Events: Investment Review – Part I
December 29, 2015
SUMMARY INFO: Williams Companies
- NYSE: WMB
- Recent PPS: $24.81 (12/28/15 close)
- Shares Out: 750 million
- Market Cap: $18,608
- Standalone Financials:
- 2016E Pre-Tax EPS: $2.75
- 2016E DPS: $2.39
- 2016 Pre-Tax PE: 9.0X
- 2016 Dividend Yield: 9.6%
SUMMARY INFO: Energy Transfer Equity
- NYSE: ETE
- Recent PPS: $13.47 (12/28/15 close)
- Shares Out: 1,045 million
- Market Cap: $14,076
- Pro Forma Financials:
- 2016E Pre-Tax EPS: $1.32
- 2016E DPS: $1.15
- 2016 Pre-Tax PE: 10.2X
- 2016 Dividend Yield: 8.5%
(The 17 Mile ‘Investment Mosaic’ is a four-layer margin of safety framework comprised of: Valuation + Business Quality + Entry & Upside Catalysts + Expert Opinion.)
Elevator Pitch: Extreme forced selling creates highly attractive entry point into deeply undervalued, catalyst-rich US Energy infrastructure company with robust secular growth outlook.
- Valuation – ETE is worth approximately $30 today, which translates to a WMB FVPS of $56. Margin of Safety: High
- Business Quality – Critical infrastructure, with limited to moderate pricing power. Cyclical end market risk largely offset by highly attractive long-term secular outlook. MOS: Moderate
- Catalysts – Deal closing acts as ST ‘upside catalyst’ with 1.6% gross ‘MARB’ spread; negative YE positioning – tax loss selling and credit-related shorts – acts as highly attractive ‘entry catalyst’; while LT upside catalysts include incremental growth projects related to secular US Energy buildout, Lake Charles project completion, formation of additional MLPs (ET LNG, Mexican gas), and accretive reorganization of WPZ assets. MOS: High
- Experts – MOS: High
WMB History. In 2011 WMB spun of its E&P arm, WPX Energy, to become a pure-play midstream company; in 2012 it lost out to ETE in a bid for Southern Union; in 2014 it consolidated 100% of the Access Midstream GP; and in 2015 it proposed to consolidate Williams Partners (NYSE: WPZ) to become one consolidated C-corp.
Activist investors Soroban and Corvex took a combined ‘activist’ stake in WMB in late 2013, working with the Company behind the scenes to cut costs, complete an accretive acquisition and/or sell the Company (my educated guess, as the activists did not make their plan(s) public).
ETE Deal. After more than a year of pursuit (proxy indicates talks began in February 2014), in June 2015 ETE officially proposed to purchase WMB for 1.8716 ‘ETC’ shares (an ETE C-corp share class) per WMB share, for an implied price of $64 per WMB share. WMB rejected the offer and put itself on the auction block. By September, WMB had agreed to combine with ETE, but with an $8 cash component (1.5274 shares + $8) and a dividend equalization agreement that ensures the ETC security receives the same dividend as ETE shares thru 2018.
At recent closing prices, the deal is worth $28.57 per WMB share, for a gross ‘Merger Arbitrage’ (MARB) spread of 15.2%. Assuming three months to close, the annualized MARB spread is ~61%, which clearly indicates that either the deal will not close or the terms will be amended.
By the time the deal closed in September 2015 the Energy sector was more than year into the current down cycle. ETE Chairman Kelcy Warren understands this environment; and with WMB under the umbrella, ETE will be in fantastic position to cut costs, rationalize assets between WPZ/ETP/SXL, and take share for competitors with accretive new build programs. As such, the deal is highly unlikely to break, in my opinion. However…
…With ETE taking on more than $6B of debt to fund the $8 cash portion of the deal, due to the recent credit market tightening it is likely the deal terms revert back to the original all-stock offer of 1.8716 in order to preserve the credit worthiness of the Energy Transfer family. Assuming the deal reverts to 1.8716, the current MARB spread is ~1.6% gross and 6.5% annualized, which is in line with other deals with a high probability of closing (CHTR/TWC, for example). While I am not banking on it, I have heard there is a chance ETE will have to up its offer to approximately 2.0 in order to win WMB shareholder approval. I believe that is unlikely, but who knows.
