This 12.4% Yielding Stock Is 59% Undervalued
Summary
- It was a very rough year for Energy Transfer Partners with costly delays on no less than three major projects.
- To raise the capital needed to fund its enormous growth backlog the MLP had to raise a lot of cash via asset sales and issue equity at terrible valuations.
- However, now it seems that most of these issues are behind it, and in 2017, the MLP was able to once again cover its smaller distribution, even excluding IDR waivers.
- While the distribution remains frozen for now, management is confident that it can grow once more in the future potentially making ETP a great long-term income investment.
- That being said, there are numerous risks to keep in mind and that means that while its outlook is improving, ETP remains a high risk stock, at least for now.
Source: imgflip
The goal of my high-yield retirement portfolio is to own a highly diversified group of quality income stocks that generate maximum safe yield, and strong long-term payout growth.
Pipeline MLPs are one of my favorite industries. That's because right now they represent some of the most undervalued high-yield stocks you can find in an otherwise overheated market.
Energy Transfer Partners (ETP) is one America's largest MLPs, and a popular holding for many Seeking Alpha readers. However, 2017 was a horrible time for the partnership, with numerous setbacks arising to the MLP's ambitious growth plans.
This led to the unit price crashing, and the yield spiking to nearly 15% at one point. Not surprisingly, ETP underperformed the red hot S&P 500 but also most other MLPs.
ETP Total Return Price data by YCharts
Still, management made a lot of hard but necessary choices that seem to have finally gotten its turnaround back on track. Of course, Energy Transfer still faces numerous big risks that investors need to understand before buying it.
So let's take a look at this former fallen energy giant to see why I now consider it worthy of a small (1%) portion of my portfolio. More importantly, learn whether or not its potentially bright future and high margin of safety means it fits your needs as well.
A Terrible 2017 BUT Things Look Much Brighter In 2018
Source: Energy Transfer Partners
Energy Transfer Partners is part of the Energy Transfer Empire, with various ownership stakes in other MLPs and energy transportation assets.
Source: Energy Transfer Partners Investor Presentation
The MLP is one of America's largest midstream operators with:
33,000 miles of pipelines;
11.5 billion cubic feet per day of gas gathering capacity;
15 billion cubic feet per day of gas transportation capacity;
3.8 million barrels per day of oil transportation capacity;
455,000 barrels per day of NGL fractionation capacity;
7.9 billion gallons of fuel sales (Sunoco stake); and
40% stake in Lake Charles LNG export terminal which has an export capacity of 1.8 billion cubic feet per day.
All told, Energy Transfer Partners' assets serve nine out of America's top 10 shale oil & gas formations.
2017 was a very rough year for Energy Transfer Partners. For one thing the MLP was actually bought out by Sunoco Logistics Partners (SXL), which at the time was another Energy Transfer MLP. The $20 billion all-stock deal led to the new MLP retaining the Energy Transfer Partner moniker, but resulted in a 24% distribution cut.
Further troubles came when several of Energy Transfer's growth projects hit major snags. For example, the critical Dakota pipeline (serving the Bakken formation), after years of legal battles and permit declines, finally went into service. But that was only in June, many months behind schedule.
In addition, an accident involving the $4.2 billion Rover pipeline (the MLPs largest growth project) set that completion date back as well. The Federal Energy Regulatory Commission or FERC has ordered ETP to cease construction for now, which means the MLP will almost certainly miss its Q1 2018 start date on that major project.
Meanwhile, the $2.5 billion Mariner 2 NGL pipeline had its construction halted by a Pennsylvania judge. This was just the latest legal battle with that state's regulators. That means that Mariner 2 is now expected to enter service in Q2 of 2018, 18 months behind schedule.
All told, Energy Transfer setbacks in completing its projects (which were supposed to have been in service in 2017) meant that a lot of cash flow it was counting on for financing future growth got held back. This meant that management had to scramble to obtain financing, which it planned to do with a $5 billion asset sale to Blackstone (BX).
That deal fell apart and so ETP was forced to sell $568 million in common units to Energy Transfer Equity (ETE), its general partner and sponsor. By mid-August, the MLP was forced to sell another $1 billion of highly dilutive units in a secondary offering but at a cost of equity of 20%.
