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Most high-yield investors are well aware of the fact that Energy Transfer (NYSE:ET) is currently distributing $1.22/yr to its limited partners, and many such investors no doubt also understand that Energy Transfer is currently generating far more excess cash flow than is needed to operate and maintain its assets.
Fewer high-yield investors, however, truly understand just how quickly the Energy Transfer story is changing and improving for the better. This is certainly understandable given Energy Transfer’s long history of relying upon too much leverage while engaging in too many controversial projects and acquisition efforts. As chairman and CEO for many years, Kelcy Warren worked hard to grow the company but, in so doing, he traumatized his limited partners with his efforts to build DAPL and ME2X while he brought controversy and drama with his ill-fated takeover attempt of Williams Companies, Inc. (WMB). The results were painful and many potential investors were driven away. Yet the story is now changing for the better as ET continues to strengthen its balance sheet, continues to grow its distribution and soon receives credit agency upgrades.
Energy Transfer used to maintain a Debt/EBITDA ratio well over 5.0 and, try as he might, Kelcy Warren just couldn’t seem to bring the leverage lower while also pursuing the projects and acquisitions that he deemed to be attractive. Then the Covid-19 disaster struck, volume prospects dimmed, investors panicked, the dividend was slashed, and Kelcy gave up his role as CEO. Tom Long and Marshall McCrea were promoted to CO-CEOs. The one-man show quickly became a three-man team.
Some/many skeptics no doubt viewed this change in management structure as being merely cosmetic as Kelcy Warren still remained the chairman of ET and he no doubt intended to continue to lead the company. We believe such skepticism, however, has failed to understand the wisdom demonstrated by the change in mgmt. The truth is, KW gave up managing day-to-day operations and gave up responsibility for establishing balance sheet priorities. The king replaced himself with his best knights so he could spend more time evaluating the landscape and pursuing the big picture with other industry titans. KW now sees his primary role as the visionary leader and deal pursuer while Tom and Marshall handle the daily details and enforce the discipline necessary to reach and maintain the company’s established goals.
If you ask mgmt directly, they will tell you every man and woman working at Energy Transfer is determined to see the balance sheet deleverage further. “KW is free to pursue deals and then present the ideas to Tom and Marshall, but if one of the CEOs objects to the risks and or the implications of such a deal brought to them by the chairman, then Kelcy drops the idea and walks away.” The Energy Transfer story has become one of teamwork. Mutual respect and cooperation amongst the top mgmt team at Energy Transfer really is taking place. I am told, believe it or not, that “KW walks away from deals when Tom Long says no.”
If you don’t accept this as accurate, then let the recent past speak for itself and consider for yourself what logic suggests will happen next. You can Google Moody’s comments about Energy Transfer and you will see that Moody’s stated on Dec 15th, 2022 that ET’s “steady deleveraging and strong cash flow generation drive a positive outlook.”
Moody’s states:
“Consistent debt reduction throughout 2021 and 2022 alongside solid EBITDA growth has allowed ET to improve reported leverage from 5.6x at year-end 2020 to 4.2x at September 30, 2022, including Moody’s standard debt adjustments. The company has reduced debt by $4 billion since the end of 2020 — despite assuming more than $4 billion in the Enable acquisition – and intends to reduce debt further in 2023.” – Source
Moody’s
If you ask the Energy Transfer Investor Relations Department directly, they will tell you that Moody’s analysis places ET’s adjusted D/EBITDA ratio at 4.3 while S&P’s less conservative analysis places ET’s leverage ratio at 4.2. Both numbers are well below 4.5 and both suggest that ET is well on its way toward establishing a ratio of 4.0 or possibly less.
Energy Transfer management has further explained that “Moody’s has indicated they are waiting to upgrade Energy Transfer once they are a bit more convinced ET mgmt will continue to only pursue accretive, balance sheet strengthening deals.” S&P is already at 4.2 and is most likely also waiting for a bit more time for the dust to clear before they too will lift Energy Transfer’s credit rating. Mgmt dearly wants the BBB rating and clearly understands that the continued demonstration of self-discipline is the only way to obtain and keep this higher level of respect and recognition.
