Energy Transfer Debt, Leverage, Downgrade, And Distributions

Summary

• In this article, we'll investigate Energy Transfer's debt and leverage, then look at these metrics through the lens I believe a key rating agency sees it.
• Solid 1Q 2020 DCF distribution coverage isn't the key operative, it's the "negative outlook" offered by S&P Global.
• We will look to check the data, handicap the situation, identify the risks, and consider the remedies.
• The Street is saying the current 14.7% cash distribution yield is toast, but after reviewing the pertinent info, this may not be a foregone conclusion.

Editor's note: This article was amended on 6/4/2020 to reflect minor adjustments to the text and a clarification on the EBITDA figure provided by management.

The issue of Energy Transfer's (NYSE:ET) significant debt, leverage and outsized distribution is an old topic. Recently, an S&P Global investment grade credit affirmation, but including a negative outlook has entered the fray.

Therefore, it's time to roll up our sleeves and try to unpack the situation to see how it impacts us LP investors.

In this article we will detail:

• Parent/subsidiary debt and other liabilities

• Debt-to-EBITDA leverage ratio calculations/methodology

• S&P “negative outlook” implications

• Potential remedies and impact upon the cash distribution

Financial data sources include Energy Transfer SEC filings and website investor reports.

Energy Transfer Debt

As of March 31, 2020, the company recorded $50.3 billion of long-term debt. Current maturities of long-term debt were negligible.

Since the beginning of 2020, management reduced total debt by ~$0.7 billion.

Energy Transfer Debt

	1Q 2020	YE 2019	YE 2018
Total Debt ($B)	50.3	51.0	46.1

Click to enlarge

The following table highlights the Energy Transfer parent/subsidiary debt pile:

source: Energy Transfer 1Q 2020 10-Q

For information, total operating lease liabilities total $0.87 billion. While not considered “debt” in the traditional sense, such liabilities impact the business in a comparable fashion. We will consider operating leases in the next section.

Recent Developments

In January, Energy Transfer completed a $4.5 billion Senior Notes offering. In conjunction with this activity, the company paid off six old debt issuances coming due later in 2020. The bonds/rates on the new debt was:

• $1.0 billion debt at 2.90% due in 2025

• $1.5 billion debt at 3.75% due in 2030

• $2.0 billion debt at 5.00% due in 2050

The retired debt had coupons between 4.15% and 7.5%, coming due between February and October of this year.

Aligned with the January bond offering, Energy Transfer placed $1.6 billion of preferred stock (Series F and Series G) yielding at par 6.75% and 7.125%, respectively.

On the 1Q 2020 conference call, CEO Tom Long summarized the situation, including a comment on future debt stack repayment and liquidity:

...in January we completed dual offerings of debt and perpetual preferred in the aggregate amount of $6.1 billion. A portion of the proceeds from these offerings were used to reading all of our 2020 maturities with the remainder used to pay down short-term borrowings on our credit facility. We had a strong liquidity position of approximately $4 billion at the end of the first quarter. Additionally, we have a very manageable $1.4 billion of maturities in 2021.

Observations

On the plus side, over the past year, Energy Transfer reduced total debt. Unfortunately, we will find this is by no means a silver bullet. Swapping higher-interest rate bonds for long term, lower-rate issues was another positive development, but alone it did not carry the day, either.

The utilization of preferred stock has enabled management to avoid issuing additional debt or fresh equity carrying a huge cash dividend. The coupon on preferred stock is considerably lower than the current common unit equity yield, but higher than traditional bond debt.

Key Metric: Leverage Ratios

Midstream investors should not become too focused upon total debt. The banks and credit rating agencies really look at leverage ratios. Typically, these ratios look at debt as a function of EBITDA. Organizations calculate the ratios differently. Investors should note there are nuances, some significant, associated with leverage computations. These include:

• Total debt may be reduced by cash on hand, thereby creating net debt. Furthermore, debt as defined by the credit rating agencies, often includes additional adjustments.

• Energy Transfer management utilizes preferred stock: a hybrid debt/equity vehicle. The rating agencies consider preferred stock 50 percent debt and 50 percent equity. Therefore, the debt component of the preferred stock should be included in a debt calculation.

• Operating lease liabilities may be considered debt. Long-term operating leases impact a company similarly to debt.

• EBITDA is adjusted like a pretzel by the banks and rating agencies. Generally, these adjustments do not follow Energy Transfer's “adjusted EBITDA” figures. The banks and rating agencies may all calculate EBITDA using different methodologies.

Confused? Let's try to cobble a practical, actionable model.

