Energy Transfer's (ET 0.12%) priorities have shifted over the years. An elevated leverage ratio led the master limited partnership (MLP) to slash its distribution to retain more cash for debt reduction in 2020. However, as leverage improved, the company's priority shifted back to rebuilding its payout.
Despite all that work, its valuation remains dirt cheap. That's a big reason why its distribution currently yields more than 9% despite being on an extremely sound financial foundation. That has the MLP planning to put a greater priority on repurchasing its undervalued units in the future. This move could help push its unit value higher, fueling stronger total returns for investors.
Energy Transfer is drilling down into the value proposition
Energy Transfer generates very stable earnings because about 90% of its revenue comes from predictable fee-based sources. That also gives the company lots of visibility. It currently expects its adjusted EBITDA to be between $13.1 billion and $13.4 billion for 2023.
The company trades at a low multiple of its steady earnings. With an enterprise value (EV) of $98.5 billion, Energy Transfer trades at an EV/EBITDA multiple of less than 7.5. That's a lot cheaper than analysts believe it's worth. It's also well below the trading multiple of its large-scale peers in the pipeline industry:
Image source: Crestwood Equity Partners.
As that slide shows, analysts think Energy Transfer should trade at around $17 per unit. Meanwhile, its unit price would be about $24 if it fetched the median multiple of its peer group. That implies the MLP has significant upside potential as its valuation improves.
Meanwhile, these numbers don't include the accretive impact of the company's pending acquisition of Crestwood Equity. That deal will immediately increase its earnings and cash flow per unit. In addition, the MLP expects to capture additional cost savings and other value-enhancing synergies from the combination.
Shifting its capital allocation priorities
Energy Transfer made several changes to its capital allocation strategy in recent years in hopes of boosting its valuation. It shifted cash away from paying distributions to debt reduction and internally funding growth capital expenses to enhance its financial strength. However, as its leverage ratio fell toward its target range of 4.0-4.5, Energy Transfer started shifting more cash toward paying distributions.
It returned its payout to its pre-pandemic peak and set a target to increase it by 3% to 5% per year from that new baseline. Even with that much higher payout, Energy Transfer will still produce significant excess free cash. It intends to use that money to fund capital projects and continue to de-lever its balance sheet in the near term.
However, the company expects to shift its priority from debt reduction to unit repurchases once leverage is closer to the low end of its target range:
Image source: Energy Transfer.
This shift would free up $500 million to $1.5 billion in annual cash flow that the company can allocate toward unit repurchases. That's enough money to retire up to 3.5% of its outstanding units each year at its current market cap. That's a meaningful amount. At the high end, unit repurchases alone could enable the company to achieve the low end of its annual distribution growth target without actually increasing its total cash outlay.
Taking the next step to enhance value
Energy Transfer trades at a low valuation despite all its efforts to enhance its operations and financial profile over the past few years. Because of that, the company plans to start prioritizing unit repurchases once its leverage ratio is closer to the low end of its target range. Those repurchases could enable the company to retire a meaningful amount of its dirt-cheap units. That should help bolster its valuation, which, along with its big-time distribution, could give it the fuel to produce strong total returns in the coming years.
