Valuentum Exclusive Analysis for the Discerning Investor

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We continue to believe that the MLP business model may be a goner, and the recent ETE-ETP rollup is the latest example. Though new capital may come into the space on expectations that there will be premiums in unit-for-unit rollup deals, most of the combinations are coming with implied distribution cuts.

By Brian Nelson, CFA

On August 1, Energy Transfer Equity (ETE) announced that it would roll up Energy Transfer Partners (ETP) in a unit-for-unit merger exchange. Energy Transfer Equity’s incentive distribution rights (IDRs) in Energy Transfer Partners will be eliminated, and the deal is scheduled to close in the fourth quarter of 2018. Energy Transfer Partners unitholders will receive 1.28 common units of Energy Transfer Equity for each common unit of Energy Transfer Partners owned. The deal is another in a long line of MLP rollups that serve to simplify business structures and work to regain confidence in the public following the massive fallout in midstream equity prices in late 2015, “Master Limited Partnership Simplifications on the Rise.”

We continue to believe that the days of the MLP business structure are numbered, “Nearly 60 Distribution Cuts Later, We Maintain Our View on the Hazards of the MLP Business Model.” Though we generally like the durable competitive advantages of the toll-road nature of midstream energy infrastructure (large percentage of the business is fee-based margin with minimum volume commitments), the financial models that MLPs are operating under generates far too risk for the shareholder and unitholder, particularly as it relates to capital-market dependence to support the distribution. Our view is that the MLP business model was primarily used as a source of external financing prior to the massive fallout during late 2015, and equity could be raised by the subsidiary at lofty equity prices as investors had been bidding MLP prices up on yield-based valuations.

With the self-perpetuating bubble now popped, investors have wised up to the MLP model, and management teams are choosing simplification maneuvers. Quite simply, it matters none to have a complicated organizational scheme if yield-based valuations could not be had on the subsidiary level. The market has now migrated closer to enterprise-based valuation considerations, so a convoluted partnership arrangement does little to benefit the parties involved. Ironically, however, as the MLP business model approaches obsolescence, the idea that there could be premiums offered during rollup plans may bring new capital to the equities. Here’s what we wrote in "FERC Clarifies MLP Tax Changes:"

In some ways, expectations for consolidations and more rollups are fueling buying activity across the group, as investors are hoping for premium pricing within consolidation scenarios. Ironically, it is the idea that the MLP model may not survive that is driving the recent excitement in the group, as speculators seek to embed buyout premiums.

The Energy Transfer Equity-Energy Transfer Partners deal is one such example. The unit-for-unit merger exchange between the two entities had offered an 11% premium to the pre-deal Energy Transfer Partnership common unit trading price (and a 15% premium to the 10-day VWAP). The advance in the Alerian MLP ETF (AMLP) from near-$9 per-share levels in March 2018 to over $11 per share today has, in our view, been largely driven by expectations that rollups will continue within the MLP space and that premiums will be offered to do so, even if they are non-cash-based. What was once unthinkable when we rolled out our thesis that the MLP model may not survive in late 2015, “Why the MLP Business Model May Be a Goner, Barron’s (September 2015)” has now become almost baseline expectations for many observers in the industry.

In the case of the ETE-ETP tie-up, the executive team expects to maintain the ETE distribution per unit, but we note that such a distribution remains a function of the availability of outside capital from the debt and equity markets. Management noted that the combined entity expects to fund the majority of growth capital spending with retained cash flow, but while this may sound great on the surface, it also implies that the combined entity still cannot fund both the distribution and maintenance/growth capital spending with operating cash flow. This is unlike Kinder Morgan (KMI), which following its simplification and dividend cut, is now managing its business in a more prudent manner, where operating cash flow is covering both distributions and all capital spending (both growth and maintenance), “Kinder Morgan Back on Track But We’re Watching Financial Statements Closely.”

By comparison, through the first six months of 2018, Energy Transfer Equity’s operating cash flow was $3.2 billion, while capital expenditures and distributions to partners and non-controlling interests were ~$5.9 billion combined, hardly sufficient coverage of all capital spending and the distribution with operating cash flow. The same story was true with Energy Transfer Partners during the first half of 2018, where operating cash flow (~$3 billion) was dwarfed by combined capital expenditure and distribution obligations (~$5.8 billion). We’ll have to see the regulatory filings post-combination to calculate the degree of capital market dependence, but from where we stand, the combined entity will still require new debt and equity to sustain run-rate distributions and expected capital spending.

Furthermore, in many of the MLP rollups, there have been implied distribution cuts in the combined entity, and this looks to be the case at ETE-ETP. By scooping up Energy Transfer Partners units, it swaps a $2.26 per unit distribution obligation for a $1.22 dividend obligation at Energy Transfer Equity, while Energy Transfer Partners’ unitholders only receive 28% more units. By our back-of-the-envelope math, that means the dividend/distribution equivalent of the swap for Energy Transfer Partners unitholders is a reduction from the $2.26 distribution to a $1.56 dividend ($1.22 x 1.28). On a yield-equivalent basis, as of data August 17, the implied yield following the transaction for Energy Transfer Partners unitholders is 8.7% (1.56/17.92) -- the exchange-ratio-based dividend of Energy Transfer Partners in new Energy Transfer Equity dividends divided by Energy Transfer Equity’s share price -- versus the current implied yield of 9.86% Energy Transfer Partners.

All things considered, we applaud these simplification transactions as it provides investors with better transparency and allows them to evaluate such structures on an apples-to-apples basis as a corporate, despite continued publishing of industry-specific measures such as distributable cash flow, which we have long criticized, “MLP Speak: A Critique of Distributable Cash Flow.” The idea that there would be so many distribution cuts and so many consolidations following our thesis on MLPs in late 2015 may have been hard to believe by many an investor. With each explicit or implicit distribution cut and each newly-announced MLP rollup, it seems today that our original thesis on the MLP space is only gaining greater acceptance within the investment community rather than greater controversy. This is good news.

Pipelines - Oil & Gas: BPL, BWP, DCP, ENB, EPD, ETP, GMLP, HEP, KMI, MMP, NS, PAA, SEP, WES

Related: AMZA

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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.