Midstream Stock Yields 10.5%, With 40% Upside Potential, Insiders Are Buying

Summary

• ETP is a midstream MLP which traded recently at $20.50 and yields 10.5%.
• The stock has pulled back recently due to a complex merger and a distribution cut, creating shareholder morale issues.
• ETP has strong growth projects coming online and could see massive DCF growth in the next two years.
• The stock is currently seeing upgrades. Using analysts' ratings and price targets, ETP offers a 40% potential upside.
• Based on our conservative assumptions, ETP share has at least 30% upside potential in addition to a growing yield which is likely to reach 15% by the year 2019.

This research report was jointly produced with High Dividend Opportunities co-author Philip Mause.

Energy Transfer Partners, L.P. (ETP), is an MLP (issuing K-1s) which has been declining in recent weeks. ETP traded recently at $20.50 and pays a distribution of $2.14 per year for a yield of 10.5%. ETP has just been through a somewhat confusing merger and an effective distribution cut which have created shareholder morale issues. ETP has multiple strong growth projects coming online and should see considerable growth in cash flow leading to higher distributions.

The Merger - ETP recently merged with Sunoco Logistics Partners (whose symbol was formerly SXL). We wrote about the merger in the following article: Merger Between SXL And ETP

Although ETP was by far the larger company, the merger was structured in an unusual manner. SXL actually acquired ETP by issuing one and a half shares of SXL for each ETP share. Then, SXL changed its name and its symbol to ETP. The overwhelming majority of shares in the new entity are shares exchanged for pre-existing ETP shares.

The big problem is that - prior to the merger - ETP unit holders were getting a dividend of more than $4 a unit. After the merger, an old ETP unit holder gets 1.5 units of the new ETP and receives only $3.21 in distributions. Thus, the merger effected a kind of "stealth" distribution cut. Less money is going out the door each quarter in distributions from the combined companies than was going out the door prior to the merger. And, we all know how much unit holders "love" distribution cuts.

The Business - ETP's business is best understood as consisting of five segments:

1. Interstate Natural Gas Transmission - ETP owns and operates some of the most important interstate natural gas pipelines which serve as the backbone of the nation's energy infrastructure and transport natural gas from production areas to areas of high consumption. ETP's assets include Panhandle Eastern Pipeline, Florida Gas Transmission (50% ownership), and Transwestern Pipeline. All told, ETP has over 18,000 miles of interstate pipelines providing essential services to Florida, California, and the Upper Midwest.
2. Intrastate Natural Gas Transmission - ETP has 8,300 miles of pipelines providing intrastate transmission services - largely in Texas. Because of the regulatory history of the industry, a large and distinct intrastate natural gas transmission industry emerged carrying gas from producing areas to chemical plants and other energy intensive users.
3. Midstream - ETP has extensive midstream assets - primarily in the Permian, Marcellus, and Eagle Ford regions. It is engaged in a major buildout in the Permian region.
4. Crude Oil - Although ETP has been primarily a natural gas oriented MLP, the recent merger added crude oil and refined product infrastructure assets. ETP has major crude oil pipelines serving the most active oil producing regions - including the Dakota Access Pipeline and the Permian Express. ETP has a large truck fleet and storage terminals with 32 million barrels of capacity. ETP provides fee based services and also purchases crude at the well-head for resale to the major oil companies and refineries.
5. NGLs and Refined Products - ETP's activities in this area have grown with assets acquired through the merger. ETP has four fractionation plants strategically located to provide service in areas of heavy natural gas production. It also has major natural gas liquids pipelines and terminals. Its natural gas liquids storage facilities have capacity of nearly 60 million barrels. It also has refined products pipelines and terminals.

Growth Projects - ETP has major growth projects which are coming on line in 2017 and the next couple of years. These projects should increase EBITDA and Distributable Cash Flow ("DCF") substantially starting this year and running through 2019. This is the basis for the projections of increased EBITDA (set forth below) that were prepared in connection with the proxy materials associated with the merger. Expansion projects include the Dakota Access Pipeline. This vitally important pipeline will allow crude oil produced to be transported to refineries in the Gulf area. Readers will be aware that it has been subject to environmental opposition and that there is still an unresolved issue in the litigation. Although the pipeline has obtained government agency approval, private litigants continue to oppose it and are arguing that the environmental impact statement filed in connection with the project was inadequate in some respects and that the operations of the pipeline should be suspended pending a revision of the environmental impact statement. It is always hard to predict the outcome of litigation but, in this case, it would seem that the equities would balance in favor of permitting the pipeline to continue operations pending a revision, if necessary, of the environmental impact statement. The pipeline actually started service on June 1. It is such a major improvement in terms of cost and environmental protection in comparison with alternate means of transporting the oil that it will almost certainly achieve ultimate approval although, as noted above, it is possible that a suspension of operations will be ordered, and, as long as the litigation is pending, there will be somewhat of a cloud over the project.

