Energy Transfer Merger Comes Early: 7 Important Things Investors Need To Know

Summary

• Energy Transfer Partners has struggled for years with: dangerously high debt, a liquidity trap, and distribution cuts.
• Despite an increasingly successful turnaround in 2018 management made it clear the days of a standalone ETP would be ending with ETE buying it out.
• That deal was expected to be announced in 2019 but management just surprised us by announcing a $27 billion merger about 12 months early.
• There are 7 important things investors need to know pertaining to this merger and how it effects unit holders in both MLPs.
• Most importantly, find out why the bigger and better ETE is likely to make a potentially excellent: long-term low risk, high-yield income growth stock over the next decade. Especially from today's attractive valuation.

(Source: imgflip)

My high-yield income growth retirement portfolio is now 100% focused on my best investing ideas. I define these as the stocks that offer the best combination of:

• high but sustainable (through a recession) yield
• strong long-term payout growth potential (long growth runways)
• highly favorable valuations

Recently I highlighted why I consider Energy Transfer Equity (ETE) to be a great long-term high-yield income growth investment. That was predicated on the upcoming acquisition of its MLP Energy Transfer Partners (ETP). With management telegraphing that ETE would be buying out ETP in an all stock deal, I decided to take a 5% stake in ETP as a way to arbitrage my way into more discounted ETE units once the merger closed.

At the time, this merger appeared most likely to occur in 2019. However, on August 1st, Energy Transfer pulled the trigger much earlier than expected, announcing the ETE would be buying ETP in a $27 billion all stock deal.

As with most large mergers there are a lot of moving pieces to consider, that will have important short and long-term ramifications for investors in both stocks. So let's take a closer look at the seven most important things investors in both MLPs need to know about this merger. Most importantly, find out why this deal is ultimately a great thing for Energy Transfer investors because it's likely to result in a stock that provides: generous, safe, and fast growing income over the coming decade. Or to put another way, the new ETE is going to become a low risk industry blue chip. And when combined with its attractive current valuation, one that is capable of market crushing total returns over the next 10 years.

1. Basics Of The Deal

Note that ETE is also an MLP which means its issues a K-1 tax form. This merger is NOT a c-Corp conversion and management has said it has no intention of converting to a corporation.

(Source: energytransfer.com)

Energy Transfer Equity's buyout of Energy Transfer Partners is designed to simplify its corporate structure, specifically eliminating the incentive distribution rights or IDRs. These exist to incentivize ETE (who provides the management for ETP) to grow the payout as quickly as possible. That's because 50% of all marginal distribution growth ends up returning to it in the form of highly lucrative IDR fees. The downside is that with ETP struggling to grow profitably, largely due to its cost of equity being so high (about 20% right now), these IDR fees have greatly increased its cost of capital and made profitable growth much harder.

Thus ETE is buying out ETP in an all stock MLP merger (non taxable event) where ETP investors will get 1.28 units of ETE for each ETP unit they own on the date the merger closes. This means about 1.5 billion ETE units will be issued to fund the merger, and increase ETE's total unit count to 2.6 billion (market cap about $49 billion, Enterprise value about $91 billion). The deal is expected to close by the end of 2018, assuming investor approval. This conversion factor (which was much higher than I expected) represented a 13% premium to ETP's price the day of the announcement and explains why the stock jumped 14% on August 2nd.

Included in the deal's structure is a new issuance of Class A ETE units that are designed to maintain ETE's general partner 31% voting rights in ETE. Had these units not been issued the large amount of dilution would have caused the GP's (basically management) voting rights to fall to 13.5%. The good news is that these new Class A units are not convertible to common units and have no economic rights. In other words, they receive no distributions and exist only to maintain the current status quo in terms of current management control of the MLP. Going forward any new ETE common unit issuances (say during a future merger) will be matched one for one with class A unit issuances to ensure that management always maintains 31% voting control.

