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3 Reasons to Avoid Energy Transfer Partners and Buy These 2 High-Yield MLPs Instead

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Let's explore three reasons Energy Transfer Partners' yield is too good to be true, and why the much lower yielding Magellan Midstream and Spectra Energy Partners are far superior long-term income investments.

Super-low valuations usually happen for a reason ...

MLP Yield 5-Year Average Yield Price/Operating Cash Flow 10-Year Average Price/Operating Cash Flow
Energy Transfer Partners 15.7% 7.5% 3.6 9.0
Magellan Midstream Partners 4.9% 3.9% 14.5 12.7
Spectra Energy Partners 5.5% 5.1% 8.5 13.5

Sources: Yahoo! Finance, Fastgraphs.

Energy Transfer Partners is priced at distressed levels. Meanwhile, Magellan Midstream and Spectra Energy Partners are trading somewhat close to their historical norms.

When investors see such historical undervaluation it means that Wall Street is betting Energy Transfer's distribution is unsustainable. When we examine the payout profile we can see why.

... such as a poor payout profile ...

MLP 2015 Distribution Coverage Ratio 2015 Excess Cash Flow 5-Year Analyst Payout Growth Expectations
Energy Transfer Partners 0.97 ($86 million) 4.3%
Magellan Midstream Partners 1.4 $269 million 9.6%
Spectra Energy Partners 1.2 $229 million 7.5%

Sources: earnings releases, Fastgraphs.

Note that Energy Transfer's data represents Q1-Q3 of 2015 because it has yet to report Q4 results.

Yield is the first thing dividend investors notice, but when it comes to the three components of a payout profile (yield, sustainability, and long-term growth potential), it is arguably the least important. That's because a distribution that must be cut is likely to lead to massive losses, and as we see, Energy Transfer Partners is having a tough time covering its payout.

In comparison, Magellan Midstream and Spectra Energy Partners are generating strong excess distributable cash flow, which protects the payout can be used to invest in future growth.

For example, Magellan Midstream's 2015 excess distributable cash flow is enough to fund 34% of its $800 million in capital projects in 2016.Beyond that, Magellan has over $600 million in post 2016 and potential growth opportunities management is currently evaluating.

Spectra Energy Partners' excess cash may not be enough to fund a substantial portion of its enormous capital spending (it put $2.5 billion worth of projects online in 2015). However Spectra has an ace up its sleeve that is likely to allow it to complete its $9.5 billion backlog of projects over the next three years. This is likely to result in a distribution growth rate similar to what analysts are expecting.

... and poor access to growth capital

Metric Energy Transfer Partners Magellan Midstream Partners Spectra Energy Partners
Debt/EBITDA (leverage) ratio 7.0 2.9 3.6
Operating income/interest (interest coverage) 2.52 7.2 5.35
Average debt cost 4.7% 4.3% 3.9%
Historic funding sources 58% debt, 42% equity 16% debt, 84% equity 31% debt, 69% equity
Weighted average cost of capital 6.41% 8.14% 6.11%
Return on invested capital 5.51% 19.87% 7.35%

Sources: Earnings releases, Morningstar, GuruFocus.

Investors in Energy Transfer Partners must hope that the MLP's $9 billion in new projects coming online over the next two years will grow its cash flow to the point of distribution sustainability.

However, because of Energy Transfer's previous use of debt to fund almost 60% of its growth its balance sheet is massively leveraged, resulting in higher debt costs and a risk that it simply won't be able to raise the growth capital it needs to fund these projects.

That's especially true given the severely depressed unit price, which essentially makes raising capital in equity markets impossible. This situation will probably require Energy Transfer to fund part of its planned 2016 capital spending program with asset sales, which will make growing cash flow more challenging.

In comparison Spectra Energy Partners' units are still valued high enough, and its leverage ratio low enough, that it should have less trouble funding its growth initiatives.

Bottom line

The current oil crash has proved that no energy stock's payout is a "sure thing." That is why it is essential that long-term investors look for the highest-quality midstream MLPs specifically: a strong coverage ratio, a strong balance sheet, good access to cheap debt and ongoing equity growth capital markets, and returns on capital higher than their costs of capital.

Based on all these important metrics, Energy Transfer Partners falls far short, while Magellan Midstream and Spectra Energy Partners shine as classic examples of conservative, superior, long-term-focused MLPs. Which is why they are far more likely to reward dividend lovers with impressive total returns over the next decade, especially at today's attractive prices.

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The article 3 Reasons to Avoid Energy Transfer Partners and Buy These 2 High-Yield MLPs Instead originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Magellan Midstream Partners. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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