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By Matthew Coffina, CFA | 11-11-2014 03:00 PM

Reasons to Be Cautious on Midstream MLPs

After his recent sale of Energy Transfer Equity, StockInvestor editor Matt Coffina says investors should consider more conservative MLPs whose current valuations are less dependent on future growth.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Matt Coffina. He is the editor of Morningstar StockInvestor newsletter. He recently sold Energy Transfer Equity (ETE) out of his portfolio. We're here to talk about why. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk about the sale. Why did you decide and what were some of the factors behind your decision to sell ETE?

Coffina: Energy Transfer has been a great holding for the Hare [portfolio]. We more than tripled our money. It was about a three-and-a-half-bagger if you include dividends, since we purchased the units in late 2010. So, it's been a very successful holding for us for a number of years, but what concerns me right now about Energy Transfer is just the valuation.

When we first bought the company, it had about a 5.5% yield. Now, the yield is below 2.7%, as of my sale. We don't often talk about price/earnings ratios when discussing master limited partnerships, but if we use distributable cash flow as our measure of earnings--and that's arguably an aggressive assumption already--but using distributable cash flow, ETE is trading at about 35 times current earnings. So, that's definitely a growth company kind of multiple. And investors, I think, are baking in some pretty optimistic assumptions for future growth.

On the one hand, we think that those are justified; our analyst expects ETE to be able to raise its distribution about 20% a year over the next five years. But we also need to look forward beyond that and say, "What is this company going to look like, say, five years from now?" And in that case, I think the growth is going to slow dramatically. There's no getting around it.

First of all, ETE will be a much larger company than it is now, and it's always harder to grow off a larger base. There are some temporary effects over the next five years. For example, they waived some of their incentive distribution rights from their limited partners, and those waivers will be rolling off over the next five years and that won't be continuing indefinitely. But perhaps most importantly, Energy Transfer is really benefiting from the domestic energy boom where the innovations in shale drilling have really changed the landscape for transporting oil and natural gas and related products around the country--natural gas and oil both coming from different areas than they had historically and they need to go to different areas.

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