(Source: Energy Transfer Merger Presentation)

The final important part of the deal is ETE's plans to swap its current long-term bonds for new ETP bonds (ETP has a stronger credit rating). When combined with a refinancing of its current revolver and term loan this is expected to lower the new MLP's average borrowing cost. Combined with a much lower cost of equity and elimination of IDRs, this will massively reduce Energy Transfer's cost of capital and make future growth more profitable. It will also speed up long-term distribution growth.

Ok, so now we know the mechanics of the deal. But why is it coming so early? After all in the last two quarterly conference calls management indicated that no merger was likely before 2019 at the earliest. Well the reason for Energy Transfer moving up the merger this early has very important implications for the short-term payouts that investors in both MLPs are likely to receive.

2. Why Merger Is Coming So Early

In Q4's conference call CEO and Energy Transfer founder Kelcy Warren told analysts that a merger of these two MLPs was coming.

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." -Kelcy Warren

Then in Q1's conference call Warren made it very clear that ETE would be buying ETP.

"As far as the simplification that you refer to, it would most certainly be a structure whereby ETE acquires ETP. There's – we've looked at every scenario possible to us. And we don't see any mathematical scenario that makes any sense other than that one." -Kelcy Warren

The key issue on the timing of the merger was ensuring an investment grade credit rating from all the major agencies. Remember that Energy Transfer Partners' cost of equity was so high that any equity growth capital it raised was highly dilutive unless leveraged with debt or asset sales. In Q4 management said no merger was likely until late 2019 and in Q1 that time table was moved up to early to mid 2019. However, as Kelcy Warren has always said, the true time table was "ASAP".

In 2017 Energy Transfer Partners had to make a large number of very painful capital raises, which included large amounts of highly dilutive equity issuances. At the start of the year management said ETP had sufficient capital to complete 2018's growth projects. However, beyond that in 2019 and 2020? Well that was far from certain and would largely depend on its unit price at the time.

(Source: Energy Transfer Partners Investor Presentation)

While ETP still has plenty of access to low cost debt capital, management has made deleveraging a top priority. The trouble is that ETP's turnaround and future payout growth potential hinged on its $10 billion backlog of growth projects that were slated to come online between mid 2017 and mid 2019.

(Source: ETP investor presentation)

Beyond 2018 the MLP has about $5 billion in projects it needs to fund. Apparently management wasn't confident that ETP's distribution coverage ratio would rise high enough by the end of 2018 to allow it to fund the equity portion of its future projects with retained distributable cash flow or DCF. DCF is the MLP equivalent of free cash flow and what funds the distribution.

In the past two quarters management told analysts that it was frequently discussing the merger with rating agencies and providing updates on how its major project completions were going and forward cash flow estimates that would affect its leverage and other credit ratios. Apparently ETE got the green light from the rating agencies and so decided to pull the trigger on the merger and close it by the end of the year.

This would immediately cut Energy Transfer's cost of equity in half (11% instead of about 20%). More importantly it would be highly accretive to ETE's DCF/unit and ensure both the safety of the current payout as well as provide more than enough retained cash flow to fund its remaining projects. In other words, this merger is happening early to ensure that Energy Transfer's growth momentum in 2019 and beyond doesn't run into any more funding challenges.

But while the deal is a master stroke of long-term financial engineering, there is one major drawback for ETP investors such as myself.

3. Energy Transfer Partners Investors: Short-Term Pain, But Long-Term Gain

The good news is that based on its last major MLP all stock merger (Sunoco Logistics buying ETP) this deal isn't likely to be a taxable event. The bad news is that ETP investors are looking at another significant distribution cut.

MLP	Yield
Energy Transfer Partners	9.4%
Energy Transfer Equity	6.5%
Effective Yield For ETP Investors (factoring in 1.28 ETE conversion ratio)	8.3%

Click to enlarge

(Sources: Gurufocus, management guidance)

For example, if you were to buy ETP today, then post merger you would receive 6.5% yielding ETE units that equates to a 30% distribution cut. That's similar to the post SXL merger cut ETP investors received.

