Earlier this week, Sunoco Logistics Partners (NYSE: SXL) announced that it had agreed to acquire Energy Transfer Partners (NYSE: ETP) in a $21 billion unit-for-unit deal. However, unlike most pipeline transactions, this merger is more than just about getting bigger. Instead, the companies purposefully chose a deal structure that would accomplish three overarching goals: simplification, enhancing distribution coverage, and protect the parent.
1. It is a step toward simplifying a very complex corporate structure
It has long made sense that midstream general partner Energy Transfer Equity (NYSE:ET) should consolidate its growing brood of master limited partnerships. These include not only its natural gas pipeline namesake Energy Transfer Partners and oil pipeline operator Sunoco Logistics but retail gas station owner Sunoco LP (NYSE:SUN) and gathering and processing company PennTex Midstream Partners (NASDAQ: PTXP), which is the latest addition to the family. Among the many reasons why consolidation made sense is that Energy Transfer Partners already owns sizable stakes in each of those sibling companies.
For example, it currently owns the general partner and 100% of the incentive distribution rights (IDRs) of Sunoco Logistics Partners as well as 67.1 million of the oil pipeline MLP's common units. Because of that, Sunoco Logistics was already one of its consolidated subsidiaries. Adding more complexity to the mix is the fact that parent company Energy Transfer Equity owns 81 million of Energy Transfer Partners' Class H Units, which track 90% of the underlying economics of the general partner interest and IDRs of Sunoco Logistics Partners. Needless to say, it is tangled web of ownership structures that makes it pretty confusing to grasp who owns what. This deal, however, will simplify the structure a bit by eliminating the Class H Units as well as consolidate the general partner interests, IDRs, and common units of the two MLPs into one entity.
2. It is a backdoor distribution cut for Energy Transfer investors
That said, the most logical combination would have been for Energy Transfer Partners to acquire the much smaller Sunoco Logistics Partners. However, one of the reasons that they took the opposite approach was because Sunoco pays a lower distribution. As such, under the terms of the deal, current Energy Transfer investors will receive $3.06 per unit on an annual basis going forward, which is a decrease of 27% from the $4.22 per unit they are currently receiving. In a sense, the companies chose this structure to affect a distribution cut without actually calling it one.
That reduction, however, is a necessary step given the fact that Energy Transfer Partners paid out much more than it brought in this year, and that is with a helping hand from Energy Transfer Equity. Last quarter, for example, the company paid out $876 million in cash after accounting for the $127 million in parental support, which was well above its $706 million in distributable cash flow. For the full-year, it has only covered $0.87 of every dollar it paid out.
Clearly, it was on an unsustainable path and likely would have needed to cut the payout by 15% to 25% if not for this deal. However, while the Sunoco deal implies an even deeper cut, it does put the company on a path to deliver double-digit near-term distribution growth while maintaining a greater than 1.0 times coverage ratio thanks to the combined company's stronger metrics and lower capital costs. That growth should get Energy Transfer Partners' distribution back to its former level in a couple of years. Meanwhile, if it opted just to cut the payout, it could have taken even longer to get back to even due to the company's high leverage and substantial capex requirements.
3. The real winner is the parent company
The final reason why the two companies chose this particular deal structure is that it was the best way to protect the parent company. Unlike the MLPs that make money owning energy infrastructure assets, Energy Transfer Equity makes most of its money by collecting the lucrative IDRs, particularly from its namesake MLP:
Given how the math and ownership structures work out, Energy Transfer Equity will not feel the impact of the deal to the same degree as Energy Transfer Partner's unitholders. According to Bloomberg, it will only see its income drop by 17% over the next two years compared to an initial 27% drop in the distributions to common unitholders. Because of that, it should be able to maintain its current payout, which is already on solid ground thanks to a 1.25 times coverage ratio this year.
Energy Transfer Equity chose a unique deal structure to consolidate two of its MLPs so it could accomplish all its goals in one deal. Clearly, it did just that, by reducing complexity while improving the consolidated distribution coverage of the MLPs and still managing to protect most of its income streams. While common unitholders do not benefit to the same degree in the short term, they would have likely seen their distribution decrease whether the companies made this deal or not. At least now they get the benefit of greater scale, increased diversification, improving metrics, and a simpler corporate structure to ease the pain.