4 Reasons Why Energy Transfer Is My Top Pick Right Now

Summary

ET offers arguably the safest 10% yield of any common equityin the market today.

Growth continues to be solid and management can supercharge it via unit repurchases.

Leverage metrics are now solidly investment grade.

The asset base was upgraded with the recent acquisition and will only get stronger and more diverse as new projects come online.

Units are extremely cheap by every metric and should considerably outperform the broader equity market in the years to come.

Energy Transfer (ET) is my top pick right now thanks to its extremely attractive and safe distribution, which combines with strong growth momentum, a solidly investment grade balance sheet, a continuously strengthening asset base, and an astonishingly cheap valuation to offer investors a compelling total return and risk-reward proposition at current prices.

1. Increasingly Diversified Asset Portfolio

Energy Transfer - to borrow Moody's own language - owns an "extremely large and diversified midstream asset base, generating largely fee-based cash flows." While it may lack the impressive asset base of Enterprise Products Partners (EPD), it still generates pretty stable cash flows. Nearly 90% of the MLP's cash flow is under long-term, commodity-resistant contracts. This proved vital during past steep oil price declines where the company's cash flows continued to flow steadily. Furthermore, most of its contracts are volume-committed, helping to shield it from declining usage during a recession.

Furthermore, ET has very geographically and economically diverse assets, with locations across the country as well as considerable exposure across the energy value chain (included a fully-integrated platform spanning the entire midstream value chain). ET is one of only three operators servicing all 15 major US oil & gas producing regions of the country.

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Additionally, their integrated assets allow solid commercial synergies including gas, crude and NGLs and their interstate pipelines and Texas network are exceptionally well positioned in the most active basins, with high, stable returns and efficient-scale competitive advantages. In particular, the Texas intrastate pipeline system is impressive because it is the largest intrastate pipeline network in the U.S. and is capable of serving the entire state's gas demand all year. As the only game in town for Texans, ET has strong pricing power, combined with minimal incremental capital investment requirements to drive strong returns on invested capital. Given its immense scale and impressive network, this pipeline has significant barriers to entry that should protect its pricing power for years to come.

Moving forward, the company's acquisition of SEMG will further strengthen their portfolio in the crude oil transportation, terminalling, and export areas thanks in large part to SEMG's world-class Houston Ship Channel asset. Management also expects that ET will be able to leverage its operational expertise and existing assets to unlock considerable synergies with the SEMG asset base while also improving their fixed-fee cash flow exposure.

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ET may not be at EPD's level yet, but it is making considerable progress and already possesses a portfolio capable of generating quite stable and sustainable cash flows to drive strong investor returns through all economic and energy price cycles.

2. Investment Grade Balance Sheet

Thanks in large part to the MLP's strong asset base with heavy exposure to fixed-fee contracts and diversified exposure across crude oil, natural gas, NGL pipeline services and storage, and natural gas gatthering and processing operations, they are driving their current financial leverage to a modestly lower level while maintaining high levels of distribution coverage. This is a large part of what has driven their Moody's credit rating outlook to stable and could even lead to an upgrade in the future, depending on how they allocate excess cash flow moving forward.

The credit agencies gave them this stable outlook based on the simple fact that they would be able to drive their Debt to EBITDA slightly below 5x in 2019 and distribution coverage increasing to a 1.6x to 1.8x range. Well, management has already driven the leverage to nearly the 4.5x level and distribution coverage is at 2x through the first half of the year, with management guiding for long-term coverage in the 1.8x area. These are the exact leverage and distribution coverage levels that Moody's pointed to as requirements for a credit rating upgrade. As a result - especially considering the recent credit and distribution coverage neutral acquisition of SEMG alongside management's plans to further deleverage moving forward - it is quite likely that ET could see a credit rating upgrade in the not too distant future. This will further improve the company's cost of capital and should also serve as a catalyst to boost the common unit's price.

3. The Safest 10% Yield Today

As a contributing member and research analyst atHigh Yield Landlord, I have a strong preference for investments that pay out attractive distributions. This provides a more consistent means of return to investors that can help add stability to investment performance and also strengthen our resolve while waiting for an investment thesis to play out. Quite frankly, when an asset yields a tax deferred ~10% per year with a strong likelihood of growing that distribution in the years to come, the unit price performance does not matter too much to me as long as the distribution is sustainable and even growing.

This is probably the biggest factor that draws me so strongly to Energy Transfer right now as it is arguably the most attractive and safest high-yield stock available today, though of course not without risks stemming from its ambitious growth projects, large size, and potential for new political and/or regulatory challenges.

However, the 2x distribution coverage generated in the first half of this year, backed by quite stable cash flows (for context, 1.1x distribution coverage is considered sustainable in the MLP sector) provide an enormous margin of safety for the distribution. This is particularly true because leverage is now falling to levels that could prompt a credit upgrade, new projects are coming online, and management is openly discussing the prospect of starting a unit buyback program and/or raising the distribution. This implies that distribution coverage should remain very strong for the long term and management is considerable confidence in the performance outlook for the asset base and projects coming online.

Simply put, Energy Transfer combines the yield and distribution safety of many bonds and preferred shares with the solid mid-single digit per unit growth rate of common equity. As a result, the risk-reward proposition for investors - especially income focused investors - right now is incredible. Which leads me to my fourth reason for buying ET so aggressively right now ...

4. ET is CHEAP!

First and foremost, ET trades at an extremely attractive EV/2019 EBITDA, even beating out Kinder Morgan (KMI).

It is also important to note that these valuations were determined as of May 2019. Since then, KMI has remained roughly flat while ET has fallen an additional 20% despite posting extremely strong Q2 results.

The company's distribution yield is now at nearly 10%, which, at 2x coverage, makes its DCF yield nearly 20%. For a company that is only continuing to grow its DCF per unit and is considering accelerating that growth by buying back units at an extremely accretive valuation along with the prospect of a credit rating upgrade reducing interest expense, this is an incredibly attractive price, making the 10% distribution yield seem like a major understatement of ET's cash flow generation capability.

Investor Takeaway

ET is the cheapest of the large midstream MLPs available today. Combine its 10% distribution with its 2x coverage and its double punch of lucrative current income alongside aggressive growth should make every investor salivate. While its balance sheet is not the most conservative in the sector, it is still investment grade and improving. Furthermore, the company's self-funding model should prevent any sort of investor dilution while also giving the company flexibility to repurchase units if the market fails to rewards successful growth investments.

While its large network of assets is not as widely moated as peers such as EPD, Enbridge (ENB), or Magellan Midstream Partners (MMP), ET has transformed itself into one of the largest midstream energy companies with an enviable network of natural gas infrastructure. Furthermore, management is fully aligned, owning roughly a third of the company. Energy Transfer looks like a slam dunk for any income-oriented, long-term investors. Obviously, this stock has continued to disappoint investors for year and it may continue to take a while for the market to fully appreciate the underlying cash generating potential here, but the margin of safety is so enormous that it is only a matter of time before the returns start to roll in. In fact, all it takes is for the stock to tread water at its current price for investors to achieve outperforming returns. If anything, it would be great if the stock languished for many more years, making any unit buybacks and distribution reinvestments more accretive for current investors over the long run.

(TipRanks: Buy ET)

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Disclosure:

I am/we are long ET.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.