Even accounting for the 1.28 conversion factor your income would decrease 11%. If you bought ETP primarily for income (retirees living off distributions) than that is going to hurt. It's even worse for those who were brave enough to buy ETP at a much lower price. For instance, if you bought at the 52 week low then your yield on cost was 15% and you'll be getting the income equivalent of 8.3% or a roughly 50% income cut (but 57% yield cut).

So this means that Kelcy Warren has screwed ETP investors yet again right? Actually no. For one thing ETP investors are getting very generous buyout terms. For example, Morningstar's MLP analyst, Travis Miller, calls the 1.28 conversion rate "exceedingly generous" and Morningstar expected a conversion rate closer to 1.0. That's because ETE has a much stronger negotiating position owing to ETP's likely trouble funding its growth projects beyond 2018.

In addition lifting the uncertainty over the merger has done wonders for ETP's unit price. More importantly with Wall Street now increasingly confident that Energy Transfer will be able to execute on its long-term growth plans (no more funding challenges) the price of both MLPs are far more likely to keep rising throughout the year.

Why is Wall Street likely to remain more bullish on both ETE and ETP (now linked together by that 1.28 conversion factor)? Because of the most important ramification of this merger; a shift to a self funding business model.

4. Energy Transfer Equity Self Funding Business Model Means Don't Expect Distribution Increase In 2018

One of the major speculations about the upcoming merger was whether or not ETE would boost its distribution high enough to make ETP investors whole, in terms of total income received. My fellow contributor, Trapping Value, even did a detailed analysis of the numbers and concluded that ETE was likely to raise its payout 15% to offset the lower yield on the units ETP investors would be getting from the merger.

In the comments on my last ETP/ETE merger article I admitted that, if the merger came in 2019 as then expected, ETE might indeed hike its payout in such a fashion. That would be similar to TallGrass Energy's (TGE) recent GP buyout of its MLP (which was a c-Corp conversion).

However, due to the merger coming early Energy Transfer Investors aren't going to be getting this payout boost.

(Source: Energy Transfer Merger Presentation)

That's because the primary reason for this merger coming so early was to boost ETE's coverage ratio from about 1.15 (post recent preferred unit conversion) to 1.6 to 1.9. Keeping the current distribution in place that would allow the new ETE to retain about $2.75 billion in annual DCF to fund its growth projects.

As Tom Long, Energy Transfer's CFO, explained in the merger announcement conference call, this means that ETE is trying to assume a self funding business model.

That is the goal... the goal is for the excess cash, let’s call it retained cash is to be covering the equity side of the funding." - Tom Long, CFO

There are two major benefits to a self funding business model. First, it means that the MLP's future growth potential will become almost 100% independent on fickle equity markets. Or to put another way, even if ETE's unit price were to crater and send its cost of equity soaring, the MLP could continue funding its growth capex purely through retained DCF and modest amounts of low cost debt. In fact, Morningstar estimates that between beyond mid 2019, when most of its growth projects will be completed, ETE will spend about $2 billion per year on growth capex. This means that the MLP could effectively fund 100% of its growth with retained cash and eventually achieve the industry's strongest balance sheet.

But should management see opportunities for faster growth then it could certainly spend far more. For instance, once the leverage ratio is down to its long-term target of about 4.25, ETE could maintain that ratio with a 50/50 mix of retained cash flow and low cost debt. That would give it the potential for about $5.5 billion in annual growth projects and could greatly enhance the long-term growth prospects of the distribution.

(Source: INGAA)

In other words, the new ETE will become a low risk source of high and eventually, growing yield. That's thanks to the massive need for new midstream infrastructure coming in the next 17 years. For instance according to the Interstate Natural Gas Association of America by 2035 America's energy boom will require $791 billion in new midstream projects. This creates a potentially very long and strong growth runway for the new ETE. It's also why I'm more bullish on the MLP's long-term growth capex budget than Morningstar.

The second reason a self funding business model is great for long-term Energy Transfer investors is because it will allow the MLP to rapidly complete its long-term deleveraging goals. And that is what will ultimately not just ensure the long-term growth potential of the MLP's cash flow but also its distribution.

