SUN - Energy Transfer: The Juice Is Still Worth The Squeeze

2023-08-11 13:06:54 ET

Summary

• Energy Transfer unit prices are rising.
• Energy Transfer's debt leverage ratio is higher than its peers, but it has been decreasing quickly and appears well within credit agency's target range to maintain an investment grade rating.
• Energy Transfer's EV/EBITDA ratio lags behind peers, but recent events and management performance suggest it should be higher.
• Modest multiple expansion may lead to additional unit price upside.  The current cash distribution yield is best-in-class and safe.

Introduction

I write about Energy Transfer Partners MLP ( ET ) on a regular basis. My primary objective is providing information that may assist investors better understand ET financials, business performance, and unit price valuation. Generally, I do not recap the quarterly earnings reports, though I will reference release info that pertains to topics at hand.

My recent articles about Energy Transfer have been bullish. In my last article entitled, "Energy Transfer: Looking for Warts," I remained constructive on the stock, while the upshot was to search for specific financial risks to the thesis.

In this article, we will review Energy Transfer's debt leverage ratio and compare it with several MLP peers; namely, Enterprise Products Partners ( EPD ), Plains All-American ( PAA ), and MPLX LP ( MPLX ). In addition, I've performed some valuation work for the same group. Specifically, we will examine EV / EBITDA ratios and seek to determine a reasonable Fair Value Estimate for Energy Transfer common units.

Debt Leverage Ratio

In years' past, Energy Transfer struggled with an overleveraged balance sheet. More recently, the problem has been rectified. The credit rating agencies targeted a 4.0x to 4.5x debt leverage ratio in order for ET to maintain an investment grade rating (BBB- or better).

On 2Q 2023 earnings conference call, co-CEO Tom Long remarked,

As you know, we have focused on the debt. We're very, very obviously pleased to have it down into our 4 -- kind of 4.5 range kind of at the top of it. So, we'll continue to look at moving down maybe towards the lower end of that like we mentioned in the prepared remarks.

It's important to understand the credit rating agencies do not calculate the leverage ratio the same way. Therefore, there can be a variance between one outfit and another. It's also key to realize the debt leverage ratio isn't about just paying down / lower gross indebtedness. It's about the combination of net debt as a function of earnings power; namely adjusted EBITDA.

I've calculated the debt leverage ratio using the methodology I believe closely followed the prescription utilized by S&P.

Following is a summary of the workup. The foregoing input data may be compiled via Energy Transfer earnings releases and SEC filings.

Net Debt

Net Debt is determined by starting with total debt less balance sheet cash. Operating lease liabilities are added. One-half of all the preferred stock value is added.

Next, due to Energy Transfer's capital structure, several additional adjustments are made.

Bakken Holdings (Dakota Access Pipeline) total consolidated debt is deducted, and 36.4 percent of it is added back. This is because 100% of Bakken Holdings debt resides on the Energy Transfer balance sheet, but ET owns only 36.4 percent of the pipeline.

Finally, debt incurred by Sunoco LP ( SUN ) and USA Compression Partners ( USAC ) is subtracted. Sun and USAC are stand-alone entities. Their respective debt loads are non-recourse to Energy Transfer, even though 100 percent of this subsidiary debt is on the ET consolidated balance sheet.

Adjusted EBITDA

Adjusted EBITDA is calculated by starting with Energy Transfer's adjusted EBITDA as recorded on the company's quarterly earnings release.

Then adjustments are made for non-wholly owned subsidiaries (primarily DAPL), USA Compression, and Sunoco LP. These reflect proportional ownership and “cash EBITDA.” Specifically, the methodology goes like this:

• 100 percent of the non-wholly owned subsidiaries' EBITDA is part of Energy Transfer adjusted EBITDA workup. The leverage ratio should only credit the company for its proportional share of the balance. DAPL is the major contributor to this category, but there are a number of other wholly owned subsidiaries revolving around Energy Transfer.

• 100 percent of USAC and Sunoco EBITDA is included in ET's adjusted EBITDA figure. These amounts are subtracted and replaced with actual cash distributions received by Energy Transfer from USAC and Sunoco.

After going through the arithmetic, as of June 30, 2023, Energy Transfer's adjusted debt is $44.6 billion; and trailing twelve month adjusted EBITDA is $11.2 billion.

The net debt leverage ratio appears to be ~4.0x.

Debt Leverage Versus Peers

The table below summarizes Energy Transfer's leverage ratio versus peers: using the same methodology as described above, populated by data from the same respective SEC and company web site sources.

Debt Leverage Ratios -- Energy Transfer and Peers 6/30/23

By my estimation, Energy Transfer is well-within the credit agencies' investment-grade rating target range, though it's still above the peer group.

The others are grouped within a fairly tight pack.

Let's pivot to Fair Value as measured by EV / EBITDA.

Fair Value – EV-to-EBITDA

There are multiple ways to estimate a stock's Fair Value. When debt may be a significant factor when comparing companies within the same general industry, the EV-TO-EBITDA ratio can offer insight.

In the way of definitions, EV stands for Enterprise Value. This is an approximation of how much a business may be worth if it were being acquired by an outside party. It's determined by the summation of:

• current market capitalization, including preferred stock

• all debt and indebtedness (I include lease liabilities)

• minority interest

• less balance sheet cash

Adjusted EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. Typically, management includes some other non-core puts and takes. Frankly, I'm not a big fan of EBITDA. Adjusted EBITDA is even more of a Frankenstein. However, as an investor, I recognize that within certain industries adjusted EBITDA is a coin-of-the-realm. MLPs often highlight adjusted EBITDA and Distributable Cash Flow.

