Description

ET is a dramatically undervalued and underappreciated company that we believe is set to more than double over the following 12 months.  We believe the investment has substantial downside protection based on the stability of its cash flow and high distributable cash flow yield (25%).  As the largest owner of infrastructure that transports energy products throughout the country, ET falls into an (until recently) negative sentiment industry and asset class despite strong fundamentals and business model.  Whether we are in a low rates and TINA world or a high-inflation environment, Energy Transfer has continued to deliver growing and stable cash flows while compressing from a FCF yield of ~7% historically to~25% today.  We believe that as the spending on growth capital expenditures declines, and the market begins to appreciate the cash flow inherent in the company, that multiples will revert to nearer the historical norm.

Industry Overview

Master Limited Partnerships: beginning in the late 1990s, master limited partnerships (MLPs), a public investment structure similar to REITs, with no corporate level tax, were formed for the purpose of acquiring pipelines to transport and store natural gas, oil, natural gas liquids (NGLs) and refined products.  From the period of the late 1990s to late 2000s, the vast majority of growth came through acquisitions, as the US was in a secular decline of oil production, and relatively flat on natural gas and refined products.  The MLPs would acquire gathering, transport, storage, and fractionation capacity and provide customers - Exploration and Production (E&P) companies - with end-to-end services.  They would charge customers a fee for each element of the value chain from collecting the oil or gas at the wellhead, aggregating the hydrocarbons from a local field, processing in the case of natural gas to separate the methane from other NGLs (gathering and processing or G&P), transporting the products to either a refinery, fractionator or storage, and ultimately on to the end customer whether that be a gas station, chemical plant, utility customer or export facility.  For each step in this process the MLPs charge a fee.  The integration of all these steps provides tremendous value to the E&Ps and end customers, whose business is in finding or consuming the products and not in all the required logistics.  As a result of not taking risk around price of the commodity or success of drilling / production, and by taking long term take or pay contracts with credit counterparties, the MLP’s earnings streams were highly predictable and stable and allowed the companies to borrow large amounts of debt (3.5-5x) at attractive rates (3.5-5.5% fixed), as well as attractive equity (3-5% dividend yield with 1.1-1.3x coverage or 3.3-6.5% distributable cash flow (DCF) yield).  The combination of highly predictable, synergistic acquisitions with a network effect and economies of scale, with low-cost debt and equity, allowed well positioned MLPs to grow extremely quickly and profitably.  Energy Transfer has grown EBITDA from $190mm in 2004 to $12.6B today. 

As a result of highly attractive equity and debt financing afforded to these MLPs, the asset class naturally attracted attention.  Investors - in particular retail yield seeking investors - were attracted to the generous and growing yields with positive tax attributes (much of the income is tax deferred).  While companies saw the valuations and financing terms afforded to MLPs and decided to get into the mix.  One of my first private equity investments back in 2008 was the construction of a propane dehydrogenation (PDH) plant to convert propane into propylene.  We built the plant for $700mm, and by qualifying it as an MLP we took the company public at a $2.3B valuation.  By presenting the earnings as a yield, we were able to get a much higher valuation (while a 9% yield seems attractive, it is in fact simply a 11x EBITDA – Capex ratio applied to a single asset commodity chemical plant with volatile earnings).  There were also E&P companies that structured as MLPs while oil was $100+ per barrel.  As you might have guessed, not all these high multiple volatile levered companies worked out well for investors when oil prices collapsed in 2015/16.  This led to MLPs as an asset class massively disappointing investors as earnings collapsed and distributions were cut.  The highest quality companies were able to maintain and grow their earnings and distributions through both the 2008-2009 crisis, as oil fell from $147 to $32 and credit collapsed, and again in 2014-2016 as oil fell from $110 to $28. 

