2023-06-01 07:30:00 ET
Summary
- Energy Transfer LP stock has crushed the market and broader midstream space since we bought it in December 2020.
- That said, we believe Energy Transfer LP has further outperformance in store for it.
- We share three reasons why.
Energy Transfer LP ( ET ) stock has crushed the market, represented by SPDR® S&P 500 Trust ETF ( SPY ), and the broader midstream space as represented by Alerian MLP ETF ( AMLP ) since we bought it in December 2020:
That said, we believe Energy Transfer LP has further outperformance in store for it. In this article, we share three reasons why.
Reason #1: The Yield Alone Should Drive Outperformance
Energy Transfer's current forward yield of ~10% alone should drive outperformance moving forward. The reason we are confident of this is three-fold:
- ET's distribution is highly sustainable with 1.96x distributable cash flow coverage expected this year. As a result, there is a very large buffer in place that combines with its stable cash flow profile to make the distribution sustainable even if energy prices crash.
- SPY's forward returns look quite weak, so we expect SPY's future performance to underperform its historical returns, which were roughly in-line with ET's current yield. Given that SPY looks overvalued based on just about every major market valuation model and the fact that real economic growth is likely going to be below average for the foreseeable future with interest rates likely remaining higher for longer, SPY is going to be lucky to generate mid-single digit annualized total returns over the next 5-10 years, much less double-digit annualized total returns.
- ET is actually expected to grow its payout at a 3-5% CAGR moving forward. This adds a further margin of safety to our projection that the yield alone should drive total return outperformance moving forward.
Reason #2: Attractive Growth Outlook
Another reason why we expect Energy Transfer LP to outperform moving forward is that its growth outlook is quite strong right now. With management finally providing some long-term distribution growth outlook backed by significant current distribution coverage and a substantial pipeline of high ROI growth projects, the market should be rewarding ET with a higher valuation multiple on the back of this welcome news.
Previously, Mr. Market had ET in the penalty box due to it halving its distribution in late 2020 in order to prioritize deleveraging. However, it has since paid down billions and billions of dollars in debt, dramatically reduced its leverage ratio to within its target range, and has not only restored the distribution to its pre-cut level, but has actually increased it with guidance for regular, sustainable distribution growth moving forward. This now puts it in the same league as its blue chip peers.
That said, it still trades at a steep discount to all of them. As a result, we expect Mr. Market to gradually award ET with an expanding valuation multiple moving forward as it delivers on its distribution growth guidance and proves that it belongs in the same league as its peers. This should help drive additional long-term outperformance for ET.
Reason #3: An Impending Credit Rating Upgrade
Last, but not least, ET appears to be in-line for a credit rating upgrade. S&P recently signaled that this will likely be in the cards for them in the near future by assigning a positive outlook on their BBB- credit rating. Management acknowledged that this is in their sights as well, stating on the Q1 earnings call:
Our goal is to get to that BBB flat... We think that BBB is a good place to be and that's what we're going to continue to target.
How could this help to drive future outperformance for ET units? It could do so in several ways:
- The credit rating upgrade would signal to the market that ET is an even more reliable investment, further bolstering the case for why they deserve a higher valuation multiple.
- It would likely save them interest expense by enabling them to raise and refinance debt at relatively more attractive interest rates than they are able to do today.
- Reaching this goal of theirs would also free them up from being focused on paying down debt so aggressively. Instead, they can use that free cash flow to buy back common units, redeem preferred units, and/or invest in growth projects/accretive M&A, all of which would generate more favorable distributable cash flow returns than paying down debt is. As a result, their DCF per unit growth rate would likely accelerate, driving further outperformance for common units.
Investor Takeaway
Energy Transfer LP has been on a great run over the past two and a half years, but we think it is just getting started in delivering returns for investors. With a double-digit distribution yield that is very sustainable, a promising growth outlook for the business and its distribution, deeply discounted valuation multiples (on both an EV/EBITDA and P/DCF basis) relative to peers, and an impending credit rating upgrade, the catalysts are all in place for significant long-term outperformance by Energy Transfer LP stock.
For further details see:
Energy Transfer Stock: 3 Reasons Why It Could Crush The Market