There is no question that Energy Transfer (NYSE:ET) remains the cheapest large-cap midstream play by nearly every measure. I know it, you know it, the market knows it. Ironically enough, that is the problem looking out into next year. Fresh capital that is currently sitting on the sidelines will patiently wait for catalysts to deploy new money into the name; clear structural discounts do not go away on their own. Why does this persistent “cheapness” persist? In my view, it is present for one reason: a management team that favors growth spending over capital returns. While that in itself might not be negative, when a firm has a tendency to have as many frequent missteps on project execution as Energy Transfer has had (Dakota Access Pipeline (“DAPL”), Rover, Mariner East) concurrent with a lackluster reputation on corporate governance (Energy Transfer Equity / Energy Transfer Partners merger, failed Williams' (WMB) merger shenanigans), the vast majority of the float of ownership would prefer to get paid more in cash today rather than trust their money with Kelcy Warren into the future. Heading into the end of 2019, there were four major catalysts that could have brightened the outlook for 2020. Unfortunately, all four are either disrupted or have lost their luster. While this might change, there is no question that a little bit of the speculative value has been taken off Energy Transfer heading into the new year. Will the strict valuation discount be enough to make it a top performer? Time will tell. I remain an owner but had higher hopes on a few aspects of the business a few months ago.
As an owner of SemGroup (SEMG) prior to the acquisition news, I outlined the positives of the deal (“Energy Transfer Buys SemGroup In High Value Transaction”) and how Energy Transfer was not alone in its acquisitive interest (“Energy Transfer Revealed Not To Be Sole SemGroup Bidder”). Despite the small relative size of the purchase and the lack of leverage impact, the market has not necessarily been as optimistic as I have been. My opinion that this was an opportunistic and necessary purchase runs counter to retail consensus. Instead, mainstream opinion has been that this was just another example of Energy Transfer flip-flopping, buying more growth after promising to delever and nurture its existing assets. While most were not outright bearish, some among the analyst community have at least taken a sanguine view on the bad optics, hoping that an Energy Transfer purchase might mean SemGroup gets picked apart a bit to create value. In other words, the clear prize of the purchase, the Houston Fuel Oil Terminal, would be kept by Energy Transfer and other assets sold to reduce the cost of the deal. I understand the logic. While I think the DJ Basin assets (White Cliffs, Wattenburg Oil Trunkline, Platteville) make sense for Energy Transfer to continue to hold just from a diversification perspective, the Canadian assets in particular made a lot of sense as a divestiture target. After all, the firm has no meaningful Canadian presence, nor has it ever expressed much interest in expanding up north. However, management has made it clear that it plans to stick with the SemGroup plan: continue with the joint venture partnership with private equity firm KKR (KKR) with an eventual timetable for an initial public offering (“IPO”) in about two years - assuming there is interest. That long timetable and fuzzy outlook means the market remains skeptical on the value-add stemming from this acquisition.
Investors have heard nothing but crickets on the potential sale of Rover, a major pipeline carrying Appalachian natural gas to customers in the Midwest. Plagued with delays, fines, and construction missteps, Energy Transfer had already tapped monetizing its stake in Rover once before, selling a minority stake in the holding company to Blackstone (BX) for $1,570 million. With rumors first emerging that the midstream giant might sell out completely coming out in the weeks preceding the SemGroup deal, my hope was that this was a prime example of smart capital allocation by Kelcy Warren: sell the remaining interest in Rover for a hefty multiple (>13x EBITDA) and rotate that capital into SemGroup at a cheaper multiple. That is a no-brainer capital allocation policy assuming substantially similar asset quality. Besides the potential positive timing in that regard, I’ve long pushed for a Rover sale for other reasons. The added bonus here would be that Rover is a big contributor to the wonky financial reporting at Energy Transfer, creating a massive bridge between consolidated and proportionate earnings and debt. A sale would lead to cleaner and more palatable results quarter to quarter.
The last we heard on this was that Italian midstream player Snam (OTCPK:SNMRY) - the largest gas pipeline operator in Europe - was preparing a bid. Given we are now a little over two months past that date, I would imagine that any sale, if there has been one in the works, would likely be announced before year end. The clock is ticking on this one.
