Source: Western Gas Partners
As a value income investor I absolutely love it when Wall Street freaks out and punishes all energy stocks en mass, as it has due to the worst oil crash in 50 years. That's because it provides long-term income investors incredible values on high-quality midstream MLPs that are likely to result in stellar total returns over the next five to ten years.
Take for example Western Gas Partners (WES 1.57%), and its general partner Western Gas Equity Partners (NYSE: WGP), both of which have been hammered worse than their competitors over the past year.
With so many undervalued midstream choices out there dividend investors can have a hard time deciding which ones represent the best long-term buys, and which are super cheap for a reason. To help determine if Western Gas Partners and Western Gas Equity Partners deserve a spot in your diversified income portfolio here are the four most important factors you need to focus on.
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% | 4.0% | 6.6 | 11.7 |
| Western Gas Equity Partners | 6.4% | 5.8% | 17.6 | 21.3 |
Sources: Yahoo Finance, Fastgraphs
As you can see Western Gas Partners is trading at a much more undervalued price to its general partner, both on an absolute yield, price/operating cash flow, as well as historical basis. Of course yield is just one part of a distribution profile -- the most important thing dividend investors need to focus on when deciding whether or not to invest -- the other two being payout sustainability and long-term growth prospects.
Is Western Gas Partners' valuation justified by its distribution profile? The answer, not surprisingly is multi-faceted.
Does their 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 DCF | $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) to how much its paying out. Note that Western Gas Equity Partners' 1.0 DCR (the absolute bare minimum for a long-term sustainable payout) is due to that MLP's only assets being its 36.5% stake in its MLP as well as its ownership of incentive distribution rights. 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 last 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 concerns me for two reasons. First it likely means that future distribution hikes 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 DCF could result in an unsustainable distribution and even a potential future distribution cut.
What are their respective growth potentials in a low energy world?
I am also somewhat skeptical of analysts' current payout growth predictions due to 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 to provide future growth.
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 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 | 4.0% | 4.0% |
| 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
The one thing I do like about Western Gas is its solid balance sheet. This is a function of both MLPs having relied mostly on equity markets for their growth funding up to now. 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 breeching 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 investing into 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 payouts and strong balance sheets. 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.