In fact, 2017 (and the start of 2018) was a year in which the cash strapped MLP had to raise a lot of very expensive capital via equity and asset sales. For example:
In October, ETP sold 32.44% of it $4.2 billion Rover Pipeline to Blackstone for $1.6 billion.
In November, it issued $1.5 billion in preferred stock (yield of 6.25% to 6.6%).
In January, ETP sold compression assets to USA Compression Partners in a $1.7 billion deal ($1.225 billion in cash).
Sold 17.3 million Sunoco LP (SUN) units back to that MLP for $540 million.
Despite all these setbacks, ETP was able to put a lot of projects into service including: the Dakota Bakken Pipeline, part of Rover, numerous joint ventures, and acquired a crude oil gathering system in Texas. This caused the MLP's cash flow to rise significantly.
Metric | 2017 Growth (except coverage ratio) |
Revenue | 33.1% |
Distributable Cash Flow | 15.8% |
Units Outstanding | 10.9% |
DCF/Unit | 4.4% |
Distributions | -16.4% |
Distribution Coverage Ratio | 1.2 |
DCR ex-IDR waivers | 1.01 |
Source: earnings release
In fact, despite the horrible need to issue a lot of very expensive equity, the MLP's distributable cash flow (it's equivalent of free cash flow and what funds the payout) per unit actually rose.
Best of all the coverage rate increased to 1.2. Now it should be noted that this was greatly aided by the MLP's IDR waivers from its sponsor Energy Transfer Equity.
Source: Energy Transfer Partners Investor Presentation
These are fees that the MLP should have paid to ETE but were waived due to its financial difficulties. In 2017, ETE waived a total of $656 million in IDRs, but in 2018 and 2019, those numbers will decrease substantially. By 2020, they will go away entirely which is why investors need to focus on ETP's distribution coverage ex-IDR waivers.
The good news is that in 2017, ETP's coverage not including waivers was 1.01, and in Q4 2017, it rose to 1.09. Keep in mind that in the MLP industry, 1.1 or higher is considered a sustainable payout capable of further growth.
The best news, however, comes from the MLP's CFO Thomas Long who told analysts during the most recent conference call:
proceeds from the sale of CDM, and the SUN unit sale, and anticipated excess coverage in 2018 [will] provide us liquidity to fund our 2018 growth projects. While we continue to expect that we will not need to issue equity at least through the middle of this year, we are targeting not having any equity needs in 2018."
In other words, ETP thinks that it's done raising cash to fund its growth for 2018. And with no expected equity issuances in the near term, that should mean that its ex-IDR coverage ratio continues climbing during 2018.
But don't think that this necessarily means that investors are likely to get further payout hikes anytime soon. Long also explained that:
Even with ETP's great fourth quarter and the contribution from major projects coming online, we felt with ETP's current cost of equity, it was prudent to temporarily suspend the distribution growth in order to retain excess cash flow, to fund the equity component of our growth projects and continue to reduce our leverage."
However, while some might find this payout freeze disappointing, I consider it a highly prudent capital allocation decision. That's because the current yield is more than generous. More importantly by retaining more DCF to fund growth internally, ETP is able to substantially lower its cost of capital.
Source Of Capital | Cash Cost Of Capital |
Retained DCF | 0% |
Debt | 4.2% |
New Equity | 19.8% |
Historical DCF Yield On Invested Capital | 6.3% |
Source: earnings release, FastGraphs
That's because retained cash flow is the cheapest form of funding. And every dollar funded in this way reduces the MLP's need to sell further units at ridiculously unprofitable levels.
The bottom line is that after a very rough 2017, ETP appears to be on the right track. In fact, its long-term growth prospects appear very bright indeed.
Long-Term Potential Remains Strong
The core of this MLP's investment thesis lies in the large growth backlog. For example, management expects that between mid-2017 and mid-2019 it will put $10 billion in new projects into service. $4.5 billion of these are expected to be completed in 2018 and would serve the booming Eagle Ford, Permian, and Marcellus/Utica shale formations.
