders. They are of great benefit for their owner because they provide huge jumps in incoming cash, but they can make raising capital by issuing new shares extremely expensive. Since Plains is largely dependent on debt and equity raises to meet its long-term capital needs, getting rid of these incentive distribution rights will make it much more cost-effective to issue shares.
Now What: The dividend cuts were necessary for both Plains All American and Plains GP Holdings if the companies had any hopes of growing over the long term. Wall Street is happy about this move because the dividend cuts will free up some cash that needs to go somewhere other than investors' pockets, and it looked as though an even larger dividend cut was already priced into the stock.
While this gives some promise that Plains will be a better investment in the long run, there are still questions about the company reducing its debt load while funding its multibillion-dollar expansion plans over the next several years. It may take a few quarters after the cut in dividend takes hold before we can make a definitive judgement whether it will have the effect that we really want. So investors should probably just sit tight on this one.