Company Overview

ET has the largest and most balanced collection of energy infrastructure assets in the United States.  It is connected to every major basin in the US and operates across all hydrocarbon types.  There is no other operator in the country that has either of these attributes.  ET’s portfolio is highly balanced, with 27% natural gas pipelines, 18% oil, 21% NGLs, 24% G&P, 10% other.  In oil, it has the Dakota Access Pipeline, which is the only pipeline accessing the Bakken basin, all other barrels are transported by truck or rail.  It also has a large presence in the Permian basin, the most economical field for oil production in the country.  It has the largest intrastate gas pipeline network in the state of Texas, a fact that proved valuable in 2021 as they generated $2.4B in excess profits in 2 weeks during winter storm Uri (at the time over 10% of the company’s market cap).  It has a nationwide network of natural gas, NGL and refined products pipelines, including in the northeast where it is extremely difficult to construct.  It is the largest exporter of NGL’s in the world with a 20% global share and growing.  It is in the process of greenlighting a brownfield liquified natural gas (LNG) facility – a conversion of gasification site a la Chenier.  ET’s major network connections were just completed in March of this year with the finalization of Mariner East in PA.  Now that the overall system is completed, ET can enjoy the easier job of infill, optimization, and accretive tuck-in acquisitions.  It hasn’t been simple to get to this point, no other company has done so, and it will inure to ET’s benefit for decades to come.

Earnings Trajectory

Ultimately the market is valuing ET as if its cash flows are going to be in rapid decline.  I believe ET is positioned to meaningfully grow its already-impressive cash flow yield.

The global demand for hydrocarbons continues to grow and is expected to do so for at least the next 10 years.  This is almost a universally shared forecast, with a range of expectation for peak oil varying between 2030-2045, while natural gas and NGL demand is expected to continue to grow far into the future. 

The US is well-positioned to continue to grow and at least maintain its share in the production of these hydrocarbons.  The US is endowed with the second largest natural gas reserves in the world, the largest oil field in the world (Permian), and is by far the leading producer of NGLs, and has the largest refinery capacity.  It is also a net consumer of oil, and therefore has a strategic interest in growing domestic production as to lessen dependence on foreign supply.  The US has some of the best combination of infrastructure, quality rock, and is not a war-torn country, political basket case, or nationalization risk.  Over the past 10 years, the US has been responsible for the majority of global growth in hydrocarbon supply, I believe it is likely it will at least keep pace with global growth if not continue to take a greater share.  The war in Ukraine has also reinforced the importance of energy supply security, and any risk of the Biden administration shutting pipelines for political expediency has evaporated.  ET is exposed to all these positive trends as the largest NGL exporter in the world with a comprehensive well-head to water portfolio of infrastructure.

2007     2021     CAGR   AVG    

DCF/unit          0.37      2.67      15%

Price                8.81      9.54

DCF Yield        4.1%    25.3%               7.3%

ET is the most unique combination of high-quality business and low valuation I am aware of in the market today.  This business traded for an average valuation of 15x EV/EBITDA and 7% distributable cash flow yield from 2007-2017.  Today it trades at 7.5x EV/EBITDA (only 2.5x of which is common equity) and 25% DCF yield.  This is a business that I believe could be trading at 2.5x its price today and not be overvalued given its defensive nature and ability to continue to grow cash flows.

