Normally, I would pass.
An income yield that approaches 10% is more often a value trap. The yield trends higher because the investment price trends lower.
We see the dynamic at play with Energy Transfer LP (NYSE: LP), the Dallas-based pipeline and storage master limited partnership (MLP).
Energy Transfer’s distribution yield trends higher. It approaches 10%, even though the quarterly distribution has held firm at $0.305 per unit since February 2018.
That means one thing: a falling unit price.
Indeed, Energy Transfer units were trading near $17 a year ago. The price has trended lower since. The units trade near $12.50 today.
If I may be so bold as to elaborate, investor sentiment has deteriorated.
When an MLP’s yield trends higher with no concurrent distribution increases, a growing percentage of investors believe the distribution is at risk.
Few investments have their value tethered as tightly to income as MLPs. As the distribution goes, so goes the unit price. If you think the distribution is at risk, best to get while the getting is good. You can be sure the unit price will be cut when the distribution is.
Kelcy Warren, Energy Transfer’s chairman and CEO, rarely hesitates to expand the empire if the price is right. Warren has spent a lot of money over the year past four years expanding the empire.
Warren’s giddy-up growth strategy is observable in a top-line trend. Revenue has swelled to $55.1 billion over the trailing 12 months. Annual revenue was $36.1 billion only four years earlier.
But growth comes with a cost. Long-term debt at the energy MLP has swelled to a belt-stretching $47.3 billion at last measure. Energy Transfer has added $10 billion of long-term debt since 2015.
That’s an area of concern for many investors, but I’m not one of them.
Energy Transfer’s leverage ratio was above its 4.0-to-4.5 times EBITDA (earnings before interest, taxes, depreciation, and amortization) target range at the end of the second quarter. While that’s above the anticipated peer group average of 3.4 times, it’s hardly a vertigo-inducing high.
Nevertheless, many investors think Energy Transfer should call a timeout on growth and focus on reducing the dept. No surprise here, CEO Warren thinks otherwise.
Energy Transfer announced in September that it would get even bigger. The energy MLP will do so by acquiring SemGroup (NYSE: SEMG), a smaller pipeline and storage company, for $5 billion in cash and equity.
The $5 billion distills to roughly $17 per SemGroup share – a 65% premium to the share price before the deal was announced.
Price is what you pay, value is what you get. I’m unconcerned about the price because Energy Transfer will get value.
SemGroup strengthens Energy Transfer’s terminalling and export capabilities, particularly in the Gulf of Mexico. SemGroup’s Houston Fuel Oil Terminal brings 18.2 million barrels of crude oil storage capacity. Energy Transfer also gets more crude oil and natural gas liquids infrastructure.
SemGroup increases Energy Transfer’s portion of fee-based cash flows from fixed-fee contracts. SemGroup generates cash flow. That’s a big deal because cash flow matters.
Energy Transfer is on course to generate a Niagara River flow of cash. Management guided for between $10.6 billion and $10.8 billion of EBIDTA (a cash-flow measure) this year, 12.5% more in EBITDA compared with 2018.
Management is confident it will hit its bullish forecast. I am, too. Therefore, I see a secure high-yield payout and an enticing entry price for the energy MLP.
The distribution consumed less than half the partnership’s distributed cash through the first half of the year. By all account the scenario will unfold in the second half.
A coverage ratio above 1x is considered respectable. Energy Transfer’s coverage ratio exceeds 2x.
Normally, I’d pass when confronted with a falling unit price coupled with a rising yield.
Life is peppered with exceptions, and this is one of them.
The reward of capturing Energy Transfer’s historically high-yield (and sustainable) distribution is worth confronting and enduring the risk.
Normally, I would pass.