That should cause DCF to soar, especially if it can avoid issuing any more equity. However, potentially even better news is that ETP is so focused on deleveraging its balance sheet.
Source: Energy Transfer Partners Investor Presentation
Remember that all MLPs have to rely on a lot of debt to finance growth. Currently, ETP's average borrowing costs are just 4.2%, thanks to it still maintaining an investment grade credit rating. ETP was able to renegotiate and extend its two revolving credit facilities at the end of 2017, which means it now has $2.5 billion remaining in low cost borrowing power.
And as projects come online and start generating stable and recurring cash flow (most projects have fixed fee, take or pay contracts), leverage will decline to a highly secure level. For example, currently, the average MLP's leverage ratio is 4.5, which means that a ratio of 4.0 by the end of 2018 would likely get ETP a credit upgrade. That in turn would ensure ongoing access to cheap borrowing and refinancing even in a rising rate environment.
It's likely that ETP's change of heart about payout growth may be an indication that ETE plans to eventually simplify the MLP's corporate structure. In fact, ETE CEO Kelcy Warren has pretty much confirmed that ETE and ETP will consolidate in the future.
If we're allowed to accelerate a consolidation of ETE and ETP, we will do that. It's just fundamentally simple as in – Ross you know the numbers about as well as anybody in the industry. We just can't risk any kind of negative view by rating agencies and until we get our financial health improved and the family, we will not be doing any kind of consolidation. But as soon as we can, we will."
That's certainly been a popular trend in the industry with numerous GPs either allowing their MLPs to buyout their IDRs or merging with them including:
Plains All American Pipeline (PAA)
ONEOK (OKE)
Williams Partners (WPZ)
MPLX (MPLX)
Spectra Energy Partners (SEP)
Holly Energy Partners (HEP)
There are two reasons for such a potential merger or IDR buyout. First, MLPs without IDRs tend to trade at a premium. And so likely such a deal, if done at reasonable terms, might help to expand ETP's multiple. That's because IDRs mean that 50% of ETP's distribution growth goes to ETE, meaning not just higher costs of capital but also slower payout growth in the long term.
By eliminating those IDRs, ETP would enjoy lower costs of capital which means that the profitability on new investments would increase. It also means that management's pool of potential growth projects would expand.
And that pool is certainly expected to grow strongly in the coming years. That's because the OPEC led oil crash didn't shatter the US shale industry as Saudi Arabia had hoped. Instead, it forced it to become more efficient than anyone previously thought possible.
Source: Enterprise Products Partners Investor Presentation
For example, thanks to advances in fracking technology (like longer laterals, more wells per drill pad, more fracking stages, and greater use of frack sand), today's shale producers can break even at gas prices under $2, and oil prices of $30 to $40. Even at low gas and oil prices of just $3 and $45, respectively, today's shale producers can generate sufficient internal rates of returns to justify further investment. Today, gas is about $2.75 and oil is $63.
Saudi Arabia has indicated that it wants oil at a long-term price of around $70. That would translate to a US oil price of about $67 and would be a major catalyst for future growth in US energy production. For example, the International Energy Agency estimates that by 2023 the US will be by far the largest producer of crude oil, condensates and natural gas liquids in the world. In fact, the IEA forecasts that US production will rise by 3.8 million barrels per day to 17 million bpd, and that US oil exports will rise by 3 million bpd (to 5 million bpd).
And the IEA is hardly the only one predicting boom times for the US shale industry. The US Energy Information Administration or EIA expects US energy production to continue growing strongly for decades.
Source: EIA
Of course, increased production isn't possible unless there is sufficient midstream infrastructure to: gather, transport, store, process, and export it. This is why analyst firm IHS projects that by 2040 North America will need up to $900 billion in new midstream infrastructure.
In other words, the US midstream industry is likely to benefit from a major megatrend, which would be a huge growth catalyst for ETP's cash flow and payouts. That's even more so if it can consolidate with ETE in some way to eliminate the IDRs and thus throw the growth taps wide open.
