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This High-Risk, High-Yield Stock Could Fuel Big-Time Gains for Investors in 2018

By Matthew DiLallo - Updated Nov 30, 2017 at 1:11PM

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With a jaw-dropping yield approaching 15% and a dirt-cheap valuation, it's easy to dream about the upside of Energy Transfer Partners. But the potential reward does come with some risk.

Energy Transfer Partners (NYSE: ETP) has lost more than 35% of its value this year. That's despite the fact that the company finally turned around its sinking earnings and cash flow thanks to the recent completion of several expansion projects. That growth enabled it to continue increasing its already lucrative distribution, which now yields a stunning 14.5%. That's roughly double the yield of the average master limited partnership, mainly because Energy Transfer sells for an absurdly low valuation versus its peers.

That said, Energy Transfer is on sale for a reason, which is that investors remain deeply concerned about the company's financial situation. They see that precarious picture potentially causing a massive distribution cut at some point in the future. However, if Energy Transfer can alleviate those fears by delivering on its growth promises, it could fuel significant gains for risk-tolerant investors in 2018.

Silhouette of a man jumping over an abyss at sunset.

Image source: Getty Images.

The bear case for Energy Transfer

On the surface, Energy Transfer's lucrative distribution appears to be on solid ground. Last quarter, the company generated $1.05 billion in distributable cash flow and only sent $925 million to investors, implying a 1.13 times coverage ratio. Meanwhile, for the full year, it has covered its payout with cash flow by 1.14 times. The only reason it covered the payout with room to spare, however, was that parent company Energy Transfer Equity (ET 2.42%) gave it a helping hand by agreeing to relinquish a portion of its incentive distribution rights (IDRs). Without that assistance, coverage would have been 0.96 times both last quarter and for the year. That's a concern because Energy Transfer Equity's support will decline from $163 million last quarter to just $153 million for all of 2018.

In addition, Energy Transfer has a relatively weak balance sheet. Last quarter, for example, its debt-to-adjusted EBITDA ratio was 4.92 times. While that's a dramatic improvement from 5.74 times at the end of last year, leverage and distribution coverage are at weaker levels than those of the top MLPs.

Master Limited Partnership

Coverage Ratio

Leverage Ratio

Enterprise Products Partners (EPD 2.02%)

1.2 times

3.8 times

Magellan Midstream Partners (MMP 2.33%)

1.2 times

3.5 times

MPLX (MPLX 3.14%)

1.3 times

3.6 times

Plains All American Pipelines (PAA 2.75%)

1.5 times

4.7 times

Williams Partners (NYSE: WPZ)

1.17 times

4.5 times

Data source: Enterprise Products Partners, Magellan Midstream Partners, MPLX, Plains All American Partners, and Williams Partners.

As a result, Energy Transfer has had to be much more creative in securing the capital needed to finance its expansion projects. Recent moves have included selling stakes in expansion projects to offload a portion of the financing commitment, issuing higher-cost preferred stock, and selling equity at a very dilutive price. In the meantime, with several more expansion projects underway, the company will need to continue working hard to secure outside capital to finance these projects. That pursuit could ultimately lead Energy Transfer to slash its lucrative payout. 

A team of welders working on a pipeline.

Image source: Getty Images.

The bull case for Energy Transfer

Those expansion projects, however, should fuel significant cash flow growth over the coming year. The company has several projects coming on line over the next few quarters including the first phase of its Permian Express 3 pipeline in the current quarter and the final stretch of the Rover Pipeline in the first quarter of 2018. By next year's second quarter, the company should also finish Mariner East 2, the Revolution System, and several other smaller pipelines and processing plants. As these projects enter service, they will boost Energy Transfer's earnings and cash flow, which should help increase distribution coverage while continuing to drive down the leverage ratio even as the company expects to keep raising the payout at a double-digit annual rate.

At some point, the organic improvement in those two crucial financial metrics should eventually ease investor fears about the company's financial situation. That's why CEO Kelcy Warren believes that "our unit price will recover. I think at some point, there's got to be some sanity to come back into the market." When that happens, the recovery could be significant given its insanely cheap valuation compared to rivals.

Company 

Price to Distributable Cash Flow

Current Distribution Yield

Energy Transfer Partners

4.6 times

14.5%

Enterprise Products Partners

12.1 times

6.9%

Magellan Midstream Partners

14.4 times

5.5%

MPLX

9.3 times

6.4%

Plains All American Pipelines

10.2 times

6.4%

Williams Partners

12.2 times

7.5%

Data source: Energy Transfer Partners, Enterprise Products Partners, Magellan Midstream Partners, MPLX, Williams Partners, and Plains All American Pipeline.

This high-risk gamble isn't for the faint of heart

Energy Transfer Partners looks like a steal right now since it trades at a dirt-cheap valuation, which is one reason the yield has reached such an eye-popping level. That said, it's cheap for a reason as investors remain deeply concerned about its weaker financial situation. While those numbers should get better over the next year as growth projects start contributing earnings and cash flow, it will be a slow process and might not work out as planned.

Energy Transfer is therefore a high-risk bet since it could continue to slide and might eventually need to slash the payout. But if Warren is right that the market will eventually come to its senses, a gamble on Energy Transfer at today's price could pay off spectacularly.

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Stocks Mentioned

Plains All American Pipeline, L.P. Stock Quote
Plains All American Pipeline, L.P.
PAA
$11.20 (2.75%) $0.30
Enterprise Products Partners L.P. Stock Quote
Enterprise Products Partners L.P.
EPD
$27.34 (2.02%) $0.54
Energy Transfer LP Stock Quote
Energy Transfer LP
ET
$11.44 (2.42%) $0.27
MPLX LP Stock Quote
MPLX LP
MPLX
$32.21 (3.14%) $0.98
Magellan Midstream Partners, L.P. Stock Quote
Magellan Midstream Partners, L.P.
MMP
$49.97 (2.33%) $1.14

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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