Summary
- Energy Transfer stock has turned from a suspect into a prospect.
- Over the past two-and-a-half years, ET investors have enjoyed superior returns.
- When things are going well, it's time to look for the boogeyman.
- In this article, I'm poking around for him.
Introduction
Since the middle of 2020, Energy Transfer ( ET ) investors have enjoyed a fine run.
Over the past two-and-a-half years, ET common units appreciated ~82% and the 4Q 2022 cash distribution (paid February 2023) has been fully restored to the previous $0.305 mark.
Indeed, recent investor interest in ET resulted in the stock easily outpacing the Alerian MLP ETF ( AMLP ). AMLP is an infrastructure MLP index with holdings concentrated in the most prominent pipeline MLPs.
Energy Transfer Unit Price v Alerian MLP ETF (June 30, 2020 to date)
Some events contributing to Energy Transfer's surge:
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debt leverage has been reduced to 4.3x, well within the 4.0x to 4.5x range outlined by the credit rating agencies for Energy Transfer to retain its investment-grade rating.
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major growth capex spend has fallen to about a third of operating cash flow versus nearly 70% or greater prior to 2021.
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the Enable Midstream acquisition (closed December 2021) turned out to be a well-managed, well-integrated acquisition.
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as noted above, the old $1.22 annualized cash distribution has been reinstated, indicating a healthy (and safe) 9.56% yield.
Clear Sailing Ahead?
Previously, Energy Transfer management always seemed to be fighting entanglements; operational, financial, and legal. The Boo-Birds were out in force. Lately, not so much.
Therefore, this may be an opportune time to:
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search for operational / financial soft spots
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perform a routine valuation exercise; are the common units cheap or dear?
Where are the Warts?
I attempted to do some digging to see what I could uncover. In this article, I highlight the following areas:
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margin
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return-on-invested-capital
I compared Energy Transfer head-to-head with the midstream MLP many consider the gold standard: Enterprise Products Partners ( EPD ).
Note to readers: The following margin and return calculations were performed by the author utilizing SEC filings and Energy Transfer / Enterprise Products website financial reports as found here and here , respectively.
Margin Overview
I share my margin analysis findings over the following categories:
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gross margins
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DCF (distributable cash flow) margins
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adjusted EBITDA margins
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current FCF (free cash flow) margin
Let's take these one-by-one.
Gross Margins
Broadly, gross profit margin is the money left over after a company's costs to produce goods or services are deducted from its revenue and expressed as a function of total revenue.
Here's three years' worth of data for Energy Transfer and Enterprise Products Partners.
Gross Margin Analysis – Energy Transfer and Enterprise Products %
2022 | 2021 | 2020 | |
Enterprise Products | 16.1 | 20.9 | 30.1 |
Energy Transfer | 19.7 | 25.2 | 34.6 |
Energy Transfer registered better gross margins, though I would not make too much of it. The businesses are comparable, but not identical. The differentials are not tremendous. However, over the past three years margins for both companies have fallen considerably.
Initially, I was concerned when I found Energy Transfer margins had compressed so much. However, after it became evident the same thing occurred at Enterprise, the results are not alarming.
FWIW, both Enterprise and Energy Transfer recorded below-average gross margins versus the Oil, Gas, and Consumable Fuels industry.
Distributable Cash Flow Margins
DCF Margin Analysis – Energy Transfer and Enterprise Products %
2022 | 2021 | 2020 | |
Enterprise Products | 13.3 | 16.2 | 23.6 |
Energy Transfer | 9.1 | 12.2 | 14.7 |
Perhaps surprisingly, over the past three years, both companies have experienced material DCF margin deterioration.
EPD records consistently better margins.
Notably, changes in working capital can affect these margins. Last year Energy Transfer had large working capital movement, while Enterprise did not. For example, if one adjusts 2022 DCF results to eliminate net delta working capital, Energy Transfer DCF margin improves to 10.0% while Enterprise Products eases to 13.2%.
Nonetheless, on balance Enterprise has better DCF margins.
Adjusted EBITDA Margins
Another typical industry metric is adjusted EBITDA. I don't particularly care for this measure, but it's a coin-of-the-realm.
EBITDA Margin Analysis – Energy Transfer and Enterprise Products %
2022 | 2021 | 2020 | |
Enterprise Products | 16.0 | 20.5 | 29.6 |
Energy Transfer | 14.6 | 19.3 | 26.9 |
We again see a three-year reduction in EBITDA margins. It suggests despite large annual increases in total sales there's been no operating leverage.
