In the past I've covered what I believe to be some of the best MLPs income investors should consider, including Kinder Morgan, Inc. (KMI 0.27%) and Enterprise Products Partners (EPD 0.48%). However, there is another MLP that I believe offers high-yield distribution growth investors an excellent long-term investment opportunity and I'd like to explain the three reasons I think Energy Transfer Partners (ETP) deserves a spot on your income radar as well.
Low Cost of Capital
| Company/MLP | Equity Funding | Cost of Equity | Debt Funding | Cost of Debt | Weighted Average Cost of Capital |
|---|---|---|---|---|---|
| Energy Transfer Partners | 54.50% | 8% | 45.50% | 3.10% | 5.70% |
| Enterprise Products Partners | 79.40% | 8.5% | 29.60% | 3% | 7.40% |
| Magellan Midstream Partners (MMP) | 86.40% | 8.20% | 13.60% | 3.40% | 7.50% |
Source: Bloomberg Intelligence
MLPs operate in a very capital intensive industry and because they pay out almost all their earnings as distributions, (tax advantaged dividends) in order to grow they need to raise lots of money. This is primarily done through either issuing equity or taking on debt.
You can think of a MLP's cost of capital as the minimum rate of return a project or acquisition needs in order to be worth undertaking. A low cost of capital provides a competitive advantage in two ways. First, it means higher profitability for the MLP (and thus higher distributions for unit holders) as well as more potential growth projects.
For example, Energy Transfer Partners low cost of capital, courtesy of its high reliance on cheap debt as opposed to more expensive equity, is expected to help the partnership grow immensely in the coming years. This is courtesy of an $11.85 billion project backlog that is expected to be completed between Q4 of 2014 and Q1 of 2017.
Strong balance sheet set to get stronger
| MLP | Debt Rating | Total Debt ($Billion) | Current Ratio | EBITDA/Interest | Debt/EBITDA |
|---|---|---|---|---|---|
| Energy Transfer Partners | BBB- | 10.9 | 0.98 | 3.67 | 5.95 |
| Enterprise Products Partners | BBB+ | 19.65 | 0.93 | 3.23 | 4.06 |
| Magellan Midstream Partners | BBB+ | 2.1 | 1.02 | 8.78 | 2.81 |
Sources: Morningstar.com, Fastgraphs, Yahoo Finance, company 10Qs, 10Ks, author calculations
This table highlights some important things to consider when investing in MLPs, including credit rating, current ratio, and the ability of a partnership to service its debt.
Credit ratings of BBB(-) or higher indicates "investment grade" and help lower a MLPs borrowing costs. The current ratio, aka liquidity ratio, is a measure of short-term assets over short-term liabilities and helps indicate how well a MLP can pay its immediate obligations. Ideally the current ratio should be above one; however, the midstream MLP industry average is slightly below that.
An MLPs ability to service its debt can be determined by four key metrics: Debt/EBITDA, EBITDA/Interest expenses, and the growth rate of EBITDA and operating cash flows.
ETP Cash from Operations (Annual) data by YCharts
As this chart shows, ETP has kept pace with its peers in recent years growing both EBITDA and operating cash flows, which mean that distributions are unlikely to be threatened by interest costs over the next few years.
For Energy Transfer Partners, the future looks bright because its current backlog of projects is expected to be completed at EBITDA multiples of six to eight. This means each project is expected to pay for itself in about seven years and offer a return of 12.5%-16.7%, far in excess of Energy Transfer's cost of capital. Management projects that when the backlog of projects is complete, operating cash flows will increase by $1 billion per year, or 38.2%.
Finally Energy Transfer's ability to fund its aggressive growth plans is helped by its $2.76 billion in combined cash and remaining available credit. This along with the partnership's rapidly growing cash flows should minimize the need for raising capital through equity issuances, which both cost more than funding through debt, and slows future growth of the distribution.
