Rida Morwa
This 12% Yielding Midstream MLP Still Has 30% Upside Potential
Jun. 10, 2018 9:45 AM•ETP
SummaryEnergy Transfer Partners has been engaged in an impressive expansion mode over the past few years.It is just now beginning to reap the rewards of its massive expansion program and is now having a banner year.Strong growth should continue for at least the next 3 years for this 12% yielder.ETP still trades at ridiculously low valuations of 7.3 time "Distributable Cash Flow" ('DCF').We will address the implications of the potential merger with its parent company ETE, and why the shares still have 30% upside potential in addition to the very generous yield.
This report was jointly produced by the High Dividend Opportunities research team and author Long Player.
Energy Transfer Partners(ETP) is a large midstream energy MLP which closed recently at $18.99. ETP has massive midstream and downstream assets strategically positioned to take advantage of the enormous growth in production in the Bakken and Permian Basins. It has large natural gas gathering systems, natural gas pipelines, oil pipelines and natural gas liquid production facilities. It also has large LNG export facilities and a massive motor fuel distribution system. ETP transports some 3.8 million barrels of crude oil per day and some 17 mmbtus of natural gas per day.
ETP has been in the process of adding major new facilities throughout its system. Whenever an MLP is in expansion mode, investors can have a difficult time discerning the likely future. The costs of expansion appear on the balance sheet before the new facilities come online, and it is difficult to project financial results for the time period in which the new facilities will be operational. ETP is just now beginning to reap the rewards of its massive expansion program and is now having that banner year that was forecasted awhile back.
There has been a serious talk of a merger between ETP and its general partner (its parent company), Energy Transfer Equity (ETE). This can lead to a discounting based on an anticipated distribution cut or the risk of a transaction which is not favorable to the acquired entity. While the simplification should save some costs and make the whole corporate structure a much easier one to understand, we would like to address concerns that this could lead to a discounting of ETP units. Until the details of the merger are announced, there is uncertainty over the specific terms of the transaction as well as when and whether it will occur.
Source: ETP Website
The proposed merger would combine one of the largest, if not the largest division within Energy Transfer Equity. This simplifies the above chart even more. The current partnership structure has been hard for the market to understand and has kept the shares of both ETP and ETE distressed. ETP and ETE are rapidly growing and still cheap given the enormous growth potential. This long-term growth is likely to continue.
Energy Transfer Partner Results
Source: Energy Partners First Quarter, 2018 Earnings Press Release
Energy Transfer Partners clearly reported a banner first quarter. Distributable cash flow ('DCF') increased by about 33% to an effective annualized rate of $2.60 per unit. At the current price, ETP is trading at a very cheap 7.3 times DCF. This price/DCF ratio would be dirt cheap if ETP was not growing, but it is ridiculously cheap, given that DCF is relatively certain to grow as additional projects come online. As shown above, earnings and other key metrics increased considerably in the first quarter on a year over year basis.
Source: Energy Transfer Partners And Energy Transfer Equity Joint Mizuho Corporate Presentation April 9, 2018
In addition to a long list of completed projects that are finishing their first year of financial results, the company has a sizable list of more projects coming online as depicted in the table above. The table lists numerous projects which did not even contribute to Q1 2018 DCF. As these projects come online through 2018 and continue through 2019 and 2020, DCF is virtually certain to grow rapidly. This makes the current 7.3 price/DCF ratio one of the best bargains available in the market at this time.
As for the debt level, those projects are leading to a natural reduction in the debt/EBITDA ratio. Some debt will be repaid. However, most of the deleveraging comes from increasing earnings that leads to higher cash flow from operations and higher EBITDA. This is virtually certain because many projections already have customers with long-term contracts and volume commitments.
Normally, investors in a company with these characteristics could happily project income increases for the near future; this would logically lead to a valuation based on a mid-teen price/DCF ratio. But the coming proposed acquisition (or merger) with Energy Transfer Equity is causing a discounting of what would otherwise be very bullish projections.
