Source: Energy Transfer Partners
One of the most dangerous things dividend investors can do is invest solely on the basis of high-yield. This is particularly true during this current oil crash, when almost all midstream MLPs have been brutalized and many are now offering yields not seen since the financial crisis.
A perfect example of this is Energy Transfer Partners (ETP), who, compared to competitors such as Magellan Midstream Partners (MMP), and Spectra Energy Partners (SEP), may initially seem incredibly undervalued.
Let's explore three reasons why Energy Transfer Partners is likely offering a yield that is too good to be true. More importantly, learn why the much lower yielding Magellan Midstream and Spectra Energy Partners are far superior long-term income investments.
Super low valuation usually happen for a reason...
| MLP | Yield | 5 Year Average Yield | Price/Operating Cash Flow | 10 Year Average Price/Operating Cash Flow |
| Energy Transfer Partners | 15.7% | 7.5% | 3.6 | 9.0 |
| Magellan Midstream Partners | 4.9% | 3.9% | 14.5 | 12.7 |
| Spectra Energy Partners | 5.5% | 5.1% | 8.5 | 13.5 |
Sources: Yahoo Finance, Fastgraphs
Energy Transfer Partners has never traded at a premium however as this table shows currently its priced at distressed levels. Meanwhile Magellan Midstream and Spectra Energy Partners are trading somewhat close to their historical norms.
When investors see such historical undervaluation it means that Wall Street is betting Energy Transfer's distribution is too good to be true. When we examine the payout profile of these three MLPs we can see why.
...such as a poor payout profile...
| MLP | 2015 Distribution Coverage Ratio | 2015 Excess DCF | 5 Year Analyst Payout Growth Expectations |
| Energy Transfer Partners | 0.97 | ($86 million) | 4.3% |
| Magellan Midstream Partners | 1.4 | $269 million | 9.6% |
| Spectra Energy Partners | 1.2 | $229 million | 7.5% |
Sources: earnings releases, Fastgraphs
Note Energy Transfer's data represents Q1-Q3 of 2015 because it has yet to report Q4 results.
Yield is the first thing dividend investors notice but when it comes to the three components of a payout profile (yield, sustainability, long-term growth potential) it is arguably the least important. That's because a distribution that must be cut is likely to lead to massive losses and as we see Energy Transfer Partners is having a tough time covering its payout.
In comparison Magellan Midstream and Spectra Energy Partners are generating strong excess distributable cash flow which, not only protects the payout, but can be used to invest in future growth.
For example, Magellan Midstream's 2015 excess DCF is enough to fund 34% of its $800 million in capital projects in 2016.Beyond that Magellan has over $600 million in post 2016 and potential growth opportunities management is currently evaluating. This is why I am confident that management can hit its 10% and 8% respective payout growth targets for 2016 and 2017.
Spectra Energy Partners' excess DCF may not be enough to fund a substantial portion of its enormous capital spending (it put $2.5 billion worth of projects online in 2015). However Spectra has an ace up its sleeve that is likely to help it to complete its $9.5 billion backlog of projects over the next three years, which is likely to result in a distribution growth rate similar to what analysts are expecting.
...and poor access to growth capital
| Metric | Energy Transfer Partners | Magellan Midstream Partners | Spectra Energy Partners |
| Debt/EBITDA (Leverage) Ratio | 7.0 | 2.9 | 3.6 |
| Operating Income/Interest (Interest Coverage) | 2.52 | 7.2 | 5.35 |
| Average Debt Cost | 4.7% | 4.3% | 3.9% |
| Historic Funding Sources | 58% debt, 42% equity | 16% debt, 84% equity | 31% debt, 69% equity |
| Weighted Average Cost of Capital | 6.41% | 8.14% | 6.11% |
| Return on Invested Capital | 5.51% | 19.87% | 7.35% |
Sources: Earnings releases, Morningstar, Gurufocus
Investors in Energy Transfer Partners need to hope that the MLP's $9 billion in new projects scheduled to come online over the next two years grows its DCF to the point of distribution sustainability.
However, due to Energy Transfer's previous use of debt to fund almost 60% of its growth its balance sheet is massively leveraged, resulting not just in higher debt costs than either Magellan Midstream or Spectra Energy Partners, but also a risk that it simply won't be able to raise the growth capital it needs to fund these projects.
That's especially true given the severely depressed unit price which essentially makes raising capital in equity markets impossible, and is likely to result in Energy Transfer having to fund 20% of its planned 2016 capital spending program with asset sales, which will make growing DCF more challenging.
Worse yet, any debt Energy Transfer does manage to raise (to grow or refinance its debt) is likely to be at higher interest rates, which will only increase its cost of capital. With its return on invested capital already so low this might make profitable growth impossible and destroy long-term investor value.
In comparison Spectra Energy Partners' units are still valued high enough, and its leverage ratio low enough, that it should have little trouble funding its growth initiatives. The same is true for Magellan Midstream, who, though a smaller project backlog than its peers, has returns on capital so high that each new project is extremely accretive to DCF and should allow for many more years of sustainable distribution growth.
Bottom line
The current oil crash has proven that no energy stocks' payout is a "sure thing". That is why it is essential that long-term investors look for the highest quality midstream MLPs specifically: a strong coverage ratio, a strong balance sheet, good access to cheap debt and ongoing equity growth capital markets, and returns on capital higher than their costs of capital.
Based on all these important metrics Energy Transfer Partners falls far short while Magellan Midstream and Spectra Energy Partners shine as classic examples of conservative, superior long-term focused MLPs. Ones that are far more likely to reward dividend lovers with market crushing total returns over the next decade, especially at today's attractive prices.