So, I've learned to live with it.

Running the math for Energy Transfer, the current EV is $102.7 billion and trailing twelve-month EBITDA is 13.1 billion. Therefore, the EV / EBITDA ratio is 7.8x.

Or is it?

If we plug in the S&P generated adjusted debt and adjusted EBITDA into the equation, we get a materially different result. An alternative calculation shows $95.7 billion EV and $11.2 EBITDA, resulting in 8.5x EV / EBITDA.

The difference is because backing out proportionate debt and EBITDA for non-wholly owned subsidiaries, Sunoco LP, and USAC are sizeable changes.

Which one approach is better?

Offhand, I believe the “straight” calculation is best.

Why?

Most investors don't consider (or know how to apply) the S&P credit rating adjustments. Indeed, while the S&P modifications make business sense, I suspect using them when comparing the valuation ratio versus peers may be trying to grind things into too fine a powder.

EV / EBITDA Versus Peers

The table below highlights the EV / EBITDA ratios for Energy Transfer and the peer group.

EV / EBITDA Valuation Ratios – Energy Transfer and Peers

note: EV and valuation ratio calculations performed by author

The peer group retains better EV / EBITDA multiples. Energy Transfer lags.

Is this reasonable?

One may be able to reconcile the difference between ET and the pack through the lens of the debt leverage ratio; ET is higher and has a checkered past. However, the gap appears large in the face of Energy Transfer management's recent focus and results to bring down leverage per rating agency guidelines. In time, multiples better-aligned relative to peers seem to be a reasonable expectation.

Before looking towards a Fair Value Estimate for ET units, let's look at one more datum set.

Market Cap, Credit Rating, and Distribution Yield – ET and Peers

Unsurprisingly, Enterprise Products has the best S&P credit rating and greatest market cap. Energy Transfer, and the others have lower investment grade credit ratings.

By a considerable margin, Energy Transfer offers a superior cash distribution yield.

General Risks to the "Buy" Thesis

ET units have had a good run. However, the go-forward thesis isn't without risks. There are several key risks that have the propensity to upend the three-year uptrend.

The first is an energy commodity price collapse. As ET is primarily in the energy transportation business, there is some natural insulation to energy price fluctuation. Materials continues to move regardless of price. Nonetheless, the company retains some exposure to commodity prices. Furthermore, history indicates the Street tends to sell off all energy stocks when commodities are under pressure.

Second, Energy Transfer faces litigation risk. Currently, no issues appear pressing. Co-CEOs Tom Long and Mackie McCrea have been more conservative, taking more of a stewardship role. However, the nature of ET's business model and the industry in general tend to attract litigation.

Third, there some investors continue to believe the company is on the verge of an unbridled spending spree, whereby growth capital is spent with disregard for adequate returns, thereby jeopardizing Energy Transfer's financial foundation. Even after the last earnings report, some investors interpreted management discussions about growth projects to mean the company was about to mortgage itself on the altar of business growth. On the Street, perception is often just as important as reality.

Fourth, for a company with the size and span of Energy Transfer, there is always execution risk. ET has a lot of irons in the fire. Management must ensure new projects are completed on time / on budget, and the capital stack is well-managed, while operational and financial objectives are balanced with the expectations / promises made to the stockholders.

Fifth, Energy Transfer units have enjoyed an outstanding run; leading the peer group. The differential is wider after considering Energy Transfer's superior cash distribution returns. From this point, the potential total return upside isn't as great as it was after the post-C19 crash. Here's a three-year price chart illustrating ET's performance versus peers.

It can be hard to lead the pack year-in and year-out.

Pulling It Together

Currently, Energy Transfer has the credit leverage issue fixed. The ratio is within the credit agencies' target range; thereby ensuring an ongoing (and stable) investment grade rating. While the debt leverage ratio is higher than peers, it's not a lot greater; and it's been coming down quickly.

When considering the EV / EBITDA ratio, investors know that this particular valuation metric considers debt.

We find the ET multiple lags peers by a significant margin. In my opinion, given recent events and management performance, the margin isn't justified.

I believe the view is further supported by the fact that Energy Transfer common units offer investors a superior cash yield. The current distribution is well-covered by Distributable Cash Flow. Management has stated their intent to raise the payout by three to five percent a year. ET is not a company struggling to find its financial footing.

Therefore, on balance, these data points point to higher multiples and higher unit values.

If Energy Transfer maintains its current debt load, annual cash distribution, and adjusted EBITDA, I find it reasonable to forecast an 8.0x to 8.5x EV / EBITDA multiple. Backing into unit values, the following table provides a summary of projected unit prices as a function of EV / EBITDA multiples.

Energy Transfer Unit Price Valuation Summary

note: calculations performed by author

Given my opinion Energy Transfer management is likely to 1) continue to raise the distribution, 2) meet or exceed TTM $13.1 billion adjusted EBITDA in 2023, and 3) maintain or improve debt leverage, I plant my FVE flag in the ground at ~$14.50 to $15 per unit.

A $14.50 unit price plus the current cash distribution indicate a 20 percent uplift. The juice is still worth the squeeze.

Please do your own careful due diligence before making any investment decision. This article is not a recommendation to buy or sell any stock. Good luck with all your 2023 investments.

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