Yesterday, August 2, Energy Transfer Partners (ETP) announced an expected consolidation with its general partner, Energy Transfer Equity (ETE). Energy Transfer was the largest remaining MLP that had not eliminated its general partner and the associated Incentive Distribution Rights (IDRs). IDRs give ETE, the general partner, a right to a share of the MLPs distributable cash flow. In ETP’s case the IDRs totaled about 40% of ETE’s cash flow or over $1.7 billion annually. In this non-taxable transaction, ETE will acquire all shares of ETP in exchange for 1.28 units of ETE. The transaction is expected to close at year end. The transaction will effectively reduce the distribution by 31%, leaving ETP trading at about a 6.5% yield on this reduced distribution, in line with its peers such as Enterprise Products Partners. While ETP had been trading at a double digit yield in expectation of this move, the market did not expect the announcement this quarter and there was some uncertainty over the valuation for ETP. Both factors worked in favor of ETP’s shareholders and the MLP rallied on the announcement.
ETP, while owning some of the best assets in the midstream energy sector, has struggled with its complicated corporate structure, leverage and high burden of IDRs. The company had not increased its distribution over the past year. This transaction potentially solves all three issues. The corporate structure is simplified to a single entity – ETE, which is better aligned with all shareholders. Due to an aggressive acquisition strategy during the growth period before oil prices collapsed in 2014-2015, Energy Transfer had increased its debt levels to the edge of what its investment grade credit rating would tolerate. The consolidation and reduced distribution will allow a paydown of debt from the current level of 5.2x EBITA down to a more manageable level of 4.5x at which point the company will likely begin increasing the distribution. The reduced distribution compensates for the elimination of IDRs, which had prevented ETP from meaningfully increasing its distribution over the past few years. The 14% gain in ETP recognized the increased value from eliminating this liability.
At the close August 2, the Alerian MLP Index had returned 9.2% year-to-date compared to 6.9% for the S&P 500. Active strategies emphasizing the higher quality MLPs had performed even better. Investing in MLPs and other midstream energy stocks has been a frustrating experience over the last several years, but with record oil and gas production and now the implementation of needed reforms to corporate structures, the industry now appears poised for several years of sustainable growth.