Credit Ratings Are As Strong As the Weakest Link

A recent release by S&P should color investors' thinking. On May 12, the S&P maintained Energy Transfer's BBB- rating, but indicated a “negative outlook.” In the release, the agency forecast 2020 leverage to be in the range of 5.5x, then falling to ~5.0x in 2021.

The S&P tends to be more conservative than other rating agencies. Nonetheless, “a chain is only as strong as its weakest link.” As investors, we need to try to understand how S&P is thinking about Energy Transfer's debt and leverage. A credit downgrade below BBB- would be a big deal to Energy Transfer.

Calculating Leverage: Debt Is The Numerator

“Straight” debt off the financial statements is $50.3 billion. If we add long-term operating lease liabilities, the total debt benchmark rises to $51.2 billion.

Adjustments

Banks and rating agencies include various puts and takes. On the 1Q 2020 conference call and associated 10-Q report, we know Energy Transfer remains in compliance with all bank debt covenants.

However, overarching is S&P and its “negative outlook.” So we need to hone in on that.

Here's what I believe approximates the S&P debt model. On balance, it's a 'cash EBITDA' methodology:

• Include operating lease liabilities to total debt for a $51.2 billion starting point.

• Preferred stock is considered 50 percent debt. Add $2.4 billion debt to account for total preferred stock issues totaling $4.7 billion.

• DAPL (Dakota Access Pipe Line) is 36% owned by Energy Transfer, yet the entire $2.5 billion debt is consolidated on the ET balance sheet. Therefore, subtract the $2.5 billion DAPL debt, then add back $0.9 billion to reflect Energy Transfer's 36% interest.

• Subtract $1.9 billion debt attributed to USAC (a non-controlled, stand-alone entity)

• Subtract $3.7 billion debt attributed to Sunoco LP (SUN) (a non-controlled, standalone entity)

Doing the arithmetic, I believe the S&P views 2020 “adjusted” debt to be $51.2 billion less $4.8 billion adjustments = $46.4 billion.

Calculating Leverage: EBITDA Is The Denominator

Like debt, EBITDA may be thought about in various ways.

Using GAAP financials, “straight” ttm EBITDA (EBIT plus depreciation and amortization) = $8.72 billion.

In the 1Q 2020 earnings press release, Energy Transfer management guided for 2020 adjusted EBITDA between $10.8 billion and $10.6 billion.

Note to readers: I believe Energy Transfer will have to guide 2020 EBITDA down. 1Q 2020 management adjusted EBITDA was $2.64 billion. It stands to reason 2Q 2020 results will be worse than the first quarter. I'd be surprised if ET can make current guidance.

Conservatively, I believe Energy Transfer can generate ~$10 billion EBITDA in 2020.

Adjustments

Using the same general S&P principles for calculating debt, here's my estimate for S&P “adjusted” EBITDA:

• Starting baseline EBITDA is 10.0 billion (my 2020 estimate, perhaps shared by S&P) versus management's $10.7 billion midpoint.

• Subtract $1.0 billion EBITDA for DAPL, add back $0.36 billion EBITDA to reflect Energy Transfer's 36% ownership interest.

• Subtract $0.7 billion EBITDA for Sunoco LP, add back expected $0.17 billion SUN cash distributions to ET

• Subtract $0.4 billion EBITDA for USAC, add back $0.09 billion expected USAC cash distributions to ET

The bottom line suggests 2020 adjusted EBITDA will be a $10.0 billion baseline less $1.5 billion adjustments = $8.5 billion.

The Rubber Hits The Road

Now for the punchline.

“Straight” debt-to-EBITDA leverage is 5.0x [50.3 / 10]

Estimated S&P “adjusted” leverage is 5.5x [46.4 / 8.5] NOTE TO READERS: This matches S&P's release indicating the firm expects Energy Transfer's 2020 leverage to be in the range of 5.5x. I believe this figure is what counts. ET management must work from it.

For info, if we accept Energy Transfer management's current $10.7 midpoint guidance, then make the aforementioned S&P adjustments, the leverage ratio falls to 5.0x [46.4 / 9.3]

S&P Leverage Calculation/Credit Rating Implications

A credit downgrade is a big deal to Energy Transfer. Indeed, management has run the ragged edge for years; juggling debt, leverage, growth projects, and the distribution... all the while defending the investment grade rating. A downgrade, even by just one agency, is likely to tip over the apple cart. So we have to presume Energy Transfer leadership is highly focused upon the issue and will continue to defend a BBB- credit rating. Hence, S&P Global now controls the narrative.

How To Interpret An S&P “Negative Outlook”

I don't believe a credit downgrade is imminent. S&P doesn't operate that way. No, S&P is signaling ET management the need to get ahead of the debt and leverage issue now: show progress and action.

