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posted on 23 December 2015

What Are A Billionaires Promises Worth?

by Ari Charney, Investing Daily

Investing Daily Article of the Week

When surveying the wreckage among MLPs, the words of Energy Transfer's fearless dealmaker Kelcy Warren come to mind.

In an interview with the Dallas Morning News earlier this month, Warren observed:

"I'll get hated for this, but with the price of crude plummeting, that's a great thing. You really make money during the dark times when other people are struggling. You can buy quality assets pretty cheaply."

We've expressed similar sentiments ourselves. But the problem is that the quality assets in the midstream space are often encumbered by significant financing needs at a time when capital is becoming increasingly scarce. That means vultures from outside the MLP space, such as private equity, may end up being the ones who profit most from the sector's downturn.

As income investors, we want to lock in attractive yields, but not at the expense of watching our portfolios tank when firms that levered up during the boom realize during the bust that they can't deliver on all the promises they've made. And Warren has made a lot of promises.

The question that prompted Warren's remarks pertained to Energy Transfer Equity LP's (NYSE: ETE) announcement in late September that it had finally reached a $58.1 billion deal to acquire The Williams Companies Inc. (NYSE: WMB).

The market has had a hard time accepting a mega-deal during a sector-wide downturn. You can't help but wonder if Warren, who along with Richard Kinder has been one of the more aggressive players in the MLP space, has finally bitten off more than he can chew.

And in the wake of the Kinder Morgan debacle, the market has painted a giant bullseye on Energy Transfer, with the share price of the general partner and the unit price of its largest MLP subsidiary Energy Transfer Partners LP (NYSE: ETP) getting absolutely hammered this month. Investors are clearly worried that the Energy Transfer empire is about to face a similar reckoning.

Will the market be right? There are so many factors at play right now that we'll only know in hindsight. But it's important to remember that while all MLPs are having to adjust to an environment where they're locked out of the equity market and face significant borrowing constraints, each should be evaluated according to its particular situation.

Let's start with ETP. We already know the MLP under-earned its distribution during the third quarter, with a coverage ratio of 0.84x, though if you're feeling charitable it was closer to 0.98x when you back out a couple of non-recurring items. On a year-to-date basis, the coverage ratio is 1.02x, which is full, albeit thin coverage.

When asked during the third-quarter earnings call about whether ETE is prepared to subsidize any MLP subsidiaries that fall below coverage of their distribution, Warren replied:

"We're going to do whatever is necessary. If ETP needs help in the way of IDR subsidies, IDR givebacks, things of that nature to make projects more accretive and improve ETP's financial health, you can guarantee ETE will do that. We're watching that closely. At the same time ... we're not giving away candy bars around here. We're trying to get everybody to stand on their own feet, do their job. But as you know, the math tells you, when you get as big as ETP is, the GP needs to step up and subsidize growth from time to time, and we will do that."

Well, the market is saying that it's time for ETE to give ETP a candy bar. But it almost seems that if ETE were to do that, the market would take that as an admission of weakness and send share prices spiraling lower.

So what are ETP's funding needs for next year? It looks like it will need at least $2.75 billion above and beyond the cash it expects to generate in order to fund all its obligations while investing in growth projects.

In a normal year, that would be no big deal. But this isn't a normal year. Based on a presentation earlier this month, management had planned to raise $1 billion through a combination of at-the-market issuance of equity ($575 million) and its dividend reinvestment program ($425 million). At current unit-price levels, that's not an attractive option.

Alternatively, management discussed raising cash by selling non-core assets and collecting inflows from the aforementioned DRIP, while issuing no other new equity through 2017.

The balance was going to be funded with $1.75 billion in debt, but to be ultra-conservative, let's assume no equity issuance next year, which brings that amount to $2.75 billion.

ETP has $3 billion available on a credit revolver due in 2019, so it could tap part of that for next year, and raise the balance by issuing debt.

