We continue to be grateful for the favorable reception of our research and analysis. Our mission to help investors of all types remains our core focus and a cause buttressed by our independence and analytical integrity. You can read more here about Valuentum and its President of Equity Research Brian Nelson, CFA.
It appears there continues to be a significant amount of confusion about the securities associated with the Energy Transfer companies, a collection of assets that includes the corporate parent Energy Transfer Equity (ETE) as well its consolidated subsidiaries: “Energy Transfer Partners (ETP), ETP GP, ETP LLC, Regency, Regency GP, Regency LLC, Panhandle, Sunoco, Inc., Sunoco Logistics (SXL), Sunoco LP (SUN), Susser and ETP Holdco (per Energy Transfer Equity, L.P, Form 10-K).” The distinction that requires more clarification, at least it seems, is that Energy Transfer Equity—trading under the symbol ETE—is a different security than Energy Transfer Partners—trading under the symbol ETP—despite sharing a very similar name.
The leverage analyses of the two are separate and unique, albeit intertwined, and the SEC filings of both are different, though their economics are inextricably linked. In this light, we maintain our view that evaluating the latest information regarding the fully-consolidated entity, Energy Transfer Equity (ETE), is of critical importance to the analytics of the subsidiaries, including perhaps its most widely-followed, Energy Transfer Partners (ETP). Critically, evaluating Energy Transfer Equity (ETE) through its reported SEC filings, in our opinion, puts the whole picture of all its subsidiaries together, as through ETE they are tied together, even as we note that consolidated debt plus off-balance sheet debt (from unconsolidated joint ventures/JVs) at Energy Transfer Equity (ETE) is even higher than its reported total debt numbers (ETE Form 10-K, page 39 “excluding the debt of our joint ventures”). The reported SEC filings are still the best place for unbiased information, in our view, and viewing the whole consolidated picture from ETE down is most informative of related-party risk.
Energy Transfer Equity’s massive ownership stake in Energy Transfer Partners’ (ETP) common units ties the economics of the two (ETE and ETP), and we maintain our view that the financial health of Energy Transfer Equity (ETE), while a separate and distinct security from Energy Transfer Partners, is still of considerable analytical importance and “information value” to Energy Transfer Partners (ETP). Here’s why, from Energy Transfer Partners’ (ETP) Form 10-K:
The credit and business risk profiles of our General Partner, and of ETE as the indirect owner of our General Partner, may be factors in credit evaluations of us as a publicly traded limited partnership due to the significant influence of our General Partner and ETE over our business activities, including our cash distributions, acquisition strategy and business risk profile. Another factor that may be considered is the financial condition of our General Partner and its owners, including the degree of their financial leverage and their dependence on cash flow from the Partnership to service their indebtedness (page 31).
Absent direct commodity price risk (~5% at ETP, per the latest available information) and customer credit risk, two factors to be addressed later in this piece, the following is what concerns us most from a financial analysis standpoint about the collection of Energy Transfer companies, particularly in light of collapsing energy resource pricing and a tightening credit environment. Again, we point to consolidated, all-in analysis of Energy Transfer Equity (ETE) as the best, “most complete” and available information to get a read on the entire picture of all subsidiaries together.
Through the first nine months of 2015, Energy Transfer Equity’s reported operating income fell more than 6% (it fell more than 20% in the third quarter alone–a lot for a supposedly “commodity-price immune” entity), while cash flow from operations dropped to $2.15 billion from $2.5 billion in the nine-month period. Meanwhile, capital spending outflows soared to $6.69 billion through the first nine months of the year, resulting in traditional free cash flow, as measured by cash flow from operations less all capital expenditures, of -$4.52 billion (negative $4.52 billion). This compares to traditional free cash flow of -$1.21 billion (negative $1.21 billion) through the first nine months of last year, a substantial decline mostly due to capital spending build.
Through the first nine months of 2015, Energy Transfer Equity’s (ETE) ‘distributions to partners’ and ‘distributions to noncontrolling interests’ totaled $2.5 billion ($790 million and $1.7 billion, respectively). By extension, we estimate that free cash flow after all distributions was more than -$7 billion (negative $7 billion) through the first nine months of the year. Of note, Energy Transfer Equity’s current market capitalization is $11.6 billion. We continue to believe the industry’s definition of distributable cash flow, which excludes growth capital that drives future net income, which itself is included in distributable cash flow, is an imbalanced metric, and one not to be used in the intrinsic valuation context.
From our perspective, economic performance at the consolidated entity, Energy Transfer Equity (ETE), is deteriorating meaningfully, as measured by reported operating income and reported traditional free cash flow declines, and the entity’s leverage picture isn’t improving either, from our point of view. We published a consolidated, all-in analysis of Energy Transfer Equity’s (ETE) reported net debt to EBITDA, which as mentioned before includes all of its subsidiaries, including Energy Transfer Partners, but not off-balance sheet (JV) debt, and we concluded that, in light of Energy Transfer Equity’s deteriorating operating performance, the entity was on track for reported net debt to EBITDA metric of 7x+ on an annualized, consolidated basis from the SEC filings.
