Published by Nicholas McCullum on May 9, 2017
On April 28, Sunoco Logistics (SXL) and Energy Transfer Partners (ETP) closed on their merger after announcing on April 26 that the merger had been approved by ETP’s unitholders.
The pro forma company has a unique investment proposition thanks to its has improved growth prospects and very attractive dividend yield. Energy Transfer Partners’ current $0.535 quarterly distribution is good for a forward dividend yield of 9.5%, giving it a very high yield – well north of 5%.
Despite the company’s current attractive position, Energy Transfer Partners’ merger with Sunoco Logistics has created some uncertainty for investors. It appears that ETP may have cut its dividend, though this is not exactly the case due to the nature of the merger.
This article will discuss Energy Transfer Partners’ recent merger and the investment prospects of the new company in detail.
At a security level, the merger between Sunoco Logistics and Energy Transfer Partners was quite complicated.
‘Old’ ETP shareholders received 1.5 shares of ‘old’ SXL for every 1 share they held of ‘old’ ETP. Then, ETP was delisted from the New York Stock Exchange. The next trading day – May 1 – saw the SXL security re-listed under the ticker ETP.
From a distribution perspective, SXL unitholders who hold for the long-term will only see dividend growth and will benefit from the partnership’s bolstered growth prospects.
‘Old’ ETP shareholders who hold for the long-term have unfortunately received a yield reduction of ~25% but will benefit from improved dividend safety and robust pro-forma growth prospects.
While the distribution cut is undesirable for Energy Transfer Partners’ existing shareholders, the partnership was already approaching a likely dividend cut prior to the merger as its cash flows failed to fund its distribution payments.
Energy Transfer Partners’ fourth quarter earnings release saw the company report a distribution coverage ratio of just 0.89x and 0.87x for the quarter and the year, respectively. These numbers were both down from 0.98x and 0.98x in the year prior.
After the merger, the ‘new’ Energy Transfer Partners is spreading its debt over a base of cash flow generating assets. The new company released its first combined earnings report on May 3, announcing a distribution coverage ratio of 1.13x (down from 1.27x the year prior).
Based on this metric, Energy Transfer Partners’ new distribution appears safe for the foreseeable future.
The company expects significant synergies to be achieved after the completion of the merger. Given the history between Sunoco Logistics and Energy Transfer Partners, it is likely that their synergy predictions will be realized.
The management teams of Sunoco Logistics and Energy Transfer Partners have a proven track record of successfully integrating acquisitions. Combined, the two companies have closed on six major acquisitions since 2011.
Source: ETP-SXL Merger Presentation, slide 12
The odds of a successful integration post-merger are also improved by the company’s intimate familiarity with one another. Both of the legacy businesses – Sunoco Logistics and the ‘old’ Energy Transfer Partners – were part of the Energy Transfer Equity (ETE) ‘family’ of oil and gas assets, as shown below.
The familiarity of ETP and SXL’s management teams increases the probability that the merger will be executed as planned.
The new Energy Transfer Partners is a publicly-traded master limited partnership whose general partner is a wholly-owned subsidiary of Energy Transfer Equity. Energy Transfer Equity also has a 0.3% limited partner interest in the new Energy Transfer Partners. Energy Transfer Partners also has a 45% limited partnership interest in Sunoco L.P.
More details about the corporate structure of Energy Transfer Partners can be seen below.
Source: ETP-SXL Merger Presentation, slide 6
After the merger, Energy Transfer Partners owns and operates one of the largest and most diversified portfolios of oil and gas assets in the country.
This is because the legacy Energy Transfer Partners was primarily involved in the business of natural gas distributions, while the legacy Sunoco Logistics was primarily involved in liquids distribution. Combining these businesses has not led to any meaningful operational redundancies.
Source: ETP-SXL Merger Presentation, slide 7
The pro-forma entity is expected to be the second-largest midstream MLP based on enterprise value and the largest midstream MLP based on annualized adjusted EBITDA.
You can see how the new Energy Transfer Partners compares to its peer group below.
Source: ETP-SXL Merger Presentation, slide 10
This size and stability give Energy Transfer Partners a distinct competitive advantage over its smaller peers (more on that later).
Energy Transfer Partners’ near-term growth prospects are largely related to the synergies expected to be realized post-merger.
