It’s no secret that inflation is raging at a rate not seen in decades. In fact, US inflation – which some business leaders like Elon Musk are claiming – is far worse than reported in the official CPI numbers – has hit a four-decade high at over 8.5% year-on-year:
With rising costs straining consumers’ wallets and driving up input costs for businesses, companies that benefit from the current economic climate are the exception rather than the rule. Finding companies that are currently undervalued, have healthy balance sheets and solid long-term business prospects is even harder. and are beneficiaries of rising inflation. However, we believe that we can do such a business in Energy Transfer (NYSE:ET).
In this article, we will present five reasons why we believe it is poised to continue outperforming in an environment of high inflation, and highlight some of the risks to this proposition.
Reason #1: Energy benefits from inflation
As the chart below clearly shows, the energy sector has proven over time to be the strongest inflation hedge there is, crushing gold and other precious metals, agriculture, industrials and other commodities by a considerable margin:
In the current environment, energy demand is increasing as the global economy reopens as COVID-19 headwinds ease, global energy supply chains are strained by increasing regulation and restrictions in the United States, and sanctions and other conflict-related disruptions are disrupting the flow of energy from Russia. As a result, energy prices are being pushed higher than normal in an inflationary environment with no end in sight.
This obviously bodes well for ET’s unit price as it has historically been shown to be highly correlated with energy prices. Since the beginning of 2007, ET has shown a very close correlation to the energy sector (VDE), especially compared to the S&P 500 (SPY).
More importantly, from a long-term perspective, rising energy prices are helping ET’s fundamentals as it strengthens its customers’ balance sheets — thereby improving the security of its contracts — and generally incentivizes higher production, which in turn drives demand for its midstream infrastructure elevated. Additionally, higher commodity prices give a nice boost to the optimization and marketing business and impact the ~10% of expected 2022 Adjusted EBITDA, which is commodity price sensitive.
In addition, the current environment for ET’s export-oriented assets is bullish as demand for US energy exports is also increasing with increased demand in Europe due to the supply disruption on the continent amid the war with Russia and ET recently signed numerous deals including one with South Korea.
Reason #2: Increasingly leaner business model
ET is also poised to weather inflationary headwinds better than some might expect, as the business model has become increasingly efficient thanks to management’s strong focus on operational efficiencies during the lean days of COVID-19. As management explained during the Q4 2020 earnings call:
As we discussed on previous phone calls in 2020, we have implemented cost reduction measures across all of our corporate offices and field offices. For full year 2020, we achieved over $500 million in G&A and OpEx savings. We expect about $300 million to $350 million of that to return in 2021.
Many of these savings continue today and are likely to be even greater due to inflationary pressures.
Additionally, ET’s capex budget has declined sharply in recent years as growth investments have been cut. This also makes ET less vulnerable to inflationary cost pressures:
Reason #3: Inflation-linked contracts
Another key reason why inflation should give ET a boost is that its pipeline contracts are linked to indices, which should provide a significant boost to cash flow in the coming months. During the third-quarter 2021 earnings conference call, management stated:
In most of our contracts, certainly in all of our liquid contracts around our transportation and fractionation and around our crude oil contracts, we have an index. It’s usually a FERC index… next July we expect a significant increase. We heard up to 5% or 6%, and we have these increases in the vast majority of our rig contracts as well as many if not most of our gas contracts. So we have, whether it’s the CPI index in our gas contract or the FERC index and our liquidity contracts, we have that in most of them, and we will benefit from inflationary cost growth, or at least not be harmed by it.
Reason #4: Strong Current Cash Flow and Payouts
One of the main reasons tech stocks have plummeted so much over the past year is rising inflationary pressures on companies that lack strong profitability and high dividend payouts. Because when calculating the present value of an investment, future cash flows are discounted to the present. When inflation rates and interest rates are higher, the discount rate used is generally higher. This means that cash flows that are expected to be good in the future are worth significantly less than cash flows that are expected in the short term.
In contrast, ET today is the epitome of strong cash flows along with strong payouts to shareholders. It has a Distributable Cash Flow Yield (ie “DCF”) of 19.2% at the current share price and a Forward Distribution Yield of 6.73%. Even more appetizing are management’s comments, which imply continued payout increases over the coming quarters until the payout hits an annualized rate of $1.22, which would represent a 10.5% yield on the current share price. As a result, ET’s intrinsic value — with its promise of massive cash flow today — is far more resilient to rising inflation and interest rates — than many other investment options on the market today.
Reason #5: A cheap valuation offers a margin of safety
Last, but not least, ET’s valuation remains undervalued relative to its history as well as relative to investment-grade peers.
Its current forward EV/EBITDA is 8.22x, which is well below its five-year average of 9.32x and also below that of peers such as MPLX (MPLX) (9.63x), Magellan Midstream Partners (MMP) (11.05x) and Enterprise Products is ahead of Partners (EPD) (9.74x) and Enbridge (ENB) (13.20x).
As a result, it enjoys a significant margin of safety against rising interest rates, which could lead to yield expansion and multiple compression in the stock market as a whole.
While the bull case for ET is very clear and compelling in our view, there are some risks to consider here.
First and foremost is the fact that ET has a poor track record of generating shareholder returns. Despite the fact that founder and chairman Kelcy Warren owns a large number of entities and regularly expands his position, the total return of common equity entities has lagged the midstream sector (AMLP) in recent years:
This underperformance is largely due to unfortunate acquisitions and growth projects that have generated a lot of negative publicity for the partnership while also eroding returns on invested capital.
Additionally, units experienced a massive 50% cut in quarterly payouts in 2020 as the balance sheet became over-leveraged due to high capital expenditures and insufficient returns on those expenditures.
Concerns that management may deviate from its current trajectory of aggressively paying down debt and expanding the payout linger, thanks in part to Mr. Warren’s 2021 comment:
i want to buy someone
in relation to a chemicals and plastics business. While such a transaction could be profitable for investors, ET’s track record here is not good and investors worry that this could be another setback to their hopes of finally seeing ET as a reliable, low-leverage, high-return investment.
Finally, concerns about the hydrocarbon energy industry and ET’s MLP structure continue to weigh on share prices. Between the cumbersome (for some) K1 tax form the partnership issues to shareholders at tax time each year, the growing reluctance to invest in hydrocarbons fueled by the meteoric rise of ESG investing in the United States, and general perceptions on Wall Street With hydrocarbon demand set to fall significantly as the world becomes more electrified, there is real capital flight out of the midstream MLP sector that has left multiples fairly low. ET in particular has been hit hard by the ESG movement, given its status as a political lightning rod, thanks to Mr. Warren’s close ties to prominent Republican politicians such as Donald Trump and Rick Perry, and ET’s numerous confrontations with environmentalists and Native American activists Groups became a lightning rod over its pipeline projects.
Far from being a risk-free investment, ET certainly has a checkered past. However, given the bullish environment for energy, its increasingly lean business model, inflation-linked contracts, robust cash flow generation and heavily discounted valuations, it appears poised to continue crushing the market in the current high-inflation environment.