Thesis: Energy still looks golden
Readers familiar with my writings know that a main theme of my 2022 articles is bullish on energy. I wrote a series of articles explaining the positive catalysts the sector enjoys. For the main topic of today, Energy Transfer (NYSE:ET), I started arguing for a bull thesis in early 2021 when the prices were around $10. For example, an article published in March 2021, titled “Ukrainian/Russian Conflict And Impact On Energy Stocks: Exxon Mobil And Energy Transfer”, explained why both ET and Exxon are best poised to benefit from rocketing oil and natural gas prices. Indeed, both stocks did superbly well amid the overall 2022 market carnage. To wit, ET returned a total of 35.8% since that article, while the overall market lost 5.3% (see the screenshot below).
If you are regretting not entering the sector in 2022, it is not too late. Kevin O’Leary, the star at Shark Tank, sees the energy sector full of golden opportunities today also. In particular, he said the sector looks golden for its cash flow and distributions. Quote:
“I love energy. Everybody hates energy… Go where people hate it. Energy is the driving pivot.” O’Leary said. “The cash flow, the distribution… that sector is looking golden right now.”
In the remainder of this article, I will explain why I fully agree with his assessment above. And furthermore, I will explain why ET not only provides both rich cash flow and generous distribution but also a few other big pluses.
Cash flow and distributions
ET enjoyed solid advances in both revenues and earnings during 2022. And I anticipate that the company continued to maintain an elevated market share for its energy-related products and services due to the chronic supply-demand imbalance. As repeatedly argued in my earlier articles, I view the imbalance as a structural problem accumulated due to years of underinvestment in the sector. It is a long-term problem that won’t go away in any near future in my view. The Russian/Ukraine war only serves as a catalyst to reveal the extent of the problem.
As such, I anticipate the company to keep generating plenty of cash flow to support its generous dividends. Currently, the stock’s dividend yield sits around 7.7% on a TTM basis (shown by the blue line in the chart below) and 9.42% on an FWD basis (shown by the green line in the chart below). And as you can see, these levels of dividends are not only mouthwatering on an absolute basis, but they are also near the peak levels of ET’s own historic record except for the brief outlier periods of 2016 and 2020.
ET not only provides rich cash flow and generous distributions but also offers several additional advantages. And I will analyze 3 of them next: plenty of near-term catalysts, strong capital structure, and heavily discounted valuation.
Current conditions provide a favorable setup for the midstream energy sector in general the way I see things. And I think ET is better positioned than the sector average to benefit from the tailwinds.
Over the past few years, the company has heavily invested in many capital projects, and these investments are now bearing fruits. Additionally, starting in 2025, ET will also start to benefit from a 20-year sales and purchase agreement for Liquid Natural Gas (“LNG”) with Shell NA LNG. This agreement is one of several contracts the company has signed to supply a total of 7.9 million tons of LNG each year. When deliveries begin, I expect the company’s cash flow to receive a further boost from the transportation of natural gas through the Trunkline pipeline system from the Lake Charles facility.
Despite the heavy investment, the company’s capital structure stays stable and strong thanks to its robust profitability, as detailed next.
Strong capital structure and robust profitability
The chart below displays ET’s capital structure over the past decade. While it is true that the company’s debt burden has significantly increased, which has worried many investors. But note that its capital structure has remained strong and stable due to improved profitability (more on this later) and generally low borrowing rates over the past ten years.
Specifically, the equity-to-enterprise value (“EV”) ratio has averaged around 40.0% over the past decade, and the average ratio during 2022 is also 40%, consistent with the ten-year average. The debt-to-EV ratio has averaged 64% over the past decade, and the current ratio of 60% is both below the average and lower than the starting level in 2012. Looking forward, I expect the company’s capital structure to continue to improve thanks to the factors mentioned above and its strong profitability, examined next.
To assess ET’s profitability, let’s begin by examining its cost of capital, as presented in the table below. In this analysis, I utilized the standard capital asset pricing model (CAPM). As detailed in my earlier articles, the key inputs to the WACC are:
This analysis uses the Weighted Average Cost of Capital (“WACC”) to evaluate its cost of capital. The WACC is calculated as:
WACC = portion of equity * cost of equity + portion of debt * cost of debt * (1- tax rate)
And the next chart shows the WACC results. Note that the cost of equity, according to the CAPM model, is determined by the volatility of the stock (the beta) and the risk-free return (the 10-year treasury bond yield).
The results from the WACC analysis are summarized below. As seen, ET’s WACC has fluctuated between about 5.0% and 8.7% over the past decade, with an average of 6.1%. The chart also provides ET’s profitability, in terms of its return earned on capital employed (ROCE). Its ROCE has ranged from approximately 9% to 16% since 2017, with an average of 12.9%. As such, its average profitability in recent years is more than double its average WACC. Given the catalysts mentioned earlier and the macroeconomic supply-demand imbalance in the energy market, I anticipate the profitability-WACC gap to further widen.
Compressed valuation translates to wide margin of safety
Yet, ET’s valuation remains very compressed and thus offers a wide margin of safety to investors. With regards to P/E ratios, the multiples are in the single-digit range only. Its TTM P/E ratio is only about 8.3x as of this writing. To better contextualize this number, its median P/E ratio over the past decade is approximately 11.5x. Thus, its current TTM P/E ratio is discounted by about a quarter from its historical median.
Given ET’s track record of paying dividends (and also the fact that it is a partnership that pays out most of its owners’ earnings as dividends), it is appropriate to use a discounted dividend model (“DDM”) to assess its valuation too. My DDM analyses are illustrated in the table below. As mentioned earlier, ET’s WACC has ranged from 5.0% to 8.7% in the past, with an average of 6.1%. And this is the range of WACC that my analyses considered. Assuming a terminal dividend growth rate (“DGR”) of 2.5% to 3.0%, a conservative rate that only maintains pace with inflation in my view, the fair value of the stock should range between $19 and $27. Note that here I also assumed the WACC to be 1-2% higher than its historical average of 6.1% due to higher interest rates.
Based on these parameters, a few basic scenarios:
- A base case that considers a long-term growth rate of 2.5% to 3% and a WACC of roughly 7%. In this case, my fair value projection is about $23 per share. In this scenario, the current price ($12.95 as of this writing) represents a margin of safety of 78%. The margin of safety is more than 100% in a more bullish case as seen in the second table below.
- A bearish case that considers an unfavorable set of conditions: even higher WACC at 9% and an even slower growth rate of 1.5%. In this case, the fair valuation is approximately $19, still below the current price by a significant margin of 47%.
Final thoughts and risks
Lastly, investing in ET (as well as the broader energy sector) comes with its own set of risks, both in the short and long term. In the short term, the ongoing conflict between Russia and Ukraine remains a major source of uncertainty. The length and eventual outcome of the war are unpredictable and could have a significant impact on the energy market. Specific to ET, sequential comparison in 2023 will be tough, given the record energy prices in 2022. At the same time, interest expenses could also further elevate with additional interest rate hikes. In the longer term, high oil and energy prices often morph into political and/or even societal issues. And this could subsequently trigger policy changes that are unfavorable for the energy sector, such as higher taxes and tightened regulations. Take ET as an example, the company has been involved in legal disputes frequently, which could lead to project delays or shutdowns. And the recent protests against its Dakota Access pipeline serve as an example point.
All told, my verdict is that the above risks are more than compensated by ET’s current valuation compression already. Combined with the catalysts afoot, cash flow, and generous dividend distributions, it is still looking golden right now as much as it did in March 2022 when I first wrote about it.