Payout Profile: Still Risky But Headed In the Right Direction
MLP | Yield | 2017 Payout Coverage | 10 Year Projected Distribution Growth | 10 Year Potential Annual Total Return |
Energy Transfer Partners | 12.4% | 1.01 | 2% to 8% | 14.4% to 20.4% |
S&P 500 | 1.9% | 2.0 | 6.2% | 8.1% |
Sources: earnings release, FastGraphs, Multpl.com, CSImarketing
At the end of the day, my approach to income investing is based on fundamentals. That means my primary concern is the payout profile which consists of three parts: yield, distribution security, and long-term growth potential.
ETP's 12.4% yield is indeed impressive, and enough to grab the attention of almost any income investor. However, personally, I'm only interested in owning high-yield stocks with sustainable payouts. So that's why I'm very happy to see ETP's ex-IDR waiver coverage ratio is now back in the black. Hopefully, in Q1 2018, it rises above 1.1, which is generally considered a relatively safe coverage level in this industry.
However, there is more to a sustainable distribution than just a good coverage ratio. The balance sheet is also vitally important. After all, as Kinder Morgan's (KMI) tragic dividend cut showed even sustainable payouts (its coverage was 1.07 at the time of the cut) can get cut if debt levels are dangerously high.
MLP | Debt/Adjusted EBITDA | Interest Coverage | Debt/Capital | S&P Credit Rating |
Energy Transfer Partners | 4.9 | 4.9 | 48% | BBB- |
Industry Average | 4.5 | 4.5 | 52% | NA |
Sources: earnings release, FastGraphs, Gurufocus, CSImarketing
Fortunately, ETP's balance sheet has been getting progressively stronger as management has used asset sales and new projects coming online to deleverage. Today, the debt/adjusted EBITDA ratio is slightly above the industry average, but the interest coverage ratio is firmly on solid footing.
And thanks to management's plan to get leverage down to 4.0 by the end of the year, I expect ETP to get a credit upgrade this year. That will help to insulate it from rising interest rates and allow it to continue funding growth; hopefully without the need to issue insanely expensive equity.
As for long-term growth potential? Well, that depends on how/when/if ETP and ETE consolidate and on what terms. Beyond 2020 there is no giant backlog of growth projects to drive significant growth. However, like with most MLPs, management is constantly evaluating new potential investments as part of a "shadow pipeline". And with the likely midstream spending boom that so many are expecting, ETP could very well end up achieving the 8% long-term distribution growth that analysts are currently expecting.
Personally, I prefer to err on the side of conservatism and expect only 4% payout growth over the next decade. However, given the sky-high yield, no actual payout growth is necessary to beat the market's likely returns. And if ETP can indeed deliver what analysts expect? Then at today's valuation it's likely to prove to be one of the best long-term investments of the coming decade.
Valuation: Mouth Watering Price Means This Might Be A Good Contrarian Investment
ETP Total Return Price data by YCharts
Undoubtedly it's been a rough year for ETP which has lagged the beaten down MLP sector, and has been smoked by the S&P 500. However, for the value conscious value investor, that kind of underperformance, especially if it comes with strongly growing cash flow, could be a great buying opportunity.
P/DCF | Yield | Historical Yield | Percentage Of Time Yield Has Been Higher |
5.1 | 12.4% | 7.8% | 3.4% |
Sources: earnings release, Gurufocus, Yieldchart
That's because as ETP's fundamentals have improved, the unit price has not reacted. In fact, the MLP is now trading at a remarkable five times 2017 DCF, and on a forward basis even less. It's the same level as it was in February 2016. That's when a 76% oil crash, interest rates rising 1%, and the first stock market correction in four years combined to beat down ETP to depression era multiples.
In fact, since its IPO, ETP has only offered a higher yield 3.4% of the time. Or to put another way, despite numerous challenges, ETP's current valuation is so low that the stock offers a very high margin of safety (discount to fair value).
I base that on a long-term (20-year) discounted distribution model which I use to approximate the intrinsic value of dividend stocks I'm considering buying.