5. Distribution Growth Likely To Resume By Second Half Of 2019

During the post merger conference call management made it very clear that the top priority was using the new ETE's retained cash flow to complete its 2019 projects and continue deleveraging.

Specifically Tom Long stated, and Kelcy Warren confirmed, that the new ETE's long-term leverage target would be 4.0 to 4.5. That's in line with the current industry average of 4.4 and would likely get the MLP a credit upgrade to BBB. That in turn would further lower its borrowing costs (and cost of capital) and potentially even open up the possibility of future M&A activity, which would take advantage of the MLPs much lower cost of equity. Note that for now management says it sees no good buyout candidates so Energy Transfer investors shouldn't be concerned about any more major mergers coming anytime soon.

What matters to ETP and ETE investors (soon to be the same group) is when exactly will ETE start growing its distribution again? Well that depends on how quickly the new ETE can get to a safe leverage level of 4.5 or less. As Kelcy Warren said in the conference call "like Tom said 4 times to 4.5 times (leverage) is very important to us."

This means that the earliest ETE is likely to increase its payout is when the leverage ratio (4.7 when merger closes) will fall to 4.0 to 4.5. Currently analysts expect ETE to hike its 2019 payout by 8%, or about 2% per quarter. However, that depends on how quickly the MLP brings its projects online and how quickly its cash flow grows and what it's leverage ratio will look like in any given quarter.

Fortunately, with most of its remaining backlog of projects slated to go into service by mid 2019, I think it's likely that ETE will resume at least some payout growth in the back half of next year. Because as Kelcy Warren said in the conference call regarding distribution growth:

We have a duty to our unitholders. I mean, that’s what MLPs are supposed to do, I think most people have forgotten that. But we’re supposed to reward our unitholders and increase our distributions. We will in fact resume that at the appropriate time." - Kelcy Warren

But just how fast is ETE likely to grow its payout over the long-term? Well that's the good news. Because the new and improved ETE is likely to prove a great high-yield income growth stock over the coming decade.

6. Payout Profile: Post Merger Energy Transfer Becomes A Low Risk High-Yield Income Growth Stock With Market Beating Potential

Note that since ETP will likely cease to exist in 2019 the remainder of this article analysis will focus exclusively on ETE.

The most important part of any income investment is the payout profile which consists of three parts: yield, payout safety, and long-term growth potential.

MLP	Yield	Forward Coverage Ratio	Projected 10 Year Distribution Growth	10 Year Potential Annual Total Return	Valuation Adjusted Total Return Potential
Energy Transfer Equity	6.5%	1.75	6.5% to 13.0%	13.0% to 19.5%	14.6% to 21.9%
S&P 500	1.8%	2.6	6.20%	8%	0% to 5%

Click to enlarge

(Sources: management guidance, Gurufocus, FastGraphs, Yardeni Research, Multpl, BlackRock, Vanguard, Morningstar, Gordon Dividend Growth Model, Simply Safe Dividends)

Energy Transfer Equity's current yield may be below the 8.5% average for MLPs but is still more than three times that of the broader market. More importantly post merger that distribution is going to be one of the safest in the industry. That's because a coverage ratio of 1.1 is considered low risk, and most MLPs currently have a DCR of about 1.2. For self funding business models most MLPs maintain a DCR of 1.2 to 1.5. ETE's post merger coverage ratio of 1.6 to 1.9 means that investors will not have to worry about the safety of its payout. Especially since 85% of its cash flow is under commodity insensitive, long-term, volume committed contracts.

Of course the other side of the payout safety equation is the balance sheet. In a highly capital intensive and growth oriented industry such as this a strong balance sheet is essential.

