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Why Energy Transfer Partners Could Still Be 25% Undervalued

Trying to catch the bottom on the oil and gas sector has likely felt like a game of catching falling daggers. The team at Bank of America Merrill Lynch has come out and defended its long-term thesis for Energy Transfer Partners L.P. (NYSE: ETP), noting that its growth trajectory is still underappreciated even if risks are still there near-term. Merrill Lynch has a Buy rating, and it has taken down its upside price objective of $64.00 down to $60.00 in the mid-day analyst call.

Energy Transfer Partners had a $48.32 price per unit for the call, implying 24% in raw upside. If you add in the distribution rate being north of 8% on a yield-equivalent basis, this implies upside of more than 30% on a total return basis. Merrill Lynch is very bullish longer-term, but it does admit that near-term cash distributions look tight.

Tuesday’s analyst call is after Energy Transfer beat expectations on EBITDA distributable cash flows in August. That was reported as EBITDA of $1.49 billion for the second quarter, above the BofA Merrill Lynch estimate of $1.27 billion and the consensus estimate of $1.42 billion. Distributable cash flow was $894 million, higher than the Merrill Lynch target of $794 million. This implied 1.03 times its distribution coverage.

Additional management commentary was also factored in. The first half of 2015 was said to see much progress on growth funding. The outfit issued a net of $4 billion in debt during the first half, and it raised $724 million via an at-the-money equity issuance. The group also added $1 billion to its cash balance from the SHC dropdown to SUN.

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Merrill Lynch’s MLP team said:

We view this robust level of funding positively especially given somewhat constrained MLP capital markets. We are still of the opinion ETP’s reasonable leverage profile (~5x net debt/EBITDA), strong ATM issuance program, drop-downs to SUN during 2016, and potential sale of its various equity stakes (SUN/SXL LP units and PES) could mean no public marketed equity issuances for the foreseeable future.

Despite our positive outlook for ETP, we recognize its near-term cash distribution coverage ratio may be relatively tight. Weaker NGL prices (we estimate currently $0.43/gallon versus an average of $0.49/gallon during the second quarter) may offset ETP’s near-term growth projects and expected synergies from the recent RGP acquisition, in our opinion. We forecast 1.0 to 1.1 times distribution coverage through 2016. However, we note ETP’s assets are overwhelmingly fee based (we estimate 85% to 90%+ expected 2015 margin).

What Merrill Lynch is trying to do in its report is focus on a longer-term value story, where its outlook underappreciated despite near-term volatility. Energy Transfer’s growth backlog is said to support meaningful distributable cash flow accretion in 2017 and beyond. The team also thinks that the current market expectations may be overestimating the MLP’s real funding needs.

While Merrill Lynch lowered Energy Transfer’s price objective, this was a mere trimming of a target versus other cuts and was based upon a weaker sector valuation theme. It was also based upon a target forward distribution rate of 7.25%. The report said:

We see yield compression at ETP from one of the highest yields among large-cap peers given ETP’s sustained rate of distribution growth. The completed RGP merger may be a headwind for the short-term given increased commodity exposure. However, we think ETP’s robust growth backlog and multiple avenues to unlock liquidity in its SXL/SUN stakes will support out positive outlook.

The Merrill Lynch view was based upon a unit price of $48.32, but the units were down 1.6% at $48.36 shortly before the close. Energy Transfer Partners has a consensus price target closer to $63.00 and a 52-week range of $41.00 to $69.66.

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By Jon C. Ogg