Forward Distribution | Projected 10-Year Payout Growth | Projected Payout Growth Years 11-20 | Fair Value Estimate | Annual Payout Growth Baked Into Current Price | Discount To Fair Value |
$2.26 | 2% (conservative case) | 1% | $40.68 | -50% | 55% |
4% (likely case) | 2% | $44.44 | 59% | ||
8% (bullish case, analyst consensus) | 4% | $54.28 | 66% |
Sources: Gurufocus, FastGraphs
I use a 9.1% discount rate because since 1871 this is what a low cost S&P 500 ETF would have generated, net of expenses. Most investors consider this to be the best default investment option, and and their benchmark. So I consider it the opportunity cost of money, and thus a good discount rate.
Now of course any long-term discounted cash flow model will be far from perfect. After all, it requires assuming long-term smoothed out growth rates that are impossible to predict with any certainty.
That's why I use a range of what I consider to be reasonable growth scenarios, ranging from conservative to bullish. No matter what scenario I model one thing is abundantly clear. ETP is dirt cheap. In fact, the stock is basically pricing in a 50% annual distribution cut for the next decade.
Don't get me wrong, there is still a lot that could go wrong for this MLP, which I'll discuss in detail shortly. However, at just five times trailing cash flow, ETP is essentially priced for death. And that's not what the fundamentals or short- to medium-term outlook indicate is likely.
This is why I plan to add ETP to my portfolio next week (on Monday which is when I buy stocks with fresh savings). However, I am only planning to take a very small stake, 1% of my portfolio. That's because, despite ETP's impressive turnaround, I still consider it a high risk stock.
Why ETP Is Still A High Risk Stock
There are still a few reasons why I consider Energy Transfer Partners a high risk stock, though one with a positive outlook.
Dividend Risk Ratings
Low risk: High dividend safety and predictable growth for 5+ years, max portfolio size 10% (core holding).
Medium risk: Dividend safe and potentially growing for next two to three years, max portfolio size 5%.
High risk: Dividend safe and predictable for only next year, max portfolio size 1%
Ultra High Risk: Dividend cut is likely in the next year or two (like WPG), max portfolio size 1%. Note that I personally do not invest in ultra high risk dividend stocks.
Safety Outlooks:
Negative outlook: Fundamentals of industry and/or company are deteriorating, rising risk of safety downgrade.
Stable outlook: Fundamentals are stable, or if in turnaround management plan seems likely to work, risk of safety downgrade low.
Positive outlook: Fundamentals are rising and or turnaround is succeeding, chance of safety upgrade
First is the the nature of the MLP's cash flow. While 95% of its long distance oil and gas pipelines are indeed fixed-fee, take or pay (no volume risk), about 20% of ETP's cash flow is tied to commodity prices directly. This is mostly from the NGL business. However, up to 50% is potentially commodity sensitive (no volume guarantees). That means that ETP's ex-IDR waiver coverage ratio needs to be a lot higher than it currently is for the distribution to be considered medium to low risk.
The bigger risk I see is that completing pipelines on time and on budget. As 2017 showed, that is easier said than done. And now with the Trump administration trying to impose 25% steel tariffs, construction costs for such projects can be expected to increase. In fact, the Association for Oil Pipelines expects the average pipeline project cost to increase by $76 million, with some larger ones (like Keystone and Rover) rising by $300 million or more.
Of course, often the biggest hurdle to completing pipelines is navigating the maddening maze of regulatory approvals and legal challenges. For example, ETP's Rover pipeline continues to get delayed by permitting issues, and now is expected to be completed in Q2 2018.
Meanwhile, on February 23rd, a federal judge revoked the permit for ETP's Bayou Bridge oil pipeline in Louisiana, citing "irreversible environmental damage" that the project would create. Energy Transfer is appealing the ruling in the US 5th Circuit Court of Appeals, but the point is that these kinds of delays can be both costly and drag on for years.
But who cares? ETP's payout is sky-high and well covered right? And it's only going to get more so as the company's $4.5 billion in fully funded projects get completed right? Well, not exactly. Remember that ETP's confidence that it now has all the funding it needs for 2018 is based on completing projects on time and on budget.
In addition, like with the Dakota Access pipeline, some of its financing is tied to future cash flows from projects expected to come into service this year. That means that should it continue to face project completion headwinds, then further funding may be needed.
