Energy Transfer Still Looks Golden According To Graham

Thesis

This is an update to an earlier article on Energy Transfer (NYSE:ET). That article was posted on November 13, 2022. At that time, the company had just lifted its full-year earnings outlook and its stock prices were pushing toward a 52-week high. And I argued for a bull thesis based on its strong volume, the robust commodity pricing, and also its large valuation discount at that time. This update is motivated primarily by two changes since then: commodity prices and also its valuation changes. in the remainder of this article, I will explain why I remain bullish on the stock after considering these changes.

First, the commodity pricing environment has become less favorable since then than I anticipated. As a result, ET had a slower start to 2023. Coming off a lackluster fourth quarter in 2022, 2023 Q1 revenue fell 7%, year over year, to $19 billion. The primary contributors to this decline were lower natural gas and liquid natural gas prices. However, looking ahead, I see a good chance for oil and natural gas (“NG” prices to recover. Especially for natural gas prices, I expect the supply-demand imbalance to worsen this summer due to above-average cooling demand and production/storage limitations as detailed in a recent article. Furthermore, I also see good growth potential in the transportation, fractionation, storage, and terminal services segments which can make up a good part of the deficit should oil/NG pricing remains soft.

And second, its valuations still remain attractive despite the stock price changes since then. As seen from the chart below, the stock prices advanced by about 4% since my original thesis. While the company’s fundamentals improved substantially since then judging by its dividend payouts (which is a good measure of its economic earnings given its MLP structure). To wit, it now pays out a dividend of $0.3075 per unit now, vs. $0.265 per unit in the 4th quarter of 2022, an increase of 16%. As a result, its current dividend yield (~8.72% on a TTM basis) is substantially higher than that back in Nov 2022 (about 7.2%) as seen in the chart below. Of course, we should not talk about valuation in isolation. It has to be always considered in the context of other business fundamentals such as growth potential and financial strength.

And this is precisely what I will elaborate on next using the framework developed by Benjamin Graham.

Benjamin Graham’s Framework

The framework I will use here is taken from Benjamin Graham’s classic, The Intelligent Investor. The framework is detailed in my earlier article and briefly summarized below. The remainder of this article scrutinizes ET against each point.

1. Is the company large, prominent, and conservatively financed? The specific metrics to look for are stable financial strength, consistent capital structure, and a long record of continuous dividend payments.
2. Especially the dividend record. Graham emphasized countless times the importance of dividend records – for good reasons. In his own words, he thinks “a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating”.
3. Has the company demonstrated an adequate level of Earnings Growth in the past? For defensive investors, growth is not the key and “adequate” is enough. In Graham’s mind, a minimum increase of at least one-third in per-share earnings in the past ten years is adequate enough.
4. Finally, are the valuation multiples moderate? As a value investor to the core, he also recommended a series of methods for investors to gauge the price they should pay. And also, being fully aware of the uncertainties in his own method, he emphasized that you should always leave a safe margin of safety.

Is it large, prominent, and conservatively financed?

My answer is YES to all three parts of this question. I view ET as a leading energy company with a strong financial position. As the world’s largest exporter of natural gas liquids (NGLs), it accounts for approximately 20% of the global NGLs market. It also owns and operates an extensive network of energy assets, ranging from intrastate and interstate transportation pipelines, and storage facilities, to terminal assets.

In terms of financial strength, ET has maintained a healthy and stable financial position over the years. Its total debt has been relatively stable around an average of $48B in recent years (see the top panel of the chart below). And its current debt of about $47 billion is slightly below this average. However, its financial position is much stronger than average because its earnings have improved substantially in recent years. For example, its debt/EBITDA ratio currently stands at 3.795x, far below its historical average of 5.06x, and is at a multi-year bottom (see the mid panel). Its current interest coverage ratio hovers around 3.58x (see the bottom panel), also far above its historical average of 2.85x and near a 5-year peak level.

Does ET have a strong dividend and growth record?

As an MLP who pays out most of its earnings, my answers to both parts of the question are again a definitive YES. ET’s dividend payments have been a continuous stream of income to its shareholders for many decades. Even during the COVID pandemic, when many companies were forced to eliminate their dividends, ET maintained its payments (although with a large cut). Over a longer time horizon (say the past 10 years), ET’s dividend payouts have grown at a healthy pace of ~4.0% CAGR, meeting the minimum growth requirement posed by Graham.

ET’s earnings growth is even more impressive as seen in the bottom panel in the chart. Over the past 10 years, ET’s EPS has grown at a CAGR of 14%, far above the minimum growth rate required by Graham’s rule.

A moderate valuation

Finally, as mentioned in my earlier article:

As a value investor to the core, Graham recommended a series of methods for investors to gauge the price they should pay. Here we will examine two of them (the other methods he recommended essentially paint the same picture). First, he recommended the PE for a defensive stock should be around 8.5 plus twice the expected annual growth rate, which I call the Graham P/E. Hence, in his mind, a business that completely stagnates should be worth about 8.5x P/E.

And in ET’s case, consensus estimates project an EPS growth rate of ~1% CAGR in the next few years ($1.41 in 2023 to $1.47 in 2027).

First, I think the above projection is too pessimistic given the catalysts aforementioned. But even if ET’s earnings growth rate turns out to be only 1%, its Graham P/E would still be 10.5x as shown in my following analysis. This is significantly higher than its current market P/E of 9.06x (by about 14%).

Graham was very aware of the limitations of his valuation methods (or any other valuation method), so he developed other metrics to help investors assess the margin of safety. One such metric is the Graham Number, which is calculated by taking the square root of 22.5 times the company’s earnings per share and book value per share. The rationale of the Graham number is quoted below:

The long-term and macroscopic risks associated with ET have been detailed in my original article. These risks include regulatory risks, geopolitical tensions, et al. I don’t see any change in these risks since my last writing and I won’t further elaborate on them here. Here I will mention a specific uncertainty that has developed since my original thesis. The uncertainty involved the decision from the U.S. Department of Energy (“DOE”) to deny ET’s request to extend the export deadline of its Lake Charles LNG facility. The denial created uncertainties for the company’s resources that have already sunken into the project (estimated to be about $350M according to Citi analyst Spiro Dounis). It could also potentially lead to a lengthy legal battle.

Although I do not view the above uncertainty as a major factor in play. Furthermore, it is more of a longer-term uncertainty. In the near term, I see the positives far outweigh the negatives and hence remain bullish. To recap, the key considerations for my bullish thesis include recovery of oil and especially NG gas prices, strong financials due to improved earnings and below-average debt, and finally large valuation discounts as shown by various metrics (dividend yield, Graham P/E, and Graham number).