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Article Thesis
Energy Transfer (NYSE:ET) is one of the cheapest energy midstream companies investors can choose from. It just announced another hefty double-digit hike, and statements from management and its strong cash generation suggest that more hikes could be coming in the next couple of quarters. Investors can buy a midstream company that has improved its strategy dramatically and that offers both a high dividend yield as well as income growth and capital appreciation potential.
Energy Transfer’s Dividend Hikes Continue
When Energy Transfer reduced its dividend during the pandemic, many investors were furious. Indeed, it came at a time when many investors could have used the income to pay at a time of crisis. But an uncertain outlook and tightening financial markets made management decide that cutting the dividend in half would be prudent in order to be on the safe side cash-flow-wise. In retrospect, one can argue that this wasn’t necessary. But at the time of the dividend cut, it wasn’t clear how the pandemic would progress, what financial markets and access to debt financing would look like, and last but not least, not too many people had correctly prognosticated what energy markets are currently looking like two years ago.
Following the dividend cut, Energy Transfer’s payout dropped to $0.1525 per share per quarter, or $0.61 per year, versus a pre-pandemic annual payout of $1.22. As Energy Transfer saw that its cash flows were pretty resilient during the pandemic, and since windfall profits from last year’s Texas winter storm allowed for some additional deleveraging, the company decided that it wants to reinstate its old dividend over time.
Early this year, the company increased its payout by 17%. One quarter later, Energy Transfer added another 14% dividend raise. With the just-announced dividend increase, to $0.23 per share, which makes for a 15% hike, Energy Transfer has now increased its dividend by a total of 53% so far this year. The first two dividend increases were $0.025 each, but the current dividend increase was a little larger, at $0.03. One can thus say that Energy Transfer has gotten more aggressive with its dividend increases, at least in absolute terms. If the company hikes its dividend by another $0.03 in three months, the dividend would be $0.26, which would make for a $1.04 run rate. That would be up by 70% from the 2021 dividend payout, which would be a very hefty dividend increase. But even if ET were to keep the dividend stable, the 50%+ raise so far this year is quite compelling. Since ET has now hiked the payout for several quarters in a row, and since management has stated that upping the dividend to the pre-crisis level is the “top priority“, I do believe that there is a high likelihood that we will see another dividend increase later this year — but even if that were not to happen, 2022 would be a good year for investors. A 50%+ hike and a current dividend yield of 8.5% are quite compelling.
ET Dividend Safety Analysis
Once Energy Transfer has raised its dividend to the old level of $1.22 per year, the dividend yield, based on a current share price of $10.90, will be 11.2%. That’s very attractive. Even better, it is quite achievable, and the dividend will, I believe, be relatively resilient at that level.
According to YCharts, the current consensus EBITDA estimate for Energy Transfer for the current year is $12.7 billion. Not all of that will be free cash flow, of course. We can make the required adjustments in order to get to the amount of money Energy Transfer could theoretically pay out to shareholders without requiring any debt financing.
Starting with $12.7 billion in EBITDA, we have to make adjustments for EBITDA that does not belong to ET, but to Sunoco (SUN) and USA Compression Partners (USAC), as well as for cash interest expenses and preferred equity distributions. I estimate that these four positions will total around $3.5 billion combined, which gets us to around $9.2 billion in operating cash flow, which we can round down to $9 billion in order to be on the conservative side. From that, we need to subtract Energy Transfer’s capital expenditures, both for maintenance and growth projects. Originally, around $2.5 billion was planned for this year, but we can round that up to $3 billion in order to factor in inflation and potential execution issues. This gets us to around $6 billion of free cash that Energy Transfer should be able to generate this year — under somewhat conservative assumptions. Next year, when Energy Transfer plans to spend less on growth projects, and when interest expenses should be somewhat lower due to debt paydown in the meantime, free cash flows should be even higher — potentially approaching $7 billion.
If Energy Transfer were to pay out dividends of $1.22 per share going forward, that would cost the company around $3.8 billion, based on a current share count of 3.08 billion. If Energy Transfer hikes its dividend by another $0.03 three months from now, its total payout for the current year will come out to $2.7 billion. ET should thus have a surplus cash flow of at least $3.3 billion, likely more since we made conservative assumptions in the above calculation. Next year, when free cash flow could approach $7 billion, surplus cash left over after paying a potential $1.22 dividend per share would still be $3.2 billion.
We see that ET will not have any issues in raising its dividend to the old level, although we do not yet know the exact timing when this will happen — whether there will be a couple more $0.025 or $0.03 raises, or whether ET wants to announce one large dividend increase at some point. Investors may get more information on management’s plans in the upcoming earnings call, on August 3. No matter what, I do believe that investors don’t have to worry about management’s plans to reinstate the dividend fully. That should, based on the free cash flow outlook for the coming years, be easily possible. Even when the dividend has been raised to $1.22, ET will have ample surplus cash to follow through on other imperatives, such as reducing its debt levels further. Buybacks are another highly attractive option to pursue, as those would be very accretive since ET is trading at a free cash flow multiple of just around 5. In other words, shares could be bought back at a ~20% free cash flow yield right now, which theoretically makes for a 20% return of investment for those buybacks. I thus would love to see meaningful buybacks from ET, but debt reduction has advantages, too. The interest cost savings aren’t as high as the potential returns on buybacks, but a less indebted ET might attract additional investors, which could result in a higher valuation. That would, in turn, allow for share price gains, all else equal.
Energy Transfer is well-positioned to increase its dividend in the coming quarters, as it has done over the last year. Even once fully reinstated, the dividend would not take up a too-high portion of cash flows. Energy Transfer could still spend several billions of dollars on other purposes, such as debt reduction or buybacks. Both of these would be attractive and should create shareholder value in the long run. I personally would favor buybacks, at least at the current valuation, but ET might do a mix of both or decide to focus on further deleveraging first.
Takeaway
Energy Transfer provides infrastructure that is absolutely essential, as energy can’t be moved to the markets where it is needed without the pipes that are owned by ET and its peers. ET’s counterparties are highly profitable in the current environment, which reduces risks, and high inflation could result in meaningful rate increases going forward.
One of the biggest reasons to own ET is its dividend, now yielding 8.5%. That’s pretty attractive already, but investors can expect further dividend increases in the coming quarters. When ET hits the $1.22 mark eventually, investors that buy today would be looking at an 11% dividend yield — and that dividend would be well-covered.
ET has had its issues in the past, but more recently, execution was strong and management seems to be focused on creating shareholder value, instead of chasing growth for growth’s sake. I am long ET and happy with how things are developing, which includes a 50%+ raise so far this year.
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