ET - Energy Transfer: 3 Big Takeaways From The Lotus Midstream Acquisition

2023-03-28 10:28:20 ET

Summary

• ET announced that it is acquiring Lotus Midstream.
• This move provides additional ammunition to both bears and bulls on ET.
• We share 3 big takeaways and our updated outlook on ET units.

Energy Transfer (ET) recently announced that it is acquiring Lotus Midstream. The total price of the acquisition is $1.45 billion and ET plans to pay for it by issuing 44.5 million common units and allocating $900 million of its cash. The acquisition will provide ET with the Centurion Pipeline system, which comprises 3,000 miles of pipelines and 1.5 million bpd of storage capacity, as well as the Lotus Midstream Midland Terminal, which offers two million barrels of crude storage and additional connectivity. ET will also indirectly gain a 5% stake in the Wink-to-Webster pipeline, which transports over one million bpd of crude from the Permian to the Gulf Coast. The acquisition is a bolt-on purchase that management anticipates with create strong synergies with ET's existing infrastructure.

Management justifies the deal by pointing out that the deal:

• is leverage neutral
• is accretive to free cash flow and distributable cash flow per unit
• lays the groundwork for future growth investments.

Overall, this move provides additional ammunition to both bears and bulls on ET. In this article, we look at this deal from the perspective of both the bears and the bulls by sharing three big takeaways from the deal and our updated outlook on ET units.

Takeaway #1: ET Is Back To Its Acquisitive Ways

As we discussed in our article earlier this year, perhaps the main bear thesis specific to ET is that - with Kelcy Warren still looming large as the Executive Chairman and largest individual unitholder - the partnership was destined to resume its aggressive acquisitions once the leverage ratio target had been achieved and the distribution had been restored to its pre-cut level.

After pointing out that ET remains deeply undervalued relative to peers, we stated that the steep discount exists largely due to the fact that - despite its impressive progress towards deleveraging - management has continued to signal its desire to continue with acquisitions. For example, at an investment conference Kelcy Warren declared :

I want to buy someone.

And then on its Q2 2022 earnings call, management stated :

[We] expect our strong coverage and balance sheet strength to allow us to further prioritize growth within our capital allocation strategy...We also continue to evaluate opportunities in the petrochemical space, which would include developing a project along the Gulf Coast as well as potential M&A opportunities.

Kelcy [Warren] gave us the directive that we need to step in to petchem, we certainly are doing that...from an M&A perspective, anything that's for sale, we'll take a look at pretty much like anything in the industry

Finally, on its Q4 2022 earnings call, management stated :

we're going to allocate dollars to the continued growth of the company.

As a result, this acquisition - which is really quite modest compared to the ~$100 billion enterprise value of the partnership - should come as no surprise. Nevertheless, bears will certainly see this as confirmation of their pessimism on ET and a further justification of its discounted valuation. While the acquisition is supposed to be leverage neutral, time will tell if that will ultimately prove to be the case. Furthermore, if the company had instead poured that $900 million of cash into debt reduction - or even preferred equity buybacks - ET's leverage ratio would have actually declined.

Takeaway #2: ET Is Flexing Its Growth Platform

While the bears' concerns are not unfounded and certainly are worth taking into account when appraising ET as a potential investment, there was also fuel for the bulls in this announcement. At a time when many of ET's peers - such as Plains (PAA)(PAGP) and Magellan (MMP) - are digging in on their core assets and effectively acknowledging that their cash flows will probably (and hopefully only gradually) shrink over time, ET is flexing its growth platform. Thanks to its broadly diversified and large midstream footprint, ET has numerous options for making strategic growth investments through organic growth projects, bolt-on acquisitions, or a combination of the two.

In addition to making deals like this one that are expected to be immediately accretive to cash flow per unit, they also position them to unlock synergies and invest in additional attractive growth projects all while bolstering the competitive positioning of their assets. In so doing, they better position themselves to emerge as long-term survivors and winners in the decades to come as the energy transition plays out. ET remains one of the few true long-term growth potential plays in the midstream sector.

Takeaway #3: ET Is Signaling Bullishness On The Industry

While virtually every midstream business would likely claim that they remain confident in the industry's long-term prospects and point to facts and figures that indicate that the reports of oil's demise are greatly exaggerated, it is much harder to find midstream businesses that are putting their money where their mouth is.

As mentioned previously, there has been a major decline in growth spending across the midstream sector in recent years with a major pivot towards aggressive debt reduction and an uptick in returning capital to unitholders as well. While we do not disagree that much of this capital allocation shift has been prudent, it also still signals that management teams are far less bullish on midstream than their rhetoric indicates.

In contrast, while ET has aggressively paid down debt in recent years, this was done largely at the expense of unitholder distributions rather than meaningful long-term cuts to growth spending. Now that the distribution has been restored to its pre-cut level and the target leverage ratio has been achieved, management appears to be pivoting hard back to doubling down on the midstream space.

This deal in particular was a bullish bet on the sector because through it ET significantly increased its exposure to crude, widely viewed as at far greater risk of disruption from the energy transition than natural gas or NGLs.

The acquisition is expected to increase ET's crude pipeline footprint across the Permian Basin, add ~3,000 miles of crude gathering and transportation pipelines that extend from Southeast New Mexico across the Permian Basin of West Texas to Cushing, Oklahoma, and enhance ET's storage capacity in Midland, Texas by ~2 million barrels.

What ET is effectively saying by executing this deal is that it remains bullish on the long-term potential of midstream, especially for those midstream businesses that consolidate effectively.

As Kelcy Warren predicted last year:

[energy companies] must consolidate if they're going to make it.

If ET did not feel so bullish on midstream's future, it could have poured the money it spent on this acquisition into unit buybacks, preferred repurchases, additional distribution increases, and/or debt reduction, all of which likely would have been deemed excellent uses of capital by Wall Street and unitholders alike. These approaches to capital allocation would have also been much more in line with the actions being pursued by many of its peers, with industry gold standard Enterprise Products Partners (EPD) lowering its already very conservative target leverage ratio even further recently. However, ET continues to buck the industry trend by pursuing growth over deleveraging and/or unitholder capital returns once it deems that its leverage ratio and distribution level are at acceptable levels.

While it is hard to know how accretive this acquisition will be to DCF per unit given the lack of details being released, it would be interesting to know how much more accretive (if at all) this deal is going to be than if all of that capital was invested in unit repurchases and debt reduction in a leverage neutral manner.

Investor Takeaway

ET continues to distinguish itself from midstream peers as an aggressive consolidator in the industry. This of course further fuels the bears' narrative that the Kelcy Warren founded partnership is recklessly aggressive and destined to long-term underperformance due to its spend-happy growth ambitions. However, the bulls can also point to the fact that ET is flexing - and building - one of the more impressive growth platforms in the midstream industry due to its significant geographical and asset diversification and substantial scale.

Most of all, by doubling down on its crude business segment ET is signaling its bullishness on the long-term viability of the midstream industry and the hydrocarbon energy industry in general.

While we would have preferred that they use that excess cash to pay down debt and buy back units given that ET remains undervalued relative to peers and is still only one notch above a junk credit rating, we think that overall this deal is accretive to unitholder value and is certainly not a bad use of unitholder capital.

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