Zacks_Analysts' Blog : Move to Neutral on El Paso Corp. - Analyst Blog

We have downgraded our recommendation for El Paso Corp. (EP) to Neutral from Outperform, following its third quarter results, which were affected by weaker-than-expected production and higher-than-expected unit costs at the Exploration & Production (E&P) segment. Poor equity earnings and other income at the Pipeline segment were also responsible for the downgrade.

El Paso essentially operates in the pipeline and E&P businesses. Earlier this year, El Paso Corp. had announced plans to split into two publicly traded companies, one comprising its Pipeline Group, Midstream Group, and general and limited partner interests in El Paso Pipeline Partners L.P., and the other comprising its exploration & production wing.

Additionally, investor focus remains on the impending buyout by Kinder Morgan Inc. (KMI). El Paso Corp. will be acquired by Kinder Morgan for $38 billion, including the company’s debt as well as MLP interest in El Paso Pipeline Partners L.P.

The transaction would create the largest midstream and the fourth largest energy company in North America, and is expected to produce immediate shareholder value through strong cash flow accretion. It will also offer significant future growth opportunities, proving to be a win-win for both companies. The takeover is expected to materialize by the second quarter of 2012.

In addition to being accretive to Kinder Morgan’s dividends per share and distributions per share of the MLPs Kinder Morgan Energy Partners L.P. (KMP) and El Paso Pipeline Partners L.P. (EPB), El Paso believes this transaction will provide even greater value to its shareholders than its planned E&P business spin-off.

Further, El Paso continues to undertake growth projects that would improve its position in North America. During the second half of 2011, the Pipeline Group achieved reasonable success on its five major projects targeted for 2011. Of these, the Ruby pipeline project, Gulf LNG and the TGP 300 Line are already in service, while FGT Phase VIII and the Phase II of SNG's South System III expansion are progressing smoothly.

Despite these positives, we prefer to remain on the sidelines, pending improvement in El Paso’s Pipeline results and fruition of the takeover bid.

Other risks typical to El Paso's E&P business are rising drilling and services costs, drilling rig and completion equipment availability, pipeline capacity availability, government regulations and finding and developing hydrocarbons on the company’s leasehold acreage.

Additionally, the capital-intensive nature of the energy industry creates ongoing liquidity risk that must be actively managed by the company.

El Paso Corporation currently retains a Zacks #3 Rank, which translates into a short-term Hold rating.