Energy Transfer: A Good Place For New Money With Its 7.77% Yield

Summary

• Energy Transfer is one of the largest and most well known midstream partnerships in the United States.
• The company will add approximately $1 billion in cash flow from the Enable Midstream acquisition.
• The future for the industry is bright as demand for energy grows globally, resulting in climbing volumes.
• The company broke its streak last year by cutting the distribution but it did not actually need to as the distribution is extremely well covered.
• The company looks like a good place to park some money today and earn a 7.77% yield.
• Looking for more investing ideas like this one? Get them exclusively at Energy Profits in Dividends. Learn More »

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Energy Transfer LP (NYSE:ET) is one of the largest and most well-known midstream partnerships in the United States. The company has long been a favorite of income investors due to its historically high distribution yield, although the company earned the ire of investors last year when it joined the ranks of those midstream companies that reduced their distributions due to the uncertainty surrounding the pandemic. With that said though, there are still some reasons to be confident in the future of the company and it could be an attractive way to earn a 7.77% yield as the growth story plays out.

About Energy Transfer

As mentioned in the introduction, Energy Transfer is one of the largest midstream companies in the United States. The company owns a network of pipelines, storage infrastructure, and shipping terminals that spreads across much of the country:

Source: Energy Transfer

One of the advantages that this infrastructure provides the company with is exposure to every major basin in which hydrocarbon resources are produced. This is nice because each of these basins has somewhat different fundamentals. For example, upstream producers typically target areas like the Bakken shale for the production of crude oil whereas a basin like the Marcellus is targeted for the production of natural gas. This provides a certain amount of diversity that helps to protect Energy Transfer against events such as what we saw last year where crude oil prices and production plunged but natural gas held up much better. The fact that Energy Transfer has exposure to both could thus improve the company’s ability to weather through such situations.

The fall in crude oil prices last year caused the market price of the companies in the midstream sector to decline. Energy Transfer was certainly not spared from this. However, these companies are generally insulated against commodity price fluctuations due to the business model that they use. Basically, Energy Transfer charges a fee to its customer for each unit of liquids or natural gas that moves through its infrastructure. This is why these companies are sometimes equated to toll roads as they make their money based on volumes and not based on the value of the resources that are handled. The company performs these transportation services under long-term contracts, which should add a measure of security to the company. This is because these contracts should last through any short-term economic disruption, such as what we saw last year. While all of these things will improve the company’s ability to weather through economic or industry problems, there may be some readers that point out that several upstream companies reduced their production in response to the fall in oil prices, which could be expected to have an adverse impact on volumes. After all, lower production means that fewer resources need to be transported to the market. Fortunately, Energy Transfer has a way to protect itself against this too. The contracts that the company has with its customers contain what are called minimum volume commitments. These commitments specify a certain minimum quantity of resources that the customer has to send through Energy Transfer’s pipes or pay for anyway. Thus, this should help the company maintain its cash flows through any broader industry problems. Fully 95% of Energy Transfer’s cash flows come from these contracts, which is one of the highest percentages in the entire midstream industry:

Source: Energy Transfer

Energy Transfer is fairly well diversified among the various different types of products that it carries. With that said though, it is somewhat more weighted towards natural gas than it is towards crude oil:

Source: Energy Transfer

As I mentioned earlier, the demand for natural gas held up somewhat better than the demand for either crude oil or refined products following the outbreak of the pandemic. This does make a certain amount of sense since the lockdowns greatly reduced the demand for transportation and transportation is the primary use for crude oil and refined products. People in lockdown still needed to heat their homes and cook their food, which helped to maintain the demand for natural gas. Thus, the fact that natural gas accounts for a larger portion of the company’s cash flows than any other product likely helped it weather through the worst of the effects of the pandemic. This could also provide Energy Transfer with some significant growth potential, as we will see in just a moment.

Back in mid-February, Energy Transfer announced the acquisition of Enable Midstream (ENBL) for approximately $7.2 billion. Under the terms of this agreement, unitholders of Enable Midstream will receive 0.8595 units of Energy Transfer for each unit of Enable Midstream. I have discussed Enable Midstream and its significant potential in the past and this potential should carry over to Energy Transfer through this acquisition. Enable Midstream has a substantial presence in the Bakken, the Mid-Continent, and the Ark-La-Tex basins, which are all areas in which Energy Transfer’s presence is a bit light:

Source: Energy Transfer

The acquisition will thus significantly increase Energy Transfer’s footprint in these areas. In addition, this infrastructure will connect quite well to Energy Transfer’s existing infrastructure, which could prove to be an advantage. This is because Energy Transfer will be able to transport the resources away from the basins and to the coasts where they can be exported without needing to hand the resources off to another midstream company. This is something that may be appealing to Energy Transfer’s customers and thus might help the company in contract negotiations.

