Energy Transfer And Plains All American: Strong MLP Buys

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In 2020, the energy industry was hammered by a “perfect storm” of COVID-19 crushing demand, major capital projects coming to completion leading to a supply glut, and Russia and Saudi Arabia getting into a pricing war that further exacerbated the problem. As a result, many energy companies saw their cash flows take a hit and their equity valuations fall even further.

However, a mere two years later we see energy prices soaring to new heights on the back of another “perfect storm” in the other direction: COVID-19 headwinds are dissipating leading to increased demand, increased regulations and reduced market sentiment has taken a bite out of supply, and Russia’s war with Ukraine and the accompanying sanctions have further reduced supply.

In response to this dramatic shift in the energy sector, many oil companies have soared. However, one sector that saw its valuations get hammered in the wake of the 2020 energy crisis but lag during the current upswing is midstream (AMLP). In particular, there are several midstream MLPs that remain deeply undervalued.

In this article we will cover the two midstream MLPs that we believe are the strongest of the strong buys today.

#1. Plains All American Pipeline (NASDAQ:PAA)

PAA’s strength lies in its well-located midstream energy infrastructure in the lowest-cost U.S. shale basin (Permian Basin). In fact, it has such substantial scale and strategic positioning in the Permian Basin that Morningstar speculates that:

It’s not much of a stretch to state that there is a high probability that in some fashion Plains touches every barrel of oil the Permian produces, earning a fee, if not multiple fees.

While weakness in volumes from the basin relative to supply of infrastructure has led to poor financial results for PAA in recent years, demand is beginning to recover in the basin and we expect PAA to be a big beneficiary of this trend. Wall Street analysts seems to agree with consensus estimates for distributable cash per unit expected to improve at a 7.9% CAGR over the next half decade, despite growth capital expenditures set to decline to a mere $275 million in 2022 (down from $950 million in 2020).

Management is allocating the extra free cash flow primarily towards paying down debt in an effort to further strengthen its investment grade standing and set the business up to better weather any future downcycles like it experienced in 2020.

Additionally, PAA has been allocating free cash flow towards equity unit repurchases – accelerating its buyback pace in Q4 – and is also growing its distribution at a brisk pace (just hiked its quarterly distribution by 20.8%) in an effort to restore it to its pre-cut level. With an expected 2022 free cash flow level of $1.3 billion, PAA currently offers a mouth-watering 16.5% free cash flow yield that covers its recently increased distribution by more than two times. This – when combined with expectations of strong per-unit distributable cash flow growth over the next half decade – will enable PAA to deleverage, grow its distribution, and buy back units at a very solid clip and should lead to outsized total returns for unitholders.

The biggest risk to the thesis will be if oil prices pull back sharply in the coming years due to an aggressive shift towards electrification and renewable energy generation that has already picked up a lot of momentum. If this does happen, it could lead to a continued unfavorable supply-demand balance in the Permian Basin, leading to poor re-contracting and utilization of PAA’s assets and ultimately, declining cash flows. This, in turn, would force PAA to focus on paying down debt with excess cash flows and reduce its unitholder capital returns.

PAA also suffers from a loss of confidence from investors as it has generated poor returns on invested capital in the past that have left the balance sheet overleveraged. This in turn crushed income investors by forcing management to enact several nasty distribution cuts in order to salvage the investment grade credit rating.

Still, with oil prices through the roof and demand for energy recovering sharply, PAA currently has a rosy outlook and should be priced considerably higher than it is. In addition to its 16.5% forward free cash flow yield and 7.2% distribution yield, its 9.6x EV/EBITDA is discounted compared to its 5-year average of 10.17x and is also significantly below the multiples sported by most of its investment grade peers.

#2. Energy Transfer (NYSE:ET)

In contrast to PAA – which has a highly geographically concentrated portfolio – ET is one of the most diversified midstream infrastructure businesses in the world, with a particularly impressive pipeline network that extends from Texas into the U.S. Midwest and reaches nine of the top 10 U.S. production basins.

While this empire is impressive, it has not come without cost. Similar to PAA, ET has generated disappointing returns on its investments over the years and remains bogged down on a few major projects/assets. This has led to an overleveraged balance sheet and a nasty 50% distribution cut in late 2020 in order to reduce leverage and secure the investment grade credit rating.

That said, since replacing founder and Chairman Kelcy Warren in the CEO role, ET has taken a different course. While they still have been on the acquisition trail by acquiring Enable Midstream and hinting at potential expanding further, the company has also aggressively paid down debt, secured the investment grade credit rating, and has begun to raise its distribution. In fact, management has stated that restoring the distribution to its pre-cut level of $1.22 per year is a “top priority.”

This should be very doable as ET is expected to reach its target leverage ratio sometime this year while generated distributable cash flow per unit of $2.27. This would provide very conservative distribution coverage of nearly 1.9x. However, this can be misleading as distributable cash flow includes growth CapEx and can therefore be highly subjective. When we look at the expected free cash flow generation for 2022, our concerns are allayed as ET is expected to generate a whopping 75.6% free cash flow conversion ratio of distributable cash flow, meaning that it should be able to generate $1.72 in free cash flow per unit this year. This would still provide 1.4x distribution coverage at the $1.22 annual rate, leaving management with plenty of cash (~$1.5 billion) to pay down debt.

Of course, ET is unlikely to pay out $1.22 in distributions this year as they will likely prioritize a more aggressive course of debt repayment, but it shows the massive cash flow capacity of ET. In fact, its current free cash flow yield is 15.3%, making it almost as cheap on that metric as PAA.

On top of that, it is even cheaper than PAA when evaluated on an EV/EBITDA basis, trading at just 8.34x compared to its 5-year average of 9.39x. If it were to simply trade on par with its 5-year average EV/EBITDA multiple, ET units would see over 36% upside from current levels. As the distribution recovers towards its pre-cut levels and management further deleverages the balance sheet, we fully expect the unit price to continue rising.

Investor Takeaway

Both PAA and ET have checkered pasts leading to vicious distribution cuts in 2020 and therefore have been put in the penalty box by investors in recent years. However, PAA and ET have taken strong steps since then to right their respective ships and look poised to deliver strong returns in the coming quarters as they continue to grow their distributions back to their pre-cut levels.

Both have paid down debt aggressively over the past year and a half and are on course to continue doing so as they slash growth capital expenditures. Meanwhile, cash flows should enjoy tailwinds from the current strength in energy prices and recovering demand for energy infrastructure in North America.

Last, but not least, both ET and PAA look very undervalued relative to investment grade midstream peers:

It is also important to note that PAA’s growth profile moving forward is stronger than some of its peers’ due to its concentration in the Permian Basin, which is expected to see above-average volume upside moving forward.

Given the recent strength in the energy sector, the risk-reward for PAA and ET is perhaps more attractive today than it has been in a long time, if not ever. As a result, we view them as the two strongest of the strong buys in the sector.

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