ET - Energy Transfer: A Look At The Undervalued Crestwood Preferred Shares

2023-11-23 06:15:54 ET

Summary

• Energy Transfer LP's preferred shares, previously issued by Crestwood Equity Partners, have undergone changes as part of the merger.
• The changes include eliminating penalties for missed distributions and reducing the majority requirement for future changes to the preferred shares.
• We examine the valuation here and tell you why we are holding on despite a stellar performance from these.

On our last coverage of Energy Transfer LP ( ET ), we looked at the three classes of preferred shares, and explained why we exited Energy Transfer LP 7.60% CUM PFD E ( ET.PR.E ).

At this time our strategy is to slowly increase fixed rate preferred shares into progressive weakness. We want quality credit and we want them to be "cheap" on a relative basis even if we see extended 5.5% Fed Funds rates. We have started getting a few names that meet these criteria and suspect we will get a lot more in the months ahead.

Source: Redemption

At the time we already owned the preferred shares of the entity known as Crestwood Equity Partners L.P. These preferred shares have been absorbed into the ET fold and are now listed as Energy Transfer LP SER I FXD RT PER ( ET.PR.I ). We look at these and tell you how they stack up vs other high yield choices.

A Little Background On The Crestwood Preferreds

We will start with the original conditions on these shares before getting to the small modifications that were recently approved as part of the merger. The Crestwood preferred shares were easily the most original set of preferred shares you could find listed on the US exchanges. Some of their features were as follows.

1) Zero call risk.

The shares could not redeemed by the company so they had huge potential in a deflationary environment.

2) Cumulative Distributions With A Penalty Rate

Crestwood could not suspend the distributions without cutting common unit distribution first. This is of course a feature of all preferred shares. But here the distribution was cumulative (all missed amounts would need to be paid) and the distribution rate would jump 21.6% (from $0.2111 to $0.2567 per quarter) for having missed a payment.

3) Preferred shares also had voting rights.

This is extremely rare from the start. Most preferreds tend to get this privilege but it and usually comes in only after the preferred payments are suspended for several quarters.

4) Forced Redemption

If Crestwood was to get delisted, thanks to a private buyout, you could force them to redeem at $9.21.

The Changes

As part of the merger with ET, Crestwood/ET proposed some changes for the preferred shares.

1) Eliminate the increase to the preferred share rate if any distribution is missed.

2) Eliminate the two-third majority requirement to create additional changes to preferred shares. A simple majority is now required.

3) Increase the redemption price at the time of closing of the deal to $9.857484. This was only valid on the deal closing, but this likely forms a floor in the future as well.

These conditions were not particularly onerous though one might argue that the first condition would increase the likelihood of ET stopping preferred distributions in a liquidity crunch.

These conditions were voted for in the affirmative and have become part of the package. ET also threw in a theoretical benefit for these units to participate in any special distributions but we don't assign much value to this feature.

Valuation Today

With the current price of $10.00, you have the distribution rate of $0.8444 per annum or $0.2111 per quarter creating an 8.444% yield. Some tend to immediately compare this with the last rung of investment grade yield (BBB-). The reason for that is that this is also what ET is rated at Fitch. S&P has them a notch higher at BBB . So the yield looks drastically high (price low/undervalued) relative to where Baa (equivalent of BBB- at Fitch and S&P) trade.

But in both those cases, the rating is a reference to bonds. Not to the preferred shares. Fitch actually rates the preferred shares several notches lower.

Fitch Ratings - New York - 09 Feb 2023: Fitch Ratings has affirmed Energy Transfer LP's Long-Term Issuer Default Rating and senior unsecured debt at 'BBB-'. In addition, Fitch has affirmed ET's Short-Term IDR and CP rating at 'F3' and preferred equity rating and subordinated debt rating at 'BB'.

Source: Fitch

Now, some might argue that Fitch is behind the curve. Others might suggest we incorporate the fact that S&P rates them higher or the fact that Fitch has a positive outlook and hence will move them higher. Both valid points. But neither change our argument. Even using the BB level yields, we can see that ET.PR.I is undervalued.

Plus, ET.PR.I has no call risk and a deep embedded option on yields really catering in a deflationary shock. Worst case here, we think it should trade 50 basis points wide of the BB yields. So we would envision this trading with a 7.60% yield and that would get the price up to $11.11.

Verdict

While the ET empire building has not necessarily been enthralling to the patient investor, the latest acquisition has presented an interesting security. ET.PR.I yields far less than what the two floaters from ET, Energy Transfer LP 7.375% Preferred Series C ( ET.PR.C ) and Energy Transfer LP 7.625% Preferred Series D ( ET.PR.D ) currently pay. Both those started floating in 2023 and currently yield north of 10%. ET.PR.E will float starting in May 2024. That was designed as a three-month LIBOR plus a spread of 5.161% per annum. We will be using SOFR on this too but the yield on current price will be well over 10.5% here as well. But with all 3, you have risks on both sides. They all could be called if we have a renewed surge of inflation and rates move higher. They all could have substantially lower payouts if the market is correct in pricing in 4 interest rate cuts next year. ET.PR.I offers a solid return prospect even after the appreciation we have seen to date. We got in at $8.65 in October 2022 , and while we have been tempted to book our gains, have stayed the course.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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