TC PipeLines Cut to Neutral

We have downgraded pipeline operator TC PipeLines L.P. (TCLP) units to Neutral from Outperform purely on valuation grounds, as we see limited near-term price upside.

Formed in 1998, Calgary, Alberta-based TC PipeLines is a master limited partnership (“MLP”), with interests in four pipeline systems: the Northern Border Pipeline Company (NBPL), the Tuscarora Gas Transmission Company, Great Lakes Gas Transmission, L.P and the North Baja Pipeline, LLC.

Recently, the partnership entered into an agreement to acquire a 25% ownership interest in two pipeline systems from parent TransCanada Corp. (TRP) for $605 million.

With its investments in low-risk energy infrastructure assets, the partnership has been able to historically provide stable cash distributions. Over the last few years, TC PipeLines has consolidated its business, achieved through a combination of organic efforts and accretive acquisitions.

We believe future growth prospects for the partnership have improved considerably following the North Baja Pipeline acquisition and the subsequent capping of general partner incentive distribution rights (“IDRs”) at 25%. In particular, the 25% IDR cap (which only a handful of MLPs have adopted until now) allows limited partners to benefit from the partnership’s growth.

We also like TC PipeLines’ steady cash-flow generating pipeline assets, which provide the stability and financial capacity to deliver cash distributions in a disciplined manner.

However, at current valuations, we have a difficult time justifying sufficient potential return to support an Outperform rating. We expect TC PipeLines’ valuation to remain subdued, as the partnership struggles with weak natural gas fundamentals. Additionally, we believe that while distribution is stable, growth is likely to be a challenge for the partnership.

Consequently, we see the partnership performing in line with the broader market. Our new long-term Neutral recommendation is supported by a Zacks #3 Rank (short-term Hold rating).

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