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Reviewing Energy Transfer LP's Income Appeal

Founded initially in 2002, Energy Transfer LP (ET) was formed out of the $27 billion all-stock merger of MLP Energy Transfer Partners (ETP) and its sponsor Energy Transfer Equity (ETE) in October 2018.
Source: Energy Transfer Investor Presentation
Energy Transfer is one of the largest integrated midstream MLPs in America. The firm owns a sizable network of assets that gather, process, transport, and export oil, gas, and natural gas liquids (NGLs), as well as liquified natural gas (LNG).
Source: Energy Transfer Investor Presentation

The MLP's total assets include:

  • Over 80,000 miles of pipelines
  • 3 major oil terminals with 31 million barrels of storage capacity
  • 513,000 barrels per day of NGL production capacity
  • 7.6 billion cubic feet/day of gas processing capacity
  • 11.6 billion cubic feet/day of gas gathering capacity
  • 15 million tons per year of LNG export capacity

Energy Transfer's midstream network serves 90% of America's most important shale formations and reaches about 70% of all oil & gas rigs currently operating in the country. 

The new MLP continues to issue a K-1 tax form and pay distributions, a tax-deferred form of dividend

Business Analysis
Fundamentally, midstream MLPs are somewhat comparable to a utility in that they tend to operate as regulated, tollbooth-like businesses. 

Specifically, new pipelines are regulated at the state and local level. Due to their sometimes lengthy approval process (sometimes several years) and high cost (a new pipeline can cost billions of dollars), they generally don't get approved or initiated unless contracts covering most of their capacity are already in place.

Those contracts tend to be long-term (up to 25 years), fixed-rate, and often include volume commitments ("take or pay"). In other words, often customers (energy producers and end users like regulated utilities) will reserve capacity on the system, and the MLP will get paid the contracted revenue regardless of the actual volumes of product shipped.

In Energy Transfer's case, approximately 90% of the firm's cash flow is under long-term contracts, with 80% in the form of "take or pay" contracts.

As a result, most midstream MLPs have highly stable, recurring, and commodity and recession resistant distributable cash flow, or DCF. DCF is similar to free cash flow in the midstream industry and funds a firm's distributions. 

Theoretically, due to their tollbooth-like business model, midstream MLPs were supposed to be a great source of safe and growing income, in all manner of economic, energy industry, and interest rate environments. 

However, the industry has been mired in a multiyear bear market resulting from the crash in the price of oil (oil plunged 76% between mid 2014 and early 2016), which severely challenged the industry's previous business model.

Before the oil crash, MLPs would distribute the majority (90% to 100%) of DCF in the form of distributions, funding their growth needs with cheap debt and equity capital (selling shares, or what MLPs call units) rather than using internally generated cash flow (little to none was left after paying distributions due to the high payout ratios in the space). 

This worked fine in a low interest rate environment, which combined with $100 per barrel oil prices, created high demand for MLPs (resulting in low costs of equity, meaning it made sense to issue new units to fund growth projects). 

But unfortunately, MLPs like Energy Transfer Partners had a bad habit of growing their distributions too quickly to appease investors and maintained low distribution coverage ratios (DCF/distribution). 

When the oil crash spooked credit markets (fears of energy producers going bankrupt and breaking contracts) and stock prices plunged, many MLPs found themselves heavily leveraged and unable to profitably fund their growth projects.

This liquidity trap was further worsened by something called "incentive distribution rights" or IDRS. These incentivized the sponsor or general partner of an MLP (who manages the assets) to grow the payout as quickly as possible. 

That's because above a certain amount, 50% of all marginal cash flow gets paid to the general partner (rather than common unitholders) in the form of IDR fees. IDRs greatly increase an MLP's cost of capital and can make profitable growth in a bearish stock market even more challenging. 

Energy Transfer Partners found itself in this very situation back in early 2016. As a result, Energy Transfer Equity, which at the timed was the sponsor of three MLPs, merged Energy Transfer Partners with Sunoco Logistics Partners (SXL). 

