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In this article, let's evaluate the investment merits of Energy Transfer Partners (NYSE:ETP), as well as its distribution.

Structure of the Oil And Gas Pipeline Industry

Firms in the oil and gas pipeline industry own or operate thousands of miles of pipelines and terminals - assets that are nearly impossible/uneconomical to replicate. Most companies act as a toll road and receive a fee for transporting natural gas, crude oil and other refined products (and generally avoid commodity price risk). Though there is much to like, most constituents operate as master limited partnerships and pay out hefty distributions that can stretch their balance sheets. Additional unit issuance (dilution) has become common, and capital-market dependence is a key risk.

Energy Transfer Partners' Investment Considerations

Energy Transfer Partners' Return on Invested Capital

Energy Transfer Partners' Distribution

(click to enlarge)

Energy Transfer Partners' yield is excellent, offering roughly a 7.5% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Energy Transfer Partners fits the bill thus far.

We think the safety of Energy Transfer Partners' distribution is good. We measure the safety of the distribution in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend/distribution in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends/distributions over the same time period. We make some adjustments for pipeline MLPs (namely adding back cash from future equity issuance to the numerator), but the interpretation is the same. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Energy Transfer Partners, this score is 2.5, revealing that on its current path the firm can cover its future distribution with net cash on hand and future free cash flow roughly two and a half times.

Now on to the potential growth of Energy Transfer Partners' distribution. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is not the case for Energy Transfer Partners. We have them rated as having good growth potential, but only due to the fact that growth hasn't occurred recently. We think the future is brighter. In fact, as the image above shows, we think Energy Transfer Partners' distribution growth will accelerate.

And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Energy Transfer Partners' case, we currently think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we like the potential growth and safety of Energy Transfer Partners' distribution. We include it in our Dividend Growth portfolio.

Source: We Think Energy Transfer Partners' Distribution Growth Will Accelerate

Additional disclosure: ETP is included in our Dividend Growth portfolio.