On the surface, it would seem like Energy Transfer Partners (ETP) is a no brainer for income investors. The company currently yields a gaudy 9.3% and plans to increase the payout by a low-double-digit rate over the near term while maintaining at least 1.0 times distribution coverage. Moreover, it intends to achieve that growth while progressively improving its leverage ratio from the current 5.0 times debt-to-EBITDA to below 4.0 times over the next 12 to 18 months.
Those things certainly seem to put it ahead of Kinder Morgan (KMI 0.27%). Not only is its current yield just 2.6% but its leverage ratio is 5.4 times at the moment. That said, the company plans to get that number below 5.0 times in the future, which would enable it to finally start growing the dividend again, though the company has yet to release its growth forecast. However, while Energy Transfer Partners has the appearances of being a better investment, especially for income seekers, there is one crucial difference between the two that makes Kinder Morgan the better option for long-term investors.
Image source: Getty Images.
A big cut off the top
That difference is the fact that Energy Transfer Partners pays a significant portion of its cash flow to its parent Energy Transfer Equity (ET -0.19%) each quarter via incentive distribution rights (IDRs). This fee really adds up. Just take a look at last quarter:
Data source: Energy Transfer Partners. Chart by author. In millions of dollars.
Overall, Energy Transfer Partners generated $859 million in distributable cash flow and distributed $806 million of it to partners. However, as that chart shows, Energy Transfer Equity got a significant portion of the money. While those IDRs entitled it to receive nearly $400 million in cash last quarter, it's currently providing some financial support to Energy Transfer Partners by relinquishing a portion of those rights, so it only received a net $220 million from the IDRs last quarter. That still amounted to about a quarter of the total distributions paid to partners even though it just owns 2.5% of the common units.
There are two other things worth pointing out about that relinquishment agreement. First, without it Energy Transfer Partners would have paid out $100 million more in distributions last quarter than cash collected, resulting in less than 1.0 times distribution coverage, implying it can't afford its current payout rate without the support. Further, this support agreement will start winding down next year, resulting in a much smaller relinquishment that will cease by 2020. Because of that, an even larger portion of Energy Transfer Partners' cash flow will get paid to its parent company in the coming years.
These rights really add up
Long-term investors can't overlook the impact of these IDRs. Using the first-quarter run-rate, Energy Transfer Partners is on pace to pay $810 million in cash to its parent this year in IDRs alone and would have handed over $1.5 billion if we factor out the relinquishments. In ten years' time, and assuming no growth, that's $15 billion in cash that could flow up to Energy Transfer Equity instead of being allocated to benefit unitholders in Energy Transfer Partners. The company could use that money to pay an even higher distribution, internally finance additional growth projects, or repay debt. Any one of those options would create more value for investors than the transfer of wealth those IDRs represent.
Now, let's contrast this with Kinder Morgan, which gets to allocate 100% of its cash flow toward creating value for investors because it doesn't pay any IDRs. In 2017, it plans to do that in several ways. Of the $4.46 billion in distributable cash flow it expects to generate this year, about a quarter will head back to investors via dividends. It then plans to invest $3.2 billion in growth projects, leaving it with about $150 million in excess that it will use to reduce debt. By allocating its cash flow this way, the Kinder Morgan doesn't need to tap the debt or equity market this year to finance growth, though it did just announce plans to launch an IPO of its Canadian business so it can pre-fund a significant portion of an upcoming expansion project in that country. Meanwhile, in future years the company could allocate as much as 100% of its cash flow to paying dividends or some other value enhancing initiatives such as buying back stock if either option would create more value for investors. That's flexibility Energy Transfer Partners simply does not have because 25% to 50% of its cash flow will head to its a parent company each year via the IDRs.
Investor takeaway
Kinder Morgan has a huge competitive advantage over Energy Transfer Partners because it's not sending a big chunk of cash up to a parent company on a recurring basis. Those fees are already eating a significant portion of Energy Transfer's current cash flow and will only grow over time once its parent starts reducing its support. Without that drag on its ability to create value for investors, Kinder Morgan should deliver higher returns than Energy Transfer Partners over the long-term.