Energy Transfer Equity Outlook
Source: Energy Transfer Equity First Quarter 2018 Earnings Press Release
One of the reasons that ETE is growing quickly is because its income generated by its interest in Energy Transfer Partners is also growing very fast. As shown above, by far, the largest determination of corporate cash flow is the money received from Energy Transfer Partners - mostly in the form of incentive distribution rights (IDRs). Based on the most recent quarter, ETE's annualized DCF provides 148% coverage of its distribution and is equal to $1.37 per unit. It is poised to increase due to the fact that the percentage of distributions going to IDRs increases as the distributions themselves increase. As the new projects discussed above come online, ETP will likely increase its own distributions which will have the automatic effect of increasing ETE's IDRs.
ETE's high level of distribution coverage of 148% may suggest a second reason for the simplification. ETP distributes far more cash flow than ETE as a percentage of cash flow from operations or even distributable cash flow. Mr. Market has previously taken a very dim view of low distribution coverage, but the recent growth of ETP has proved Mr. Market wrong. The coming merger would allow the surviving company, ETE, to continue the policy of Mr. Market favoring well covered distributions while avoiding the hot button issue of distribution reductions.
Merger Talk
As shown below, ETP shares are up lately largely due to strong Q1 results and a strengthening crude oil market.
Source: Seeking Alpha Website May 22, 2018
ETP should grow revenue and DCF substantially this year. The distribution is well covered (115%), yet it trades at a ridiculously low multiple for a fast growing company. The steady parade of completing capital projects set forth above should assure very positive EBITDA and DCF comparisons the rest of the year.
Source: Seeking Alpha
ETE unit pricing has remained fairly strong in the face of the potential acquisition news from the conference call. It has a lower distribution per unit than ETP and also has a lower DCF. It also has a higher coverage ratio. This creates complex considerations in determining what a "fair" deal for a merger would be.
There will be speculation on what the terms of the merger may turn out to be. It is possible that ETP investors will feel that they have been treated unfairly. One solution to this problem is for investors to buy equal percentage shares in both entities (ETP and ETE). The share counts of the two entities are very close (on a fully diluted basis, 1.155 billion shares for ETE and 1.164 billion shares for ETP). Thus, an investor owning roughly the same number of shares in each of the two entities will be substantially indifferent to the deal terms (he will wind up owning roughly the same percentage of the combined entity regardless of the deal terms).
It is likely that the merged entity will initially have a somewhat lower distribution than the ETP distribution but a somewhat higher distribution than the ETE distribution. If the entities are merged, there will be no more IDRs. Investors' morale problems created by a somewhat lower distribution (for ETP legacy holders) may be assuaged by the improving numbers created by new projects coming online which may also allow distributions to move back up to the old ETP level.
Valuation
Making a simplifying assumption that each ETP unit is exchanged for one new ETE unit, the combined entity would have a DCF of approximately $2 per unit without any growth after Q1. Given growth prospects and the removal of the uncertainty due to a pending merger, the combined entity should trade at a level of at least 12 times DCF which would suggest a price of $24 a unit. Investors who want to hedge against uncertainty as to the merger deal terms should consider buying an equal number of shares in the two entities which will make them substantially indifferent to the deal terms. An investor buying equal numbers of ETE and ETP units would reap a gain of roughly 30% if the combined entity (under the above assumptions) traded at $24 per unit.
There will be a temptation to "wait until the dust settles" and postpone entering this investment until deal terms are announced or a merger is unambiguously abandoned. This is unlikely to turn out to be a wise strategy. ETP's numbers should keep getting stronger as additional expansion projects come online throughout 2018 and beyond. ETP is cheap now, and investors should pile in at this point.
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Disclosure: I am/we are long ETP, ETE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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About this article:
Tagged: Dividends & Income,Dividend Ideas,Basic Materials,Oil & Gas Pipelines,Alternative Investing
Includes: Energy Transfer Partners, L.P. (ETP),ETE
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