Introduction
On October 22, 2023, I wrote an article titled 2 Champs, 1 Winner: Energy Transfer's 9% Yield Beats Enterprise Products' 7% Yield."
Since then, Energy Transfer (NYSE:ET) shares have added roughly 7%, excluding distributions.
After tremendous struggles during the pandemic and years with volatile oil and gas prices prior to that, the stock has returned roughly 60% over the past five years. Over the past three years, investors have seen a total return of 144%, which includes its distribution.
We are clearly seeing a massive shift in the market, which has started to favor deep-value stocks since 2021, with a recent move back to growth stocks.
Now, I expect money to rotate back to value stocks, backed by sticky inflation and my belief that Energy Transfer is still extremely undervalued.
In this article, I'll tell you why, starting with my view on inflation and what this means for asset allocation.
So, let's get to it!
Inflation, It's Sticky
The other day, I tweeted the following chart on Twitter, which shows the 5-year breakeven inflation rate. This number is a market-based estimate of what the average inflation rate over the next five years is expected to be.
As I have written in countless articles since the pandemic, I believe we are in a new environment of above-average inflation caused by structural issues like labor shortages, changed energy supply dynamics, supply chain relocation, and the fact that inflation seems to be working its way "through the system."
On top of that, it needs to be said that we were very lucky during the 2009-2021 period, as a lot of factors paved the way for low inflation. This included very cheap energy, cheap production in China, no major war with Russia, and other factors.
Adding to that, I believe that elevated debt loads may require higher inflation, as I wrote in a recent in-depth article, which received more than 100 comments.
Apollo seems to agree with me, as they recently wrote that "the underlying trend in inflation is moving higher."
Bloomberg's John Authers confirms this as he found that while the most recent headline PCE numbers appeared stable, a closer look revealed troubling trends in the "supercore," particularly in services inflation excluding property.
Moreover, the trimmed mean, which is a measure the Federal Reserve likes to use, also indicated somewhat concerning month-on-month increases in inflation.
As one can imagine, this is bad news for the Fed, which would love nothing more than to be able to cut rates as soon and as aggressively as possible to support the government's massive debt load.
However, despite the market expecting four rate cuts this year, this is far from certain.
Bloomberg also quoted Steven Blitz from TS Lombard, a company I highly respect.
If the economy continues to expand apace (wage and salary disbursem*nts, chiefly), there is little chance for service inflation to decelerate further and for goods prices to keep deflating (CPI goods ex food & energy turned up in January).
Sure, inflation may fall - especially if the economy were to hit a recession.
However, I don't care about short- and mid-term developments. I care about the bigger picture and what this may mean for my and your money.
That's where value stocks come in.
Why?
Because in an environment of elevated rates, value stocks perform best.
Looking at the chart below, we see two things.
- Value stocks are extremely cheap relative to growth stocks.
- Higher interest rates favor value stocks.
This means that once the market starts to realize rates may remain higher for longer, it will start to rotate trillions from growth to value.
That is if I'm right. If I'm wrong, growth stocks may continue to outperform.
Now, with all of this in mind, I believe Energy Transfer is a fantastic value stock poised for much more gains in the future.
However, before I continue, I need to mention one thing.
Energy Transfer is a Master Limited Partnership. This means a higher tax complexity, as investors receive a K-1 tax form. MLPs are not taxed on a corporate level. This may have benefits for investors.
Unfortunately, because I am a non-U.S. investor, it would make my own tax situation too complicated, which is why I stick to U.S. C-Corps in the midstream sector, as much as I would love to own a piece of ET.
Also, when dealing with MLPs, shares are called units. MLP's don't technically pay dividends, but rather distributions.
8.4% Yield And Too Cheap
Readers who are familiar with my style probably know that I like companies with wide moats that are critical to the industries they serve. I love railroads, oil drillers, healthcare suppliers, agriculture stocks, aerospace suppliers, and related companies.
Energy Transfer is similar. This midstream energy company does not produce oil. It supports the companies that do.
The company has natural gas and crude oil pipelines, storage facilities, terminals, and processing assets.
According to the company (emphasis added):
Through our intrastate transportation and storage segment, we own and operate (through wholly owned subsidiaries or through joint venture interests) approximately 12,200 miles of intrastate natural gas transportation pipelines with approximately 24 Bcf/d of transportation capacity, three natural gas storage facilities located in Texas and two natural gas storage facilities located in Oklahoma.
On top of that, it has many more assets, including 5,700 miles of NGL pipelines and refined product marketing terminals with a storage capacity of 8 million barrels.
Furthermore, what makes the company's business so special is that it operates relatively independently from commodity prices.
The biggest part of its EBITDA is generated through fee-based operations, which creates more visibility and subdued earnings volatility.
Although I'm bullish on energy commodities, I like to buy midstream exposure as well, as these companies often come with an attractive risk/reward.
The biggest risk is demand risk caused by a potential implosion in energy prices. In those situations, upstream companies may reduce output, which lowers the need for pipeline and storage space.
Right now, the midstream industry is doing very well, boosted by strong crude oil and gas production and an economy that supports strong end-user demand as well.
At the end of last year, the U.S. was producing close to 85 billion cubic feet of shale gas per day, with accelerating growth in key basins like the Permian, which benefits ET.
We see growth even in a lower gas price environment with the higher oil prices, we continue to see growth, and we are projecting modest if not fairly significant growth out of the Permian Basin. - ET Q4'23 Earnings Call
In 2023, the company achieved a record-adjusted EBITDA of $13.7 billion, which marks a 5% increase over the previous year.