MLP	Pro Forma Debt/Adjusted EBITDA	Pro Forma Interest Coverage Ratio	S&P Credit Rating	Average Interest Rate
Energy Transfer Equity	4.7	4.7	BBB-	4.5%
Industry Average	4.4	4.5	NA	NA

Click to enlarge

(Sources: Morningstar, Gurufocus, FastGraphs, management guidance)

Because ETE has some debt of its own, the combined MLP will have a leverage ratio of 4.7, even taking into account the new cash flow coming online from the rest of 2018's projects. While that's a bit higher than the industry average it's likely enough to maintain ETP's current BBB- credit rating. That's because the new ETE will have above average interest coverage and modest borrowing costs. Upon the completion of its deleveraging process and bond conversions, ETE's interest costs should fall to about 4.0% to 4.2%. And with 99% of its debt fixed rate long-term bonds, the MLP should have minimal growth sensitivity to rising interest rates.

What about ETE's future distribution growth prospects? Well currently analysts expect it to be capable of growing its DCF/unit by about 13% annually over the next decade. That's due to America's strong ongoing energy boom, which creates a long growth runway of new midstream projects to build. However, in order to be conservative, I assume that ETE's distribution will grow only half as fast as most analysts currently project. This is to account for both the lack of IDRs as well as possibility that the MLP potentially doesn't start raising its distribution until its leverage falls to 4.0.

However, even with just 6.5% payout growth ETE will likely make an excellent long-term, low risk, income growth investment. In fact, based on its current valuation I think it's capable of close to 15% annualized total returns through 2028. In other words buying ETE today might quadruple your money over the next decade. That's in contrast to the S&P 500 which Morningstar, Vanguard, and BlackRock think is likely to generate just 0% to 5% annual returns over the same time period. And of course if ETE achieves the faster payout growth rates then its total returns will likely come in much higher.

Basically the post merger Energy Transfer Equity offers a great mix of: superior (and low risk) yield, faster income growth, and about three to four times the total return potential of the S&P 500.

7. Valuation: Energy Transfer Equity Still A Good High-Yield Deal

ETE Total Return Price data by YCharts

Thanks to a strong recovery in MLPs this year, as well as the announcement of this merger (less uncertainty), ETP has managed to crush the market, while ETP has matched it over the past year. However, despite the recent rally I still consider ETE a good buy.

Now there's no 100% objectively correct way to value a stock. While there are dozens of potential metrics and models you can use, each has its own limitations. This is why I use a combination of factors to create a more robust valuation model that minimizes the chances of overpaying for a stock.

My approach begins with the Gordon Dividend Growth Model or GDGM. Since 1956 this valuation model has proven relatively accurate for modeling the total returns of stable business model stocks (like MLPs). The model assumes:

• a stock begins at fair value
• valuation changes cancel out over time (mean revert)
• payout ratio is constant (MLP DCR is fixed)
• distributions grow in line with DCF/unit

If these assumptions hold true than an MLP's total return will approximate yield + long-term distribution growth. My goal is to only recommend income stocks with a realistic chance of beating the market (on a CAGR basis) over time. However, given that the S&P 500 is likely to post weak returns for the next few years, to own a stock in my own portfolio I require a minimum valuation adjusted annualized total return potential of 13+%. ETE passes this initial screen, even assuming no valuation multiple expansion.

However, if a stock starts out undervalued, then mean reversion over time will actually boost total returns above that projected by the GDGM. This is where my other valuation techniques come in.

The first is looking at the forward price/DCF, which is the MLP equivalent of a PE ratio. This is useful in two ways when combined with a formula created by Benjamin Graham, Buffett's mentor and the father of modern value investing.

That formula says that the fair value PE of a stock is: 8.5 + (2X 10 year projected growth rate) / discount rate (in decimal form).

We can use this formula in two ways. The first is by estimating what DCF/unit growth rate is baked into ETE's current price. The second is by using a conservative growth assumption (half analyst consensus) to determine what a fair price/DCF (and thus unit price) would be.