They're telling management a 5.5x ratio is too high. Leverage must come down, and in accordance with S&P's internal methodology and adjustments. However, by stating its expectations, 2021 leverage should fall to about 5.0x, the S&P is putting a "soft" stake in the ground. The S&P is saying Energy Transfer management has 12 to 18 months to get on top of matters and drive leverage down towards the 5x bogey. If so, the negative outlook comes off, and the investment grade credit rating stays in place.

Furthermore, I don't see a 5.0x leverage ratio as a line in the sand; this what I meant by the aforementioned "soft" stake comment. The agency expects to see clear, demonstrable, and significant progress heading into 2021. If management does the right things, and updated 2021 leverage is projected to fall to a low 5x level, I contend Energy Transfer will be fine. A 20 or 30 bps miss, but solid progress is acceptable. A positive line-of-sight towards 2022 could further bolster the case.

Can Energy Transfer Do It? What About The Cash Distribution?

To meet objectives, management has five potential levers to pull:

1. Cut capex and/or opex

2. Grow EBITDA

3. Sell assets

4. Reduce debt

5. Cut the cash distribution

We know management's already yanking the first lever, cut capex/opex. From the 1Q 2020 earnings conference call:

CFO Tom Long

...we have identified and are executing on significant cost-cutting initiatives both in our corporate offices as well as our field operations. As a result, we expect to save $200 million to $250 million relative to our 2020 budget. We have also further reviewed our growth capital expenditures for 2020 including project spend today, completion date, economic impact on delaying particular projects, and near-term cash flows.

Approximately 70% of the growth capital spend in 2020 will be spent on projects that are 60% or more complete and are expected to be in service in 2020 or early 2021. This includes Mariner East, the Lone Star Express expansion, and the Orbit and other LPG export projects at Nederland. However, we have decided to delay some projects including Frac VIII and select Canadian projects, as well as change the scope of the Ted Collins pipeline.

Based on our outlook for the current market, we are reducing our 2020 growth capital expenditures by at least $400 million to $3.6 billion and we are evaluating another $300 million to $400 million for potential reduction this year. Although we anticipate growing the business over the next several years and we are continually evaluating new opportunities given our asset footprint, we view it is unlikely we will add any major organic growth projects to our backlog for 2021.

Grow EBITDA is tougher. Presuming oil patch conditions improve, EBITDA is likely to build. However, Energy Transfer management cannot control commodity prices. IMHO, if WTI oil prices can climb to just $40, and hang around that range, the company may see modest 2021 EBITDA improvement, but I doubt current 2020 guidance will be met without a bigger bump. Of course, higher oil prices mean even better performance.

Asset sales are another option; however, the current environment doesn't offer much in the way of receipt of asset value. I wish Energy Transfer management offloaded Rover last year, but that didn't happen. Maybe Energy Transfer can generate a few bucks by peddling non-core SemGroup assets.

Under the immediate conditions, this option doesn't have a lot going for it, but it could shave a little around the edges.

Reduce debt is possible, though I don't envision much in the way of a straight debt paydown. A more likely scenario is debt retirement refinanced by issuing preferred stock. On one hand, the cost to uphold preferred stock dividends is higher than traditional debt service; on the other hand, the rating agencies consider preferred stock only 50 percent debt. Energy Transfer distributable cash flow is good, so this option is plausible.

Which leads us to the last option: cut the distribution. I suspect this option is at the bottom of management's hit list. Nonetheless, ET investors must handicap scenarios, watch the fundamentals and the tape, premise the future, then consider the possibility.

What Events May Be A Precursor To A Distribution Cut?

Well, if Energy Transfer makes good on its current 2020 EBITDA forecast, this option is most likely off the table. (But I don't think that's a probable outcome).

However, I contend if Energy Transfer can simply meet the expected S&P debt/EBITDA/leverage model parameters ($10 billion EBITDA, $8.5 adjusted), the distribution stays safe.

Derailing factors include: 1) oil prices slip back below $30, 2) domestic energy demand stays soft, with no 2H 2020 uplift, or 3) renewed global oil oversupply, thereby disrupting domestic producers. In any or all of these cases, all bets are off.

Certainly, a 2020 COVID-19 resurgence or renewed energy commodity price war could flip the tables. On the other hand, a constructive, orderly domestic economic recovery and a reasonable global oil supply/demand scenario would be a tonic that refreshes.

Being an optimist, I remain long ET. Over the years, management has dodged many a boogeyman. I think they've got another juke or two in 'em.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2020 investments.

Analyst’s Disclosure: I am/we are long 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.