For context, more hydrocarbons will be transported, stored and processed in North America over the next five years than any five year period in the history of the continent. The previous high-water mark for hydrocarbon volume was the last five years, and the record high before that was five years prior.
Most recently, a sharp decline in the price of oil and natural gas created pockets of stress throughout the midstream energy sector, including a temporary spike in the cost of capital to prohibitive levels for many companies in the industry. However, as real as the recent challenges have been, the scale of the problem is frequently exaggerated by industry participants in need of a scapegoat. I submit certain members of the board of directors of The Williams Companies, Inc. (NYSE:WMB) as exhibit A for such scapegoating, and the proxy advisory service, Institutional Shareholder Services, or ISS, as exhibit B.
If we are to believe the road show documents filed by WMB to promote the company's sale to Energy Transfer Equity LP (NYSE:ETE), the same network of pipelines, storage facilities and processing plants owned by WMB and its affiliate, Williams Partners LP (NYSE:WPZ), would struggle to produce free cash flow if operated by WMB as a standalone company, yet somehow deliver prosperity as a junior affiliate of ETE.
The analysts at ISS apparently bought into this same story. According to ISS, WMB shareholders stand to benefit by owning "nearly half the equity in a combined company anticipated to have much stronger free cash flow - particularly as the oil and gas sector recovers - than Williams on a standalone basis."
These assertions are logically incompatible because WMB is expected to contribute more than 40% of the future cash flow for the combined companies if the merger goes through. The future cannot simultaneously be bright for the consolidated company, and dire for WMB on a standalone basis, because the exact same assets at WMB would be called upon to deliver the goods in either scenario.
The impossibility of this logic is reinforced by the fact that no material commercial synergies are expected to be achieved through the merger. How is the same set of assets supposed to deliver two opposing outcomes when there are no commercial synergies to account for the difference?
The solution to this riddle cannot be found in the capital structure of either company. Indeed, the burden of debt service upon free cash flow would be substantially higher for the merged companies than for WMB on a standalone basis because the capital structure of a post-merger ETE would include all of the existing debt at WMB and ETE, plus an additional $6 billion bank loan to pay for the cash portion of the merger consideration.
The WMB road show documents and the ISS report also neglect to address the expected hit to cash flow for the merged entity from the mandatory sale of WPZ's 50% interest in the Gulfstream Natural Gas System that serves Florida. The sale of this asset was recently imposed by the Federal Trade Commission (NASDAQ:FTC) as a requirement for approving the transaction.
As a standalone company WMB would not be required to sell this valuable pipeline system, although it might choose to do so to reduce debt and/or support its capital spending program. Importantly, WMB shareholders would enjoy the full economic benefits of such a maneuver as a standalone company, whereas post-merger, the proceeds would be spread throughout the Energy Transfer family of companies, even though the asset would have been contributed by WMB. The WMB road show materials and the ISS opinion are silent on this topic.
For those like myself who believe the merger agreement between WMB and ETE was ill-conceived from the outset, the most offensive element of the ISS opinion may be its effort to complement the WMB board of directors for its "commitment to doing the right thing for shareholders, as perhaps most evident in the protections, as well as the economic terms it negotiated in the first place." Meanwhile, the stock market values of WMB and ETE have been decimated since the deal was announced.
The magnitude of shareholder value that has been destroyed by the proposed merger cannot be blamed on "industry conditions," as promoters of the deal like to espouse. Measured from the day before the transaction was announced in September, through June 16 of this year, the Alerian MLP Index of peer group companies in the midstream energy sector delivered a positive total return of 3.8%, including dividends. WMB and ETE are both down by more than 40% over the same time period, also including dividends.
This stern verdict from the stock market does not seem to describe a board decision that deserves praise from anyone. Yet the ISS report goes even further with its endorsement of the WMB board by encouraging WMB shareholders to "entrust the board with evaluating and negotiating any prudent revisions in terms." Here, ISS must be referring to speculation that the WMB board might agree to an all-stock transaction to reduce the strain on free cash flow from the $6 billion bank loan needed to pay for the cash component of the transaction.
This notion of an all-equity structure for the transaction deserves particular scrutiny, in my opinion, because it would not appear to solve anything. Investor support for midstream energy stocks is driven first and foremost by the dividends these companies pay to their shareholders. If the cash component of the merger consideration is replaced with more shares in Energy Transfer Corp. (ETC), the strain on cash flow for the merged entity would simply shift from debt service to dividend coverage. That is, unless ETE elects to minimize the dividends it pays to future ETC shareholders.
Rational people can disagree about the likely treatment of ETC shareholders a few years down the road. Certain members of the WMB board of directors and the analysts at ISS have faith in ETC's prospective overseer, Kelcy Warren. Here is the take from ISS: "Given the structural mechanisms the Williams board negotiated - in particular the true-up mechanism - the risk of mistreating ETC shareholders, and even the risk that the market will suspect future mistreatment of ETC shareholders, seems clearly to accrue far more to current holders of Energy Transfer units (including management, which holds 28 percent) than to current holders of Williams shares."
Perhaps...but such an outcome would require a complete reversal of Mr. Warren's treatment of ETC to date.
In fact, I would argue that the abuses already inflicted upon ETC by its general partner make it nearly impossible for future distributions at ETC to keep pace with the dividends WMB seems capable of delivering as a standalone company. This assertion has nothing to do with Mr. Warren's incentives around ETC, and everything to do with simple math.
Due to the substantially dilutive impact of 1) a recent private offering of convertible preferred shares, 2) an immediate 10% increase in the number of ETC shares at closing from a "Long-Term Incentive Program" for ETE executives, 3) the original 1.15 billion shares of ETC created for the merger itself, and 4) other outstanding options and stock awards, the combined share count of ETE and ETC is expected to explode by nearly 135% as a consequence of the merger. From a starting point of approximately 1.047 billion shares of ETE today, the fully diluted share count is projected to reach approximately 2.458 billion shares of ETE and ETC combined by the time the preferred shares are converted into common units in two years.
With 135% more mouths to feed on a per share basis, consolidated cash flow will need to expand by at least 135% just to keep the pre-merger shareholders from sliding backwards as a consequence of the deal.
With such a high hurdle just to stand still it is no wonder both companies' stocks tanked by more than 12% the day the deal was announced; and no wonder both stocks have subsequently underperformed their peers in the midstream energy sector by more than 40 percentage points ever since.
ISS clearly feels more comfortable than I do about "entrusting" the WMB board to serve the interests of WMB shareholders, but they are entitled to their opinion. There seems to be less room for disagreement about the simple math of the proposed merger now that ETC's general partner has diluted its value so substantially.
The fully diluted share count of ETE and ETC is already projected to more than double. If the cash portion of the merger consideration is replaced with more shares of ETC, the situation would only get worse.
While I would not put it past certain WMB directors to accept an all-stock offer from ETE, I do not share the opinion of ISS that such an exchange would improve anything. Indeed, it would seem to make a bad deal even worse for WMB shareholders.
Disclosure: I am/we are long WMB, WPZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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