Other growth projects include:

1. The Rover Pipeline (scheduled to come on line in July 2017),
2. The Panther Processing Plant (January 2017),
3. The Arrowhead Processing Plant (Q3, 2017),
4. The Comanche Trail and Trans-Pecos (Q1, 2017),
5. The Mariner East 2 (Q3, 2017),
6. The Revolution System (pipelines and processing plants) (Q4, 2017),
7. The Bayou Bridge (Q4, 2017).

These projects are targeted at areas of increased drilling and should all increase ETP's financial performance as we move forward.

Q1 2017 - For Q1, 2017, ETP has prepared a pro-forma financial report setting forth results for the combined company:

• Adjusted EBITDA came to $1.414 billion, and DCF came in at $907 million - with a unit count of 1.084 billion common units.
• ETP distributions totaled $582 million to common units and some $220 million to IDRs.
• If we annualize these numbers, assume no growth, and give common units $50 million credit for the undistributed DCF (the difference between the $907 million in DCF and the $802 million actually distributed to common unit holders and IDRs), we get quarterly DCF of $635 million available to common units and an annual total of roughly $2.540 billion or $2.34 per unit.
• This would imply a Price/DCF ratio of 8.7 times. This is a reasonable price level for a large, well diversified MLP. Unfortunately, the analysis is not so simple due to complexities associated with the IDRs.

The IDR/Relinquishment Issue - Based on recent SEC filings (dated 3/24/2017) the new, merged entity will also have a somewhat complex IDR situation. IDRs kick in at low distribution levels with IDRs set at:

• 13.39% of distributions over 8.33 cents per quarter;
• 35.39% of distributions over 9.58 cents per quarter;
• and 48.33% of distributions over 26.38 cents per quarter.

Distributions are now set at 53.5 cents per quarter. With unit count at 1.084 billion, IDRs would normally have been $377 million for Q1 2017. This would have resulted in total distributions to IDRs and common units of $959 million - considerably more than Q1 2017 DCF of $907 million.

To help solve this problem, the manager - Energy Transfer Equity, L.P. (ETE) - has a "relinquishment" program in effect under which $655.5 million, $153 million, and $128 million in earned IDRs will be relinquished (simply not taken), respectively, for the years 2017, 2018, and 2019. After 2019, there will be a perpetual relinquishment of $33 million per year. Thus, in the past quarter, the new ETP generated some $907 million in DCF and distributed $582 million to unit holders. It would normally have been required to distribute $377 million in IDRs which would have meant that distributions of $959 million would have exceeded DCF. But the relinquishment program reduced IDR distributions by $157 million with the result that total distributions came to $802 million. ETP proudly announced that it had a distribution coverage level of 1.13. Of course, without relinquishment, the distributions would not have been covered at all. Thus, without any growth whatsoever, ETP would likely have to cut distributions sometime in 2018 after the generous 2017 relinquishment levels are replaced by much lower levels of IDR relinquishment. This is because the cost of paying IDR's will increase once the level of IDR relinquishment is substantially reduced (and thus the amount actually paid out in IDRs increases). An investor may reasonably ask - how can distributions increase once IDR relinquishment decreases? The answer is simple: ETP is clearly planning for substantial DCF growth. In fact, its management asserts that it should be able to generate double-digit distribution growth over the next two years.

Growth Projections - ETP is planning for substantial growth in cash flow and has numerous large projects coming online this year and next. ETP is projecting that it will be able to have low double-digit increases in distributions for the next couple of years. This will require very large cash flow increases from these new projects. While ETP has not issued guidance in this regard, it has published projections in its proxy statement (available on its corporate webpage) in connection with voting on the merger. These projections purport to show future results of each of the two merged companies if they were to continue as independent entities. They also include projections of EBITDA for the merged company used by Barclays which was retained in connection with the merger (Barclays report is described in an SEC filing dated 3/24/17 - a proxy statement - at page 92). We have calculated DCF for the merged company by subtracting $2 billion a year to account for interest payments and maintenance capital expenditures. This $2 billion per year estimate is based upon an annualization of the amount by which EBITDA exceeded DCF in the first quarter of 2017 - which was roughly $500 million. When we subtract this $2 billion from each year's EBITDA estimate for the merged companies, we derive an estimate of the annual DCF for the merged companies. The tables below show projections for each of the original companies as standalone entities and a projection for the merged entity. All numbers are in billions of dollars.