Forward Price/DCF	Implied 10 Year DCF Growth Rate	Ben Graham Fair P/DCF (6.5% DCF growth)	Implied Discount To Fair Value
8.8	0.2%	19.5	55%

Click to enlarge

(Sources: management guidance, earnings releases, Benjamin Graham, FastGraphs)

Energy Transfer Equity's forward pro-forma (post merger) price/DCF is currently 8.8. Generally anytime you can buy a quality income producing stock with growing cash flow at a multiple of 10 or less, you're likely to make money. That 8.8 forward cash flow multiple implies a 10 year DCF/unit growth rate of just 0.2%. That's far below even the most bearish analyst growth estimates I've seen (3% per year). Or to put another way, ETE's current price/DCF is likely too low and can be expected to rise over time.

Per the Ben Graham formula (and using a 10% discount rate) if ETE achieves 6.5% annualized DCF/unit growth through 2028 then a fair price to pay is 19.5 times DCF, or $42 per unit. However, that 55% discount to fair value is very high and so sends up a red flag. Specifically, that we need to confirm this valuation estimate with other models.

One of those would be comparing the yield to its five year and 13 year median values. That's because yields for stable business model stocks tend to be mean reverting and thus cycle around a relatively stable point that approximates fair value. For example Energy Transfer Equity's five year and 13 year median yields are 6.0% and 5.9%, respectively. This indicates that a 6% yield is close to the fair value for the stock.

Yield	5 Year Average Yield	13 Year Median Yield	Discount To Fair Value (5 Year Average)	Discount To Fair Value (13 Year Median)
6.5%	6.0%	5.9%	8%	10%

Click to enlarge

(Sources: Simply Safe Dividends, Gurufocus)

This means that ETE is likely only 8% to 10% undervalued, and probably indicates the Graham model figure is an outlier. To further confirm that I often use a three stage discounted cash flow or DCF model, such as provided by Morningstar.

A DCF model estimates fair value based on the net present value of all future cash flow. Theoretically it's the purest form of valuation and the most accurate. In reality, like all models, it's only as good as the assumptions you use, including smoothed out growth rates over decades, and a discount rate (target return) that's different for everyone.

However, as one valuation method among several, I consider Morningstar's estimates useful for two reasons. First, its analysts are purely focused on long-term fundamentals (not short-term prices). Second, Morningstar DCFs tend to be extremely conservative and assume growth rates far below that of most analysts or even management itself. Thus Morningstar fair values offer a good low ball estimate of intrinsic value.

Morningstar Fair Value Estimate	Discount To Fair Value
$22	14%

Click to enlarge

(Source: Morningstar)

In this case Morningstar estimates ETE, post merger, will be worth $22 indicating a 14% margin of safety. And that's even assuming far smaller growth project spending than I consider to be likely ($2 billion per year and 3% DCF growth).

To normalize my own fair value estimate using all of these methods, I remove the largest outliers, meaning the smallest and largest figures, and then take the average of the remaining estimates.

Estimated Fair Value	Discount To Fair Value
$21.50	11%

Click to enlarge

(Sources: Benjamin Graham, Morningstar, Gurufocus, management guidance, FastGraphs, Simply Safe Dividends)

Thus I come to my own estimated fair value of $21.5 per unit, and a 11% margin of safety from today's price. That isn't necessarily a large figure but since ETE is likely to generate about 13% total returns from fair value, it's enough to boost its expected returns to highly attractive levels.

It's also enough for me to still recommend ETE today, especially since the post merger ETE will represent a low risk blue chip in its industry.

Bottom Line: Mega Merger Coming Early Ultimately Makes ETE A Much More Appealing Long-Term High-Yield Income Growth Investment

Don't get me wrong, I understand if long suffering ETP investors feel that yet another distribution cut means they are getting screwed. However, it's important to realize that ETE's merger offer is very generous. So while ETP investors are indeed facing a sharp payout cut, at the end of the day we'll be left with a far healthier, low risk, high-yield industry blue chip.

One with a rock solid distribution, a strong balance sheet, and great long-term payout growth potential. And from today's attractive valuation, that translates into very impressive market beating total return potential. This is why I feel confident in recommending ETE to new high-yield investors. At least those comfortable owning an MLP that issues a K-1 (as ETP does).

Disclosure: I am/we are long ETP. 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.