CA - 3 Reasons Why TC Energy Is A Better Buy Than Energy Transfer

2023-09-04 08:00:00 ET

Summary

• TRP and ET are high yield midstream infrastructure stocks.
• Both boast investment grade balance sheets and well diversified portfolios that generate stable cash flows.
• We compare them side by side and offer our take on which is the better buy right now.

TC Energy ( TRP ) and Energy Transfer ( ET ) are two investment grade, high yielding midstream infrastructure businesses that have large and well-diversified portfolios. Moreover, we own both and think both are undervalued at present. While ET has long been - and still is - our largest single position, we believe that TRP is currently a better buy than ET and in this article we will share three reasons why:

#1. TRP's Balance Sheet Is Stronger Than ET's

Both businesses have solid balance sheets and ET's balance sheet in particular has been strengthened considerably in recent years. After slashing its distribution in half in late 2020 in the wake of the energy market crash and its investment grade credit rating being threatened, ET management has aggressively paid down debt and brought its leverage ratio down to within its long-term target range of 4.0x-4.5x. As a result, it has not only secured its investment grade status, but has even earned an upgrade from S&P from BBB- to BBB. Moving forward, ET seems content to maintain its credit rating at its current level while keeping its leverage ratio in its target range while investing its excess cash flow in growth projects while also growing its distribution over time.

Meanwhile, TRP has a better credit rating than ET, with a BBB+ scoring from S&P, albeit with a negative outlook. However, TRP took a significant step forward in securing its credit rating and strengthening its balance sheet by selling a $3.9 billion stake in its Columbia Gas Transmission and Columbia Gulf Transmission systems. As a result, it is now on much firmer financial footing and has more flexibility moving forward to invest in growth projects and return capital to shareholders.

In addition to its slightly higher credit rating, what sets TRP's balance sheet apart from ET's is that its debt maturity ladder is in better shape. As of the end of 2022, 41% of ET's debt matures by the end of 2027 putting considerably pressure on them to either pay down debt aggressively as it matures (which would in turn limit ET's ability to invest in growth projects and/or grow returns of capital to unitholders) or potentially absorb meaningfully higher interest expense given that interest rates have risen so rapidly in recent years.

Meanwhile, TRP's weighted average term to maturity is a whopping 20 years, with much of its debt not due for decades to come. This gives it a very stable cost of debt profile, which is very valuable at a time when interest rates have risen so rapidly. Moreover, its recent large asset stake sales give it considerable capital to pay down debt that matures in the near future.

While ET has closed some of the gap with TRP in this category over the past few years, TRP's recent asset stake sale continues to give it the edge in balance sheet strength.

#2. TRP's Asset Portfolio Is Superior To ET's

TRP's greatest strength relative to ET is its asset portfolio. While ET is certainly well diversified and generates the vast majority (~90%) of its cash flow from fee-based contracted assets, TRP has a superior combined contracted/regulated exposure (~95%) compared to ET's. Moreover, much of its 95% contracted/regulated exposure comes from regulated assets, which are utility-like in nature with investment grade counterparties, making them inherently more defensive and higher quality in nature than ET's contracted assets. TRP's contracted assets are also extremely competitively positioned with lengthy contract terms, giving them a more stable cash flow profile than ET's assets have, in aggregate.

With some of the very best midstream assets on the North American continent, TRP's portfolio is built to last. As Morningstar describes its portfolio:

The combination of top-tier asset and contract quality, regulatory protection on existing pipelines, attractive near- and long-term pipeline projects, and a vast, diverse pipeline network allows TC Energy to generate durable excess returns on invested capital...TC Energy’s assets are some of the highest-quality assets we cover.

#3. TRP Stock Has More Upside Potential Than ET Stock

Last, but not least, we think that TRP stock has more upside potential than ET stock at the moment. As you can see in the chart below, ET stock has risen nicely over the past year whereas TRP's stock price has lost nearly one quarter of its value:

While ET remains slightly undervalued in our view - thereby justifying its stock price appreciation over the past year - TRP has traded down to at least some degree in a manner that is unjustified. Mr. Market disliked the uncertainty that came with the asset sale program, was somewhat disappointed by the valuation that the company fetched for its asset stake sale, and now appears to be a bit unhappy about its announced spin-off of its liquids business. However, the underlying asset portfolio remains very high quality and performing quite well, the balance sheet is in quite solid shape, and we believe that the spin-off will actually likely unlock value for the business. Meanwhile, the dividend remains very well covered, the yield is very attractive, and the long-term growth streak is highly likely to continue for years to come.

While TRP's EV/EBITDA is considerably higher than ET's at the moment, this premium is justified because:

1. Its assets and cash flow profile are much higher quality, particularly given its substantial regulated exposure.
2. TRP issues a 1099 tax form instead of the K-1 that ET issues, making it more suitable for many investors, including institutions, non-U.S. investors, and those seeking to invest in their retirement accounts.
3. TRP has an active 23 year dividend growth streak, whereas ET halved its distribution as recently as less than three years ago. As a result, TRP's management is more trustworthy than ET's when it comes to prudently managing the balance sheet and prioritizing returns to investors.

Moreover, while ET trades nearly in-line with its average EV/EBITDA of the past three years, TRP trades at a steep discount to its three-year EV/EBITDA average. TRP also trades at a larger discount to its five-year EV/EBITDA average than ET does:

As a result, we anticipate TRP achieving greater valuation multiple expansion in the coming years relative to ET. Moreover, TRP's growth outlook (5.4% EBITDA CAGR through 2027 compared to 3.7% for ET based on consensus analyst estimates) is stronger as well.

Investor Takeaway

While ET's yield is ~150 basis points higher than TRP's at the moment, largely offsetting the expected growth differential, TRP's greater multiple expansion potential and lower overall risk profile - stemming from its stronger balance sheet and asset portfolio - make it a better risk-reward proposition than ET at current prices.

Other factors to keep in mind are that ET is a U.S.-based MLP whereas TRP is a Canada-based company, so keep in mind the tax implications that come with both of these structures. Moreover, TRP is more defensively positioned whereas ET is more aggressively positioned relative to the overall energy industry. As a result, if the energy sector booms in the coming years, ET is likely going to outperform relative to TRP. However, if the energy sector stagnates or struggles, TRP is likely going to outperform ET. Overall, we rate ET a Buy and TRP a Strong Buy right now and think both make for excellent high yield picks.

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