Energy Transfer Q3: Mr. Market wasn’t cheering, but we were (ET)

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energy transfer (New York Stock Exchange: ET) recently reported its third-quarter results and discussed its outlook for the future. While Mr. Market didn’t celebrate ET’s third quarter results and earnings call as the unit price fell after the results were reported, we did. In this article, we share why We think Mr. Market didn’t like the ET report, but we did.

Why Mr. Market didn’t like the ET report

The main reason Mr. Market probably wasn’t too excited about ET’s report is that while he had previously announced significant increases in distribution that were already priced in, it implied that there were no more significant returns on capital for shareholders. on the table for the foreseeable future.

As management stated on the earnings call:

At this point, we’re planning this quarter by quarter on the distribution side and looking at it. there are there has been no dialogue about anything around distribution growthWhen it comes to unit buybacks, we’re going to continue to look at paying off that debt. We really want to get that leverage target in that 4 to 4.5 range. And we’d be very happy to take it to… closer to rank 4. And we’re going to have some opportunities next year with all the free cash flow that we’re seeing and some of the debt maturing, we’re going to keep looking at that. So we would put it higher than unit buybacks to get to the lowest leverage, but also the big capital projects that we’re talking about. Those also set a little higher than unit buyback. So let’s get to that point. It’s a good healthy discussion that we have quarter by quarter with our Board of Directors as we look at distribution and how we’re going to do that. But right now, our goal is to get to $1.22.

In other words, ET is focused on getting distribution back to $1.22 like they said earlier, but beyond that they have no plans. Distribution hasn’t been discussed at all (in other words, it’s not a big priority at all at this point), and unit buybacks follow debt reduction and growth investments high on the priority list. Given that management spent much of the call raving about how many attractive growth investments they had while also saying they wanted to maximize free cash flow by 2023 to pay off as much debt due next year as possible, it doesn’t seem like it’s unit buybacks are likely to be implemented for the foreseeable future.

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As other midstream peers such as Magellan Midstream (MMP), MPLX (MPLX), Western Midstream (WES), Kinder Morgan (KMI), Plains (PAA)(PAGP) and others have been buying back units on top of distribution growth and debt reduction, this lack of commitment to higher returns on capital beyond a return at an annualized accounting rate of $1.22 greatly disappointed Mr. Market, especially given that ET is right where it said it wants to be in terms of leverage and the energy market is so positive right now.

Why We Liked the ET Report

By the way, while we’d obviously love to see more commitment to distribution growth, we still really liked ET’s report. The reasons we liked it were:

  • Strong fundamentals and higher EBITDA guidance for the year
  • Continued progress towards deleveraging
  • Strong indication that CapEx is unlikely to surprise on the upside next year
  • A firm commitment to pay down debt aggressively and seek an upgrade in credit rating.

ET generated strong cash flows thanks to Consolidated Adjusted EBITDA of $3.1 billion, which was up approximately 20% year-over-year and would have actually increased 28.5% year-over-year were it not for two negative one-time losses. Impacts As a result, distributable cash flow was $1.6 billion for the third quarter, up 23.1% from the prior year. While this growth was strong, it was partially inorganically driven by the acquisition of Enable Midstream in December 2021.

In addition to strong cash flow generation, volumes were also higher across all of ET’s business segments, including record volumes flowing through its midstream, intrastate, crude oil and fractionator assets. ET had excess free cash flow (ie distributable cash flow less distributions and growth capital expenditures) of $265 million.

Thanks to its solid EBITDA generation, retained free cash flow and consistency in debt payments in recent quarters, ET’s leverage ratio continues to approach its target range. On top of that, it is highly liquid as evidenced by management’s statement on the earnings call that:

Total liquidity available under our revolving credit facility was approximately $2.32 billion.

The good news about CapEx was pointed out by management towards the end of the Q&A session:

Analyst:

it just seems like there is a limited upside to 2023 capex…it seems pretty established from the slide deck you guys provided that there doesn’t seem to be any big new projects in 23 capex and it’s actually more of a 24 and the event ’25 if those projects come to fruition.

tom long:

Yes. That is a fair assumption. I’ll leave it as a fairly immaterial amount until 2023.

As a result, ET should generate significant free cash flow next year, allowing it to not only pay off its target distribution of $1.22, but also pay off a large amount of debt as it comes due. In fact, management discussed this directly on the earnings call and also alluded to the potential impact it could have on your credit rating:

were clearly looking to pay as much as we can. We still have a little way to go to get to what our free cash flow will be. But to be fair, we have a very good capacity left in our revolver from our line of credit. So we have options on how to navigate that, and we’re going to be careful. I really don’t want to go out there and try to pre-announce it. But You were right when you said that we seek to pay as much as we can of [2023 debt maturities] if not moving some of it to the revolver just because when you look at the rest of the year and you see how free cash flow continues throughout the year we have a lot of financial flexibility right now is the way I’d like to leave that, and we’re going to play the best options we can to reach all the goals we want us to pursue.

As should be obvious from this exchange: ET is laser-focused on maximizing debt reduction in 2023, which we think is a very prudent use of capital at this point for three reasons. First, it reduces balance sheet risk by reducing reliance on debt markets and interest payment obligations. Second, it should give them a credit rating upgrade in the future, which in turn should lower their cost of debt. As management stated on the earnings call:

Pretty much all 3 agencies advertise that you’re closer to maybe the lower end of that range [of 4 to 4.5 times leverage], is now checking for updates and that is important to us. We really want to keep getting into that 4, 4.5 and get to the next higher level in the rating agencies. All the dialogue we have had with them has been very constructive, by the way. We think they listen to us. We think we have a lot of credibility with them. And we’re going to continue to have this dialogue with them. And that is why it continues to be a priority, I would say, to continue paying the debt in order to be within those objectives.

Third, debt reduction should increase shareholder value in four ways:

  1. By reducing debt, ET is increasing the equity portion of its enterprise value, meaning that, all other things being equal, for every dollar of debt reduced, its market capitalization should increase by one dollar.
  2. By de-risking the business model, getting a credit rating upgrade and redeeming its reputation and regaining investor confidence, ET should be able to earn a higher valuation multiple in a league similar to that currently enjoyed by MPLX, EPD and MMP. resulting in a significant appreciation of the unit price.
  3. Debt reduction also lowers your interest rate expense, especially at a time when interest rates are soaring. This, in turn, should increase the cash flow that reaches the bottom line.
  4. Finally, it creates greater long-term flexibility for management. While stock prices and interest rates rise, it’s better to pay off debt (while trading at a discount on the open market). Then, when interest rates and/or the unit price fall again, ET may have the ability and flexibility to aggressively buy back units and/or purchase longer-term debt to lock in lower rates.
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Investor Takeaway

While ET unit pricing has been lackluster so far in the wake of ET’s latest earnings report and conference call, we’re delighted with the progress the business is making. Would we like to see a strong commitment to grow distribution beyond the $1.22 level? Absolutely. Just as important to us, however, is seeing them prioritize continued aggressive debt reduction rather than reverting to their previous habit of leveraging growth and acquisition spending.

Instead, it appears they are charting a new path of focused debt reduction with capital spending as a secondary priority. Once they get to a point where they get an upgrade in their credit rating, we wouldn’t be surprised to see them increase distribution and/or look for more aggressive growth investments, especially if interest rates have dropped by then. We remain bullish on ET and give it a Buy rating.

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