In a recent note, Evercore/ISI suggested to the ETE/WMB boards that they should amend the offer to all stock, but utilize up to 50% of the $6B bridge loan (in place to fund the $8 cash offer) to inject capital into WPZ and ETP for additional LP units. This is an interesting proposal, and one that could easily be in the works given how the WPZ units have been trading…
…And lastly – in this vein I would not be surprised to see ETE propose a concurrent consolidation of WPZ via ETP and SXL carving up the assets and swapping their own units with ETE for the WPZ LP units ETE will inherit from WMB.
‘New ETE’. Post-transaction WMB shareholders will own ~52% of ‘New ETE’, a predominately Transportation & Midstream Company comprised of the following MLPs:
- Williams Partners (NYSE: WPZ): 54% of ETE DCF
- Energy Transfer Partners (NYSE: ETP): 34%
- Sunoco Logistics (NYSE: SXL): 7%
- Energy Transfer LNG (ETL): 5%
- Sunoco (NYSE: SUN): 0%
New ETE’s Transportation business will move approximately 15% and 30% of US oil and gas production, while the Midstream business is comprised of Gathering & Processing, NGL Production and Fractionation operations. A large portion of ETE’s growth capex in place is targeted at expanding the Midstream business; and despite pressure from low commodity prices – for now – not only there is ample expansion opportunity to relieve bottlenecks, but a fully-integrated offering is an attractive competitive advantage for contract negotiations with producers looking for a clear path to higher realized pricing. Lastly, the bulk of the WMB synergy opportunity is derived from accretively moving WPZ NGL bbls onto ETE systems in order to rationalize capacity.
Legacy ETE + WMB/WPZ board-approved growth projects total more than $53B at the time of the September 2015 merger announcement; and ETE expects commercial synergies to amount to approximately $2B, on ‘synergy capex’ of ~$5B.
Market Conditions. Since ETE’s proposal was made public in June 2015, ETE (and thus WMB) has taken a straight-line trip to below $11 at the recent lows). The leading cause was crude oil’s decline from over $60 to under $40 at present, as “Energy investors” project a complete cessation of future growth projects due to uneconomic commodity prices. YE positioning by taxable investors harvesting losses and credit investors hedging illiquid bond portfolios via equity short sales have exacerbated the declines.
Importantly, industry contacts confirm that private market values for midstream assets remain materially above current public market quotes; a dynamic that is further confirmed by the fact that the credit market for quality Midstream assets has declined concurrently with the equity market, as oppose to leading the equity market down. In E&P land, the picture is quite different – private market values remain below public quotes; and there is no such thing as a ‘quality’ E&P with debt, as the credit market is leading the equity market downward…
The Opportunity. The market’s concerns are centered on 1) the outlook for oil production and 2) the long-run sustainability of the MLP business model.
While the market is correct to discount little to no oil volume growth over the next 1-2 years, it is incorrect in the long run. In the long-term the world needs moderate-cost US oil – at (much?) higher production levels – to meet demand. The world has gone from a ‘call on OPEC’ world to a ‘call on US shale’ world. The problem for the market – and the opportunity for the ‘enterprising investor’ – is that the global oil market is undergoing a painful transition to the ‘call on US shale’ world.
US shale operators utilized cheap credit to finance the initial land grab/production surge from 2010-2014. Due to plummeting commodity prices, credit is no longer cheap, and US shale operators are being forced to cut costs, high-grade production, and pay down and/or restructure debt. In a nutshell, US Energy production is not going away, but rather is shifting from the CHKs of the world to the XOMs of the world.
Alongside the US shale land grab/production surge, the US Midstream industry built out supporting infrastructure. As my power & utilties friend recently stated, the industry needs a couple of years to “digest” this build out, that is “admittedly over leveraged”. With a terribly unstable ownership base comprised primarily of yield-seeking investors, the equity market is trying to ‘puke’ rather than ‘digest’ this infrastructure, which has created a terrific long-term buying opportunity for those willing & able to look across the ‘chasm’.