Focus within midstream has shifted. Long gone are the days where strict distributable cash flow (“DCF”) yields hold the highest importance among large investors. Instead, these buyers want to see conservatively run operations: distributable cash flow covering both distributions to shareholders and growth capital expenditures. It is a lofty goal, but one that a handful of companies (e.g., Kinder Morgan (KMI)) will achieve next year. While this might seem like a funny trend to have occur in a sector first built to pay out all of free cash flow and no retention, this push is reflective of the current business environment in midstream characterized by fewer project opportunities, tightening capital markets, and a business-unfriendly regulatory environment.
What I think was unfortunate in the Energy Transfer guide is that the Street was looking for $3,500 million or less in 2020 spend. Management did essentially deliver just that in their most recent $4,000 million 2020 outlook... if market observers back out the pushed forward capital expenditures from 2019 (Source: Energy Transfer, November 2019 Investor Presentation, Slide 5). While that might not make a difference in actual dollars spent, the push reduces the rate of change year over year.
This has become a 2021 story. As spend from upcoming projects like the Mariner East system completion, Nederland LPG, and other projects winds down, there is a gaping hole in the 2021 and forward growth projects. While currently uncommitted yet planned projects (VLCC export terminal, LNG terminal) will certainly boost that, management has emphasized that its hurdle rate for capital investment has moved up significantly as it tries to be more discerning. The market is still in the “show me” stage when it comes to Energy Transfer showing that it can bring large projects into service on time and on budget.
In mid-November, the FBI announced it had begun a corruption investigation into Pennsylvania Governor Tim Wolf’s administration, looking into the process of how it approved permits for the construction of Mariner East, a key Energy Transfer project. As the focus of this investigation revolves around permitting and whether senior officials forced environmental protection staff to approve permits, the unstated implication is that there is the possibility that bribery was involved. The company stated it had not been contacted by the FBI and that it was unaware of the investigation, but unfortunately, that had done little to assuage fears. Coupled with open investigations from county and state prosecutors, Mariner East has clearly become yet another albatross for Energy Transfer to bear.
Many investors have long since noticed the uncanny correlation between high-profile pipeline lawsuits and Energy Transfer's involvement. According to records, Energy Transfer has racked up $500 million in penalties since 2000; peers like Enterprise Product Partners (EPD), MPLX (MPLX), and Plains All American (PAA) have racked up a fraction of the fines in both number of occurrences and total penalty value. Simply put, many are taking the view that where there is smoke, there is fire. While I think many come to the conclusion - and sometimes rightly so - that safety and environmental violations are sometimes too strict or used as a political tool, the entirety of the midstream universe should be impacted in the exact same way proportionately. For institutional investors that pay much closer attention to the long-term track record like this in order to avoid risk - they often cannot unwind positions quickly in response to major bad news - the permitting and safety record remains a major concern. This investigation could not have come at a worse time, even if it does not result in any actual finding of cause when it comes to wrongdoing.
Energy Transfer remains a great value, and the distribution is remarkably well-covered. In my opinion, the structural discount that persists in the company is far too wide, and investors that buy units today and hold for the long term are highly unlikely to be disappointed. Nonetheless, it is hard to see why a re-rate of the company to higher multiples will occur in 2020 versus 2019 unless new potential catalysts emerge.
As a more recent unitholder, recent news flow has been a touch disappointing, and I've not been too surprised at the sell-off given what we have seen. I think the positives outweigh the negatives on balance, and there are clear signs that management is at least cognizant and aware of what the market is looking for and is responding in kind. Hopefully, that continues and owners see some of the bad news fade into the back half of next year.
Are you an investor looking for sustainable high income? The energy sector is filled with opportunities to do just that. At Energy Income Authority, the focus is on finding high quality companies with the asset footprints necessary to throw off dividends for years to come.
Tired of lackluster coverage that barely breaks the surface? Deep dive analysis forms the cornerstone of the platform. Hundreds of companies fall under the coverage universe, from pipelines to refiners to the producers themselves. Members receive actionable research to keep their portfolio thriving.
Sign up for a NO OBLIGATION FREE TRIAL today to find out more.
This article was written by
I have a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, I am a full-time investor and "independent analyst for hire" here on Seeking Alpha.
Disclosure: I am/we are long MPLX, ET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.