Determining Whether Energy Transfer Will Continue Raising Its Distribution

Summary

• ET recently declared a $0.305 quarterly distribution, thereby achieving its long-advertised goal of restoring the distribution to its pre-cut level.
• While the market has been rewarding ET for sticking to its word since cutting the distribution back in 2020, it remains deeply discounted relative to peers.
• We believe this is largely because Mr. Market remains highly suspicious of management's capital allocation strategy after achieving its leverage and distribution targets.
• We take a peak at what management's capital allocation plan may be moving forward, including whether or not they are likely to continue raising the distribution.
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Baris-Ozer

Energy Transfer (NYSE:ET) recently declared a $0.305 quarterly distribution, thereby achieving its long-advertised goal of restoring the distribution to its pre-cut level. While the market has been rewarding ET for sticking to its word since cutting the distribution back in 2020, it remains deeply discounted relative to peers. We believe this is largely because Mr. Market remains highly suspicious of management's capital allocation strategy after achieving its leverage and distribution targets. In this article, we take a peek at what management's capital allocation plan may be moving forward, including whether or not they are likely to continue raising the distribution.

The 2020 Distribution Cut

ET slashed its distribution for the first time in 14 years by a whopping 50% in 2020 despite having very strong distributable cash flow coverage, a relatively stable cash flow profile, and an investment grade credit rating.

Why did they cut it, then? Due to a combination of poor balance sheet management (leveraging up with debt to help finance growth projects that ran into delays, regulatory and political headaches, and cost overruns), misfortune (leaky pipes and protests at its project sites), and a perfect storm of black swan events (the Saudi-Russian oil price war happening simultaneously with the COVID-19 lockdowns, effectively flooding the market with supply while demand was also being destroyed), ET's investment grade credit rating was at risk and - given the enormous uncertainty hanging over the energy industry at the time and its rapidly declining access to capital - management felt it prudent to accelerate deleveraging efforts.

They explained their strategy, stating back in October 2020:

The reduction of the distribution is a proactive decision to strategically accelerate debt reduction as we continue to focus on achieving our leverage target of 4 times to 4.5 times on a rating agency basis and a solid investment grade rating.

We expect that the distribution reduction will result in approximately $1.7 billion of additional cash flow on an annualized basis that will be directly used to pay down debt balances and maturities. This is a significant step in Energy Transfer’s plan to create more financial flexibility and lessen our cost of capital. Once we reach our leverage target, we are looking at returning additional capital to unitholders. This will come through unit buybacks and or distribution increases with the mix being dependent upon our analysis of market conditions at the time.

In so doing, they hoped to save the investment grade credit rating, put the business on a firmer long-term trajectory, and hopefully restore the distribution to its pre-cut level in the not-too-distant future. Since then, they have delivered exactly as promised, maintaining a maniacal focus on deleveraging the balance sheet and securing the investment grade credit rating (which they have achieved) while also aggressively restoring the distribution back to its pre-cut level.

Enter The "New" Energy Transfer

With management delivering exceptionally well on their stated goals back in late 2020 and achieving a much stronger balance sheet, there is a rapidly strengthening argument that ET now deserves to be valued more closely in line with investment grade MLP peers like MPLX (MPLX) and Enterprise Products Partners (EPD). Bulls argue that ET has changed significantly and for the better over the past few years:

1. Kelcy Warren is no longer the CEO. While he maintains his role as Executive Chairman of the Board of Directors and is also ET's largest unitholder, he is no longer running the business and allocating the capital on a daily basis. This certainly does not mean that he still cannot interfere and return ET to its old ways, but this somewhat symbolic move by the business is a signal to investors that the approach to business at ET has changed.
2. As already stated, ET has shown incredible discipline over the past several years, avoiding the temptation to spend big while aggressively deleveraging and increasing (restoring) unitholder capital returns with excess cash flow.

If this positive trajectory continues well into the future, ET certainly deserves to be valued on par with - or at least close to - the likes of MPLX and EPD.

Why Energy Transfer Remains Deeply Undervalued

Despite this immense progress and some recognition from Mr. Market since the announcement of the cut:

Data by YCharts

ET remains deeply discounted relative to peers. ET's EV/EBITDA multiple is just 7.85x while EPD's is 9.37x and MPLX's is 9.78x. Its discount looks even larger on a P/DCF multiple basis.

Is this discount really warranted and why does it persist? The short and simple of it is that while ET inflicted pain on its investors with the 50% haircut to the distribution in 2020, MPLX and EPD not only maintained, but continued to grow their distributions alongside unit repurchases through the market turmoil. Given that MLPs are largely viewed as income investments, trust in management to prioritize and protect the distribution throughout economic cycles often commands a valuation premium from investors. The midstream sector right now is a place where investors in general want to see a commitment to balance sheet health and maximized capital returns via distributions and buybacks rather than an aggressive focus on capital investments and acquisitions.