Energy Transfer Equity’s most recent income statement and balance sheet can be found here (pdf). The balance sheet can be found on page 1-2 of the pdf, and the income statement can be found on page 3. Net debt can be calculated by adding ‘long-term debt, less current maturities’ to ‘current maturities of long-term debt’ (page 2) and then subtracting cash and cash equivalents (page 1) on the balance sheet and reported EBITDA can be calculated by adding operating income (EBIT) to depreciation, depletion, amortization (page 3) on the income statement.
Here’s what we wrote December 10:
In the nine months ended September 30, Energy Transfer Equity’s operating income was $2.16 billion, while depreciation and amortization was $1.53 billion, good for $3.69 billion in EBITDA, or $4.92 billion in EBITDA on an annualized basis.
The company noted short and long-term debt of $36.3 billion and cash and cash equivalents of $1 billion, resulting in a net debt position of $35.3 billion…By our calculations, Energy Transfer Equity is nearly 7.2x leveraged ($35.3/$4.92).
[Please note that this is our estimate Energy Transfer Equity’s (ETE) degree of leverage, which includes Energy Transfer Partners (ETP) and other subsidiaries, but not JV-related debt. Also, please note that additional confusion has arisen about whether previously-closed acquisitions prior to the beginning of the third quarter have been considered in third quarter operating results. They are or they should be. It is therefore important to emphasize that Energy Transfer Equity’s operating income was $650 million in the three months ended September 30, down from $822 million in the prior-year period. Annualizing that EBIT and corresponding period DD&A gets to ~$4.7 billion in annualized reported EBITDA (on the income statement), not that far from the $4.92 billion annualized measure we used in the analysis above. In other words, the most recent quarterly performance, which we assume includes all consolidated activities prior to the beginning of the third quarter, means Energy Transfer Equity may be in worse shape than originally believed.]
We maintain our view that balance is very important in the context of any calculation of leverage. Let us explain. If a line item is added to the denominator in the leverage calculation (i.e. EBITDA), it is our view that the corresponding debt associated with that line item must also be added to the numerator (i.e. net debt). Due to the near-infinite ways imbalances can occur, we continue to believe annualized GAAP reported leverage at Energy Transfer Equity (ETE) is the best available representation of leverage, per its most recent Form 10-Q (annualized). Importantly, however, if credit analysts are adding ‘adjusted EBITDA related to unconsolidated affiliates’ to reported EBITDA, which they might be doing, the proportionate unconsolidated debt of joint-ventures (or all of it in its entirety depending on economic substance and recourse) should also be included in the leverage calculation. If not, an imbalance would reside in the leverage metric.
Let’s explain further.
As mentioned above, through the first nine months of 2015, reported EBITDA from the income statement (page 3) at Energy Transfer Equity was $3.69 billion and adjusted EBITDA to unconsolidated affiliates was $487 million, per management, amounting to reported EBITDA, including that from unconsolidated affiliates, of ~$4.2 billion (~$5.6 billion annualized). If unconsolidated EBITDA is added in the leverage calculation, Energy Transfer Equity’s proportionate share of the ~$3 billion in outstanding off-balance sheet debt at the joint-venture level is ~$1.5 billion must also be added, too (or all of the off-balance sheet debt depending on the analyst’s assessment of economic consequence and/or recourse).
Therefore, through the first nine months of the year, assuming a non-GAAP, all-in calculation that factors into a) the proportionate share or b) all of JV-related debt, Energy Transfer Equity’s leverage would stand at a) 6.5x ($36.8/$5.6) or b) 6.8x ($38.3/$5.6), the latter assuming that from an economic (and/or recourse) standpoint, Energy Transfer Equity (ETE), or its subsidiaries would be on the hook should any partnership get into trouble (note: Energy Transfer management noted that, based on the process we outlined and with a variety of additions to the denominator, some we don’t think are warranted (e.g. compensation), and including just the proportionate share of JV debt, net debt to EBITDA would be ~6.25x.) This is still substantially greater than the 4.5x that many may continue to believe Energy Transfer Equity (ETE) is leveraged, however; please also remember that Energy Transfer Equity (ETE) is a consolidated representation of all subsidiaries, including Energy Transfer Partners (ETP), and the two are economically, if not inextricably, linked.
In light of Energy Transfer Equity’s degree of financial leverage (6.25x-7x+ depending on how you measure it), deteriorating operating income through the first nine months of the year (down 20% in the third quarter alone), increasing credit risk among its customer base due to collapsing energy resource pricing, and the general tightening credit environment among energy-related entities, we were shocked that Moody’s put the outlook for Energy Transfer Equity’s currently junk-rated debt (Ba2) to positive in September, despite Energy Transfer Equity’s decision to take on $6 billion of more debt and become the “co-obligor of Williams’ (WMB) existing long-term debt, which approximates $4.25 billion.” We noted, through the first half of 2015, Williams Co had a net debt to annualized adjusted EBITDA mark of 7.3x and that free cash flow after dividends/distributions paid was -$1.5 billion (negative $1.5 billion). Energy Transfer Equity and Williams Co had the two biggest traditional free cash flow shortfalls compared to distribution obligations in our entire midstream coverage universe. You can see the first-half 2015 calculations here.
