Energy Transfer Looks Cheap—But Is It a Value Trap or Income Opportunity?

TradingKey - Growing interest has recently been placed on Energy Transfer(ET), primarily due to its valuation as one of the best valued stocks in the midstream segment of energy. The valuation is determined by how low their earnings multiple is and what dividend yield they provide; with this information we can determine if the fact that they currently trade at below market prices for similar companies indicates an opportunity or a problem.

Why Does Energy Transfer Stick Out as an Energy Company?

In North America Energy Transfer has one of the largest pipeline networks for transporting natural gas, crude oil, and natural gas liquids. The company does not produce its own oil or gas, but instead collects fees from others for transporting their product; therefore, their revenue is based more on volumes of product handled than on prices for the products they handle.

Because of this fee based model, Energy Transfer has historically shown relatively stable cash flows and has not been heavily impacted by volatility in energy prices and will continue to show relative stability over the course of the current business cycle, yet their stock price continues to be less than most of their publicly traded peers.

High-Yield & Low Valuation - Basic Bullish Argument for ET Stock

A primary argument for an investment in ET stock is based upon the huge and continuing income profile of ET. The strength of its income profile, primarily the extremely high yield on common stock, makes it a valid alternative for income-seeking investors who want an alternative to bonds and low-yielding stocks.

What adds to the attractiveness of ET is the compressive valuation. Compared to the overall market, and more specifically, the energy sector, ET's price-to-earnings ratio is very low. The combination of a high dividend yield and low price-to-earnings ratio forms the foundation of the bullish argument for continuing to invest in ET.

From a cash flow perspective, Energy Transfer continues to generate large amounts of available cash from operations and will continue to have the ability to continue fulfilling its dividend requirements and fund its ongoing capital expenditures. This financial flexibility is of key importance to a capital-intensive business such as energy infrastructure.

The Importance of the Business Model to Ensure Stability Through Scale

The large asset portfolio of Energy Transfer provides it with an advantage over its competitors. The company's pipeline and storage infrastructure creates a solid competitive barrier that connects production areas and consumption areas.

The long-term, fee-based contracts that account for a large portion of Energy Transfer’s revenue allow it, to a great extent, to maintain consistency in its revenue. This stability results in less exposure to fluctuating prices of crude oil and natural gas over the short term.

For investors considering purchasing shares of Energy Transfer, stability is the biggest differentiator from other midstream energy companies. Midstream companies like Energy Transfer are a more defensive investment due to the unpredictability in the energy sector.

Growth Catalysts: Expansion and Energy Demand Trends

In addition to its current operations, Energy Transfer is continually investing in expansion projects to increase existing infrastructure to accommodate increasing demand for natural gas and natural gas liquids.

In addition to increasing capacity and meeting growing domestic demand for natural gas, Energy Transfer can also take advantage of the long-term trend towards U.S. energy exports, especially in the form of liquefied natural gas (LNG).

This means that ET is not only a source of income, but has some growth potential through global energy-related trends.

Debt, Complexity, and Market Sentiment as Areas of Risk

While Energy Transfer has numerous positive attributes, the company also has anxiety-inducing exposures.

First and foremost, Energy Transfer operates with a high amount of debt, which has historically raised investors' concerns about repayment capability. Although cash flows support payments of interest and principal to lenders, in times of restricted credit paths, the high level of debt would reduce liquidity and limit the operational options available to Energy Transfer.

Second, the complexity of Energy Transfer's business model and the way that capital was allocated into the various segments of the business have created doubts for a number of investors that may contribute to the subdued value of Energy Transfer's common stock.

Finally, long-term demand for fossil fuel related assets may decline as the global energy industry transitions to the use of renewable energy over time; however, this will be a multi-decade event, requiring a long time period to be fully realized.

Takeaways: Is Energy Transfer (ET) Stock Unreasonably Cheap or a Maybe Mispriced Opportunity?

There is an ongoing debate whether the market is appropriately pricing ET's risk or not.

Investors seeking an income investment will find Energy Transfer appealing because it has solid operating cash flow, produces a very high yield, and has relatively stable operations. Simultaneously, negative sentiment exists because of Energy Transfer's debt level and its history of execution issues.

Investors prepared to accept the perceived risks may view Energy Transfer as an incorrectly priced energy investment offering solid income. There are also many investors who prefer simple investment opportunities with strong balance sheets and therefore the perceived discount may reflect appropriate pricing.

As the market has increasingly become focused on growth narratives, ET stands out as being perceived as a traditional value and income investment, which will reward those with patience to hold through the associated risks.