Even though the oil and gas sector has been running laps around the broader market in 2022, there are still loads of companies in the space selling for dirt-cheap valuations and sky-high yields. One company that stands out as looking incredibly cheap is Energy Transfer (ET 0.44%). The midstream oil and gas company currently sports a distribution yield of 8.1%.
Is this juicy payout too good to be true? Let's see if Energy Transfer's operations can support this kind of high-yield payout and whether you can trust it enough to be a buy.
The appeal
If you read through the company's investor presentations, valuation, and current distribution yield, you can see why many people would see the opportunity here. As a midstream operator of pipelines, processing facilities, storage terminals, and a liquefied natural gas (LNG) export terminal in the planning phase, it is in one part of the oil and gas industry where commodity prices don't matter as much. Management estimates that 85% to 90% of its annual revenue comes from fixed-price fee contracts for the use of its assets.
Furthermore, about 70% of its revenue comes from either natural gas or natural gas liquids (NGLs). For those concerned about the long-term viability of fossil fuels, this is encouraging because most energy outlooks project natural gas use lasting considerably longer than other fossil fuels. Also, natural gas liquids are primarily used in petrochemical manufacturing. Gas and NGLs are projected to become an even bigger portion of the pie as more than 90% of Energy Transfer's capital spending is on natural gas or NGL assets.
Energy Transfer has also posted some growth rates that would impress most investors. In 2022, it expects adjusted EBITDA to come in about 73% higher than the fiscal year 2017. There aren't a lot of oil and gas companies that can claim that kind of EBITDA growth over the past five years.
On top of it all, the company pays a distribution that yields 8.1% at the time of this writing. The amount of cash coming in the door is more than enough to pay this current dividend, and management says it plans to increase its payout with potential share buybacks in the future.
The concerns
For all the statistics that point to Energy Transfer being a decent investment today, there are a few things that just don't sit quite right here. Let's start with EBITDA growth. It sounds good at first, but Energy Transfer has had a reputation for investing to "empire build" rather than growing shareholder value. Over the past 10 years, it has had some of the lowest returns on invested capital among its peers.
ET Return on Invested Capital data by YCharts.
Growing quickly but at a lower rate or return means that it requires more capital than its peers to achieve that growth. So it's no surprise that Energy Transfer has historically had much more debt on its books than its peers.
That debt burden was so onerous that the company was forced to slash its payout to investors by 50% back in 2020. The company was at risk of losing its investment-grade credit rating. Needing cash to fund its capital spending plans, it slashed its payout to reduce its reliance on debt and equity to fund growth. This isn't the first time its payout has been cut, either. The company went through several restructurings and consolidations of subsidiary partnerships over the past decade that resulted in lower payouts for Energy Transfer shareholders.
Despite the recent payout cut and the smaller capital spending plan for 2022, investors may not be out of the woods yet. Management has yet to give the green light to build that prospective LNG export terminal mentioned above. If it does, though, it will likely cost tens of billions of dollars that will need to find funding somewhere. Also, management made a $485 million acquisition in August.
The verdict
Perhaps this current slate of capital spending and acquisitions will generate higher returns than its previous slate of projects. Considering management's track record, though, it's a bet against history. Unless we see significant improvement in its leverage metrics, then it would not be surprising if we see another distribution cut when that LNG export terminal gets the green light.
While Energy Transfer's underlying business and its high yield look appealing, there are other midstream companies with better balance sheets and similar valuations right now.