Factors that drive ET’s undervaluation

1.     Management: One of the primary reasons ET trades at a substantial discount to its peers despite having perhaps the best asset base is the negative sentiment toward management, in particular its chairman Kelcy Warren.  Kelcy is a savvy and shrewd businessman - he built ET from nothing to over $12.5B in EBITDA and made himself a multibillionaire in the process.  Before the consolidation between ETP and ETE into ET, Kelcy did, to some extent, take advantage of the unitholders of ETP for the benefit of ETE (where his economic interests were).  Typically, this meant acquisitions that would substantially benefit ETE, but may be a neutral or slightly dilutive to ETP investors.  Then, in 2016 while trying to get out of an ill-timed and leveraging acquisitions of Williams Co., management executed a preferred unit offering that was only available to management and insiders that was a sweetheart deal.  This is clearly a negative, but over the 16 years as a public company, this was the sole instance of self-dealing that was a negative to unitholders and was done partially to try to get out of a transaction Kelcy felt was a mistake.  At this point investors of ET are on the same economic terms and structure as Kelcy.  Furthermore, he takes a total compensation of $6,200 per year, and no stock comp.   He also has bought more stock back personally over the last year (>$100mm) than almost any other executive we are aware of.  Despite all the vitriol toward Kelcy, in the end he has grown distributable cash flow per unit holders of ET by over 600% over the last 14 years, while at the same time paying out distributions in excess of the current unit price.  Regardless, in the last couple of years, Kelcy has stepped back from day-to-day operations and Co-CEOs Mackie McCrea and Tom Long have run the company responsibly, decreased leverage, executed an accretive acquisition and moved forward attractive projects with an eye toward attractive returns on equity.  I would expect as this continues the market’s “Kelcy discount” will subside and fundamentals will prevail.

2.     Leverage / Complexity: When entering the 2015/16 energy downturn, ET was the most levered and complex entity in the space.  It had a corporate structure that would confuse all but the most expert analysts and was levered more than 6x through the structure – not a fun place to be entering a $110->$28 oil price collapse and shutting of equity markets.  Fast forward, and ET is a single entity without any incentive distribution rights (IDR)s, completely aligned with management / ownership and leverage will likely come into target range of 4-4.5x as of either June 30 or Sep 30 quarter.

3.     Empire-building: A common refrain against ET is that the company and its chairman are empire builders who will hurt unitholders to acquire at all costs.  I think people are missing something here.  We have the single largest and most strategic set of infrastructure assets in the country, which was built all while increasing cash flow per unit from 37c in 2007 (the first full year as a public company) to $2.67 in 2021 and growing, during which time the partnership has distributed $12 per unit.  We would expect combination of paying out multiples of the original offering price ($5.25) plus growing cash flow per unit by over 7x during this period would be given some credit, but that’s not yet been reflected in the share price.  These things can change.

Where are numbers heading?

This is the most constructive environment of midstream earnings in a decade.  The boom in US oil and gas production brought with it a boom in midstream infrastructure building.  This involved laying out several billions of dollars per year in capex for ET and its peers, peaking in 2017 at $8.4B.  This essentially allowed ET to create a nationwide network of pipelines, processing and storage assets which is now largely complete.  Cash flow from operations has gone from $4.6B in 2017 to $9.5B currently.  Whether ET is a screaming buy or overvalued depends upon trajectory of its earnings and cash flow in the current, more-stable environment.  It takes a lot of capex to build a single complex of assets that connects every major US hydrocarbon basin with gathering, processing and storage capabilities across oil, gas, NGLs and refined products.  ET has completed this.  It also has export capabilities in both the gulf coast and northeast.  No other company has the breadth and scale of ET.  Its scale and scope of assets will allow ET to continue to acquire assets accretively and plug it into its system to realize both cost and revenue synergies. 

Supply / Demand

Not sure if you’ve been reading the news, but it’s hard to build pipelines these days.  Between the dramatically increased scrutiny of pipelines and concerns around long term demand trends, most operators have stopped greenlighting major infrastructure projects.  Meanwhile we’re in a world where demand for oil, gas, and NGLs continues to rise and the US is in the best position to increase supply of any country (UAE and Iraq are two of the only others that are underproducing their capabilities, most are in secular decline).  US oil production is currently at 12mm barrels per day, down from 13mm at the start of 2020.  This will need to rise, and is doing so, as the world re-opens and other countries are unable to increase supply.