Immense growth opportunities ahead
| MLP | Enterprise Value ($Billion) | Total Project Backlog ($Billion) | Company backlog per $1 Billion in Enterprise Value |
|---|---|---|---|
| Enterprise Products Partners | 92.74 | 6.3 | $69 million |
| Energy Transfer Partners | 41.65 | 12 | $290 million |
| Magellan Midstream Partners | 22.62 | 4 | $180 million |
Sources: Yahoo Finance, investor presentations, earnings call transcripts
This table highlights the fact that Energy Transfer Partners' backlog of nearly $12 billion is, relative to its size is much larger than competitors, thus providing it with a potential growth catalyst to achieve the distribution growth rates Wall Street is predicting over the next five years.
| MLP | Yield | Historic Dividend/Distribution Growth Rate | 5 Year Projected Dividend/Distribution Growth Rate |
|---|---|---|---|
| Energy Transfer Partners | 5.8% | 8.45% over 10 years | 17.58% |
| Enterprise Products Partners | 3.80% | 7.95% over 16 years | 6.96% |
| Magellan Midstream Partners | 2.9% | 13.42% over 13 years | 14.43% |
| S&P 500 | 1.88% | 5.05% | 5.05% |
Sources: Fastgraphs, investor presentations
Note that Energy Transfer Partner's historical distribution growth rate is based on a compounded annual growth rate that conceals the fact that it cut its distribution in 2008 and between 2009 and Q3 2013 the distribution grew by only 0.8%.
To help Energy Transfer Partners maximize its growth potential management is targeting two major energy megatrends as growth catalysts for the future.
The first is fast growing production of the hyper prolific Marcellus and Utica shale. Production from these two gas formations has already increased 16 and 10 fold in the last seven and two years, respectively, and according to analyst firm Wood Mackenzie production is set to jump by another 112% by 2024.
Source: EIA July 2014 production update
Energy Transfer Partners is investing heavily into its Rover pipeline system, which will connect the partnership's existing interstate pipeline systems with these valuable formations. The pipeline will carry 3.25 billion cubic feet/day of gas and is already fully contracted. It is scheduled to go online in two stages, beginning in December 2016 and finally in mid-2017.
The MLP is in negotiations with other companies/MLPs to partially finance the $3.8 to $4.4 billion cost of the project but management says that Energy Transfer Partners will own at least 65% of the project.
The second major mega trend expected to fuel Energy Transfer Partners' growth is liquefied natural gas (LNG) exports. Energy Transfer Partners is partnering with its general partner Energy Transfer Equity (ET -0.19%) to spend $9.6 billion to expand the Lake Charles LNG terminal to 15 million metric tons/year of export capacity by the end of 2020.
Energy Transfer Partners will own 40% economic interest in the venture, which has procured 25-year contracts from BG Group. Management estimates that Energy Transfer Partners will see an average distributable cash flow benefit of $500 million annually over the length of the BG contracts. In addition, the company is expanding its Trunkline Gas pipeline system by 24%. The larger system will supply the Lake Charles terminal with 2.6 billion cubic feet/day of gas.
Risks to watch for
There are two risks I would advise investors in Energy Transfer Partners to watch out for. The first is weaker margins and operating efficiencies. This can be a sign of managment making less than stellar decisions about capital allocation. It doesn't matter how large a project backlog an MLP has if it can't convert that investment into profits and cash flows to grow the distribution. Management has stated that its current backlog averages an EBITDA multiple of six to eight, indicating returns on investment of 12.5% to 16.7%. If management can deliver on that guidance than its profitability metrics should greatly increase in the years ahead.
| MLP | Operating Margin | ROA | ROE |
|---|---|---|---|
| Energy Transfer Partners | 3.80% | 0.10% | 0.20% |
| Enterprise Products Partners | 7.40% | 6.80% | 18.70% |
| Magellan Midstream Partners | 40.80% | 15.80% | 46% |
| Industry Average | 9.70% | 2.70% | 9.30% |
Source: Morningstar.com
Second is the MLP's high debt levels. Energy Transfer Partners' low cost of capital has largely been made possible by its heavy use of debt and with its Debt/EBITDA ratio already above the 4.5 that credit rating agencies usually allow for an investment grade rating. Energy Transfer could face a downgrade if it takes on too high of a debt load. So it's possible the partnership will be forced to use higher cost equity in the future to fund its growth pipeline.
Thus, despite many projects that management promises will have higher returns on invested capital, whether or not Energy Transfer Partners can meet Wall Street's growth expectations will largely depend on keeping the possible growth in capital costs less than the increased profitability of upcoming projects.
Bottom line: high yield with strong growth prospects
Energy Transfer Partners is blessed with low costs of capital, an above average balance sheet, and several major growth avenues. I believe that the future of this MLP is bright, with likely strong distribution growth that should not only make for generous income, but also maximize the probability of long-term market beating returns.
