Energy Transfer (NYSE:ET) pays a monster cash distribution. Given the big slide in its unit price, -- they're down more than 50% in the past year -- the master limited partnership currently yields an eye-popping 18.7%. Usually, when a payout's that high, it's because the market doesn't believe it's sustainable.
However, when it comes to Energy Transfer's payout, it's not so cut and dried. Here's a look at why it's not clear what the future holds for this massive payout.
Why the payout can survive
Energy Transfer's distribution was a key topic on its second-quarter conference call. CFO Thomas Long discussed the payout, noting that the company announced its latest one in July, which at $0.305 per unit, was consistent with what it paid the prior quarter. He further noted that the company generated $1.27 billion of cash during the second quarter, which was enough to cover that payout level by 1.54 times. The company ended up producing $448 million in excess cash.
While impressive considering the steep drop in energy prices and demand, it wasn't enough in light of two other factors. First, the company is on track to invest $3.4 billion on expansion projects this year, implying an $850 million quarterly run rate. While it's not uncommon for midstream companies to finance capital spending with a 50-50 blend of equity and debt, Energy Transfer's leverage ratio is well above its 4.0 to 4.5 times debt-to-EBITDA target. It's stretching itself thin by continuing to borrow.
On a more positive note, capital spending is on track to decline sharply over the next few years. Long noted on the call that "as we think about our future capital spend, we currently expect our 2021 growth capital expenditures to be approximately $1.3 billion, and we now expect growth capital for 2022 and 2023 to be in the range of $500 million to $700 million per year." He said the company "still expect[s] to be free cash flow positive in 2021 after growth capital and equity distributions." This comment suggests that the company intends to maintain its current payout since it can cover the distribution and future planned capital spending with room to spare, giving it some excess to repay debt.
What might cause a reduction
While Energy Transfer currently has no plans to reduce its payout, that doesn't mean it won't. Long made clear on the call that our "investment-grade [credit] rating is very important." The company must bring down its leverage ratio and align it with what rating agencies want, which is that 4.0 to 4.5 times debt-to-EBITDA range. Right now, "we're in and around that five number," according to Long. That level should begin declining in 2021 as market conditions improve, its current slate of expansions come online, and it starts generating free cash to pay down debt.
However, reducing capex to generate free cash is only one of the levers the company can pull to bring down leverage. Another, according to Long, is "distributions," which "are a topic when we discuss how to get the leverage down." If the company cut its payout, it could earmark that cash toward debt repayment, which would accelerate its deleveraging process. It's a lever the company would likely pull if it were about to lose its highly valued investment-grade credit rating.
However, cuts to spending and the payout are only two of the many levers the company could pull to reduce leverage. Another option is asset sales. For example, Long noted that "we've been pretty open about our investment in USA Compression (NYSE:USAC)." The company eventually plans to monetize that stake, though it doesn't want to harm the current value by forcing a sale. It could also consider selling other assets, though Long did comment on the call that "we don't have really a long other list of assets that we're working on" selling.
Another possible way to reduce leverage is through a merger. CEO Kelcy Warren stated on the call that the company would certainly consider M&A, but it "would need to be deleveraging." Unfortunately, "it is very difficult for us to even contemplate anything really because our units are trading so poorly," according to Warren. Though, if its valuation improves, and the right deal came along for an under levered peer, the company could use that type of transaction to help drive down its leverage ratio.
The payout's future seems uncertain
Energy Transfer clearly values its investment-grade credit rating above its current distribution level, and it would cut the payout if that were the key to keeping its rating intact. That leaves the payout's future up in the air, making Energy Transfer a less-than-ideal option for income investors these days since there's a risk that its big-time payout might not last.