Morgan Stanley On Upstream MLPs: Memorial Production, Vanguard National Downgraded

• Memorial Production Partners LP MEMP shares have plummeted 36 percent since November 30, while Vanguard Natural Resources, LLC VNR shares have plunged 44 percent.
• Morgan Stanley’s Tom Abrams downgraded the ratings on both the companies from Overweight to Equal-Weight, while reducing their price targets.
• While lower commodity assumptions translate to a reduction in EBITDA forecasts, valuations in the sector could be negatively impacted by the shift to cash flow based targets, Abrams stated.

Analyst Tom Abrams wrote, “We are updating our EBITDA forecasts to reflect a lower commodity deck closer to the strip in 2016-18 and for the distribution reductions seen this quarter at ARP, BBEP, and VNR.”

Upstream MLP liquidity continues to be sufficient for the next 1-2 years due to hedges, despite the commodity-led EBITDA reductions. Abrams added, however, that low or negative free cash flow would continue to expert pressure on the companies. Memorial Production and Vanguard National are expected to reduce their distributions in coming months in order to boost their finances.

The analyst added, “The sub-sector will have completely moved away from the full payout MLP model of the past several years…The new model may evolve toward a variable distribution policy. The fundamental focus for 2016-18 will be on financial healing via free cash flow generation and asset sales rather than distribution growth.”

Referring to valuations, Abrams commented that the importance of EV/EBITDA or similar cash flow metrics could rise. He expects valuations to be adversely impacted by this shift, since yield-based targets are “generally more supportive” than cash flow based targets.

The ratings for Memorial Production and Vanguard National have been lowered from Overweight to Equal-Weight since their “relative company specific strengths are being overwhelmed by the macro environment.” The price target for Memorial Production has been reduced from $8 to $6, while that for Vanguard National has been cut from $11 to $7.