Energy Transfer (ET) is one of the more problematic companies to analyze. The company is not only large, but also has many divisions that need to be analyzed.
Source: Seeking Alpha Website June 17, 2020.
The problem revolves around the current yield. This investment grade partnership (that issues a K-1) appears to have some challenges ahead in the eyes of Mr. Market. Clearly the units have rallied along with the industry recovery. But generally investment grade partnerships do not have this kind of yield without a reason.
Furthermore this partnership has gone nowhere since I first started on this article at the end of May. That puts the performance, even including the yield far behind the performance of many other partnerships in the same time period. That lagging does not bode well for future prospects unless it changes soon.
Part of this high yield is due to the fact that Energy Transfer is so complicated to analyze. A confused mind tends to say no. Mr. Market may be throwing in the towel on all the layers (subsidiaries) of companies with the various debt levels and preferred stock.
The consolidated statements do not make things easier either. The preferred stock does not show up on the Energy Transfer consolidated balance sheet as a separate item. Instead, that preferred stock is consolidated as part of the investment in that subsidiary. Investors are left to figure out for themselves how a leveraged subsidiary, possibly with preferred stock figures into the safety of the distribution that really is based upon money received by the parent company. Probably it is best to examine a couple of public subsidiaries to get an idea as to how Mr. Market came up with that opinion. Then investors can determine for themselves whether or not it is worth the time to examine the whole company one division at a time to determine how accurate Mr. Market might possibly be.
A Preliminary Glimpse
Interestingly, this management does attempt to provide some investor guidance into the situation.
Source: Energy Transfer First Quarter 2020, Earnings Press Release
Once management calculates the consolidated EBITDA, this management takes the extra step to calculate the cash flow that actually gets to the parent company so it is available to distribute. This company consolidates several subsidiaries (like USA Compression (USAC)) but does not have all that cash flow available as there are other non-controlling subsidiaries. Therefore there is an attempt made to actually demonstrate to investors the cash available to pay the dividend. Of course the selling point is that the distribution is well covered.
The problem is that the consolidated debt is $50.299 million and that debt has grown more than $200 million since the end of fiscal year 2019. In addition, Energy Transfer Operating (known as ETO) issued yet another $1.6 billion (approximately) of preferred stock. Preferred stock distribution are paid using after-tax dollars.
Furthermore, unlike interest payments, preferred stock distributions are not a deduction leading to cash flow from operating activities. Instead the preferred stock distributions are shown elsewhere (even though they are ahead of any common claims). For investors of any common units, preferred stock and their distributions are best considered similar to debt when calculating leverage ratios. In the case of Energy Transfer, that does raise the leverage ratios considerably. Energy Transfer literally has billions of preferred stock in various subsidiaries.
That preferred stock is a particularly expensive way to finance growth. In fact the preferred dividends could be offsetting anticipated earnings growth and therefore be the reason that distributions are not increasing. Should the lack of earnings and cash flow continue, it would indicate the need to upgrade capital projects.
There are some comments and actions to verify that capital projects need profitability upgrading. The biggest indicator was that the latest acquisition (SemGroup) was “priceless” or worth just about anything management wanted to bid due to the location. A second indication was when Shell (RDS.B) decided to exit the Lake Charles joint venture. That action by Shell (RDS.A) could be an indication that the profitability of the project is not what it should be. Shell has a higher financial strength rating that could indicate better financial controls on profitability.
Cracks In The Organization
Energy Transfer has businesses that are not really associated with a typical midstream business. At least a couple of these businesses are more volatile than the typical midstream business. A usual assumption would be that the diversification offsets the volatility of some businesses. The problem is that we are currently in a situation that is nothing close to normal.
Furthermore, some of these business has preferred stocks. The preferred stocks in effect separate the risk of the lenders from the risk of common unit holders by the amount of preferred stock. The debt may have an investment grade rating. But the outstanding preferred stock may still make this partnership too risky for some shareholders.
That preferred is superior to the common. While some of the challenges listed below will not affect debt payments, those challenges may affect cash flow enough to endanger distributions both to the parent company and too common unit holders.
