Energy Transfer: Tale Of The Tape Offers Surprising Results (ET)

Post-4Q2023 earnings, there’s been no less than eight S.A. articles published about Energy Transfer Partners (NYSE:ET). I last wrote about the company six months ago, so along with S.A. colleagues, I thought it’s time to weigh-in with my take on the current state.

In this article, I elected to focus primarily upon fact-checking how Energy Transfer is performing versus peers.

Let’s begin with a brief investment thesis:

• Energy Transfer has become one of the best-performing large-cap midstream / MLP operators in the space;

• Significant free cash flow generation and good debt metrics provide management the flexibility to deploy excess cash into business growth, acquisitions, and capital return strategies;

• The cash distribution is safe;

• Common units appear undervalued.

Who Are Energy Transfer’s Peers?

This question may appear academic, but it’s important.

Would one compare Bank of America (BAC) with Horizon Bancorp Inc. (HBNC)? No. BoA is an international mega-bank, while Horizon is a small community bank. Yes, they’re both banks, but the span, scope, and business dynamics are less than comparable.

The same goes for Energy Transfer.

I reviewed several sources for a short list, including Energy Transfer’s 2023 10-K report (See Pages 144 and 147). After researching and noodling on it, here’s my peer comparison list:

• Enterprise Products Partners LP (EPD)

• MPLX LP (MPLX)

• Kinder Morgan Inc. (KMI)

• Plains All America Pipeline LP (PAA)

• Williams Companies (WMB)

Selected Peer Group v Energy Transfer – Market Cap and 2023 Sales

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Energy Transfer Excess Cash Flow v Peers

Primarily, pipeline transportation companies seek to generate cash flow. Cash flow is essential for business growth and permits management to return capital to unitholders / shareholders. For various reasons, GAAP earnings are less relevant when seeking to understand the business.

Yes, there are many metrics that may be tracked. For pipelines, I contend cash flow to be a prime mover.

The following chart highlights:

• GAAP operating cash flow,
• total capital expenditures,
• common unit / stock cash distributions / dividends, and
• preferred stock dividends.

All figures are in $B. The bottom line indicates excess free cash flow after all distributions / dividends were paid.

Input figures were obtained from company earnings releases and SEC filings.

2023 Cash Flow Metrics – Energy Transfer v Peers ($B)

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Stepping back and upon review, a few items warrant attention.

1. Among peers, Energy Transfer generates the most operating cash flow.

2. By a wide margin, Energy Transfer creates the greatest amount of free cash flow.

3. Energy Transfer records the highest level of excess free cash flow after distributions.

Before moving on, let’s use these figures to analyze an additional metric: free cash flow yield. Free cash flow yield may be defined by dividing free cash flow by market capitalization.

2023 Free Cash Flow Yield – Energy Transfer v Peers

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Energy Transfer ranks in the top half of the group with a 12.6% FCF yield.

For reference, on an absolute basis, a free cash flow yield above 7 percent may be considered excellent. There are no duds in this peer group.

Energy Transfer’s RoIC v Peers

Over the past several years, I’ve argued Energy Transfer may not have warranted equivalent valuation multiples versus peers due to historically low RoIC (Return on Invested Capital). It is prudent to re-examine the metric for 2023.

There are multiple ways to calculate RoIC. I elected to use this formula:

RoIC = DCF / Total Assets minus Current Liabilities minus Cash

where

DCF is Distributable Cash Flow as recorded on each company’s year-end earnings / financial report.

Total Assets include Intangibles and Goodwill

Current Liabilities are self-explanatory

Cash is cash and marketable securities held on the balance sheet

Input figures were obtained from company earnings reports and SEC filings.

Here’s the scorecard:

2023 Return-on-Invested-Capital — Energy Transfer v Peers

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Note: Williams Companies does not provide DCF data for investors. For the RoIC calculation, I substituted adjusted EBIT. This may have overstated an apples-for-apples return.

We find Energy Transfer remains on the low-end of the peer group.

I offer several notes and observations.

Energy Transfer Returns Exceed Its WACC:

Energy Transfer’s 7 percent RoIC is above the company’s 6 percent WACC (Weighted Average Cost of Capital). This indicates there is value creation.

Invested Capital May Be Overstated Relative to DCF:

Using DCF in the RoIC numerator may understate Energy Transfer’s return figure.

Why?

Indeed, the DCF figure accurately provides how much cash the company generated after routine capex. However, the Energy Transfer balance sheet carries subsidiary debt. That affects the Invested Capital denominator of the equation. Specifically, 63.6% of the Bakken Pipeline, Sunoco LP, and USA Compression Partners debt is carried on the balance sheet; yet this aggregate $7.1 billion is non-recourse to Energy Transfer LP. This capital is really not part of ET’s invested capital. It is owned, managed, and invested by outside management teams.

Removing this shadow “invested capital” revises Energy Transfer’s RoIC upward to 8 percent.