For Confirmation, here’s S&P’s published comments in a nutshell:
NEW YORK (S&P Global Ratings) Dec. 15, 2022–S&P Global Ratings today took the rating actions listed above. We expect Energy Transfer L.P.’s credit ratios to remain well below 4.5x over the next 12-24 months. As of the third quarter, the partnership achieved S&P Global Ratings-adjusted financial leverage of approximately 4.4x on a trailing basis. We expect the partnership to end the year with adjusted debt leverage below 4.25x and improve to approximately 4x in 2023. This compares to our previous expectation of adjusted leverage of approximately 4.5x and 4.3x, respectively, in 2022 and 2023.
If you are worried that Energy Transfer may abandon its pursuit of a BBB upgrade, don’t be. Go listen to the quarterly conference calls. Kelcy Warren has placed his confidence in Tom Long and Marshall McCrea. They are not going to wreck the work and progress done to date. Repeatedly, they tell us “if the Lake Charles LNG deal, for instance, cannot be done in an accretive, safe manner, then it won’t be done.” Again, speaking with the IR department, it is clear they all understand that a finished Lake Charles LNG facility could add roughly 5% to EBITDA but to do so, ET must find and complete more long-term contracts. Presently, ET has 8.5 tons of capacity spoken for, but to reach an FID, ET must reach 13 tons (out of a total potential of 16 tons). If ET can promote Lake Charles successfully to 13 tons or more, they will proceed, but if not, they won’t. Lake Charles must compete with other investment opportunities, mgmt is not going to squander money simply to own an LNG facility, they have too many other attractive options to waste funds on a dubious prize. Everyone at ET understands all eyes are watching their behavior and Moody’s in particular has made it clear their credibility is dependent upon persistent, steady management of their balance sheet. Furthermore, mgmt has steadily stated they are not going to jeopardize the progress made to date for any one deal or project. Soon we shall know if they speak the truth, I think Tom and Marshall do.
Now, let’s look at the leverage ratio and do a little analysis of our own. The exercise ought to help demonstrate just how “easy” it is going to be for Energy Transfer to reach a D/EBITDA ratio of 4.0 or less.
In 2022, Energy Transfer generated a gross EBITDA of $13.1 billion. If we strip away the SUN and USAC sub-companies partially owned by ET and we adjust for partial ownership of DAPL, Rover, and whatnot, we roughly get to an adjusted EBITDA number that is about $2 billion less. ($13.1 – $2.0 – $11.1 billion adjusted EBITDA). Taking this number of $11.1 billion and multiplying it by 4.25 (the average of Moody’s and S&P’s leverage ratios), gives us a relevant debt figure of ($11.1 x 4.25 = $47.175 billion). We are going to use this debt amount solely for the purposes of the informative exercise below.
Mgmt has provided guidance for 2023 of EBITDA of roughly $13.1 billion but it is clear that mgmt has grown fond of guiding low and then routinely beating guidance. In 2022, mgmt finished the year generating a full $1.0 billion of EBITDA higher than they had initially guided, for instance. If we accept Wells Fargo’s analytical work (Mike Blum is rated #1) and JPMorgan’s analytical work (Jeremy Tonet) and take an average of the two, then we accept that these analysts currently assume Energy Transfer is going to finish 2023 generating roughly $13.4 billion in EBITDA, with both analysts assuming that ET continues to grow EBITDA into 2024 and beyond. Granted, the economy may not cooperate, but for purposes of this exercise, let’s assume ET generates $13.4 billion EBITDA either in 2023 or 2024 and is able to continue to maintain that sort of number in future years. (In truth, I expect them to grow at roughly 3% a year for many years to come).
