Energy Transfer (NYSE:ET) stands as a sturdy play for income-focused investors. It pairs an alluring dividend yield with resilient business operations. The stock’s current dividend yield mirrors its historical average, discounting the anomalies in 2016 and 2020 when significant dividend cuts dragged it down.
While there’s been chatter around ET’s dividend appeal, skeptics often highlight the 2020 annual dividend slash of approximately 40%. Additionally, they refer to ongoing lawsuits, which could potentially prompt a distribution adjustment if ET faces penalties.
The crux of this article is to dissect the key drivers behind the 2020 dividend cut and assess whether investors should brace for a repeat performance.
The 2020 Cut: Trimming the Excess
If one were to pinpoint the primary reason for ET’s decision to slash the annual distribution by around 40% in 2020, it would be its excessive leverage.
During a Q2, 2020 conference call, an analyst posed a pivotal question about ET’s strategy for deleveraging and its implications for dividend payments. Tom Long, Chief Financial Officer, alluded to the significance of preserving the investment-grade rating and hinted at the potential need to cut distributions to alleviate the leverage burden.
Before the decision to reduce cash distributions, the management had already sensed the looming possibility given the strain on the balance sheet. A look at the chart below provides a visual context.
In a span of approximately four years leading up to the 2020 cut, ET amassed substantial external leverage to fund M&A and organic growth endeavors that failed to yield returns. Before the dividend cut, ET’s debt to EBITDA ratio spiked to about 7.5x, characteristic of high yield and/or speculative-grade businesses.
Consequently, ET had to tap into distributable cash flows to bridge the gap between debt service costs and the incremental cash inflows associated with new investments. This move was also in line with ET’s efforts to attain investment-grade status, which would keep capital costs in check and render future investments more appealing.
Why This Time is Different: A Shift Toward Stability
The answer lies in a fortified balance sheet, a derisked business, and the commitment to maintain a balanced leverage profile.
For instance, since signaling a substantial distribution decrease, ET has utilized the retained funds to optimize its balance sheet. The financial debt to EBITDA ratio has shrunk by approximately 50%, while annual EBITDA has surged by over 30%, surpassing $3 billion compared to 2020 levels.
True, the prevailing interest rate environment has changed, with each dollar in debt incurring higher costs. While the debt has decreased, annual interest expenses have plateaued at around $2.3 billion.
The game-changer here is the underlying growth in EBITDA, which has expanded the base of distributable cash flows by about 28%. Moreover, ET has evolved into a more diversified and larger-scale business, increasing its asset pool by over $10 billion through a series of M&A maneuvers.
ET has explicitly committed to targeting a debt to EBITDA ratio in the 4-4.5x range before considering further M&A moves or share buybacks. Furthermore, recently, the company obtained an investment-grade credit rating, ensuring access to cheaper capital for new investments.
Potential Red Flags: Assessing the Horizon
While ET appears solid based on its financials, the possibility of additional dividends cuts cannot be dismissed. The company is entangled in numerous outstanding lawsuits, and the outcome of these legal battles could significantly impact its financial position.
