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Now May Not be the Time to Buy Western Gas Partners

By Adam Galas - Feb 11, 2016 at 8:05AM

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Western Gas represents a highly undervalued high-yield MLP. However, there are two things investors need to be aware of before investing their hard-earned money.

Source: Western Gas Partners.

As a value income investor, I absolutely love it when Wall Street freaks out and punishes all energy stocks en masse, as it has because of the worst oil crash in 50 years. Long-term income investors can find incredible values on many midstream MLPs that could result in stellar total returns over the next five to 10 years.

Take, for example, Western Gas Partners (WES 2.01%), and its general partner Western Gas Equity Partners (NYSE: WGP), both of which have been hammered worse than their competitors over the past year.

WES Chart
WES data by YCharts

Yet with so many undervalued midstream choices out there, dividend investors can have a hard time deciding which ones represent the best long-term buys. To help determine if Western Gas Partners and Western Gas Equity Partners deserve a spot in your portfolio, here are the four most important factors you need to consider.

How undervalued are they?

MLP Yield 5-Year Average Yield Price/Operating Cash Flow 5-Year Average Price/Operating Cash Flow 
Western Gas Partners 10.4% 4%  6.6  11.7 
Western Gas Equity Partners 6.4% 5.8%  17.6  21.3 

Sources: Yahoo! Finance, Fastgraphs.

Western Gas Partners is trading at a greater discount to its general partner, both on an absolute yield, price-to-operating cash flow, and a historical basis. Of course, yield is just one part of a distribution profile, the other two being payout sustainability and long-term growth prospects, both which are often more important than yield.

Is Western Gas Partners' valuation justified by its distribution profile? The answer is multifaceted.

Does the distribution profile justify the valuation?

Metric Western Gas Partners Western Gas Equity Partners 
Q1-Q3 2015 distribution coverage ratio 1.13 1.0 
Q1-Q3 2015 excess distributable cash flow $55 million $553,000
5-year analyst annual distribution growth projections 5.3% 11.5%

Sources: earnings releases, Fastgraphs.

The distribution coverage ratio compares how much distributable cash flow (which funds the distribution) an MLP generates to how much it's paying out. Note that Western Gas Equity Partners'  current coverage ratio comes from its 36.5% stake in its subsidiary MLP, as well as its ownership of incentive distribution rights, as its only assets. Thus, the sustainability of Western Gas Equity Partners' distribution is solely a function of its MLP's payout security.

Initially it appears as if Western Gas Partners' payout is sustainable. However, investors need to be aware that in the past two quarters, due to management's aggressive 15% year-over-year payout growth policy, its coverage ratio has been declining with Q2's and Q3's respective coverage ratios coming in at 1.24 and 1.05.

This is concerning for two reasons. First, it probably means that future distribution growth will have to be lower, which analyst forecasts clearly show. However, it also means the sustainability of the payout could potentially be threatened owing to the fact that 32% of the MLP's gas volumes have no minimum volume or revenue commitments.

Thus, should Western Gas Partners' largest customer, Anadarko Petroleum (APC) -- which also owns the vast majority of Western Gas Equity Partners -- be forced to pull back on gas production, the hit to the MLP's cash flow could result in an unsustainable distribution and even a potential distribution cut.

What are their respective growth potentials in a low energy world?
Another concern is that growth predictions may be overstated because of a highly limited drop down pipeline from Anadarko Petroleum, which has provided all of Western Gas Partners' growth up to now.

Of the 13 midstream assets Anadarko owned when it launched its MLPs, only three remain.

Source: Western Gas Partners investor presentation.

While future oil and gas production (as well as organic growth projects) may very well provide Western Gas Partners' with some additional growth in the future, this isn't likely to happen until energy prices recover.

Do they have strong balance sheets and good access to growth capital?

Metric Western Gas Partners Western Gas Equity Partners 
Debt/equity (leverage) ratio 3.3 3.3 
Operating income/interest (interest coverage) ratio  5.32 5.08 
Average debt cost 4% 4% 
Historic funding sources 31% debt, 69% equity 26% debt, 74% equity 
Weighted average cost of capital  7.6% 10.18% 
Return on invested capital 8.94% 14.74% 

Sources: Morningstar, GuruFocus.

Two things I like about Western Gas is its solid balance sheet and a return on invested capital that's higher than its WACC (which allows it to invest profitably into future growth).

In addition, because both MLPs having relied mostly on equity markets for their growth funding up to now, the MLPs still have access to cheap debt to replace equity growth capital that is drying up. In fact, Western Gas current has $1 billion in available credit under its revolving credit facility, and thanks to its low leverage ratio, it is able to borrow all of it without risking breaching its debt covenants.

This means that the MLP likely has more than sufficient capital to finish acquiring the rest of Anadarko's midstream assets as well as funding organic growth projects. It also means Western Gas potentially has time for energy prices to recover while it continues growing cash flows in 2016 to secure its payout.

Bottom line
Western Gas Partners and Western Gas Equity Partners have a few things working in their favor, such as currently sustainable payout, strong balance sheets, and ongoing access to cheap debt. However, in my opinion there are far more attractive midstream MLP alternatives currently available that can provide superior payout security and far longer growth runways.

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Stocks Mentioned

Western Midstream Partners, LP Stock Quote
Western Midstream Partners, LP
$24.38 (2.01%) $0.48
Anadarko Petroleum Corporation Stock Quote
Anadarko Petroleum Corporation

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