Energy Transfer Q1 Preview: ~10% Yield In Focus (NYSE:ET)

Thesis

Energy Transfer (NYSE:ET) is scheduled to report earnings on May 2 for its FY Q1 ending March 2023. I expect to see sequential declines in its first quarter EPS of 2023, consistent with consensus estimates (see the first chart below). Although, investors should not be alarmed by such an EPS decline in my view. The decline is only relative, the result of a tough comp set up by the record oil prices in the past 1~2 years.

Instead, I see plenty of reasons for long-term investors to be optimistic about. And this article will focus on a few of these catalysts (summarized below). I expect some comments from the management during the earnings call to either confirm or contradict my expectations. And I will listen attentively either way.

1. I expect to see more progress in integrating its recent acquisitions. I expect ET to report further rewards from these acquisitions as the company continues to expand its economies of scale.
2. I expect to hear management’s comments on the impacts of elevated interest expenses. And I expect its balance sheet strength to continue. I expect the impacts from elevated interest expenses to be more than offset by the positive catalysts (such as the acquisitions just mentioned, the relatively high oil price, and also the robust demand).
3. Finally, I expect its cash flow and financial strength to further improve in the next ~3 years. Starting in 2025, ET will benefit from the 20-year Liquid Natural Gas (“LNG”) sales and purchase agreement with Shell. Once deliveries start, I expect a substantial rise in its cash flow from its LNG segment, especially from the Lake Charles facility through the Trunkline pipeline system.

Next, I will elaborate on these catalysts from the perspective of its dividends. As a partnership in a community sector, I view dividends as the most reliable indicator of its economic earnings. And I will explain why its yield on cost based on today’s price can approach 10% quickly and continue to be well-covered.

Yield approaches 10%

A 10% yield somehow has a “magic ring” for dividend investors for both good and bad reasons. On the one hand, it represents a return on investment that is high enough to be in the double digits. However, on the other hand, it can trigger suspicion about the company’s ability to sustain its dividend payments in the long term. In ET’s case, its yield is approaching 10% quickly.

To wit, its board recently announced a quarterly cash distribution of $0.3075 per common unit, translating into $1.23 on an annualized basis. As such, based on its current price of $12.79 as of this writing, its current FWD yield stands at 9.61% (not sure why the chart below shows 9.55%). Furthermore, its board also announced the plan to keep increasing its dividend distributions at a 3% to 5% annual target rate.

Assuming a 4% dividend growth rate, the yield on cost at today’s price would exceed 10% in 1 year already as seen in the chart below.

And next, I will explain why I do not see any red flags at all.

Limitations of payout ratios

Before delving into the details, I think it is a good idea to first point out the limitations of common payout ratios. These ratios are the first things that all dividend investors check. But they can be misleading, as in the case of ET (and midstream companies in general).

The chart below shows ET’s dividend payout ratios together with its close peer Enterprise Products Partners (EPD) to provide a better context. As seen, in both cases, the ratio fluctuated in such a wide range to be almost meaningless. And bear in mind that EPD is a dividend champ, having a long-established history of consistent dividend increases. The fundamental reason here is that EPS is a poor measure of their true economic earnings. And that is why here I rely my analysis on dividends, which is a much more reliable indicator of ET’s owner’s earnings in my view.

Financial Strength and Impacts of Interest Rates

A full discussion of the assessment of dividend safety is beyond the scope of this article (whose focus is the incoming earnings call). Interested readers can refer to our previous article on this topic.

Here, I will focus on its debt coverage and the impact of elevated interest rates in recent quarters. As shown in the top panel below, ET’s interest coverage ratio has averaged 2.82x over the past 5 years and is currently at 3.6x. Thus, it is far above its historical average and also near a peak value in 5 years despite the hikes in borrowing rates. And again, the picture of EPD is included here to provide a broader context and to show the sector-wide tailwind.

My understanding of the underlying reason is that impacts from elevated interest expenses have been more than offset by other positive catalysts. As aforementioned, these catalysts include the benefits from its recent acquisitions, the relatively high oil price, and also robust demand.

In its Q1 earnings report and beyond, I expect to see further improvement of its financial position as detailed next.

Bright growth prospects

The midstream sector has suffered years of underinvestment in the way I see things. As shown in the chart below, both ET and EPD have been reducing their CAPEX. To wit, ET’s CAPEX has been over $8 billion in 2018 and has decreased to the current level of only $3.3 billion. The reason for such underinvestment is of course strained cash flow. As shown by the orange lines, both ET and EPD have suffered free cash flow in the negative or close to zero until about 2021.

Things have dramatically improved since 2021. Currently, ET generates plenty of free cash flow ($5.67B in the past years). As a result, I expect the company to resume its reinvestment in its facility and refuel its earnings growth.

Looking ahead, I expect a few strong catalysts to further boost its cash flow going forward. Specific catalysts, as aforementioned, include the continued synergy of its recent acquisitions and the expanded LNG volume from its Lake Charles facility and Trunkline pipeline system on the delivery to Shell starts.

Risks and final thoughts

Investment in ET entails risks both common to the energy sector and unique to its own business operations. Risks common to the energy sector include regulatory risks and sensitivity to commodity prices, which I won’t further elaborate. Here I will focus more on the risks unique to its own business operations, in particular counterparty risks and operational risks. ET’s main asset and operation is based on a vast network of storage facilities and pipelines. As such, its operation relies on a large number of customers and suppliers, and the failure of any of these counterparties could result in financial losses. At the same time, the nature and geographical spread of its assets also make it more susceptible to operational risks, including equipment failure, natural disasters, and cyberattacks.

All told, I see the above risks well compensated for by the return potentials already. In terms of expected returns, the generous and well-covered dividends can already provide a return of about 10% per year as I see it. Any growth would push the return to above 10%. To add a further layer of safety, my assessment is that the company (and the sector in general as you can see from the chart below) is trading below its fair valuation by about 10%.