Energy Transfer Q2 Earnings: High Yield And Undervalued

Energy Transfer (NYSE:ET) is a leading blue chip midstream master limited partnership (i.e., MLP) that boasts a broadly diversified portfolio of pipelines and related midstream assets.

While the partnership has a checkered track record that includes generating disappointing returns on invested capital and a severe distribution cut during the COVID-19 related energy crisis of 2020, the business appears to be back on track now.

In this article, we will discuss two important takeaways from ET’s Q2 results and provide our updated outlook on the stock, including why the market’s response was muted.

#1. ET Will Very Possibly Fully Restore Its Pre-COVID Distribution In 2023

The most encouraging takeaway from ET’s Q2 results was that it is in great position to fully restore its pre-COVID-19 quarterly distribution at some point in 2023.

The company put together strong adjusted EBITDA numbers on the strength of volumes, commodity pricing, the Enable Midstream assets joining the business, and additional growth projects coming online over the past year. As a result, adjusted EBITDA rose by a whopping 23.3% year-over-year in Q2. Distributable Cash Flow grew at an even brisker pace, rising by 35.3% year-over-year.

As a result, ET management is increasing its full year guidance by an impressive $300 million at the midpoint, combining with continued aggressive debt reduction to push management’s expected timeline for achieving their target leverage ratio by the end of 2022. On top of that, management stated during the Q&A section of the earnings call that this raised guidance is actually quite conservative, so they could very well end up outperforming it.

What this means is that ET will soon have no more excuse for not fully restoring its distribution to its pre-COVID cut level. As management stated back when it initially halved the distribution:

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.

On top of that, ET’s liquidity position remains solid with nearly $2.5 billion in cash and revolving credit facility capacity. As management stated on the earnings call:

We are pleased with the progress we have made toward reaching our leverage target range we remain focused on improving our financial flexibility and paying down debt in order to further strengthen our balance sheet. In addition, we will continue to evaluate returning additional capital to our equity unitholders through distribution growth on a quarterly basis.

With $2.39 in distributable cash flow per unit forecast for 2023, ET should be easily able to distribute $1.22 in cash to unitholders over the course of the year given that there will not be a pressing need to pay down a bunch of debt to hit a leverage target.

#2. Kelcy Warren Is Still Very Much In-Charge

That said, there is one large wild card that may prevent that from coming to fruition as quickly as it would otherwise, and it featured prominently in the Q2 earnings call: Executive Chairman Kelcy Warren and his insatiable appetite for bold acquisitions and growth projects.

For example, when discussing capital allocation strategy once the leverage target is achieved, management had this to say:

I think it’s very important to note with all the projects we’re talking about right now that are very good, high-returning projects. We’re going to continue to look at that…and we’ll have a good, healthy discussion internally here with our Executive Chairman as well with our Board as we continue to focus on that.

Management also made numerous other references to growth investments, stating things like:

[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.

Then there was this:

Kelcy 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

Finally, management stated:

we do feel very, very strong that consolidation makes a lot of sense in the midstream space…we continue to look at on the international front, too. We’ve talked about the Panama project.

Given the repeated emphasis on acquisitions during the call – including two explicit references to Kelcy Warren – it is obvious that Kelcy Warren is still the one calling the shots at ET. Once the leverage gets back in-place, it seems increasingly likely that ET plans on resuming its shopping spree.

Investor Takeaway

ET put together another very strong quarter, enabling it to raise guidance for the year and give a clear date for reaching its leverage target. While this is very good news and positions the company very well for fully restoring its pre-COVID distribution level, the market still responded negatively, sending the unit price lower by 1.33% today, despite several other midstream businesses seeing their unit prices heading higher.

While this might baffle some investors, the reason is clear: ET signaled that the “old ET” is still very clearly present and Kelcy Warren’s hunger for growth spending is as strong as ever. While it is still very likely that ET will restore its quarterly distribution to pre-cut levels in 2023 or 2024, the likelihood of additional capital returns via additional distribution growth or unit buybacks just took a huge hit.

It appears ET does not get it: Mr. Market clearly wants ET to reign in its acquisition and growth project spending and instead focus keenly on debt reduction and unitholder capital return acceleration. However, ET appears to be dedicated to simply reaching a certain leverage target, restoring the distribution to pre-cut levels, and then focus heavily on growth spending. While this could pay off, ET’s past track record does not bode well. At a time when other midstream businesses like Plains All American (PAA) and Magellan Midstream (MMP) are clearly cutting back spending and focusing increasingly on unitholder returns and free cash flow, ET is barreling forward with its old approach. This is only serving to push equity investors further away.

Overall, however, we remain very bullish on ET as its valuation remains exceptionally cheap, the balance sheet is in pretty good shape right now, and the distribution is already quite attractive with more significant set to take place in the coming quarters.