Analysts at Barclays are bullish on Williams Companies (NYSE:WMB). That is evident by their decision to reinstate coverage on the stock and award it an overweight rating. They also set a $35 price target, which is above the stock's current $31 price tag due to the upside they see from potential catalysts on the horizon. While those catalysts make sense, investors need to be aware that they are increasing their risk when going overweight on a stock, especially when doing so to capture the upside from possible catalysts.
Going in for a second helping
Analysts use several frameworks when rating stocks, one of which is a three-tiered weighting system consisting of overweight, equal weight, and underweight ratings. In this system, an overweight rating means an analyst thinks that investors should hold more of a stock or sector than the benchmark weighting or their personal weighting system. For example, if an investor typically invests 5% of a portfolio in a stock or sector, he or she should invest above that level in something rated overweight.
In other words, Barclays thinks Williams' investors should boost their allocation to the stock in an outsized bet on its future performance. That said, they are not quite as bullish on its master limited partnership (MLP) Williams Partners (NYSE:WPZ), which received an equal weight rating. Because Williams Partners does not have the same upside, investors should either keep their allocation where it is, or reduce it, if it has an outsized position in their portfolios.
Why so bullish?
There are several reasons why Barclays is more bullish on Williams than on Williams Partners. First, Williams Companies made substantial progress this year on addressing its issues, including cutting the dividend to help support Williams Partners. Those moves set the stage for future moves, which could be catalysts for the stock price.
One catalyst that analysts think could be on the horizon is another attempt to combine the two companies, an approach Williams abandoned last year after it accepted an ill-fated merger proposal with Energy Transfer Equity. There are certainly reasons to think that Williams would consider a second try to merge with its MLP, not the least of which is the fact that it is already slowly heading in that direction by participating in a distribution reinvestment plan (Drip), which is gradually increasing its ownership interest in the MLP. Barclays believes that Williams appears to be positioning so it can eventually reinvent itself into a standard C Corp, which internally funds capital expenditures with cash flow and debt while using any remaining cash flow for dividends or buybacks.
Not only does Barclay's view make sense, because Williams clearly liked this approach before and is heading in that direction, but several of its peers have had success with similar strategies. For example, Targa Resources (NYSE:TRGP) acquired its MLP Targa Resources Partners earlier this year. Since that time, Targa Resources has taken advantage of its increased scale and lower cost of capital to refinance debt and improve its balance sheet. Those improvements put Targa Resources in the position where it could issue equity to fund capex, because its stock price has taken off since completing the merger.
Of risks and reward
In Barclay's view, what makes Williams worth overweighting is the possible realization of event-driven catalysts, which could drive the stock higher. However, the potential problem with this view is that it's a conjecture, not based upon Williams' stated plan, which is to support the MLP through its heavy capex commitments over the next year and position both companies for dividend growth in 2018.
Before boosting their allocations, investors need to be mindful of the risk that Williams could stick to the current plan. While the current strategy could create value for long-term investors, it likely will not lead to a quick pop in the stock price, which might result from the announcement of a combination transaction. Furthermore, there's no guarantee that investors will react positively to a deal, given Williams recent history with mergers and acquisitions. Williams still has several issues yet to address, including the need to improve its junk-rated credit and to close the gap between cash inflows and outflows at Williams Partners. These problems will not necessarily vanish if the two companies combine.
Barclays clearly likes the direction it sees Williams heading, and believes there are more catalysts on the horizon, including an eventual combination with its MLP. While that is certainly possible, investors who overweight their portfolio to capture this potential catalyst need to realize they are increasing their downside exposure as well. For now, given Williams' financial state, and the possibility this catalyst never comes to fruition, it's an extra helping of risk that investors are better off avoiding.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.