Investors should be aware, however, that these projections cannot be taken to the bank and spent today. They assume, for example, that the oil price will be $50 in 2017, $55 in 2018, and $60 in 2019. While ETP is not directly exposed to the oil price the way oil companies are, volumes on its pipelines would be affected by the level of drilling in the United States which would, in turn, be affected by the oil price. The projections also assume a constant unit count of roughly 1.1 billion common units. In addition, the DCF projection for the merged companies is not from Barclays but instead uses the EBITDA projection used by Barclays and then assumes that interest plus maintenance capital expenditures will continue to equal the roughly $500 million per quarter experienced in the first quarter of 2017. It is entirely possible that this offset will increase due to higher interest rates, increased debt due to capital expenditures, and increased maintenance capital expenditures due to additional facilities. For all of these reasons, we have made some conservative assumptions to arrive at a valuation. If the newly merged ETP can hit these numbers (or anything reasonably close to them), this stock will be a huge winner. Management is projecting double-digit distribution increases in the "near term".

We can use these estimates to calculate potential distribution levels. In order to calculate sustainable distributions, we will use the perpetual relinquishment level of $33 million rather than the higher, temporary, levels which prevail in 2017, 2018, and 2019. The present distribution of $2.14 per year would actually cost roughly $3.8 billion if the IDR "relinquishment" level were reduced from $655.5 million (the actual 2017 level) to $33 million (the level which will prevail perpetually starting in 2020). Every 10 cents of increased distribution adds roughly $210 million to the money going out the door to common unit holders and to IDRs - assuming no IDR relinquishments. This is derived by first calculating the amount to be paid to unit holders (ten cents times the number of units - 1.084 billion) and then adding the amount to be paid in IDRs (4833/5167 times the amount paid to unit holders). Thus, ETP could increase the distribution by 22 cents at a cost of $440 million in 2018 and by 24 cents at a cost of $500 million in 2019 if these projections play out. The total cost of distributions in 2018 would be $4.250 billion - well below projected DCF of $5.475 billion. In 2019, the cost could be $4.750 billion - again well below projected DCF of $6.178 billion. The table below sets forth estimated distributions, the full cost of those distributions (assuming an IDR relinquishment of $33 million a year), and the projected DCF for 2017, 2018, and 2019.

	2017	2018	2019
Distribution	$2.14	$2.36	$2.60
Full Cost	$3.800B	$4.250B	$4.750B
Projected DCF	$4.558B	$5.475B	$6.178B

Click to enlarge Click to enlarge Click to enlarge

Indeed, the 2019 numbers would support a $3.00 distribution for a yield of 15% at the current price. A $3.00 distribution would cost roughly $5.8 billion (with no IDR relinquishment) leaving roughly $378 million in undistributed DCF for use to pay down debt, buy back stock, or invest in expansion. If ETP is perceived to be growing both DCF and actual distributions at this, it could easily trade at a yield of 7.5% which would support a unit price of $40.

Valuation - We will use a very conservative valuation methodology. We are assuming that DCF growth is exactly one half as fast as in the projections used by Barclays. Starting with the Q1 2017 DCF level of roughly $900 million, we get an annualized current DCF level of $3.6 million. Then - for each subsequent time period, we are assuming that the DCF increase over the baseline of Q1 2017, of $3.6 billion a year is exactly half as much as the increase reflected in the above projections. For example, the above projections show DCF of $5.475 billion in 2018. This would be an increase of $1.875 billion over the current DCF level of $3.6 billion. We are assuming that only half of this increase ($937 million) is achieved, resulting in 2018 DCF of $4.537 billion. We are also backing out all "relinquishments" of IDRs in excess of the $33 million perpetual relinquishment. We are doing this in order to get a sense of long-term sustainable performance.