That poses a problem for ET's units because Mr. Warren remains interested in growing via acquisitions. Over the past few years - during ET's intense deleveraging phase - the following has been communicated to investors:

Kelcy Warren declared at an investment conference:

I want to buy someone...[energy companies] must consolidate if they're going to make it.

Management stated on a recent earnings call:

[We] expect our strong coverage and balance sheet strength to allow us to further prioritize growth within our capital allocation strategy...We also continue to evaluate opportunities in the petrochemical space, which would include developing a project along the Gulf Coast as well as potential M&A opportunities.

Kelcy [Warren] gave us the directive that we need to step in to petchem, we certainly are doing that...from an M&A perspective, anything that's for sale, we'll take a look at pretty much like anything in the industry

Clearly, ET has not forsaken their old DNA entirely, so the risk that management will overpay for an acquisition that fails to deliver is still very much there.

Will Management Continue Growing ET's Distribution?

With all of that said, ET is also very well positioned from a cash flow standpoint. Analysts expect it to cover its $1.22 annualized distribution rate by over two times with distributable cash flow this year and the recent $2.5 billion debt raise gives it plenty of liquidity to handle upcoming maturities this year. As a result, it should have some excess cash to play with, either for a major acquisition or to further increase capital returns to unitholders.

When it declared its latest distribution, management stated:

The distribution per unit is an approximate 75 percent increase over the fourth quarter of 2021 and is a 15 percent increase over the third quarter of 2022. This distribution increase represents another step in Energy Transfer’s plan to return additional value to unitholders while maintaining its target leverage ratio of 4.0x-4.5x debt-to-EBITDA. Future distributions will be evaluated, while balancing the partnership’s leverage target, growth opportunities and unit buy-backs.

The use of "another step" in that announcement indicates that ET does not consider itself finished with increasing capital returns to unitholders and also seemed to confirm that the business did indeed achieve its leverage ratio target of 4.0x - 4.5x by year-end. Management went on to say that "future distributions will be evaluated..." once again implying that growing the distribution further is definitely on the table for the business.

With all of that said, our expectation is that ET will likely prioritize capital allocation in the following order moving forward:

1. Further deleveraging (management has said as much in recent comments as they are actively pursuing a credit rating upgrade to at least BBB from BBB-).
2. Opportunistic growth projects.
3. Opportunistic acquisition in the PetChem space.
4. Unit repurchases and/or distribution increases depending on the unit price at the moment

For 2023, we think there well under a 50% chance that ET will raise its distribution again beyond what it has already accomplished, given that it has a lot of debt maturing in the next few years that it has stated it wants to pay off as much as possible with retained cash flow and it will also likely continue to be on the prowl for an acquisition.

If nothing materializes on the acquisition front and capital spending comes in on the low end of management expectations, and the unit price continues to move higher, there is a slight chance that we might see one more distribution hike later this year. However, our expectation is that ET will find other uses for that cash this year. We also think that ET will only pursue an acquisition in the PetChem space if such a deal would be deleveraging and credit rating accretive in its effect on the overall balance sheet.

That said, given the massive distribution coverage ratio and the expectation that DCF per unit will likely continue to increase moving forward (due to a combination of declining interest expense from debt reduction, new projects coming online, continued strength in the energy sector, and inflationary bumps to some of ET's contracts flowing through to the bottom line this year), we do expect ET to raise the distribution again in 2024 and likely beyond. Once this commitment to distribution growth becomes apparent to Mr. Market and particularly if/when ET achieves a credit rating upgrade to BBB, we expect Mr. Market to reprice it significantly higher at a valuation multiple that is much closer to EPD's and MPLX's.

Investor Takeaway

ET has a checkered past and Mr. Market is not yet ready to embrace the partnership as a peer with the likes of EPD and MPLX, which are very much in investors' good graces (and for good reason). That said, there is a clear path ahead for ET to overcome the lingering stigma and overhang on its valuation if it can continue to maintain its leverage ratio in the 4.0 - 4.5x range while also showing a consistent commitment to growing the distribution moving forward on an annual basis.

Once Mr. Market is convinced of those two things, we see little reason why it would not earn a full valuation upgrade into within at least half a turn of the valuation multiples currently being assigned to EPD and MPLX.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I/we have a beneficial long position in the shares of ET, EPD either through stock ownership, options, or other derivatives. 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.