Growth was provided by record volumes across its various business segments, including record volumes in NGL pipelines and fractionators, crude oil transportation, and midstream operations.
In fact, the company achieved seven operational records in Q4'23 alone and was able to grow beyond prior records before the inclusion of acquired growth.
[...] we moved record volumes across all of our segments for the year ended 2023, which included record volumes on our legacy assets before including contributions from assets acquired in 2023. In addition, we exported a record amount of total NGLs out of our Nederland and Marcus Hook Terminals in 2023. - ET Q4'23 Earnings Call
Additionally, Energy Transfer generated distributable cash flow ("DCF") of $7.6 billion in 2023, resulting in excess cash flow after distributions of approximately $3.6 billion. This indicates a 2.11x coverage ratio.
These are the numbers that really matter, as it means the company's distribution is well-covered and poised for future growth.
On January 25, the company announced a quarterly cash distribution of $0.315, which translates to $1.26 per year and a yield of 8.4%. It's also 3.3% higher compared to the prior distribution.
Adding to that, the distribution is protected by a healthier balance sheet, which was upgraded to BBB by Standard & Poor's last year with a stable outlook.
In the years ahead, I expect this rating to be upgraded to BBB+.
Generally speaking, stocks with BBB-range ratings are safe, as evidence from the Great Financial Crisis suggests. Once companies enter the double-B range, they tend to survive major recessions.
Going forward, ET continues to expand its empire through strategic investments. This includes the recent acquisition of Crestwood Equity Partners.
The integration of these assets is expected to generate significant cost synergies worth $80 million per year by 2026, excluding any additional benefits from financial or commercial synergies.
Additionally, the company is actively targeting organic growth projects, including the expansions to its NGL export terminals at Nederland and Marcus Hook, to capitalize on the growing demand for energy products both domestically and internationally.
On top of increasing its butane storage capacity by 33%, it bought two pipelines. One leading from Mont Blevieu to its Nederland terminal and one from Mont Belvieu to the Ship Channel.
The pipeline to Nederland is expected to have a capacity of 70 thousand barrels per day.
Going forward, the company expects to generate EBITDA of at least $14.5 billion in 2024. It generated $13.1 billion in 2022 EBITDA, which shows tremendous progress in a short period of time.
Worldwide demand for crude oil and natural gas liquids and refined products continues to grow, and we will continue to position ourselves to meet this demand by strategically targeting optimization and expansion projects that enhance our existing asset base, generate attractive returns and meet this growing demand for our price services.
Moreover, with regard to the Biden Administration's decision to pause LNG export facility approvals, the company noted during its earnings call that it believes that studies will show that LNG exports are in the public's interest, which is why its Lake Charles LNG facility applies for a new LNG export authorization.
I agree with the company. Especially low natural gas prices make it easier for the Biden Administration to approve of higher exports.
On top of that, my political sources tell me this is likely a political stunt to pressure the State of Texas, as there have been some issues with regard to immigration.
In other words, I do not expect any major headwinds for ET. Not even minor headwinds.
So, what about the valuation?
Valuation
Analysts agree with the company's rosy outlook.
Using the data in the chart below, we see that operating cash flow ("OCF") is expected to rise by 13% in 2024, potentially followed by 2% growth in 2025.
While these numbers are subject to change, they are good news for the business and its distribution, which is already well-covered.
Furthermore, even after the stock price rally of the past few years, ET still trades at a blended P/OCF ratio of just 4.8x. Its long-term normalized valuation is 6.3x. Even that is low, as high-quality midstream companies tend to trade at 9-10x OCF.
However, as ET has a somewhat shaky past, including a distribution cut, investors have always given it a lower valuation than high-quality MLPs like Enterprise Products Partners (EPD).
Technically speaking, the stock has room to run to $22, based on a 6.3x OCF multiple and $3.51 in 2025E OCF.
That's roughly 50% above the current price. The average price target is $18.20.
As a result, I will give ET a Strong Buy rating, believing it is a fantastic undervalued business for a period where value stocks may become increasingly attractive - especially on a relative basis to growth.
Takeaway
In a market potentially shifting towards favoring deep-value stocks, Energy Transfer stands out as a compelling opportunity.
Despite recent gains, I believe it is still undervalued, offering a strong yield and potential for significant growth.
With a focus on fee-based operations and a resilient balance sheet, the company remains well-positioned to capitalize on increasing energy demand without being overly dependent on energy prices.
Meanwhile, strategic investments and a bullish outlook further enhance its appeal.
Pros & Cons
Pros:
- Strong Yield: With a current yield of 8.4%, ET is an attractive income tool.
- Resilience: Despite past challenges, ET has shown resilience and stability, improving its business since the pandemic.
- Growth Potential: A record-breaking performance in 2023 and strategic investments signal promising growth opportunities.
- Undervalued: Trading at a low P/OCF ratio (compared to peers), ET offers potential for significant upside.
Cons:
- Complex Tax Structure: As a Master Limited Partnership, ET's tax implications may be an issue (for non-U.S. investors).
- Dependency on Energy Prices: While fee-based operations offer stability, ET's performance is still influenced by fluctuations in energy prices, meaning very steep price declines could cause investors to sell.
- Regulatory Risks: Uncertainties surrounding regulatory approvals, such as LNG export facility authorizations, could impact future growth prospects.
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