Energy Transfer (ET 0.12%) offers a prodigious income stream. The master limited partnership (MLP) currently yields over 9%.
At first glance, that big-time payout might not seem sustainable. A quick peek at the energy midstream company's second-quarter results shows that its monster distribution significantly exceeded its reported net income.
However, a deeper look at the company's financial results tells a much different story. Here's why the MLP's big-time payout is much safer than it seems.
Drilling down into Energy Transfer's second-quarter results
Energy Transfer reported $1.2 million in net income during the second quarter. That was down 24% from the prior-year period. Here's a snapshot of Energy Transfer's income statement showing what drove the decline:
Image source: The Motley Fool.
As that graphic shows, lower revenue and some higher expenses weighed on Energy Transfer's earnings in the second quarter.
The final number was even worse. After stripping out net income attributable to non-controlling interests, its actual reported net income was even lower at $911 million, or $0.25 per unit. This result might initially have income-focused investors a bit unnerved, considering that the MLP's current quarterly distribution rate is $0.31 per unit. It suggests the company is paying out more than 100% of its net income. While that's technically true, there's much more to the story here.
Energy midstream companies like Energy Transfer are asset-heavy. They own large networks of pipelines, processing plants, export terminals, and storage complexes to support their operations. As assets age, companies depreciate their value, which reduces their current taxable net income.
However, depreciation is a non-cash expense. Because of that, the actual cash flows the company's vast asset base produces are much higher than its reported net income.
After adding back depreciation and subtracting maintenance and a few other expenses, Energy Transfer generated $1.6 billion of distributable cash flow during the second quarter. That's free cash flow the company could distribute to investors.
Energy Transfer only paid $975 million to investors in the period. That gave it a distribution coverage ratio of 1.6 times, enabling it to retain $579 million in excess cash after funding its distribution. It reinvested $387 million of this money into expansion projects while keeping the rest to strengthen its balance sheet. That allowed the MLP to maintain a leverage ratio toward the lower end of its 4.0 to 4.5 times target range.
With Energy Transfer generating more cash than it needs to fund its distribution and expansion projects, its high-yielding payout is on a very firm foundation.
The big-time payout is not only safe but also heading higher
Energy Transfer's ability to produce excess cash after paying distributions gives it lots of financial flexibility. It allows the company to continue expanding its asset base, which it did during the second quarter. In addition to investing $387 million across several organic expansion projects, Energy Transfer also spent $1.5 billion to acquire Lotus Midstream. That deal closed in early May and should be immediately accretive to its distributable and free cash flow.
The company plans to continue spending money to expand its asset base. It anticipates investing $2 billion to $3 billion into organic growth capital projects each year, including $2 billion in 2022. The MLP has several projects underway and more in the pipeline. For example, it's in discussions with customers to expand its Gulf Run Pipeline. It also recently secured several customers to support its proposed Lake Charles LNG export terminal. These investments would give it more fuel to grow cash flow in the future. Meanwhile, it can continue making acquisitions as opportunities arise.
The company's expectations that cash flow will grow over the long term support its plan to continue increasing its distribution. Energy Transfer recently raised its quarterly distribution by another $0.0025 per unit (its second such raise at that rate this year), a pace it plans to continue. That puts it on track to grow its already high-yielding payout by 3% to 5% per year.
This cash flow machine has plenty of fuel to support its payout
Pipeline companies are a bit more complicated to understand. Investors need to shift their attention from more familiar metrics like reported net income to the actual cash flow their assets produce.
In Energy Transfer's case, it generates plenty of cash to cover its monster distribution with room to spare. That gives it some excess money to reinvest into expanding its asset base, which should grow its cash flow in the future. These growing cash flows support the MLP's plan to continue increasing its already massive payout. That makes it a great option for income-seeking investors to consider.
