Energy Transfer Is a Top Midstream Pick
When it comes to the energy midstream space, Energy Transfer LP (NYSE:ET) is one of the most attractive stocks out there with the largest footprints in the space and one of the cheapest valuations. Let's take a closer look.
Company profile
Energy Transfer has one of the largest and most diversified midstream footprints in North America, with about 125,000 miles of pipeline and associated infrastructure in 44 states. It transports over a third of all crude produced in the U.S. and over a quarter of all U.S. natural gas. It is also responsible for approximately 20% of worldwide natural gas liquids exports.
The company also owns the general partner interests and 46.1 million common units of USA Compression (NYSE:USAC), as well as the general partner interest, the incentive distribution rights and 28.5 million common units of fuel distribution operator Sunoco (NYSE:SUN). These assets contribute about 11% of Energy Transfer's Ebitda.
Approximately 90% of Energy Transfer's adjusted Ebitda is fee-based. Meanwhile, 5% to 10% comes from commodity exposure, while 0% to 5% is expected to come from spread income.
Valuation
Energy Transfer trades at around 7.10 times the 2024 Ebitda consensus on a consolidated basis of $14.62 billion. That compares to an enterprise value/Ebitda multiple of 8.90 for fellow midstream giant Enterprise Products Partners (NYSE:EPD) and 8 for Kinder Morgan (NYSE:KMI).
It has a robust free cash flow yield of nearly 11.5, and trades at a price to distributable cash flow ratio of 5.80. Note that DCF excludes growth capital expenditures.
The stock currently yields about 9%. Energy Transfer cut its distribution of $1.22 in half in October 2020 to focus on improving its balance sheet. It began increasing it at the start of 2020 and it is now at a run rate of $1.25, above the level it was at before it cut the distribution. It is now projecting annual distribution growth of between 3% and 5%.
Currently, year-end leverage looks like it should be hovering near 4 times, while it will look to generates between $500 million and $1.5 billion in free cash flow after distribution payments.
Opportunities
The biggest catalyst for Energy Transfer's stock is for it to rerate as it continues to increase its distribution and improve its balance sheet. Its assets are too good and too diverse to trade at such a large discount to its large-cap midstream peers. An over 11% free cash flow yield is also just way too cheap on an absolute basis as well.
Outside of that, Energy Transfer continues to be a consolidator in the space and is always on the lookout for assets that become more valuable within its interconnected platform than by themselves. It has shown the ability to do this time and again. With its acquisition of Enable at the end of 2021, it was able to give customers access to premium markets through its combined system, also converting some pipes to carry different products. Meanwhile, with the Semgroup acquisition at the end of 2019, Energy Transfer was able to greatly improve a strategic but underutilized asset in the Houston Fuel Oil Terminal by building the Ted Collins Link. This project now enables Energy Transfer to transport up to 300,000 barrels per day of crude oil out of the Houston market to other port locations.
Energy Transfer's most recent larger acquisition is Crestwood Equity Partners, which closed in November. With Crestwood, Energy Transfer will expand its gathering and processing footprint in Delaware and Williston Basins, while also getting what has been a strong performing NGL & Refined Products storage and logistics business. Crestwood's core Williston gathering assets should nicely feed into its long-haul Dakota Access Pipeline. Meanwhile, Crestwood's Marketing unit has been a strong natural gas arbitrageur in its own right.
The Lake Charles LNG project could also be a catalyst for Energy Transfer. Liquified natural gas is one of the hottest investment themes in the market, and these facilities are not the easiest to get off the ground. The project has already received authorizations from the Federal Energy Regulatory Commission, though it will need to file for a new export authorization from the Department of Energy due to delays. Energy Transfer is in the process of working with equity partners who would also take much of the volume. The company would look to keep a 20% interest in the project.
Like most projects, Lake Charles will also help other Energy Transfer assets. In this case, its nearby Trunkline pipeline system would be a big beneficiary. Just getting the go-ahead on the project could serve as a catalyst, while an actual economic benefit would be further off around 2028. It is also working with Occidental Petroleum (NYSE:OXY) on a related CCS project in the Lake Charges vicinity.
Given its large asset footprint, Energy Transfer has one of the best growth backlogs in the midstream energy space. It expects to be able to deploy between $2 billion and $3 billion in high-return growth capex per year over the next few years. Midstream companies typically target project build multiples of about 6 to 7 times.
But the real beauty of Energy Transfer is it is essentially the largest energy arbitrageur in the U.S., with clear sights of moving beyond North America. The company has long been able to take advantage of geographic and seasonal discrepancies to boost its results. Its acquisitions and projects help fuel this goal.
Risks
In the recent past, there was doubt in Energy Transfer when it traded under the symbol ETE and founder Kelcy Warren took advantage of its limited partner, trading under the ticker ETP, and its unitholders through aggressive distribution growth, high-split IDRs and using LP units to fund growth. However, with the Energy Transfer Partners merger, unitholders are now investing alongside Warren, who owns about 9.5% of the units outstanding and has long been a consistent buyer of the stock.
That said, Warren, who is now executive chairman after stepping down from the CEO role in 2020, is still a controversial figure. Investors biggest gripe now is that he is an empire builder who does not care about the stock price. When investors were calling for asset dispositions and stock buybacks, Energy Transfer was making acquisitions and it continues to do so.
While I would agree that Warren is an empire builder, I also think he always making moves to benefit the company long term, which might not align with shareholders that have shorter-term time horizons. But that is how a business ultimately should be run in my view, and Warren has assembled some of the best midstream assets in the U.S.
Energy Transfer has also been known to run afoul of government regulations. There is still a dispute over the Dakota Access Pipeline. While it has been allowed to continue to operate, the future of the pipeline still remains unclear. A complete shutdown of the pipeline would wipe out about $350 million in Energy Transfer's Ebitda, although in its SEC filings the company says it does expect any resolution will allow the pipeline to continue to operate.
Other projects have also faced scrutiny. The company has racked up about $42 million in fines from Pennsylvania regulators related to its Mariner East pipeline, where it eventually claimed no contest to criminal charges.
Energy Transfer is also going to have to pay Williams (NYSE:WMB) a hefty break-up following its botched merger in 2015. A judge ruled thatEnergy Transfer will have to pay $410 million to the company, plus another $85 million in lawyer fees. The merger breakup was also another past example where Warren put himself ahead of unitholders via a convertible preferred deal that protected him from any future distribution cuts.
As with any midstream company, Energy Transfer also faces risks associated with energy prices and volumes. Most of its Ebitda comes from fee-based contracts, but volumes matter, and volumes can be impacted by energy prices.
Conclusion
Energy Transfer has interests in the some of the best midstream assets in the country, and as such has been a beneficiary of the resurgence in oil and natural gas prices. Past conflicts of interest have largely been removed, the balance sheet has been repaired and the distribution is growing again, yet the stock trades at one of the cheapest valuations in the midstream space.
Yes, Warren is building a midstream empire, but it is one that cannot be ignored. Energy Transfer is the largest energy arbitrageur in the U.S. and, as such, is one of the most powerful companies in the world. If you don't want to invest in Energy Transfer because of Warren and his tactics, though, that's certainly understandable.
That said, I think ultimately the Warren discount should start to fade and the stock should rerate given that his and unitholder interests are now mostly aligned with no shenanigans since the merger with Energy Transfer Partners. The company's valuation discount compared to peers is just not warranted given the strength of its assets and integral role in energy transportation. Meanwhile, solid distribution growth should begin to excite retail investors, while institutional investors could start to find its 11.5% free cash flow yield too hard to ignore.
This article first appeared on GuruFocus.