One of the subsidiaries with more volatile earnings is USA Compression Partners (USAC). Management estimated their exposure to the oil fields was maybe in the 25% range of their business. This is far less than Archrock (AROC) and the far more speculative CSI Compressco (CCLP). However, 25% exposure to the oil and gas upstream is a big number for an income oriented vehicle.
All three companies reported that customers were returning purchases market for growth as the industry activity rapidly descended from the coronavirus demand destruction. Furthermore the company took a noncash goodwill impairment charge to reflect revised future reduced cash flow. Those revised, more conservative, cash flows may or may not be exceeded in the future. What is clear is that a source of future growth is probably not going to meet expectations at this time.
USA Compression partners not only has $1.9 billion of debt, but also has nearly $500 million of preferred stock ahead of any common unit holders. Net cash provided by operating activities was only $50 million in the first quarter. That is a far from satisfactory cash flow (no matter how you want to adjust it) to properly service the debt and preferred stock ahead of common unitholders. One can safely assume that the second quarter will be far worse.
Also it should be noted that common unit holders would generally subtract the preferred distributions (approximately $12 million per quarter) from the cash flow to arrive at the cash flow from operating activities for common unit holders. The current distribution to all unit holders is barely covered. The debt and preferred stock is really at unacceptable levels for common unit holders. Clearly this is some of the reason for the higher yield of the Energy Transfer distribution.
Sunoco LP (SUN) is another subsidiary where the public owns shares. This business also provides a glimpse into the Energy Transfer financial situation.
Sunoco LP reported an inventory loss related to the rapid decline of oil prices of $227 million. In all fairness that loss should be recovered as oil prices rally when business returns to normal. However that rally and the “return to normal” part remain highly uncertain.
What is certain is that net cash provided by operating activities was a mere $38 million for the first quarter. That exposes the weakness of the adjusted EBITDA and the distributable cash flow calculations. The loss taken was very real but the anticipated recovery of that loss has not yet happened. Therefore Mr. Market “gets antsy” waiting for that loss “to come back” in the current environment.
As the cash flow statement clearly demonstrates, there was no cash really available for that distribution when taking into account the debt to service and necessary capital needs. Furthermore, management cautioned Mr. Market by withdrawing guidance for the year. What should be a normal fluctuation has the potential to be anything but normal in the current atmosphere.
Demand dropped and who knows how long price could remain weak enough for that loss to take awhile to reverse?
Energy Transfer is an investment grade partnership that went into the coronavirus demand destruction with too much debt and preferred stock ahead of common unit holders. The result is some market worries about the distribution given the earnings volatility of some of the subsidiaries.
Energy Transfer does have some impressive diversification and the coming recovery from the coronavirus demand destruction rates to help this partnership post some improving results. Clearly though, cash flow is off to a less than impressive start (before adjustments).
However that preferred stock uses up considerable earnings cushion that should have been available to common unit holders. There is enough preferred stock outstanding in various subsidiaries that common unit holders could come to a very different conclusion for the common than investment grade. Those common units are last in line to collect money. The debt is first in line. So sometimes investment grade debt does not mean as much to common shareholders as one might at first want to believe.
Clearly though, management has work to do to improve the capital investment profitability and a reduction in the partnership leverage. It would also help Mr. Market immensely to either provide a whole lot more quarterly reporting by segment or to simplify the capital structure.
The current challenges could melt away with a fairly rapid and robust recovery from the current situation. Clearly Mr. Market has his doubts and those doubts revolve around the consolidated debt, preferred stock outstanding, and the ability of the whole organization to service that debt while maintaining the distribution. ETO has the most preferred stock outstanding and appears to also issue a fair amount of consolidated debt. Yet ETO is at least partially dependent upon receipts of cash from subsidiaries to service that debt.
Right now there appear to be “cracks” in the investment grade wall of ratios. It is management’s job to reassure the market that they got the message and will fix the leverage situation in the future as well as increase the profitability of capital projects. Until those actions satisfy the market, this time Mr. Market may have legitimate concerns.
I analyze oil and gas companies and related companies like Energy Transfer in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies — the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.
Disclosure: I am/we are long rds.b cclp aroc. 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.
Additional disclosure: Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.
Originally published on Seeking Alpha