After a tough couple of years, Energy Transfer Partners (NYSE: ETP) finally seemed to turn the corner last quarter. Thanks to some sense of stability in the oil and gas market, as well as the benefit from recently completed expansion projects, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) leaped 16.7% while distributable cash flow rebounded 21.5% versus last year's second quarter. That enabled the company to comfortably cover its distribution to investors with a coverage ratio of 1.18.
However, that metric is a bit deceiving because it's getting propped up by some temporary support from parent company Energy Transfer Equity (ET 0.45%). While the waning support is a concern, the payout itself is becoming a real issue.
The hidden cost siphoning off cash flow
So far this year, Energy Transfer Partners has generated nearly $1.9 billion of distributable cash flow. Given its current distribution rate, the company paid out almost $1.2 billion to its unitholders, including $30 million to Energy Transfer Equity for its small stake in the partnership. If that were the end of the story, it would seem like the company's payout is in good shape.
However, Energy Transfer Equity also holds a general partner (GP) interest and incentive distribution rights (IDRs) in Energy Transfer Partners, which entitles it to a percentage of the partnership's cash flow, as long as the distribution is over a certain level. Those IDRs really add up, already amounting to $773 million this year, while the GP interest entitled it to another $8 million. That said, the company had previously agreed to temporarily relinquish a portion of its IDRs to support Energy Transfer Partners as it works through a major expansion phase, so it will receive only $454 million in IDRs this year. That's worth noting because if Energy Transfer Equity hadn't agreed to forgo a portion of these entitlements, then Energy Transfer Partners would have paid out all its cash flow -- plus $70 million -- so far this year.
Since the IDR waivers will drop from an expected $665 million this year to just $153 million next year and $128 million in 2019, Energy Transfer Partners' coverage ratio will tighten. That's a concern -- though the company has a slew of growth projects on pace to come online over the next year, which should help cushion the blow by providing incremental cash flow.
A staggering disadvantage
Energy Transfer Partners believes its current slate of growth projects will generate enough cash flow to overcome the loss of this support, as well as enable the company to increase its payout by a double-digit rate in the near term. However the issue will remain: The company is sending a significant portion of its quarterly cash flow to its parent company. As a result, the cost of capital increases, which is a weight that could keep holding the company down.
The cost is currently staggering. That is evident by the cost the company paid to issue $1 billion in equity last month. Liam Denning highlighted that cost in a recent piece on Bloomberg, noting first that the offering created 5.6% dilution and was at a 5% discount to the prior trading price. However, that's only half of the story. Denning also pointed out the hidden cost of the IDRs:
So in considering Energy Transfer Partners' latest issuance, the ordinary distribution of $0.55 a quarter equates to a cost of equity for the new units -- priced at a discount, remember -- of 11.8%. Add in the incentive distribution rights that will have to be paid on them, though, and the total cost rises to a private equity-like level of almost 20%.
That high price puts the company at a significant disadvantage to other MLPs. For example, last fall Buckeye Partners (BPL) raised more than $500 million of equity capital to help finance an acquisition. However, because Buckeye Partners had previously bought out its general partner to help decrease its cost of capital, it won't owe any IDRs on these units. As a result, its equity cost on this deal was less than 7%, which matches its distribution yield at the time. Given that substantially lower cost, Buckeye Partners and other MLPs that aren't tied down by IDRs have the potential to create more value for investors on growth-focused initiatives than Energy Transfer Partners.
Something must give
While Energy Transfer Partners is finally starting to turn its financial situation around, the IDRs it owes Energy Transfer Equity are a weight that will continue to hold it back from its full potential. The company needs to seriously consider joining Buckeye Partners -- and the growing number of other MLPs that have undertaken similar transactions -- and eliminate these payouts permanently. Otherwise, it will continue to operate at a disadvantage, which could cause it to underperform those rivals over the long term.