Sunoco Logistics actually bought Energy Transfer Partners but retained the name. The merger was designed to increase the coverage ratio so that the new MLP could better fund future growth (and deleverage) with retained cash flow. Thus the distribution was reset (effectively cut) 24% lower to Sunoco Logistic's quarterly rate.

However, in 2017 the new Energy Transfer Partners once again ran into major problems. Delays on three of its key growth projects caused a major cash crunch that brought the coverage ratio down to 1.0 or below for several quarters. 

Management had to scramble to come up with the money to continue funding the firm's growth backlog, which ultimately resulted in a bevy of asset sales (totaling $3.8 billion) and selling $1.6 billion in units to Energy Transfer Equity (at a highly dilutive cost of equity).

In 2018, Energy Transfer Equity made it known that these MLPs would eventually be pursuing a simplification strategy in which Energy Transfer Partners' IDRs would be eliminated. Shortly after, credit rating agencies gave management the go-ahead (preserving the firm's investment grade credit rating was always the top priority), and Energy Transfer Equity acquired Energy Transfer Partners on October 18, 2018.

Even with the deal's 1.28 conversion factor (1.28 ETE units per each ETP unit owned), this acquisition effectively cut the income Energy Transfer Partners' investors received by more than 30%. However, the deal will hopefully prove to be a positive for long-term investors for three main reasons.
Source: Energy Transfer Merger Presentation
First, the merger eliminates Energy Transfer Partners' IDRs which greatly reduces the MLP's cost of capital. Going forward, future projects should be a lot more profitable and thus support stronger and more sustainable future payout growth.

Second and perhaps most importantly, the new Energy Transfer LP will be a self-funding MLP. Rather than fund organic growth via equity issuances, which depend on fickle stock prices, Energy Transfer will fund its backlog with retained DCF and modest amounts of low-cost debt.

Instead of paying out virtually all of its DCF as distributions, Energy Transfer's new coverage ratio of 1.6 to 1.9 will give the MLP about $2.75 billion a year in retained DCF (DCF minus distributions).

For context, in the MLP industry a coverage ratio of 1.1 is generally considered sustainable and capable of supporting long-term growth (under a non-self-funding business model). Self-funding MLPs tend to have coverage ratios between 1.2 and 2.0. Energy Transfer's 1.6 to 1.9 coverage ratio will be one of the highest in the industry, and thus make a future distribution cut much less likely.

Currently Energy Transfer has just over $5 billion in growth projects scheduled to come online by the end of 2020. And now that earlier delays have been resolved, the MLP's DCF is booming (up 40% in the second quarter of 2018). Effectively, Energy Transfer's retained cash flow is now large enough to fund 100% of its medium-term growth plans.

As a result, the firm's leverage (debt/Adjusted EBITDA) ratio is falling steadily. The new MLP's pro-forma (post-merger) leverage ratio is currently at 4.13 and expected to soon fall to a new long-term target of 4.0.
Source: Energy Transfer Investor Presentation
The entire MLP industry has been aggressively deleveraging since the oil crash when the average leverage ratio peaked at about 6.5. Energy Transfer's target of 4.0 would give it an above-average balance sheet that's expected to result in a credit rating upgrade in 2019 or 2020 (from BBB- to BBB). 

Industry blue-chips like Enbridge, Enterprise Products Partners, and Magellan Midstream Partners have BBB+ credit ratings. The higher the credit rating, the easier time an MLP will have in obtaining long-term, fixed-rate debt at low interest rates, even in a rising rate environment. This allows them to lock in better profitability on their future growth projects. 

Ultimately, Energy Transfer's self-funding business model makes it a much safer high-yield investment. The MLP can now fund its future growth 100% independently of its stock price, all while eventually lowering its leverage ratio to potentially even more conservative levels than currently planned (previous long-term leverage target was 4.25 and before that 4.5).

Over the long term, the MLP will also benefit from America's ongoing energy boom, which the U.S. Energy Information Administration, expects to last for decades.
Source: U.S. Energy Information Administration
Strong export demand from around the world (especially emerging markets) is expected to allow U.S. oil & gas producers to continue increasing production through 2030 for oil and at least 2050 for natural gas. 

