After seeing monetary policy rapidly tighten during 2022 on the back of high inflation, thus far into 2023 it appears the main story of the year could be a banking crisis with several banks collapsing that unsurprisingly, sparked a widespread sell-off in recent weeks. Naturally, Energy Transfer (NYSE:ET) did not escape the selloff with their unit price coming under pressure as investors fret that another downturn is on the horizon. Whilst these uncertain times can be scary, oddly enough, I nevertheless see ways they could potentially benefit from a banking crisis in the medium to long term.
The Classic Energy Transfer Plan
Much like the old adage that Rome was not built in a day, the creation of this midstream giant was not a quick journey but rather, it took decades and massive growth investments. Whilst they have spent tens of billions of dollars across the last two via capital expenditure decades building their massive asset footprint, they have also consistently acquired other companies and partnerships within the energy sector, which have contributed to reaching their impressive size.
When looking at their history, they have collectively made fourteen large acquisitions since 2004 that have played a central role in becoming what they are today, which are in addition to their various smaller bolt-on acquisitions occasionally across the years. Earlier in 2023 even before the banking crisis started dominating news headlines, they were already open to continuing their classic plan of acquisitions, as per the commentary from management included below.
“When you really look at the capital projects that we’ve talked about here, I know we start off with this CapEx number of where we are, we’re going to continue to look at acquisitions. And so when you focus on that and you see where we kind of – what we did in 2022 with some of the smaller type acquisitions, the $1.6 billion to $1.8 billion does not include anything that might come along only on the consolidation front. So we’re going to allocate dollars to the continued growth of the company.”
– Energy Transfer Q4 2022 Conference Call
If the banking crisis continues amplifying, it would almost certainly further widespread market sell-offs that should create opportunities to find acquisitions at better prices than would have otherwise been the case. In effect, a downturn could ultimately help the partnership grow larger and thus, as a result, help create more distribution growth in the medium to long-term than otherwise would have been the case absent of the banking crisis. Since this would in turn enhance the appeal of their units and support a higher valuation, after the banking crisis passes it would create more upside potential for their unit price above simply recovering losses from the widespread sell-off.
Admittedly, acquisitions are not always viewed in a positive way by investors but personally, I think they are suitable for the midstream industry. Unlike most industries, their stable earnings enhance the ability of management to accurately assess whether an acquisition is desirable. Plus, the midstream industry is already mature with limited growth prospects given the long-term outlook for oil and gas demand from the clean energy transition and thus, growing via acquisitions reduces the risk of building capacity that is ultimately not utilized to the extent envisioned. Finally, it also reduces the regulatory risks surrounding building new projects, such as their North Dakota access pipeline that faced years of legal issues or the Mountain Valley Pipeline by Equitrans Midstream (ETRN) that had permits vacated right before completion back in early 2022.
The Backup Plan
Even if market valuations crash across the energy sector from a widespread sell-off, this does not automatically guarantee they can strike a deal since acceptance is ultimately dependent upon the organization being acquired. Alternatively, if they see liquidity dry up in capital markets that as subsequently discussed is another risk, they may not even be capable of accessing the necessary debt to fund an acquisition but thankfully, it could be said they still have a backup plan.
In the past, it was not common to see Master Limited Partnerships conducting unit buybacks but in recent years this changed and seemingly become common or at least, more frequently discussed as a potential plan. Whilst they have not announced any formal unit buyback program so far, they are still open to this plan in the future, as per the commentary from management included below.
“There’s not a whole lot of other guidance at this point that we’re going to provide at this time. But we’re going to continue to look at possible unit buybacks. So we put both of those in that same returning capital to the unitholders.”
– Energy Transfer Q4 2022 Conference Call (previously linked)
In my opinion, the lower their unit price goes, the far more likely it becomes to see management roll out a new unit buyback program to seize this opportunity. Since they generate ample excess free cash flow after distribution payments as subsequently discussed, these could even run in tandem with acquisitions, depending upon their size.