The MLP has an investment-grade rating, one notch above junk, and management says they are in constant contact with the rating agencies to provide as much clarity as possible on how all the pieces of the Energy Transfer empire fit together and what kind of cash flows they're expected to generate. That kind of communication was apparently lacking for some reason at Kinder.

The company says that while it's targeting a debt-to-EBITDA ratio of 4.5x, it believes it has the support of credit raters to go as high as 5.0x, up from around 4.8x at present.

If all of next year's funding needs were financed by debt, then that would bring the leverage ratio to about 5.3x, which is uncomfortably high in this climate.

ETE could subsidize any additional shortfall by giving back some of its usual IDR take, which totals around $1.2 billion annually. But it can't give back too much, since it has its own distribution to cover.

With support of the distribution already challenged and a funding gap that will cause leverage to rise above 5.0x, we'd prefer to step aside. Although we believe management will do what it takes to support the distribution, their options are narrowing. And to paraphrase a famous comedian, a man is only as good as his options.

Add the significant overhang of the general partner's Williams acquisition, which will likely keep selling pressure on both entities (more on that below), and that's probably more pain than most income investors are willing to bear.

Meanwhile, Energy Transfer Equity is working toward closing what could be an absolutely transformative deal. And despite the fact that the market seems to hate the idea, credit raters, banks, and Wall Street analysts have been incredibly supportive.

Moody's acknowledged that

"Debt and leverage will be high and a combination of this scale is bound to present post-closing execution challenges to both entities." But the bond rater also gave the deal its blessing because of its "far-reaching scope and scale" and changed its outlook on ETE's junk rating from stable to positive.

However, that blessing is contingent upon ETE using the cash flows generated from its tie-up with Williams to quickly de-lever from the 5.3x debt-to-EBITDA level it will hit following the merger.

The transaction includes a $6 billion cash sweetener entirely financed by a bridge loan that matures next September. So the banks are cool with it.

And Wall Street analysts are uniformly bullish, though perhaps they're thinking of all the fees their firms will generate as a result of the deal.

So why does the market hate this deal? The answer requires digging into the entity from which Williams derives about 85% of its cash flows: Williams Partners LP (NYSE: WPZ).

WPZ, itself, derives the vast majority of its revenue - about 82% of full-year 2014 revenue, excluding income from investments in unconsolidated affiliates (equivalent to about 15% of revenue) - from just one customer: the troubled natural gas producer Chesapeake Energy Corp. (NYSE: CHK).

Bond investors are said to be smarter than equity investors. And a lot of Chesapeake's debt is trading at prices that indicate a distressed situation. In particular, credits maturing between 2019 and 2023 are currently priced between 71% and 74% below par value.

Chesapeake is trying to buy itself more time with a debt swap, but so far only a minority of bondholders have assented.

If the Williams deal is consummated, it will create a continent-beating midstream company in terms of infrastructure. But it's starting to feel like a leap of faith that ETE can quickly pare the high leverage that will result from the deal when Williams' primary customer is in a dire predicament in an already supremely challenging operating environment.

To prove his own faith in himself, Warren stepped in and bought 2.5 million shares of ETE for $41.3 million on Dec. 3. That's pretty good PR: Even for a billionaire, it's not exactly chump change. And he's already significantly underwater on those purchases.

Around that time, Warren said:

"The fear of failure is a very real thing, and it's something that never leaves my brain. But when you let it control your guidance that's when you cease to be good at what you do. We are driven here by growth and being smart about that growth, not getting over-leveraged."

Clearly, our definition of over-leveraged is very different. And while the deal seems to have been endorsed by everyone on Wall Street, we're worried about Chesapeake, as well as how many of the aforementioned candy bars Warren can give out to keep everything afloat, while paying down debt and integrating even more assets into a complex empire that is probably impossible for everyone but his CFO to fully understand.

We'd rather watch this drama unfold from the sidelines

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