As might be expected, the acquisition will also have a positive impact on Energy Transfer’s cash flows. The company stated that the purchase price would result in a 6.9x EBITDA multiple. That means that this acquisition should increase Energy Transfer’s annual EBITDA by approximately $1.04 billion. The actual increase might be a bit more than this, though. That is because Enable Midstream has some corporate functions that are duplicates of the functions that Energy Transfer has. For example, both companies have a human resources department or an accounting department. There is no reason why the combined firm could not eliminate some of these duplicate functions, which would save money and thus boost the company’s cash flows further. Energy Transfer estimates that the elimination of these unneeded functions would save about $100 million annually, which would ultimately flow down to the bottom line. Thus, we can clearly see that this acquisition should prove to be quite a shrewd move on the part of Energy Transfer and it should ultimately benefit the company’s unitholders.

Midstream Fundamentals

The long-term fundamentals for midstream companies like Energy Transfer are quite positive. This is especially true for natural gas-transporting companies, which includes Energy Transfer as we have just seen. This is partly due to the specter of climate change. Fears of this have caused governments all over the world to take various measures that are intended to reduce the carbon emissions of their respective nations. One of the methods that is being used to accomplish this is to convert old coal-fired power plants to natural gas-fired ones. This is because natural gas burns much cleaner than coal does. According to the International Energy Agency, this trend will cause the global demand for natural gas to increase by 27% over the next twenty years:

Source: International Energy Agency, Pembina Pipeline (PBA)

Energy Transfer does not actually produce natural gas so it directly will not benefit from this but the company will still be able to deliver cash flow growth as a result of it. This is because the United States is one of the only areas on the planet that has the ability to increase its production of natural gas in order to meet this demand growth due to the wealth of regions like the Permian Basin and the Marcellus shale. Energy Transfer is quite well-positioned to move these newly produced resources from the basins where they are extracted from the ground to the market. As the company makes its money off of volumes as already discussed, these higher volumes should drive forward growth for the company.

Distribution Analysis

One of the biggest reasons why investors purchase units in midstream partnerships like Energy Transfer is that these companies tend to have much higher yields than anything else on the market. Energy Transfer is no exception to this as the company currently pays a quarterly distribution of $0.1525 per common unit ($0.61 per unit annually), which gives the company a 7.77% yield at the current price. Unfortunately, the company broke its streak of steady to rising distributions back at the end of 2020, which earned the ire of many investors:

Source: Seeking Alpha

As might be expected, the distribution cut had a devastating effect on the company’s unit price, although the market did anticipate it earlier in the year so most of the damage was already done by the time of the announcement. We should investigate the company’s ability to maintain the distribution at this new level though as we do not want to be the victims of another distribution cut that further reduces our income. The usual way that we do this is by looking at a metric known as the distributable cash flow. This is a non-GAAP metric that theoretically tells us the amount of money that was generated by the company’s ordinary operations that is available to be distributed to the unitholders. In the fourth quarter of 2020, Energy Transfer reported a distributable cash flow of $1.353 billion attributable to its own limited partners. This was enough to give the company a distribution coverage ratio of 3.30x. As a general rule, analysts consider anything over 1.20x to be sustainable but I am somewhat more conservative and prefer to see this ratio about 1.30x to add a margin of safety to the position. As we can see, Energy Transfer easily meets both of these requirements, and when we consider the company’s overall relatively steady cash flows we can see that it should easily be able to maintain this distribution going forward. Of course, as I pointed out in a previous article, Energy Transfer technically was having no trouble maintaining the distribution prior to the cut so we still might see a distribution reduction but I highly doubt that management will reduce the distribution again, especially when we consider their historical dedication to it (late 2020 notwithstanding).

Conclusion

In conclusion, Energy Transfer remains very well positioned in the nation’s midstream industry. This positions it quite well for forward growth as the demand for energy globally is only likely to increase and this should result in more volumes flowing through the company’s pipes. The acquisition of Enable Midstream will only increase this potential along with adding approximately $1 billion worth of cash flow to Energy Transfer. This should further strengthen the coverage of the distribution, which the company is having no trouble maintaining. The company currently looks like an attractive way to grab a 7.77% yield.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.