Unlike acquisitions that could incur additional risks pertaining to the new assets, unit buybacks that were funded from their free cash flow do not share this same downside risk. Furthermore, unlike acquisitions that often take a year or longer to create value for unitholders given the need to integrate the new assets and achieve synergies, unit buybacks have an instant impact. Generally speaking, I normally prefer distributions over unit buybacks but with the former now reinstated back to its quarterly rate of $0.305 per unit from before the cut in 2020, it enhances the appeal of unit buybacks because as of the time of writing, their unit price already offers a very high circa 10% yield.
In theory, their distribution yield could temporarily expand even higher if this banking crisis continues amplifying and therefore creates a sharper widespread sell-off across the market. Whilst painful in the short-term, it would actually expedite distribution growth in the medium to long-term via allowing management to reduce their outstanding unit count to a greater extent than would have otherwise been possible absent of the banking crisis. Similar to acquisitions, this would enhance the appeal of their units, which supports a higher valuation and therefore, it would also create more upside potential for their unit price once the banking crisis passes.
The extent of a potential benefit from unit buybacks depends upon the length of time and severity to which their unit price remains under pressure, which largely depends upon whether this was only a mini-banking crisis that is already over or the start of a major crisis to rival that of 2008-2009. Whilst only time will tell, the beauty of this plan is that a longer and more severe downturn would see more opportunity for unit buybacks and thus in turn, create more upside potential when operating conditions eventually recover.
Very Well Positioned
In light of their very high circa 10% distribution yield alongside talk of a possible recession driven by a banking crisis, naturally, some investors may worry about a distribution cut but thankfully, they are very well positioned to handle whatever might eventuate. Despite not completely being isolated from economic turmoil, as a midstream partnership I believe their financial performance sees a relatively smaller impact from a recession than most other players in the energy sector, such as oil and gas companies.
Even more importantly given the talk of a banking crisis, it should also be considered whether they are presently a net contributor in capital markets or worse in this situation, a net taker. In the case of the former, it entails their cash inflows outpacing their accompanying outflows and in the case of the latter, it is obvious the vice-a-versa of these two variables. Namely, this is largely determined by whether their operating cash flow exceeds or falls short of funding both their capital expenditure and distribution payments.
When a banking crisis strikes capital markets at the same time as tight monetary policy, it can see liquidity dry up and thus by extension, it creates significant risks to organizations that are net takers within capital markets since they require additional capital from external sources that are no longer as plentiful. Whilst I expect that central banks will continue doing everything within their power to backstop liquidity, in these uncertain times it is nevertheless preferable to have investments that do not rely upon this being successful, especially given the added complexities created by high inflation.
To the relief of unitholders, they are presently a net contributor to capital markets as they deleverage going forwards into 2023, unless they pursue a large acquisition or announce unit buybacks. Earlier in the year following the release of their guidance for the year ahead, my previous article estimated their distribution payments should only consume roughly half of their estimated free cash flow, give or take a little depending upon whether their results landed within their guidance range. Apart from giving rise to very strong distribution coverage of circa 200% and thus dramatically lowering risks of a cut given the large margin of safety, it also means they are a net contributor to capital markets. Not to mention, this also provides ample scope to fund unit buybacks of a similar magnitude as their distributions, thereby making for a potential unitholder yield of circa 20% when combined in my view.
Whilst fragile stability seemingly returned to markets following the takeover of Credit Suisse (CS), it remains to be seen if this banking crisis is over or merely taking an intermission. If it continues amplifying, will it feel positive in the short term for unitholders? No, I highly doubt it would feel that way as their unit price likely remains under pressure. Although in the medium to long-term? Yes, it is a different story because they are very well positioned to seize upon potential opportunities to grow larger at better prices than otherwise possible. In turn, this helps the patient investor by creating room to grow distributions higher than otherwise would have been the case and thus in turn, creating more upside potential for their unit price. Whether this potentially comes via acquisitions or unit buybacks or a mixture of both remains to be seen but either way, it is positive they have options.
Even if they pass on these plans, their distributions remain very safe as they are a net contributor to capital markets, and thus, if nothing else at least their unitholders can sit back and collect their very high circa 10% yield. As a result, I still believe that maintaining my strong buy rating is appropriate heading into what appears to be uncertain but nevertheless, interesting times.
Notes: Unless specified otherwise, all figures in this article were taken from Energy Transfer’s SEC filings, all calculated figures were performed by the author.