(The following alert was sent to subscribers of Action Alerts PLUS on Thursday, Dec. 17.)
Energy Transfer Partners (ETP) has come under additional scrutiny following a recent report questioning the partnership's stated leverage ratio of 4.5x on a pro-forma basis. Specifically, "analysts" -- a.k.a. the sole identified employee -- from Valuentum Securities (a boutique, unregistered and "independent" research shop) asserted that ETP's ratio exceeded 7.0x on a net debt to EBITDA basis. The firm also suggested ETP's ability to cover distribution next year is in jeopardy as a result of its overleverage. The firm expresses concern around the company's need for debt issuance and equity financing in order to fund its "growth capital" -- a.k.a. investments used in the process of business expansion to increase operating capacity or operating income through the development of new assets, as opposed to mergers and acquisitions.
We have performed an incredible amount of due diligence and analysis which, upon conclusion, dispels all three concerns.
ETP's net debt/EBITDA ("leverage") can be calculated in several different ways. First, its net debt must be established. As of its most recent quarter (ending Sept. 30), ETP held debt of $27.45 billion against $860 million of cash and cash equivalents, resulting in $26.59 billion in net debt. That part is easy -- where the subjectivity lies is in how to appropriately calculate the company's EBITDA.
One can take the partnership's trailing 12-month (TTM) EBITDA -- a.k.a. cumulative EBITDA over the past four reported quarters -- which amounts to $5.63 billion, suggesting 4.7x leverage ratio. Next, one can extrapolate EBITDA the company has generated in the nine months to date and apply the run-rate to its fourth-quarter 2015
EBITDA input. This yields $5.8 billion in EBITDA, which represents a leverage ratio of 4.6x. Next, one can take the Street's consensus EBITDA for fiscal 2015 -- $5.6 billion -- which implies a 4.75x leverage ratio.
The final way to calculate ETP's leverage -- the way Valuentum uses -- is by using GAAP (Generally Accepted Accounting Principles) TTM aggregate EBITDA, which
amounts to just over $4 billion -- drastically lower than the prior three methods. This yields a leverage ratio above 6.5x, two turns higher than all prior calculations.
Simply, this manner of calculating EBITDA is invalid because it includes $17 billion of debt ETP assumed as part of its Regency acquisition (completed in late April), while at the same time excluding Regency's pre-merger EBITDA contribution of $1.4 billion in 4Q 2014. In other words, this method doubles ETP's net debt (inherited by Regency) without giving it credit for Regency's earnings contribution. This is not only misleading but manipulative.
The graph below compares these results. For what it's worth, credit rating agency Moody's calculates ETP's leverage at 4.75x while expecting the ratio to remain
unchanged as "ETP continues to pursue an aggressive growth program. ETP's stable outlook reflects the large scale and diversity of its midstream asset base, the stability and consistency in its large fee-based EBITDA stream."
The second criticism ETP has been hit with revolves around its ability to fund its growth capex budget for next year, which it has set at $4.95 billion. As per the graph below, the company plans to fund this budget in four ways, first by utilizing the $2.2 billion in cash proceeds it received as part of its recent Sunoco (SUN:NYSE) asset drop-down.
Second, the company has the capacity to issue roughly $1.75 billion of debt without compromising any covenants. While some are concerned about raising debt in a rising
interest rate environment, ETP's outstanding 2020 bonds are priced at interest rates between 5.75% and 6%. This would equate to an annual interest cost of $100 million,
which pales in comparison to the company's roughly $6 billion in EBITDA generation.
Finally, the company may have to tap the equity markets for financing; although this method has been criticized, ETP at current prices would only have to issue 19 million units, which is small relative to the 502 million units it has outstanding. If ETP had issued stock back when it traded near $50, the incremental dilution (when compared
to the current $30 price) is merely 1.5%. All said, ETP doesn't even need to tap the equity or credit markets -- at least to this extent -- as it has optionality, ranging from selling SUN units, a stake in Philadelphia Energy Solutions, etc. This is the benefit of operating within a broader complex.
Finally, investors are increasingly concerned about whether ETP will have to cut its distribution. We have spent countless hours running the numbers and even under our most conservative assumptions, ETP does not face a threat of a distribution cut. We have broken down our financial calculations below. As you can see, we estimate
ETP will end this year with $4.37 in distributable cash flow (DCF) per unit, well above its annualized $4.18 in cash distribution (1.05x coverage ratio). Under our most
conservative assumptions, the partnership will generate $4.25 in DCF per unit, which, when annualizing ETP's current quarterly distribution of $1.055 ($4.22), fully covers the distribution and by doing so shields them from having to cut said distribution.
We anticipate ETP can actually grow its distribution next year, as its general partner, Energy Transfer Equity (ETE), has the ability to offer concessions in order to fund any distribution deficit. ETP can grow its distribution by 1% without tapping into its GP; in order to support 2%, 4% or 7% growth, the GP would have to make a $24 million, $74 million and $125 million concession, respectively, which it has suggested it is more than willing to do. ETP may decide to be more conservative and not tap into its GP; regardless, our worst-case scenario suggests a stable to 1% growth distribution with de minimis probability of a cut.
ETP's current 14.5% yield implies a meaningful cut to distribution. Our conservative analysis indicates that implication is unjustified. For these reasons, we stand by ETP shares and believe they are incredibly attractive at current levels. We will consider buying under $29.
Source: ETP's Wells Fargo Presentation Slides (Dec. 6, 2015)