Since 2020, Enterprise Products improved revenue by 114 percent. However, adjusted EBITDA margin only increased 16 percent. Comparably, over the same period Energy Transfer revenue jumped 130 percent while adjusted EBITDA advanced just 25 percent.
None withstanding, for purposes of this analysis, EPD recorded better EBITDA margins.
Are the deltas large enough to warrant high differentials in stock valuation? Read on and you can decide.
Free Cash Flow Margin
While working on this comparison, I decided to check one more margin: FCF. Energy Transfer management doesn't highlight this figure, but Enterprise Products does. Therefore, for purposes of this exercise, I utilized the EPD methodology in order to obtain the best apples-for-apples results possible.
In 2022, Energy Transfer FCF margin handily outperformed: 6.7 percent versus 5.1 percent for EPD.
In 2021, Energy Transfer trailed 9.7 percent versus 12.1 percent for EPD.
Prior to 2021, Energy Transfer was spending so much on growth capital it skewed the results heavily towards Enterprise.
Margin Analysis Conclusions
Working through this exercise didn't offer a great deal of revelations. However, it did clarify some general trends.
For the period 2020 through 2022, neither company demonstrated positive operational leverage. High increases in sales did not translate into gross profit, DCF, or EBITDA margins.
Enterprise Products appears to have exhibited better overall margins, but whether these are material enough to prove superior operational performance is not clear.
In 2022, Energy Transfer recorded better FCF margin versus Enterprise, though these positions had been reversed in 2021.
Return-on-Invested-Capital
Return on invested capital ((ROIC)) is a calculation used to determine how well a company allocates its capital to profitable projects or investments.
For several years, I've pointed out Energy Transfer appears to generate relatively weak RoIC versus peers.
For 2022 and compared with Enterprise Products Partners, the trend remains intact.
Notably, there are several ways to calculate RoIC. First cut, I used a broad-brush approach.
RoIC = (distributable cash flow) divided by (total assets minus current liabilities minus balance sheet cash)
Typically, the numerator of this formula is EBIT or NOPAT. For midstream companies, I like using distributable cash flow.
Bottom line, in 2022 Energy Transfer RoIC was 7.9 percent, while Enterprise Products Partners came in at 14.0 percent.
Peeling the onion further, I experimented with some adjustments.
First, I thought Energy Transfer may be getting penalized for what I thought was relatively high M&A activity. So, as aligned with author Joel Greenblatt in his book, “ The Little Book That Still Beats the Market, ” I subtracted goodwill and intangible assets from the RoIC denominator.
Somewhat surprisingly, it widened the RoIC differential: ET 8.6 percent versus EPD 17.0 percent.
Next, I added 2022 asset sales into the equation. Enterprise management includes proceeds from asset sales when calculating its DCF figure. Energy Transfer does not.
The result: it didn't move the needle much. ET RoIC rose to 8.3 percent versus EPD at 14.0 percent.
RoIC Conclusion
As measured by return-on-invested capital, Energy Transfer continues to lag best-in-class midstream operator Enterprise Products by a significant margin.
A Look at Valuation
For those who've followed my Energy Transfer articles, I've utilized various valuation methodologies in order to come up with Fair Value Estimates. Today, I'll focus upon two metrics I especially like for midstream companies ET and EPD:
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Price-to-DCF
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Enterprise Value-to-EBITDA
Current P / DCF using TTM figures show Energy Transfer has a 5.3x multiple, while Enterprise enjoys a 7.3x multiple.
Pivoting to EV / EBITDA, Energy Transfer sports a 7.2x ratio. Enterprise Products Partners units command a superior 8.9x ratio.
Valuation Conclusions
Based upon the foregoing, all things considered, what is a reasonable Fair Value Estimate for ET common units?
I submit $17 to $18.
That's around a 30 percent uplift from the current bid and excludes the cash distribution.
It is no longer clear to me why the Street doesn't award Energy Transfer ballpark valuation multiples versus Enterprise Products Partners. Based upon the data and recent historical performance, ET might expect a fraction of a turn lower on various valuation multiples, but not two full turns.
Presuming Energy Transfer stock generates 2023 distributable cash flow and EBITDA comparable to 2022 (per current guidance), maintains its 4.0x to 4.5x debt leverage ratio, and continues to pay a $0.305 quarterly cash distribution, I think investors should remain patient and anticipate an eventual ~7x DCF ratio and ~8.5x EV/EBITDA ratio.
Side notes to readers : I believe ET management is considering retiring preferred stock. The earliest date any of the preferred flavors come due is May 15, 2023. Management doesn't have to tip its hand early. Let's wait for the next earnings release and conference call to see how things pan out. I see no reason to front run it.
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.
For further details see:
Energy Transfer: Looking For Warts