Energy Transfer’s Q1: 2 Very Important Takeaways (NYSE:ET)

Energy Transfer (NYSE:ET) just released Q4 and FY2022 results. For those who wish to check out the headline numbers, you can check out Seeking Alpha’s summary here.

Instead of boring you with a repetition of those numbers in this article, I will devote my focus to diving into two very important updates provided by management on the earnings call that significantly impact the investment thesis. In this article, we discuss these in detail and offer our updated outlook on ET.

Important ET Update #1: No Further Distribution Increases Likely Until 2024

In our previous article on ET, we took a careful look at where we thought management’s capital allocation strategy was headed now that they had accomplished their two main goals of reaching their target leverage range and restoring the distribution to its pre-cut level. We stated:

our expectation is that ET will likely prioritize capital allocation in the following order moving forward:

1. Further deleveraging (management has said as much in recent comments as they are actively pursuing a credit rating upgrade to at least BBB from BBB-).
2. Opportunistic growth projects.
3. Opportunistic acquisition in the PetChem space.
4. Unit repurchases and/or distribution increases depending on the unit price at the moment

For 2023, we think there is well under a 50% chance that ET will raise its distribution again beyond what it has already accomplished, given that it has a lot of debt maturing in the next few years that it has stated it wants to pay off as much as possible with retained cash flow and it will also likely continue to be on the prowl for an acquisition…That said, we do expect ET to raise the distribution again in 2024 and likely beyond. Once this commitment to distribution growth becomes apparent to Mr. Market and particularly if/when ET achieves a credit rating upgrade to BBB, we expect Mr. Market to reprice it significantly higher to a valuation multiple that is much closer to EPD’s and MPLX’s.

Well, based on what was said on the Q4 earnings call, it sounds like our expectations were spot on. Management made it very clear that continuing to reduce leverage and even potentially achieving a credit rating upgrade remain priority number one, stating:

We’re going to continue to probably keep a lot of financial flexibility and some dry powder, which means we’ll keep it at the lower end of that 4 to 4.5, so we’ll continue to focus on bringing that down as far as the leverage ratio.

It then emphasized that it will continue to prioritize investing in its “good” capital projects and opportunistic acquisitions in pursuit of growth:

When you really look at the capital projects that we’ve talked about here, we’re going to continue to look at acquisitions…So we’re going to allocate dollars to the continued growth of the company.

Then finally, it stated:

And then third, we’re going to look at returning capital to the unitholders, and that will be evaluating the distribution levels. Like I mentioned in the kind of the prepared remarks that we’re going to be looking at that distribution more on an annual type basis…we’re going to continue to look at possible unit buybacks…Clearly, when you look at the capital allocation of continuing to bring the debt down and these projects we’re talking about, we’re going to continue to look at these good projects to continue to strengthen the company. But it’s really more on an annual basis that we’ll be looking at some type of some type of an evaluation [of the distribution] as to where we are.

There it is. ET stock’s priority number one is paying down debt; priority number two is capital project spending; priority number three is acquisitions; and priority number four is returning capital to unitholders. Based on their statement that the distribution will be evaluated on an annual type basis, that strongly indicates that ET will not raise the distribution again this year and instead will focus its capital on debt reduction and growth spending this year. However, given the 2.0x coverage of the distribution that management referenced in context of future distribution growth on the earnings call and the potential for further growth along with the strong state of the balance sheet, we think it is highly likely that ET will continue to grow its distribution on an annual basis moving forward.

While it is a bit disappointing to me personally to see them pivoting back hard towards growth spending, I am happy to hear that at least they aim to continue deleveraging the balance sheet and pursuing a credit rating upgrade. Furthermore, if they truly do follow through on becoming an annual grower of their distribution alongside strengthening the credit rating and leverage ratio further, it should lead to significant repricing higher for the common equity and put it more on par with MPLX (MPLX) and Enterprise Products Partners (EPD) in the valuation department.

Important ET Update #2: A C-Corp Currency Is Likely Coming This Year

The other big update to the thesis from the earnings call was management’s response to this question from an analyst:

wondering if you could share your latest thoughts on a potential C-Corp currency? And if that is something that could be on the table here in 2023.

ET’s Tom Long:

We do have a team that’s working on that. I guess the way I would tell you is that we are spending quite a bit of time on evaluating that. And we feel pretty good about probably 2023. We’re going to be a little bit careful about putting in guidance out there right now. But it’s something that we still think makes a lot of sense and are spending a lot of time. But can’t really guide you any closer than that.

This would be a pretty significant development because it would provide the best of both worlds to ET. It would enable existing long-term unitholders (including the largest individual unitholder, founder, and Executive Chairman Kelcy Warren) to hold on to their K-1 issuing units and continue to enjoy the tax benefits that come with them. Meanwhile, it would also open up ownership of ET units to investors who previously either shied away from them or were unable to. These include major institutional investors who avoid MLPs in their strategies, international investors who shy away from the large tax withholding applied to ET’s large distributions, or simply the large number of U.S. income investors who would love to own equity in a high yielding investment grade business like ET in their retirement accounts and/or their taxable accounts without having to deal with the hassles of a K-1 tax form.

Overall, this should significantly increase demand for ET’s equity and drive up the overall valuation. A similar scenario as this has already played out at Plains All American Pipeline (PAA) which also offers an economically equivalent 1099-issuing alternative in Plains GP Holdings (PAGP). The value ad potential is evidenced by the 3.4% premium that PAGP trades at relative to PAA. Given that ET is a larger and much more popular midstream business than PAA, this could possibly have an even bigger impact on ET’s valuation than it has on PAGP. We see evidence of this with some Brookfield (BN)(BAM) securities that have pursued a similar course. For example, the 1099-issuing economic equivalent (BEPC) to the K-1-issuing Brookfield Renewable Partners (BEP) enjoys a strong 7.2% premium. Meanwhile, the 1099-issuing economic equivalent (BIPC) to the K-1-issuing Brookfield Infrastructure Partners (BIP) enjoys a whopping 24.4% premium. Whether it is a 3.4% premium or a 24.4% premium that a C-Corp currency for ET would command, it will obviously very likely be a meaningfully accretive development for ET’s overall equity valuation.

Investor Takeaway

ET’s Q4 numbers were solid and its overall 2022 numbers were excellent, especially its progress on deleveraging and restoring its distribution to its pre-cut level in-line with management’s previously stated goals and promises. Management has earned back a degree of investor trust by following through on its commitments and the unit price’s strong outperformance of the broader market and the midstream sector (AMLP) itself in 2022 reflected that.

That said, ET units remain significantly undervalued relative to peers like MPLX and – if management can continue to grow the distribution meaningfully year after year while also continuing to deleverage and earning a credit rating upgrade – it will be increasingly difficult to argue that ET does not deserve a similar valuation multiple as MPLX.

Furthermore, ET’s potential issuance of a C-Corp currency of its common equity could be a pretty strong catalyst for boosting the overall equity valuation of the partnership and is something that would undoubtedly benefit existing unitholders. As a result, we remain bullish on ET and happily long, though we are keeping a wary eye on their capital spending and potential acquisitions this year. If they begin to leverage up again in pursuit of “growth” (i.e., more Kelcy Warren empire building), that might be a sign to head for the exits in favor of safer picks in the midstream sector.