And while the market is intensely focused on the outlook for US oil production, the forthcoming ramp in natural gas demand driven by LNG exports and power generation (4-5.5 BCF/day thru 2020, according to Goldman Sachs) – and exacerbated by generational low natural gas prices – is often overlooked as a key volume stabilizer for the Midstream industry. Consider, just over half of ETP’s volumes are protected by ‘minimum volume commitments’; which means that if the entirety of unprotected volumes were linked to oil – which Goldman Sachs projects will decline by 7-8% in 2016 – total ETP volume would decline by less than 4% in 2016…hardly a catastrophe.
I would argue that the chief market concern is the sustainability of the MLP business model – one in which requires access to capital markets for growth capital since 100% of FCF is distributed tax-free to shareholders – in an environment of elevated leverage and a rising cost of capital. With industry bellwether Kinder Morgan slashing its dividend by more than 70% in early December, the market has trained its sights on any and all companies with even a whiff of too much leverage. What the market is missing with New ETE is its relatively stable base business paired with a nearly fully-funded near-term growth program that naturally deleverages the underlying MLPs thru 2018, even on a depressed commodity price deck. Consider…
…According to a recent Wells Fargo note that assumes $47 oil and $3 gas in 2016, $55/$3.59 in 2017 and $62/$3.59 in 2018, ETP leverage falls from 4.8X in 2016 to 4.1X in 2018, while distribution coverage rises from 1.00X to 1.12X; and WPZ leverage falls from 4.8X to 4.0X, while coverage rises from .90X to 1.15X. Meanwhile, ETE DCF per share grows from $1.37 in 2016 to $1.78 in 2018.
The beauty of a merger transaction is that a mountain of information is provided for public consumption. In the 11/24/15 deal proxy WMB and ETE provide detailed financial projections (page 145) assuming ‘market conditions’ even lower than those utilized in the Wells Fargo note cited above, projecting 2016-2018 WTI/gas prices of: $46/$2.98, $50/$3.14 and $54/$3.22. Under the proxy ‘market conditions’ scenario ETE DCF grows from $1.32 per share in 2016 to $2.16 in 2018 as growth projects come online and commercial synergies are realized.
As the stand-off between OPEC and Non-OPEC producers come to a head in 2016, admittedly 2016 commodity prices are a bit of a ‘jump ball’. But with projected earnings power under current 2017+ ‘strip’ prices this robust relative to recent market pricing (i.e. WMB/ETE stock prices) – and with ETP’s 2016 growth capex budget largely funded – the long-term outlook for New ETE earnings power swamps any further near-term deterioration in operating conditions. And ironically, the more pain the industry feels in 2016, the more robust the commodity price recovery will be beyond 2017. (Lastly – I was able to somewhat confirm the conservative nature of the strip pricing ETE and WMB use in the proxy with industry contacts…very likely it will prove overly conservative.)
Fat Guy In A Little Coat. More detailed industry/company/project-level analysis to come in Part II. However, as I am far from a field-level expert in the Midstream space, further detailed ‘analysis’ is simply a regurgitation of information gleaned from far too much time spent reading about the Energy industry broadly and ETE/WMB specifically, as well as extensive discussion with industry experts.
Part and parcel to the ability to identify when an investment is pounding you over the head is the ability to invest with imperfect information. This is an incredibly complex situation, on which one could spend months conducting on-the-ground analysis. I do not have those resources at my disposal, so my answer is to gather as much information as possible from those far smarter than I who have spent years either in the field or covering the Midstream space from an investment perspective. In other words – despite my lack of true expertise, I do not believe I need a ‘scale’ to recognize the ‘fat guy in a little coat’ investment set-up that is WMB/ETE.
Sources: Company Filings. Company Presentations. Goldman Sachs. Wells Fargo. Credit Suisse. Deutsche Bank. 17M Estimates.