If we take the $13.4 billion and then subtract interest payments and maintenance costs, we reduce EBITDA by another $3.0 billion. Then let’s assume ET invests $2.0 to $2.5 billion per year in new projects and pays out the $1.22 per unit on 3.1 billion units (3.1 x $1.22 = $3.78 billion):
$13.4 billion minus $2.0 billion (SUN and USAC) minus $3.0 billion (interest and maintenance) minus $3.78 billion (dividends) minus $2.0 (new capital expenditures) leaves us with $2.62 billion of excess cash flow. Let’s lift capital expenditures to $2.5 billion and that leaves us with roughly $2.12 billion of excess cash flow. Now let’s see what happens if we apply these numbers to calculate a new future D/EBITDA:
Earlier, we established that Debt at the end of 2022 (for purposes of this exercise) was roughly $47.175 billion. Remember, if we divided that $47.175 by ET’s adjusted EBITDA in 2022 of $11.1 billion, then we end up with a leverage ratio of 4.25. Now let’s use the WFC and JPM estimates for 2023 EBITDA while we also apply all of the excess cash flow expected in 2023 to reduce the debt.
First, we bump the adjusted EBITDA numbers up to $11.4 billion (as we assume gross EBITDA is going to be $13.4 billion), then we reduce debt by $2.12 billion to $45.055. Then, we divided the debt of $45.055 by $11.4 and we reach our new leverage ratio that seems “possible” by year-end 2023. $45.055/$11.4 =3.95. WOW…
Is this utter nonsense? I don’t think so, tell me where you disagree in the comments section. As I see it, this exercise shows that Tom Long is correct and Energy Transfer really is “on track to reach the lower end” of ET’s guidance of 4.5 to 4.0. As I see it, ET is about to transform itself from once being considered chronically overleveraged into being respected for truly having implemented the self-discipline needed to be a strong BBB perhaps on the cusp of striving for a BBB+ rating in future years. WOW…
The main point here, regardless of whether it takes 10 months or 22 months, is that Energy Transfer is on track to reduce its debts while also growing its EBITDA. We only need to see ET reduce its debt by $2.0 billion or so and we only need to see ET grow its EBITDA a few hundred million. The combination of these two accomplishments ought to drive ET’s leverage ratio down to 4.0.
After ET reaches a truly respectable 4.0 leverage ratio, the company still continues to generate $1.5 to $2.0 billion in excess cash flow per year. With a credit upgrade to BBB, ET can then decide whether it wants to bump the dividend distribution significantly higher, buy back units or grow more aggressively by investing more in new capital projects, perhaps they do a bit of all of the above in some combination.
I personally think it is reasonable to assume ET will raise the distribution by 5+ cents a year starting in January 2024. At the same time, I think a BBB rating will make a significant change in investors’ attitude toward ET, likely lifting the units up more in line with its peers over time. Last, I think Kelcy Warren will continue to search for accretive acquisitions and projects with the assistance and watchful eyes of Tom Long and Marshall McCrea. The net result can easily be a steadily improving balance sheet, EBITDA growth, and an increasing dividend. If carbon capture projects and Hydrogen projects gain traction, all the better.
A price target of $17 to $18 has been established by well-known brokerage firms such as Wells Fargo, JPMorgan, and Bernstein. Such a level simply brings Energy Transfer’s EV/EBITDA, Cash Flow and Dividend Yield more into line with its peers (although such targets would still suggest a meaningful discount to the likes of EPD, KMI and WMB). Plenty of published work suggests a more full valuation could easily be closer to $20 a unit. Regardless, common sense suggests Energy Transfer can easily continue to raise its dividend distribution for many years and if we assume 2024’s dividend is going to be roughly $1.28 and we place an 8% yield on such an amount, then a simplistic evaluation suggests ET stock ought to rise upward near $16 a unit, the current price of $12 a unit is simply a tremendous bargain.
Source: seekingalpha.com
