Energy Transfer’s Q3: Mr. Market Didn’t Cheer But We Did (ET)

Energy Transfer (NYSE:ET) recently reported its Q3 results and discussed its outlook moving forward. While Mr. Market did not celebrate ET’s Q3 results and earnings call – as the unit price fell after results were reported – we did. In this article, we share why we think Mr. Market didn’t like ET’s report but we did.

Why Mr. Market Didn’t Like ET’s Report

The biggest reason Mr. Market probably did not get too excited about ET’s report is that, while it had previously announced significant distribution hikes that were already priced in, it implied that no further meaningful unitholder capital returns were on the table for the foreseeable future.

As management stated on the earnings call:

at this point, we are planning this quarter by quarter as far as the distribution side of it and looking at it. There’s not been dialogue on anything around the distribution growth…When it comes to unit buybacks, we’re going to continue to look at paying down that debt. We really want to get that leverage target in that 4 to 4.5 range. And we’d be quite happy to get it to the — closer to the 4 range. And we’re going to have some opportunities next year with all the free cash flow that we’re seeing and some of the debt maturities, we’re going to continue to look at that. So we would put that up there higher than unit buyback to get to the lower leverage, but also the great capital projects that we’re talking about. Those likewise set up a little bit higher than the unit buyback. So let us get to that point. It is a good healthy discussion we have quarter-by-quarter with our Board of Directors as we look at the distribution and how we’re going to do that. But right now, our target is to get to the $1.22.

In other words, ET is focused on getting the distribution back to $1.22 as they stated previously, but beyond that they have no plans. The distribution has not been discussed at all (in other words, not a big priority at all at this point), and unit buybacks trail debt reduction and growth investments on the priority list. Given that management spent much of the call raving about how many attractive growth investments they have while also saying that they are wanting to maximize free cash flow for 2023 in order to pay down as much maturing debt as possible next year, it does not look like unit repurchases are likely to be implemented for the foreseeable future.

Given that other midstream peers like Magellan Midstream (MMP), MPLX (MPLX), Western Midstream (WES), Kinder Morgan (KMI), Plains (PAA)(PAGP), and others have been buying back units on top of distribution growth and debt reduction, this lack of commitment to further capital returns beyond a return to a $1.22 annualized distribution rate greatly disappointed Mr. Market, especially given that ET is right where it said it wants to be in terms of leverage and the energy market is so positive right now.

Why We Liked ET’s Report

Incidentally, while we would obviously love to see more commitment to distribution growth, we actually really liked ET’s report anyway. The reasons we liked it were:

• Strong fundamentals and raised EBITDA guidance for the year
• Continued progress towards deleveraging
• Strong indication that CapEx is unlikely to surprise to the upside next year
• A firm commitment to pay down debt aggressively moving forward and pursue a credit rating upgrade

ET generated strong cash flows thanks to consolidated adjusted EBITDA of $3.1 billion, which was up approximately 20% year-over-year and its actually would have been up by 28.5% year-over-year if it were not for two one-time negative impacts. As a result, distributable cash flow was $1.6 billion for Q3, up 23.1% year-over-year. While this growth was strong, it was partially inorganically boosted by the Enable Midstream acquisition in December of 2021.

In addition to the strong cash flow generation, volumes were also higher across all of ET’s business segments, including record volumes flowing through its midstream, intrastate, crude oil and fractionator assets. ET had excess free cash flow (i.e., distributable cash flow minus distributions and growth capital expenditures) of $265 million.

Thanks to its robust EBITDA generation, retained free cash flow, and consistency in paying down debt in recent quarters, ET’s leverage ratio continues to get closer to its target range. On top of that, it has plenty of liquidity as evidenced by management’s statement on the earnings call that:

total available liquidity under our revolving credit facility was approximately $2.32 billion.

The good news on CapEx was signaled by management towards the end of the Q&A session:

Analyst:

it just seems like there’s limited upside to ’23 CapEx…it seems pretty set from the slide deck that you guys provided that it doesn’t seem like any new large projects have come into ’23 CapEx and it’s really more a ’24 and ’25 event if those projects come to fruition.

Tom Long:

Yes. That’s a fair assumption. I’ll just leave it as a fairly immaterial amount as far as 2023.

As a result, ET should be generating significant free cash flow next year, enabling it to not only pay out its targeted $1.22 distribution but also pay down a massive amount of debt as it matures. In fact, management discussed this directly on the earnings call and also alluded to the potential impact it could have on their credit rating:

we’re clearly looking at paying down as much as we can. There is still a little bit to go as far as getting what our free cash flow is going to be. But in fairness, we do have a very good capacity left on our revolver from our credit facility. So we’ve got options as to how to navigate that, and we’re going to be careful. I don’t really want to get out in front of it and try to preannounce. But you nailed it when you said looking at trying to pay down as much as we can of [2023 debt maturities] if not moving some of it to the revolver only because when you look out over the remainder of the year and you see what the free cash flow continues throughout the year, we have a lot of financial flexibility right now is the way I’d like to leave that, and we’re going to play the best options we can of reaching all the targets that we want we’re going after.

As should be obvious from this exchange: ET is laser focused on maximizing debt reduction in 2023, which we think is a very prudent use of capital right now for three reasons. First, it de-risks the balance sheet by reducing reliance on debt markets and interest payment obligations. Second, it should earn them a credit rating upgrade in the future, which in turn should reduce their cost of debt. As management stated on the earnings call:

Pretty much all 3 agencies put out there that you get to that closer towards maybe the lower end of that range [of 4 to 4.5 times leverage], you’re now looking at upgrades and that is important to us. We really do want to continue to get into that 4, 4.5 and get into that next higher notch on the rating agencies. All the dialogue we had with them has been very constructive, by the way. We think that they hear us. We think we’ve got a lot of credibility with them. And we’re going to continue to have this dialogue with them. And so it remains a priority, I would say, to continue to pay down the debt to get within those targets.

Third, reducing debt should increase unitholder value in four ways:

1. By reducing debt, ET is increasing the equity portion of its enterprise value, meaning that – all else being equal – for every dollar in debt reduced, its market cap should increase by one dollar.
2. By de-risking the business model, earning a credit rating upgrade, and redeeming its reputation and earning back investor trust, ET should be able to command a higher valuation multiple in a similar league to that which MPLX, EPD, and MMP currently enjoy, resulting in significant unit price appreciation.
3. Reducing debt also reduces interest rate expense, especially at a time when interest rates are soaring higher. This in turn should increase the cash flow reaching the bottom line.
4. Finally, it creates greater long-term flexibility for management. While equity prices and interest rates are moving higher, it is better to pay down debt (while it is trading at a discount on the open market). Then, when interest rates and/or the unit price falls again, ET can have the capacity and flexibility to buy back units aggressively and/or take out longer term debt to lock in the lower rates.

Investor Takeaway

While ET’s unit price has thus far turned in a lackluster performance in the wake of ET’s latest earnings release and conference call, we are thrilled with the progress the business is making. Would we like to see a strong commitment to growing the distribution beyond the $1.22 level? Absolutely. However, just as important to us is seeing them prioritize continued aggressive debt reduction over reverting to their previous habit of leveraging up with growth and acquisition spending.

Instead, it appears that they are charting a new path of focused debt reduction with capital spending as a secondary priority. Once they get to a point where they earn a credit rating upgrade, we would not be surprised to see them raise the distribution and/or pursue more aggressive growth investments, especially if interest rates have declined by then. We remain bullish on ET and give it a Buy rating.