It has been a brutal year in the energy sector. Crude prices imploded -- including going negative at one point -- because of surging supplies amid cratering demand from the impact of the COVID-19 outbreak. That has put intense pressure on energy stocks.
Energy Transfer (NYSE:ET) is among those walloped by the downturn. It has lost about half its value this year, which has pushed its dividend yield up to an eye-popping 17.5%. That enticing payout probably has investors wondering whether now's the time to buy.
Here's the case for and against buying Energy Transfer right now.
The bull case for buying Energy Transfer
Energy Transfer currently expects to generate between $11 billion and $11.4 billion of adjusted EBITDA this year, roughly flat with last year's total at the mid-point. However, a lot has changed since it provided that outlook in late February. Commodity prices and demand have since plummeted, which will have some impact on the volumes flowing through Energy Transfer's systems and, therefore, the fees it collects.
However, since 85% to 90% of its earnings this year will come from fixed-fee sources, -- 63% of which has no volume impact -- it will have some cushion, and earnings and cash flow should hold up relatively well. Meanwhile, it has a well-covered distribution, since its payout ratio was only about 50% last year. While that would rise in 2020, given the likely decline in its cash flow, it still has lots of room to spare.
Finally, Energy Transfer has a much-improved balance sheet. Thanks to a combination of earnings growth and asset sales, its leverage ratio has been trending toward its targeted level of between 4.0 and 4.5 times debt-to-EBITDA. Meanwhile, it has no debt maturities to address this year and about $4 billion of total liquidity that provides additional financial flexibility. Those factors should help it weather this storm.
The bear case against buying Energy Transfer
While long-term contracts with volume protections secure a large portion of Energy Transfer's cash flow, those agreements don't help if the counterparties can't pay their bills. That's becoming an increasingly worrisome concern given the financial stress of oil and gas producers following the plunge in oil prices. One large driller already filed for bankruptcy protection, while several others have hired advisors to help restructure their debt. If conditions keep deteriorating, these companies might also seek to restructure their midstream contracts.
While most of Energy Transfer's customers have investment-grade credit, suggesting they should be able to keep paying their bills, it does have some exposure to financially weaker companies. About 19% of its customers have junk-rated credit, including five of the top 20, putting them at risk of being unable to meet their obligations to Energy Transfer.
The company also has a large number of expansion projects on the docket this year that it needs to finance. It initially expected to invest between $3.9 billion and $4.1 billion but has since suggested it could defer about $500 million. That's still probably more spending than the company can cover with free cash flow after paying its dividend, so it will need to borrow more money to cover the difference. That will put some pressure on its balance sheet, since leverage is already on track to rise given the likely decline in earnings. As a result, Energy Transfer may need to reduce its dividend so it can cover all its spending and keep the pressure off its financial profile.
Verdict: There's too much uncertainty to buy Energy Transfer right now
A lot has changed since Energy Transfer last updated the market on its operations and financial expectations. That makes it hard to gauge how much this downturn will affect its cash flow, customers, and ability to fund capital projects. The uncertainty makes it tough for investors to buy Energy Transfer in hopes of locking in a lucrative yield.
Some of the unknowns surrounding the company should fade next month, when Energy Transfer reports its first-quarter results. That's why it seems best to hold off on buying until after that update just in case the company reveals something unexpected.