Enbridge Rewards Spectra Energy Partners With a Weak Buyout Offer

Ever since Enbridge (ENB 1.09%) purchased Spectra Energy early last year, Spectra Energy Partners (SEP) has been the best-performing subsidiary in its portfolio -- and last quarter, it posted yet another set of solid results. For investors in Spectra Energy Partners, though, these strong earnings may be all for naught, as Enbridge is preparing to roll all of its subsidiaries up into the parent company in a way that may not be particularly beneficial to shareholders.

Let's take a look at Spectra's most recent results, why Enbridge is fully merging Spectra into itself, and why investors might not be too excited about the current buyout offer.

Spectra Energy Partners: By the numbers

DATA SOURCE: SPECTRA ENERGY PARTNERS EARNINGS RELEASE.

It's hard to make direct comparisons between this quarter and the prior one. For one thing, Spectra's results tend to be highly seasonal, as much of its business is related to natural gas. But the company also took several large one-time charges in Q4 2017, after changes to the tax code required it to write down the value of certain contracts. 

The most encouraging thing about Spectra's Q1 results was that it maintained a robust distribution coverage ratio of 1.2. That's especially important since the company recently bought out its general partner stake from Enbridge in exchange for 172 million common units in the business. Even after that significant dilution, it was able to maintain a comfortable distribution coverage, and has room to extend its 42-quarter streak of distribution increases. 

That escalated quickly

The past six months have been quite possibly the most eventful period in the financial lives of all master limited partnerships, not just Spectra Energy Partners.

Back in December, the passage of the GOP tax overhaul significantly reduced corporate tax rates, to the point where the rates on corporate income and the capital gains on dividends aren't much higher than the individual income tax rate that unitholders  pay on distributions from an MLP. 

Then, in March, the Federal Energy Regulatory Commission ruled that MLPs could no longer charge a provision for income taxes under what are known as cost-of-service contracts. At the time of the ruling's issuance, Spectra Energy Partners stated that it estimated the change wouldn't have a material impact on its earnings, as only 40% of its contracts were structured as cost-of-service contracts.

Image source: Getty Images

However, when the company issued earnings, it estimated that the change would result in a $110 million to $125 million annual impact to revenue and distributable cash flow. That's not a crippling blow, as the company generates more than $1.2 billion annually in distributable cash flow, and its coverage ratio gives it some room to absorb the hit. But it's certainly not the "immaterial" effect management had previously claimed.

These issues weren't unique to Spectra Energy Partners, though, and they wer the driving force behind why Enbridge elected to buy out the 25% of shares in Spectra it doesn't already own. The current offer is for 1.012 shares of Enbridge for every Spectra Energy Partners share, which at Enbridge's recent values, gives no premium to the MLP's stock price.

SEP data by YCharts

Dragged down by the rest

The argument could be made that Spectra Energy Partners was the best part of Enbridge's portfolio. The partnership had the best balance sheet, the best distribution coverage ratio, it's operations were the least impacted by the FERC ruling, and many of Enbridge's most lucrative growth projects were part of Spectra Energy Partners' portfolio.

Enbridge's move to consolidate all of its MLPs into the parent corporation likely has more to do with the weakness of its other subsidiaries than Spectra itself. But it wouldn't make a lot of sense to consolidate the rest and leave Spectra as an independent MLP, especially since Enbridge already owns 75% of it. 

Perhaps the most disheartening aspect of the deal is the price Enbridge is offering. Not only is Enbridge not paying any premium for Spectra's shares, converting units of an MLP to C-corp shares will mean a significant tax hit for unitholders. Some other companies that have initiated similar transactions have provided both shares and cash to compensate their investors for the tax bill. 

It's hard not to feel like Spectra's investors are getting the short end of the stick here. Spectra's board has nominated an independent conflict committee to evaluate the offer, so there's hope that public unitholders might get a somewhat better deal. However, given that the majority of shares are held by Enbridge, the chances of that aren't great.