Alternatively, substituting adjusted EBITDA for DCF in the numerator of the RoIC equation yields a 13 percent RoIC. If the peer group invested capital returns are calculated using EBITDA, it boosts their respective RoIC, too. However, the average RoIC for the group becomes 14 percent. At 13 percent, Energy Transfer moves up to the middle of the pack; not far off the midpoint.

I seek your thoughts on this in the comment section.

Energy Transfer Common Units Valuation v Peers

I believe it is imperative to perform a valuation exercise for any equity investment. Without a Fair Value Estimate, an investor has no data points from which to determine whether the investment is inexpensive or dear.

I believe simply following price is a sucker’s bet. Markets are NOT efficient in my view. Merchandise is overpriced and underpriced all the time. Overpriced merchandise should be scaled back or sold. Underpriced merchandise may be accumulated. Stocks trading around Fair Value are at the fulcrum: an indifference point.

Energy Transfer’s common unit valuation was determined by utilizing three valuation metrics I believe are relevant: EV / EBITDA, Price-to-DCF, and Distribution Yield-to-10Y Treasuries.

A table comparing trailing EV / EBITDA and P / DCF for all pipeline peers follows. I calculated these multiples using inputs from company earnings reports and SEC filings:

Click to enlarge

*Williams Companies does not provide Distributable Cash Flow data to investors.

EV / EBITDA Analysis

Peer EV / EBITDA multiples are above 9x sans Energy Transfer and Plains.

Focusing upon ET, current fundamentals highlight strong cash flow and solid cash distribution growth, while debt leverage has been lowered towards the lower end of the credit rating agencies’ target range. Recently, ET’s credit rating was bumped up to BBB.

Looking forward to 2024, Energy Transfer management guided to a midpoint 7 percent year-over-year EBITDA improvement. For peer pipelines that provided guidance, none offered a comparable growth forecast; with the exception of Kinder Morgan. Kinder Morgan’s EBITDA forecast was comparable to Energy Transfer.

Therefore, I believe it’s defensible to value ET common with an 8x EV / EBITDA multiple. This is less than a one-turn increase versus current TTM and less than the peer average; yet the 2024 EBITDA growth guidance is superior to most peers.

Premising no change to the current balance sheet net debt / capital lease balances, no change to diluted units outstanding, the retirement of preferred stock, and inserting 2024 midpoint EBITDA; then solving for price suggests a ~$17 Fair Value Estimate.

Distributable Cash Flow Analysis

Turning to P/DCF, Energy Transfer units lag the peer group average. For the reasons outlined above, I believe a 7x multiple is appropriate.

In 2023, ET generated $2.30 DCF. Presuming no increase in units outstanding and a 3 percent improvement in DCF; then solving for price indicates a ~$16.50 Fair Value Estimate.

Energy Transfer management does not provide DCF guidance. I suspect my DCF input is conservative.

Distribution Yield-to-10Y Treasuries Valuation Analysis

An old rule-of-thumb for energy MLPs says an approximate Fair Value may be obtained by comparing the current cash distribution yield with the 10-year Treasury yield. The security is ~FV when the Treasury yield plus 300bps is equivalent to the unit price cash distribution yield.

As of today’s close, Energy Transfer common stock trades at $14.69 with a 8.58 percent yield. Ten-year Treasuries yield 4.3 percent.

By process, Fair Value equilibrium would be reached when ET units yield 7.3 percent. Solving for price, ET units need to trade at ~$17.25 to yield 7.3 percent.

Therefore, by this methodology, Energy Transfer’s Fair Value is ~$17.25.

Conclusions

During the past 1-year, 2-year, 3-year and 4-year periods, Energy Transfer units’ capital appreciation outperformed most of the peer group, including all of the peer group for the 3-year period.

ET One-Year Price Return versus Peers

ET Two-Year Price Return versus Peers

ET Three-Year Price Return versus Peers

ET Four-Year Price Return versus Peers

The four-year chart includes the period when the cash distribution was cut. Beginning with the February 2022 distribution declaration, management raised the payout for nine consecutive quarters and has eclipsed the pre-cut distribution.

Bellwether Enterprise Products Partners has not outperformed Energy Transfer LP in any aforementioned period.

Energy Transfer generates more operating cash flow and excess free cash flow after distributions / dividends than peers. Significant excess cash flow permits management the flexibility to pursue business development opportunities, increase cash distributions, buy back units, and / or pay down debt.

Energy Transfer free cash flow yield is competitive with the peer group.

Energy Transfer management still records relatively lower RoIC than the selected peer group. However, the current return is greater than the WACC and the degree of separation versus peers may be partly attributed to balance sheet accounting. When adjusted for debt, or utilizing EBITDA in the RoIC numerator, apples-for-apples results indicate Energy Transfer has invested capital returns on par with peers.

Based upon a combination of several valuation methodologies, my current FVE for Energy Transfer is ~$17 per unit. This indicates a 16 percent upside. Meanwhile, the cash distribution yield is 8.6 percent. This is materially higher than peers, with the exception of MPLX. The current MPLX distribution yield is about the same as Energy Transfer.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2024 investments.