If those forecasts prove accurate, then according to the Interstate Natural Gas Association, by 2035 close to $800 billion in new U.S. midstream infrastructure will be needed to support the large increase in energy production. 

As a result, Energy Transfer's backlog of profitable growth projects should remain well stocked. While a more conservative self-funding business model means the days of rapid growth are likely over, this business should have potential to continue increasing its DCF per unit at a mid-single-digit pace for the foreseeable future, which will allow the MLP to eventually return to healthy payout growth. 

Overall, the new Energy Transfer appears to be a significantly improved high-yield investment. One whose self-funding business model and stronger balance sheet means the risk of future payout cuts is now meaningfully reduced, and future distribution growth could potentially drive healthy long-term total returns. 

That being said, as the last four years have shown, even theoretically great income investments have risk factors investors need to keep in mind. 

Key Risks
There are three important issues current or potential Energy Transfer investors need to know. 

First, while the firm's new distribution coverage ratio of 1.75 (midrange guidance) means the current payout is likely lower risk, the distribution might not grow in the short-term. Management has wisely chosen to make a self-funding business model and deleveraging the top priorities. As a result, analysts don't expect Energy Transfer to raise its distribution until 2020 (when it should then start growing in line with DCF per unit).

Second, investors need to keep in mind that the track record of Energy Transfer's management team is spotty. Kelcy Warren (CEO, Chairman and 31% owner of the new MLP) remains in charge. He's the one who ultimately made the poor capital allocation decisions of the past that resulted in Energy Transfer Partners investors facing two distribution cuts. He's also known for trying to make large acquisitions, including the $48 billion buyout of Williams Companies (WMB), which resulted in a multiyear legal dispute before ultimately failing.

Fortunately, Mr. Warren's interests are now aligned with those of regular investors, so hopefully going forward management will continue its current conservative approach to safe debt levels and strong payout coverage. 

And since the CEO and founder owns nearly one third of the MLP (directly and indirectly via its general partner's class A units), income growth investors can likely be confident that Energy Transfer will start growing the distribution as early and as quickly as it safely can. Of course, that assumes that the MLP can execute well on its growth projects and avoid more major project delays or outright cancellations (as sometimes happens in this industry).

Finally, it's worth noting that the long-term thesis behind almost any midstream investment is that America's energy boom sustains itself over the decades ahead. Long-term forecasts can change on a whim due to the volatile nature of oil & gas prices. 

While midstream cash flows are relatively insensitive to commodity prices, the industry's long-term growth potential, and thus a key part of the investment thesis, is dependent on long-term energy prices. Should long-term demand and price forecasts come in below expectations (Will renewables supplant oil & gas? How quickly?), then the need for new midstream projects could dry up sooner than currently expected.

Fortunately, that appears to be a very unlikely development for at least the next decade or two. And once the growth phase of the industry ends, MLPs should be able to use more of their DCF to repurchase units and thus keep DCF per unit and distributions growing for a period of time. 

Closing Thoughts on Energy Transfer LP
The last few years haven't been kind to Energy Transfer Partners. The oil crash,  major liquidity challenge, and years of costly project delays all combined to force not one, but two distribution cut for Energy Transfer Partners' unitholders. The good news is that the worst is very likely over, thanks to the new Energy Transfer LP adopting a much more conservative self-funding business model. 

With lower costs of capital, a stronger balance sheet, and one of the industry's highest coverage ratios, the risks of another payout cut in the future are greatly reduced. Combined with the potentially long growth runway facing all midstream MLPs, this means that within a few years Energy Transfer LP should be able to start growing its distribution again at a healthy clip. 

That being said, there remain numerous risk factors to consider before investing in Energy Transfer LP, largely tied to management's past mistakes. While the firm's self-funded business model takes some risk off the table, more conservative investors might want to look at more proven blue-chip alternatives, whose management teams have demonstrated better track records of maintaining safe and growing distributions even during the industry's recent struggles.

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