Sell ​​Alert: Why I Recently Sold Energy Transfer (NYSE:ET) at an 8% Yield

I originally purchased Energy Transfer (NYSE:ET) into my core portfolio. Since then, it has delivered very attractive returns of over 200% and outperformed the broader midstream sector (AMLP) by almost 2%. to 1 and the S&P 500 (SPY) during this period by about 4 to 1:

However, I recently sold my position and made very attractive returns. In this article, I explain in detail why.

My original ET stock investment thesis

My thesis for investing in Energy Transfer was based on several factors. First, when I bought it, the company was already heavily sold off after management cut the distribution in half. Management had promised shareholders that the excess cash flow would be used to quickly pay down debt in order to secure the company’s creditworthiness. If the valuation was on a more solid footing, that would bring the distribution back to pre-cut levels. Given the sharp sell-off, the Energy Transfer units already offered a very attractive distribution yield that was now very well covered by cash flow, so I felt that even if management reneged on its promise to bring the distribution back to pre-cut levels, I would still get a very attractive income yield.

Meanwhile, the large amount of retained cash flow used to pay down debt would at least increase the equity portion of ET’s enterprise value, which should lead to significant share appreciation over the long term. In addition, the company also had an attractive growth outlook, which I thought would potentially lead to higher earnings. I optimistically hoped they could deliver on their promise, and once the balance sheet was on a more solid footing, an aggressive distribution increase program would likely lead to a significant increase in shares.

It turns out that Energy Transfer has performed even better than I expected on its program. Helped in part by the Uri winter storm a few years ago, which gave the company a huge windfall that it was able to use to accelerate its deleveraging program, Energy Transfer has been able to not only increase its distribution back to pre-cut levels, but even beyond, and has continued to target 3-5% annualized distribution growth. In addition, the company continues to invest in growth-enhancing projects that have the potential to drive further growth in the stock.

Why I sold ET shares

Nevertheless, I recently sold my ET shares for several reasons. First and foremost, the extremely strong outperformance of ET shares has now driven its valuation into a range that is no longer particularly attractive. For example, its enterprise value-to-EBITDA multiple of 7.75 is in line with its three-year average of 7.75. Meanwhile, interest rates have risen significantly over that period. While 7.75 is still a pretty decent EV/EBITDA multiple and likely reflects at least a slight discount to the private market value of the underlying assets, it is harder to make a case for significant upside in the share price because it is trading in line with the market valuation over the past three years despite significantly increased interest rates. In addition, its distribution yield of 8.43% is actually below its three-year average of 8.55% and roughly in line with its ten-year average of 8.4%. As a result, the market appears to be valuing Energy Transfer’s yield in line with its long-term average despite elevated interest rates.

While it is true that management has invested in growth, their track record of delivering attractive returns on capital is far from positive, having only delivered a return on capital of over 10% once in the last 10 years. Most of the time, they have delivered returns on capital in the mid-single digits. When compared to peers like Enterprise Products Partners (EPD), which have consistently delivered double-digit and in some cases high-double-digit returns on capital over the last 10 years, this does not reflect well on Energy Transfer’s ability to allocate capital in a way that is truly profitable for shareholders.

In addition, management has not announced any plans to repurchase common stock, which we believe would be a much better use of capital than investing in growth projects that have so far delivered returns at or below their weighted average cost of capital. Better still, with the high distribution coverage ratio expected to be above 1.9 times this year, it would continue to drive unit price higher.

However, we currently believe that ET shares will not appreciate in value more than their annual distribution growth and could potentially grow more slowly if the market prices in higher interest rates over the longer term, which does not appear to be the case for ET stock at the moment. With all of this in mind, we believe that ET is unlikely to deliver annual total returns of more than 10-12% going forward. While this is certainly a more than reasonable annual return and will likely outperform the broader S&P 500 over that time period, it is also not particularly compelling and the margin of safety has fallen significantly.

In addition, there is always the risk that if the energy sector experiences another sharp decline, the economy falls into a deep recession, or interest rates remain elevated for an extended period, Energy Transfer could undercut that number, potentially forcing Energy Transfer to invest less aggressively in growth and focus more on further deleveraging. At the same time, there are other companies in the industry that offer similar total return profiles, such as Enterprise Products Partners, which has a distribution yield about 100 basis points lower but better growth prospects going forward, a much lower leverage ratio, and better credit quality. In addition, there are several other opportunities that we believe offer higher risk-adjusted returns than Energy Transfer in the midstream space and beyond.

As I discussed in my article “Why I Don’t Buy and Hold High Yield Stocks,” companies like Energy Transfer tend to pay high yields because they don’t have enough high-yielding assets to invest that capital internally. This is especially the case with Energy Transfer because the company has a very poor long-term track record of generating sufficient returns on invested capital. As such, we believe that holding onto such a large portion of their capital is actually damaging to shareholders’ value, and we would be much more optimistic if they accelerated distributions.

Conclusion for investors

In summary, while Energy Transfer was one of my best investments ever, its thesis has largely held true as we see little further material upside in the share price. While the yield is quite attractive and safe, it no longer stands out in the midstream space as it once did. As a result, since I am very selective and only hold my absolute most compelling picks, I no longer view Energy Transfer as a particularly attractive opportunity. As such, I have sold my shares and invested them in other opportunities such as EPD and several other picks that offer similar or higher yields, similar or higher total return potential, and lower risk prospects.