Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Kelcy Warren, the founder of Energy Transfer Partners, told Bloomberg Markets last summer that he made most of his wealth during the industry's "dark times." Luckily for him, his company's latest round of fund-raising should help him preserve his wealth. Ordinary investors may not be so fortunate.

I wrote here on Thursday about Energy Transfer's issue of convertible preferred units, which came with an unusual twist. Rather than pay for the converts upfront, the buyers agreed to forgo a portion of the dividend on their common units for up to nine quarters, after which the new securities convert into common equity. That way, Energy Transfer gets to conserve some cash when it needs it most, as it is on the hook to complete a multi-billion-dollar acquisition of Williams Cos. amid the energy industry's worst downturn in a generation.

Down the Pipe
Energy Transfer's shares have tumbled amid the slump in energy prices and questions about its purchase of Williams.
Source: Bloomberg

According to Energy Transfer's filing with the SEC, it had originally intended to offer the converts to all of its unit holders, but was apparently blocked by Williams. Thus, only "accredited investors" holding 31.5 percent of the company took the converts in a private placement. Warren's own stake of 18 percent, worth about $1.4 billion when the offer closed, represents more than half of that.

On the face of it, while convoluted, this looks like a case of the chairman and some other big investors taking the hit in the near term to help get Energy Transfer out of a tight spot. Yet the balance of risk and reward, along with the relatively small amount of money it will raise, should be a red flag for the company's regular investors.

Start with the money. Assuming the current level of dividends is maintained, Energy Transfer will get to retain about $518 million it would otherwise have had to pay out over the nine quarters.

Not to be sniffed at, obviously, but it really gets overshadowed by this number: $6 billion. That is the loan Energy Transfer has to take on to fund the cash portion of its buyout of Williams. This check, above all else, is the black hole sitting at the center of this deal.

Given the number of entities involved in structuring the merger -- six, including the acquisition vehicle --getting a clear idea of the pro forma leverage of the resulting entity is fiendishly difficult. However, this line from a report published last month by Andrew DeVries at CreditSights gives a flavor of the analysis out there:

This deal will take [Energy Transfer's] leverage right up to the brink of its current agency ratings with only future growth and the $400 million cost synergies giving the company a tiny amount of wiggle room. 

Both UBS and Wells Fargo have issued reports with detailed pro-forma models for the group in the past few weeks. Both are sprinkled liberally with the phrase "distribution cut"-- a four-letter word in MLP circles --concluding in most scenarios that this will be necessary in order to keep debt below the critical threshold of 6 times distributable cash flow. UBS calculates that Energy Transfer's parent debt will rise to north of $18 billion, 6.3 times its 2016 distributable cash flow. The annual savings from deferring $231 million of dividend payments won't move the needle much on that.

What would move the needle quite a bit more is a straight dividend cut. Once the deal with Williams closes, the number of units and shares on which Energy transfer has to pay a dividend will rise to almost 2.2 billion. At the current dividend, that is an annual cash outflow of $2.5 billion. It doesn't take a genius to see that cutting the payout offers the fastest route to paying down that $6 billion bridge loan and staying in the good graces of the credit rating agencies.

This is where those convertible preferreds come in.

While they don't save a huge amount of money for Energy Transfer, they offer the select investors who got them protection against a dividend cut on the common equity. That is because each penny of foregone dividend over the next, critical two years or so gets made up at the back end with extra common equity when the preferreds convert. Indeed, cut the distributions to zero, and they still get made whole:

Stop Loss
Dividends foregone on Energy Transfer's new convertible preferred units get made up with extra equity at the end.
Source: Company filing, Bloomberg Gadfly analysis
Dividend cuts assumed to happen after the fourth quarter of the preferred's nine-quarter span.

Meantime, depending on the severity, a dividend cut could leave regular shareholders with a capital loss as well as declines in the value of the units, which would trade down in the market to reflect the lower payout.

It is perhaps bad enough for Energy Transfer's common unitholders to see a new class of preferred investors like this get created at this time. The only way the preferred investors would lose out relative to their regular counterparts would be if dividend payments went up during the nine months. To say that is an unlikely scenario would be an understatement. Indeed, this new paper effectively acts as an insurance policy for the chairman and some other investors in the event of a dividend cut, which may actually act as an incentive to do it in order to preserve the value of Energy Transfer over the long term. That's speculation, as there is no way of knowing exactly what the motivation was; Energy Transfer's spokesperson declined several requests for comment.

For Energy Transfer's regular investors, the one, thin ray of hope here is that this latest thickening of the plot provides shareholders in Williams a reason to vote against the deal. While the latter might be reluctant to walk away from $6 billion of cash, they must also reflect on the fact that their new shares would leave them owning roughly half of an entity that, apart from this latest move, has already jettisoned its chief financial officer amid the current turmoil. Judging by the widening discount of Williams' stock to the implied offer price, maybe they are having second thoughts.

You Really Want This Deal?
Williams stock price is trading at a discount to the implied offer price.
Source: Bloomberg, company announcements

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net