Energy Transfer Partners (NYSE: ETP) seems to be following the Field of Dreams mantra to turn around its operations. That's because the company's view has been that building its massive backlog of growth projects would eventually cause the market to come to its senses and reward it with a higher valuation. That plan finally started paying dividends during the third quarter as the company's earnings and cash flow rebounded sharply.
While the company's valuation has yet to tag along, management believes it's only a matter of time before it follows suit. That was one of four key points they made on the accompanying conference call, where they laid out their current thinking on several issues, many of which are in stark contrast to the strategy of their midstream peers.
Our credit rating is more important than the coverage ratio
An analyst on the call pointed out that several of Energy Transfer's rivals have shifted their strategy from paying out nearly all their cash flow to investors and instead plan on retaining a significant portion of it to finance growth projects. For example, Enterprise Products Partners (NYSE:EPD) recently announced that it would scale back the rate it grows its distribution through 2019. By doing so, Enterprise Products Partners would eventually generate enough excess cash to finance a $2.5 billion annual growth capital budget without tapping the equity market.
CEO Kelcy Warren responded to that line of thought by saying,
First of all, we focus on the sentiment of the rating agencies...and understanding what we need to do to remain investment-grade, and I will tell you that, that governs a lot to us. In fact, we just will not risk that. So let's start with that. Then we look at what we have, we have a little bit better crystal ball than what you have. And that we know what's coming our way in terms of additional cash flow, distributable cash flow. And then as you heard us say before, we're committed to remaining above a 1 [times] coverage ratio with both ETP and Energy Transfer Equity (NYSE:ET) going forward. And with those factors considered, we feel a responsibility and the whole industry used to feel this. It is odd to me that everybody has moved away from this, but we feel responsibility to distribute a safe amount of cash flow to our unit holders, and that's exactly what we did this quarter and we'll continue to do.
In other words, the company has no intention of joining the crowd by retaining excess cash. Instead, it will continue paying out as much money as it can afford to each quarter.
We're not worried about the unit price
Because Energy Transfer continues going against the grain, its units sell for a much lower valuation than rivals. That's evident in its distribution yield, which is currently above 13.8% while Enterprise Products Partners, for example, has a distribution yield of 6.9%. However, instead of cutting its distribution and generating excess cash flow just to win the market's favor, Warren said "we do think that our unit price will recover. I think at some point there's got to be some sanity to come back into the market." So, instead of fretting about the price and doing something drastic, management plans to be patient and let the market eventually wake up to the fact that its expansion projects will drive continued improvement in its financial situation.
We have no immediate plans to change our corporate structure
One of the more drastic steps it could take is a transaction with parent company Energy Transfer Equity to eliminate the costly incentive distribution rights (IDRs) that consume a significant portion of its cash flow each quarter. Several of its rivals have done this in the last year, including Plains All American Pipeline, ONEOK, Williams Companies, and MPLX.
While these consolidation transactions are the hot trend right now, Energy Transfer has repeatedly said that it won't consider an alternative IDR structure until the end of 2019. When asked on the call if they've had a change of heart, Chief Commercial Officer Marshall McCrea quickly answered, "No."
Our biggest competition isn't the competition
One of the reasons why rivals are cutting their payouts and eliminating costly IDRs is to lower their cost of capital, which is the average cost of debt and equity used to make investments. Given Energy Transfer's currently low valuation and high-cost IDRs, its equity cost of capital is exorbitant at more than 20%. That high price puts it at a disadvantage to rivals like Enterprise Products Partners that have a much cheaper cost of capital due to its lower distribution yield.
However, when asked by an analyst on the call whether the company was losing new growth projects to rivals because of this disadvantage, Warren said,
No not really... this is a very odd market, and I think all of our peers would agree with this. We lose out on projects routinely these days to private equity, not really to our peer group. And I think others would say that as well. So...cost capital is really not influencing our loss of access to projects, but rather there's just a lot of private equity that hires management teams and they are in for the short-term, but it does matter. They are winning and we're not.
However, McCrea added that private equity might be winning, but they're doing so at rates that aren't profitable because they're underestimating costs. That could cause those emerging competitors problems down the road, but right now they're winning more than their fair share of new projects, which could impact the ability of Energy Transfer and fellow MLPs to grow.
We march to our own beat
One thing Energy Transfer's management team made crystal clear on the call is that they won't cave to market pressure and change their strategy. They believe that their growth projects will bolster their bottom line to such an extent that the market will eventually reward their patience. While it's a bold stance that could pay off big-time in the coming years, there's just as high a risk that the market doesn't come around since investors can earn lower risk returns elsewhere.