As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In this article, let's take a look at Energy Transfer Partners' (ETP) case.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):
If a company is undervalued both on a DCF and on a relative value basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Energy Transfer Partners posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish techinicals. We compare Energy Transfer Partners to peers Kinder Morgan (KMP), NuStar (NS), Spectra Energy (SE), and Williams Co. (WMB). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on Energy Transfer Partners
• Energy Transfer Partners scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 11.6% during the past three years.
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $36, we'd take a closer look at adding to our position in our Dividend Growth portfolio.
• Still, we're not too fond of Energy Transfer Partners' weak cash flow generation and high financial leverage. Although this combination does not guarantee financial problems down the road, it could potentially
be a recipe for disaster during tough economic times. That said, the company retains flexibility via future unit issuance.
• The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.
• The firm sports a very nice distribution yield of 7.9%. We expect the firm to pay out about 253% of next year's earnings to shareholders as dividends. Though this distribution is high relative to earnings, as long as the company retains access to the capital markets, we're not concerned.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Energy Transfer Partners' 3-year historical return on invested capital (without goodwill) is 11.6%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Energy Transfer Partners' free cash flow margin has averaged about -0.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum. At Energy Transfer Partners, cash flow from operations increased about 63% from levels registered two years ago, while capital expenditures expanded about 89% over the same time period.
Our discounted cash flow model indicates that Energy Transfer Partners' shares are worth between $36.00 - $60.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $48 per share represents a price-to-earnings (P/E) ratio of about 14.9 times last year's earnings and an implied EV/EBITDA multiple of about 10.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -9.7%. Our model reflects a 5-year projected average operating margin of 14.5%, which is below Energy Transfer Partners' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.7% for the next 15 years and 3% in perpetuity. For Energy Transfer Partners, we use a 10% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $48 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Energy Transfer Partners. We think the firm is attractive below $36 per share (the green line), but quite expensive above $60 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
We strive to answer a few questions that investors often ask: 1) What are the chances of a total loss of investment in this company? and 2) What is the chance that the company is really worth twice what I paid for it? The probability (fair value < 0) strives to answer the first question. It indicates the chance that the firm may encounter insolvency based on the characteristics of its cash flow stream, capital structure, and risk profile. The probability (fair value > 2x current share price) strives to answer the second question. It is our best estimate of whether investors are participating in a half-off sale by buying the company's shares at current prices.
Future Path of Fair Value
We estimate Energy Transfer Partners' fair value at this point in time to be about $48 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Energy Transfer Partners' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $52 per share in Year 3 represents our existing fair value per share of $48 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Additional disclosure: Some of the firm's mentioned in this article are included in our Dividend Growth portfolio.