Since deleveraging ahead of a possible ETP/ETE consolidation is management's top priority, that means that Energy Transfer Partners might still be forced to issue monstrously expensive equity this year, as well as 2019.
Remember that only 2018 projects are pre-funded, and so there might be more dilution coming next year, even if nothing gets delayed further. Each additional unit sold to raise growth capital means a higher distribution cost and lowers the coverage ratio.
Finally, we can't forget that ETP's long-term thesis, like the thesis of many midstream MLPs, is largely predicated on assumption that US oil & gas production grows strongly for decades.
In reality, no one knows whether or not the world's transition to renewable energy will actually take that long. For example, analyst firm McKinsey expects that oil & gas will still provide 74% of the world's power in 2050, down from 82% today. However, even they estimate that global peak oil demand might occur as early as 2030.
Or to put another way, the entire MLP industry's long-term growth runway might prove shorter than many investors expect.
Bottom Line: Energy Transfer Is Too Cheap For Me To Pass Up, But It Remains High Risk For Now
Energy Transfer Partners has certainly come a long way in its turnaround. Even excluding its temporary IDR waivers from ETE, the payout currently appears sustainable and will likely get safer as the year progresses.
In addition, the MLP's impressive ability to fund aggressive growth while aggressively deleveraging means that it's positioning itself well for a potential consolidation with its sponsor. A consolidation that would permanently lower its cost of capital and potentially set it up for very strong long-term payout growth.
However, the MLP's relatively high exposure to commodity prices, the inherent challenges in completing growth projects on time and on budget, and uncertainties surrounding future potential equity issuances, mean that it remains a high risk stock.
Don't get me wrong, at today's mouthwatering valuations, ETP is still potentially a great long-term investment. One I plan to take advantage of, but in a very measured way, using my strict risk management protocols.
As for most investors? If you have a high risk tolerance, or take a small enough position, then I can certainly recommend ETP at these levels. Just make sure you are comfortable with the risks, and as always, remain appropriately diversified.
This article was written by
Dividend Sensei (Adam Galas) is an Army veteran and stock analyst with 20+ years of market experience.
He is a founding author of the investing group The Dividend Kings which focuses on helping investors safeguard and grow their money in all market conditions through the highest-quality dividend investments. Dividend Sensei and the team of analysts (Brad Thomas, Justin Law, Nicholas Ward, Chuck Carnevale, and Sebastian Wolf) help members invest more intelligently in dividend stocks. Features include: 13 model portfolios, buy ideas, company research reports, and a thriving chat community for readers looking to learn how to invest more intelligently in dividend stocks. Learn more.Analyst’s Disclosure: I am/we are long SEP, MPLX. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (223)
EPD no material
KIM no materialI expect MLPs are going to have a good day as it appears concerns are far overblown. ENB just confirmed no material impact. Hopefully I can get a good day and get me to $100K in equity (about $1000 so away). That is a nice milestone and IBKR stops charging monthly maintenance fee if you get there. $110K I get portfolio margin and reduce my maintenance requirement 10%. Should get both within the next 6 weeks or so, maybe 4 to 5 if market breaks my way.
REUTERS 7:52 PM ET 3/7/2018March 7 (Reuters) - Pipeline operator Energy Transfer Partners(ETP) is considering a partial shift to a C-corp from a master limited partnership, its chief executive said on Wednesday, a move that rivals have made to simplify their corporate structures.Kelcy Warren, the company's CEO, said in response to a question at the CERAWeek energy conference, "we're certainly exploring at least a partial movement in that direction." Rivals Williams Cos(WMB) and Kinder Morgan(KMI) both have made the move to simplify their corporate structures and lower their cost of capital for new projects.
The end of 2019 is the earliest.
Ahh, the key to the kingdom.M* rating really isn't significant.
ETP when off the tracks so to speak in 2015 and has not mustered much of a growth potential since. So, what is new that says we will see $40/share in 12 months or so? Nada.
UBS is just one opinion, where are the rest?
Boubou, why double down on ETP, double up on a winner instead?
So, nothing loth, I intend to double down at this price.
https://seekingalpha.c...