Pricing

Saving the best for last (hopefully you’ve read this far).  Almost all pipeline contracts have inflators built in tied to PPI.  The pricing is set by FERC and based on the PPI from the prior year and takes effect July 1.  So the pricing regime that has been in place for ET and its peers for the last year was based on 2020 PPI (which was -0.1%) – a 0.2% adjustor, so essentially negative pricing.  Beginning this month, the pricing adjust will be +9.5% (9.7% PPI  - 0.2% adjustor).  This is the amount allowed by FERC for pipeline operators to offset increasing costs.  ET’s financials over the last 12 months have baked in these increasing costs but will only show the increased revenue / rate beginning in Q3.  Pricing for 2023 is also largely set as we have 6 months of PPI increases in the same high single digit range, so 2023-24 will see similar compounding of revenues.  Meanwhile, ET’s costs are mostly fixed as interest is the single largest item and are 90% fixed. 

We believe the street is meaningfully under-modeling 2023 profitability.  Q1 2022 annualized EBITDA is $13.2B, their volumes are increasing, prices are increasing, and projects are continuing to come online.  Guidance is given assuming lower commodity prices no price increases, and no benefit for Ukraine situation.  We think EBITDA for next year will be roughly 10% higher than consensus estimates, which is particularly relevant because ET’s market cap is only 2.5x EBITDA.  At the same multiple of EBITDA this implies a 33% increase in unit price, but perhaps more importantly, is that evidencing the ability to grow EBITDA without having to deploy meaningful capex could (and should) have a substantial positive effect on the multiple the market applies.

Valuation

So what happens to the multiple when people recognize that hydrocarbons are not going away and midstream for the medium-term functions as an inflation protected bond? 

Historically ET has traded at a 7% DCF yield, it is now trading at 25%.  We are entering a period of higher inflation which is positive for those with assets in the ground and long-term fixed price debt.  I believe ET will do over $14B of EBITDA in 2023, at its historical multiple of 15x that is $47 per unit.  At 9x, the low end of comps in the current depressed environment, that is $20 per unit.  I believe fair value is in the mid to high 20s, giving credit for the stable and growing cash flows and irreplicable asset base, offset by long term inevitable decline in hydrocarbon production.  For those who have an issue with not discounting the price more, since 2007 you could have made the exact same argument.  In fact, US production of oil was in structural decline from 1970 to 2010, and yet during that period, midstream companies like ET and EPD built fortunes by acquiring and synergizing assets accretively. 

When will the price move?

It has already moved somewhat: it’s doubled over the last 2 years, but really only barely in excess of its increase in CF/unit.  We believe over the next year we will see several factors come together to trigger a rerating of the space:

No more leverage concerns: Virtually all MLPs went into the 2016 downturn over-levered, with complicated structures (IDRs, multiple entities, etc.) and are just now entering target leverage range.

Increasing distributions: The majority of MLPs cut their distributions between 2016-2020 turning off many retail investors in the process - almost all are now increasing them from firm ground.  ET is currently paying $0.20 quarterly distributions and has been increasing at a rate of 2.5c per quarter with a stated intention of returning to an annual rate of $1.22, which at current rate would be achieved mid next year giving a distribution yield of 12% at the current unit price.

Ratings upgrade – ET will likely go from BBB- negative last year to BBB in the next 12 months as it enters target leverage

Buying back stock/units: All MLPs used to fund projects by issuing equity, now they are almost all buying back units (though not in record amounts as debt reduction and funding projects has been higher priority)

Headlines vs reality: ESG has been paramount in headlines, but we still need growing quantities of hydrocarbons to live the lifestyle we are accustomed to and there are billions of people living in poverty who want the lifestyle we have.  Covid allowed for a year-long fantasy world where we could talk about not needing oil and gas, we are now seeing the reality.  While E&P’s have benefited in price, MLPs have largely lagged.  MLPs may be the tortoise, but their earnings will predictably grow and when this is recognized their prices will respond.

Catalyst

Earnings beats and raises

Distribution increases

Credit upgrade

Unit buybacks

Realization of substantial pricing impact on earnings