Specifically, there are four major synergy opportunities identified by ETP and SXL’s management prior to the merger. These four priorities can be seen below.
All said, the new Energy Transfer Partners is expected to realize cost savings of $200 million by 2019. For context, the partnership reported total costs and expenses of $6.241 billion in its first quarter (the only reporting period so far for the combined company). $200 million in cost savings is a significant 3.2% decline in expenses.
The partnership is also expected to continue its historical trend of rewarding distribution growth. Management expects low double-digit distribution growth over the next several years after the merger. This is particularly impressive after considering the stock’s current dividend yield – 9.5%.
Competitive Advantage and Recession Resiliency
Energy Transfer Partners’ competitive advantage comes from its portfolio of high-quality midstream oil & gas assets.
The partnership also benefits from having significant economic clout. As the second-largest midstream MLP by enterprise value and the largest midstream MLP by adjusted EBITDA, Energy Transfer Partners has the capability to invest in deals too large for some of its smaller competitors.
While it might seem difficult to assess the recession resiliency of the new Energy Transfer Partners since it is quite new, investors can take comfort in the fact that both of the legacy businesses have strong track records of recession performance.
Prior to the merger, Sunoco Logistics had increased its dividend for 47 consecutive quarters. This is a remarkable streak that represents the ability (through strong financial performance) and willingness (through its shareholder-friendly dividend policies) to place its unitholders interests first.
The legacy Energy Transfer Partners has a similarly impressive track record. The partnership paid steady or rising dividends each year since 2001, and although it had kept distributions steady over the past six quarters, it avoided a distribution cut during one of the most difficult oil & gas operating environments in decades.
The new Energy Transfer Partners is larger and more stable than its predecessors – thus, I would expect distributions to continue to grow during all but the direst business conditions.
Valuation, and Expected Total Returns
MLPs like Energy Transfer Partners report unconventional financial metrics such as adjusted EBITDA and distributable cash flow per unit. Analyzing these securities using the traditional price-to-earnings ratio is not the best way to assess their valuation.
Rather, the most simple (and effective) valuation technique for MLPs is to compare the partnership’s current dividend yield to its historical dividend yield.
If an MLP’s dividend yield is above its historical levels, it is likely undervalued; conversely, if an MLPs yield is below historical levels, it is expected to be overvalued.
The trouble with assessing the valuation of the new Energy Transfer Partners is that the partnership lacks comparability. The pro forma company has only existed for about a week at the time of publication – so how do we know whether to compare it to the legacy Sunoco Logistics or the legacy Energy Transfer Partners?
Fortunately, the conclusion is the same in either case. Sunoco Logistics had a median dividend yield of 6.1% since inception and the ‘old’ Energy Transfer Partners had a median dividend yield of 5.9% since inception. The pro forma Energy Transfer Partners has a current dividend yield of 9.5%.
Thus, the new entity appears significantly undervalued. Today’s price represents a historically attractive opportunity to initiate or add to a position in Energy Transfer Partners – valuation expansion will likely be a strong contributor to total returns.
The other major contributor to the expected total returns of Energy Transfer Partners’ unitholders is the company’s dividend (both payments and growth).
ETP’s current quarterly distribution of $0.535 per unit yields 9.5% on the company’s current stock price of $22.53. For context, the S&P 500’s current dividend yield is 1.9%. The partnership’s combination of yield and safety makes it a compelling choice for retirees or other income-oriented investors.
Looking at distribution growth, the merger is expected to drive low-double digit distribution growth over the next several years.
Combining dividend yield (9.5%) and dividend growth (low double digits – say 10%-12%) it is very likely that the partnership will deliver mid double-digit total returns, particularly considering the potential for valuation expansion.
Energy Transfer Partners is a compelling investment opportunity right now – a 9.5% dividend yield and double-digit distribution growth over the next several years will drive robust shareholder returns.
Further, it is highly likely that this partnership’s valuation will expand significantly in the months following the merger. Based on dividend yield, the pro-forma partnership is trading at a significant discount to the historical valuations of both the legacy Sunoco Logistics and the legacy Energy Transfer Partners.
So what can investors expect from the new Energy Transfer Partners? We believe it is highly likely that the pro forma entity will deliver market-beating total returns looking forward.
This makes Energy Transfer Partners a buy.