We know that the credit rating agencies are doing the best they can to keep up with the fast-changing energy resource market environment in evaluating new exposures/combinations and stress-testing sensitivities, but from where we stand, we don’t believe that the credit outlook for Energy Transfer Equity (ETE) is improving, and we can only trust that the credit rating agencies are pursuing balance in all respective leverage calculations. The standard adjustments the agencies make don’t, in our view, add a significant amount of transparency for bondholders, who have to evaluate whether they want to continue to allow the Energy Transfer companies pay out billions to unitholders as dividends/distributions.
We maintain our view that in light of a collapsing energy resource pricing environment and deteriorating credit conditions, bondholders in the MLP (AMLP) universe may have to eventually decide whether it makes more sense for dividends and distributions to be paid out of traditional free cash flow, as measured by cash flow from operations less all capital spending, or earnings – just like most every other dividend-payer out there. For Energy Transfer Equity (ETE), whose operating income and traditional free cash flow metrics are deteriorating as it runs -$7 billion shortfall through the first nine months of the year, by our estimates (free cash flow less distributions paid) on $11.6 billion market capitalization, we’re growing increasingly more nervous for all stakeholders involved. Consolidating all subsidiaries into a corporate like Kinder Morgan (KMI) and cutting the payout seems like the most responsible course of action for the Energy Transfer collection of companies, in our view.
Notably, we continue to point investors to the idea that Energy Transfer Equity’s (ETE) fully-consolidated operating income is declining at a mid-to-high-single digit pace (and worse if we consider the third quarter alone, where operating income fell 20%+) and that its subsidiary, Energy Transfer Partners (ETP), has ~10% of its business directly tied to commodity prices or other non-fee margin, not too unlike that of Kinder Morgan. Unlike Kinder Morgan, however, we don’t have a good feel for Energy Transfer Partners’ (ETP) hedging portfolio, and whether there will be implications in 2016 when or if any hedges roll off. If the company is completely unhedged, we would expect some meaningful EBIT deterioration in coming years, given the drop in energy resource pricing. Please note, reported operating income fell 20%+ in the third quarter ($650 million versus $822 million), and this is a large decline for a company supposedly not levered to commodity prices.
It’s also worth noting that a considerable portion of Energy Transfer Equity’s net debt remains tied to floating/rising interest rates, and rate hikes in coming years may pressure junk-rated issuers, perhaps to the point where the Fed may be hand-cuffed to raise rates any further, without completely locking out the high-yield market of new capital. Given its junk-rated credit status, it is growing more and more likely, in our view, that Energy Transfer Equity (ETE) and its subsidiaries, including Energy Transfer Partners (ETP) may fall victim to a credit crunch in coming periods, though there’s never a good reason ever to panic. We also remain very cautious of Energy Transfer Equity’s customer credit profile; by what we can gather, roughly one third of Energy Transfer Equity’s customer profile is BBB- rated, one notch above junk, and Moody’s just announced that it has put 29 E&P companies from the US and 7 from Canada under review for a potential downgrade.
On this note, we think Moody’s has it right:
Industry conditions have weakened further with oil and natural gas prices at multi-year lows…E&P companies will be stressed for a longer period with much lower cash flows, difficulty selling assets and limited capital markets access… Moody’s expects weaker industry conditions through at least 2017, as lower prices lead to weaker cash flows, a challenging asset sales environment and restricted access to capital markets…Low oil and natural gas prices will reduce companies’ cash flows and further weaken their credit metrics. Asset sales are much more difficult to transact in this environment and the values of these assets are much lower. Capital markets access, both debt and equity, is limited for energy companies, heightening refinancing risk, particularly for speculative-grade rated companies. Based on the severity and potential duration of the industry challenges, Moody’s expects that many companies will be downgraded a notch and some companies could be downgraded more than one notch. However, some companies’ ratings could be confirmed as well. Moody’s expects to conclude most reviews over the next several months.
All in, we remain very concerned about the sustainability of the Energy Transfer companies, as they currently are structured and their respective payouts to investors, particularly in light of weakening operating income, deteriorating energy resource pricing, tightening credit conditions, massive capital spending plans, and huge distribution/dividend obligations. It’s always possible that energy resource pricing increases may come to the rescue (long odds given OPEC’s market share grab strategy and current near-century high inventory levels in the US, however), but in any case, we believe creditors should take a hard look at the combined entity’s unadjusted measures of financial leverage on an annualized reported GAAP basis, and if not, at least ensure that any representation of leverage provided to them is balanced, meaning that proportionate or full-recourse (or economic recourse) off-balance sheet JV debt is considered in any scenario that unconsolidated EBITDA is included.
Thank you for reading. You can always reach me at brian@valuentum.com for any questions, comments, or corrections. My best wishes this holiday season!