Applying these assumptions, we derive total DCF of $4.079 billion, $4.537 billion, and $4.889 billion - respectively, for full year 2017, 2018, and 2019. As noted above, we are also assuming away all relinquishments of IDRs except for the $33 million perpetual IDR relinquishment. This has the effect of allocating 48.33% of all increased DCF to IDRs rather than to common units. Applying these assumptions, we get DCF available to the common units of $2.506 billion in 2017, $2.744 billion in 2018, and $2.927 billion in 2019. On per unit basis, this comes to $2.31 in 2017, $2.53 in 2018, and $2.74 in 2019. We will assume that ETP maintains a distribution coverage ratio of 1.10 times. This would permit a distribution of $2.48 in 2019 with the applicable coverage.

The table below provides total DCF using the conservative assumptions set forth above, the amount of that DCF available to unit holders (assuming IDR relinquishment of $33 million per year), and the per unit amount of such DCF for the years 2017, 2018, and 2019.

	2017	2018	2019
Total DCF	$4.079B	$4.537B	$4.889B
DCF Available to Unit Holders	$2.506B	$2.744B	$2.927B
Per Unit	$2.31	$2.53	$2.74

Click to enlarge

Assuming these distribution increases, ETP should trade at more generous multiples:

• If ETP traded at a 10% yield, it would trade at $24.80/share (or 21% higher from here).
• Assuming instead that ETP trades at a DCF multiple, after such growth it would likely trade between 8 and 10 times DCF, with a mid-point at 9. At 9 times DCF, ETP would trade at $24.66/share (or 20%% higher from here).

Remember that these estimates involve an enormous downward adjustment to growth projections (growth in total DCF is cut in half), and they don't give credit for large IDR relinquishments in 2017-2019. It is striking when one can make negative assumptions and still wind up with large distribution increases and unit appreciation. It is noteworthy that the 2019 distribution level of $2.48 would produce a yield of 12.1% on original cost for a buyer of ETP at its present price level.

Recent Analysts' Upgrades - ETP has seen several upgrades from banks and financial institutions during the past two months.

Analysts' Price Target -As of June 27, 2017, there are 24 banks and analysts who cover the stock with a consensus rating of "overweight" on the stock, and an average consensus price target of $28.5, suggesting a ~ 40% potential upside from the current price (Source: wsj.com).

Insiders are buying - During the past month, two significant transactions took place by two directors totaling $256k. This provides some confidence that insiders are confident about the outlook of the company.

(Source)

Risks - ETP faces many of the same risks faced by most other MLPs. If the oil and gas markets deteriorate sufficiently, volume on its facilities will decline and - despite the existence of fixed volume contracts - ETP could be subject to the risk that counterparties will go bankrupt. ETP also engages in oil purchases for resale and - in the event that the market shifted in a negative direction - could experience losses on such transactions. As noted above, ETP is subject to litigation risk in terms of the environmental impact of its operations and - especially - of its growth projects. This litigation can be costly and can lead to the delay of the deployment of new projects which would have the effect of postponing the revenue increases projected to be associated with such projects. As noted above, another risk is that growth does not materialize. With no growth at all, distributions will have to be cut when IDR relinquishment declines starting next year.

Bottom Line - Whenever valuations are based on an assumption of growth, there are numerous risks. Anyone who has followed the Dakota Access controversy is well aware of litigation and regulatory risk. There could also be a major downturn in oil and/or natural gas production leading to lower throughput on ETP's systems. However, at its current depressed price, ETP is really not all that expensive with a yield of 10.5% and a price/DCF ratio of 8.7 times, even assuming no growth at all.

Growth projects will certainly add some additional EBITDA and DCF, and we have made very conservative assumptions leading to the conclusion that investors at this price will get continuous and increasing double-digit yield on original cost, as well as the potential for appreciation of between 20% and 40%. ETP, at the current price, is a very compelling investment opportunity.

===

If you enjoyed this article and wish to receive updates on my latest research, click "Follow" next to my name at the top of this article.

About "High Dividend Opportunities"

High Dividend Opportunities is a leading and comprehensive dividend service ranked #1 in dividends on Seeking Alpha and is dedicated to high-yield securities trading at attractive valuations. It includes a managed portfolio targeting 7-9% overall yield - and a selection of the best high yield Master Limited Partnerships, BDCs, U.S. Property REITs, Preferred Shares, and closed-end funds. We invite readers for a two-week free trial currently offered by Seeking Alpha to have a closer look at our investment strategy, our Top Buy list and our extensive report on the "Best High-Yield Stocks and Securities For 2017." For more info, please click here.

Note: All images/tables above were extracted from the Company's website, unless otherwise stated.

Analyst’s 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.