2 Reasons Why Williams Partners's Solid Earnings Still Don't Make it Worth Buying

Source: Williams Partners

Over the past year Williams Partners (NYSE: WPZ) and its general partner, Williams Companies' (WMB 0.31%), have been embroiled in a soap opera like saga over the potential merger between Williams and Energy Transfer Equity (ET 0.54%). 

Combined with the worst energy crash in over half a century investors in all three midstream operators have taken heavy short-term losses. 

WPZ Total Return Price data by YCharts

Which might make potential investors in Williams' take heart in its latest earnings results. However, there are three key risks facing Williams' that continue making it an inferior long-term investment compared to far superior peers such as: Enterprise Products Partners, (EPD 1.22%), Magellan Midstream Partners, (MMP) and Spectra Energy Partners (SEP).

Why you need to look past the good earnings

Thanks in large part to its Geismar Olefin plant, (crippled for years by an explosion), Williams Partners was able to grow year-over-year Q1 Adjusted EBITDA, and distributable cash flow, or DCF, by 16%, and 14% respectively.  More importantly the distribution coverage ratio, or DCR, increased from an unsustainable 0.89 to a far better 1.02. 

But before you run out to buy Williams and lock in its 11.3% yield be aware that this distressed midstream MLP has several major problems that this quarter's positive results did nothing to improve. 

Merger failure would spell huge trouble for Williams

As part of its $38 billion merger with Williams Companies, which owns a large portion of William Partners' units and all of its incentive distribution rights, Equity Transfer Equity agreed to pay $6 billion in cash to Williams' shareholders. 

Funding that would either mean diluting existing Equity Transfer Equity investors by selling lots of cheap equity, or taking on additional debt. Either way Energy Transfer Equity has been desperate to call the deal off as it no longer feels it makes sense for its investors. 

However, Williams Companies is equally desperate to have the deal completed and on May 13th filed a law suit to force Energy Transfer Equity to make good on the original terms of the merger.

The reasons Williams is suing to force the merger through are precisely why you need to avoid this high-yield trap. 

Mountain of debt makes profitable growth impossible

Sources: Morningstar, Gurufocus

Investor capital is both the equity and debt that's raised from investors and being able to profitably earn returns on that capital is the hall mark of good, long-term focused management. This is especially true in the capital intensive midstream MLP industry in which most DCF is paid out as high distributions to investors and external capital is continually flowing into the MLP. 

A distressed MLP can light investor's money on fire by reaching for unprofitable growth at too high a price. As long as management can keep raising new money it can thus invest in unprofitable projects and keep DCF growth, and thus its payout, alive. 

While net ROIC isn't a perfect profitability metric since it relies on the volatility of an MLP's unit price, as long as its above 0% investor's can be certain that every dollar of debt or equity raised in their names isn't being squandered. 

As the table above shows Williams' likely can't grow profitably, while Enterprise, Spectra, and Magellan do. The main reason for this is its enormously over leveraged balance sheet which imposes enormous interest costs. And since Williams' was recently downgraded to "junk" status its capital costs will only rise as it has to roll over cheap debt with far more expensive debt. 

This is probably a major reason Williams is so eager for the Energy Transfer merger to go through. If the merger closes Williams will become part of the largest pipeline empire in the world, with vast access to much cheaper capital. That in turn might help it grow profitably again, as well as improve the sustainability of its payout. This would likely cause William Partners' unit price to climb and potentially allow it to sell equity at much higher prices, further lowering its WACC and improving its profitability.

On the other hand, should the merger fall apart, then Williams would be left with a mountain of increasingly expensive debt. In addition, its largely useless growth backlog in the tens of billions that would only result in the likely destruction of unit holder value assuming it were able to raise the capital to even construct much of it.

Bottom line:

Williams Partners' has been able to sustain its sky-high payout thus far, and its possible that a strong recovery in energy prices may continue to allow this. However, the risk that creditors will force it to slash its payout in order to divert DCF to strengthening its balance sheet is high.

Thus I can't recommend that investors divert fresh capital to an investment in Williams when MLPs such as Enterprise Products Partners, Spectra Energy Partners, and Magellan Midstream Partners offer high, growing, and far more secure distribution prospects.

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