Energy Transfer (NYSE:ET) stock has all the makings of a classic battleground name. The hotly-debated pipeline operator has seen its stock plummet in recent years. However, it has managed to retain its high dividend. As a result, its shares are popular with income investors who are drawn to its mouth-watering current dividend yield of nearly 15%.
Despite the downturn of energy markets, Energy Transfer’s management has suggested that its current dividend is sustainable.
Others are less sure. The stock is down over 35% in 2020. And a major credit ratings agency just put the company on watch for a potential downgrade into junk territory. Here’s why Energy Transfer isn’t worth owning despite its current high dividend yield.
Diversification’s Drawbacks
Over the years, Energy Transfer has focused on transporting natural gas through Texas and surrounding states. That is, at its core, a good business, and one that tends to generate reliable, stable cash flows.
More recently, however, Energy Transfer has diversified away from that core business in search of additional growth opportunities. For example, last year, Energy Transfer shelled out $5 billion for Semgroup. Energy Transfer has gotten so large that it has to make huge deals to move the needle of its results at this point.
Unfortunately, it’s hard to allocate many billions of dollars a year — particularly when energy prices are sinking — without making mistakes.
I fear there may be some “diworsification” going on. Half of Energy Transfer’s cash flows now come from businesses other than its core natural gas operations. It’s involved in natural gas liquids — a market that is depressed for now and likely will continue to be — along with crude oil marketing and other ventures.
There’s quite a bit of complexity around its moving parts. That said, within its core natural gas transportation business, particularly in Texas, Energy Transfer can benefit from its large size and cost advantages.
However, in its hodgepodge of new businesses, it is unclear whether Energy Transfer has any decisive advantage. It competes with large, integrated oil and gas companies in these other areas, and it’s far from certain whether Energy Transfer is capable of besting its huge rivals in those areas.
The operations of ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX) are superior to that of Energy Transfer on a neutral field.
Energy Transfer’s Credit Risk
Listening to Energy Transfer’s management, you might get the idea that the company’s debt situation is under control and that its dividend is easily sustainable. And if everything goes according to plan, things may indeed work out for the firm. But there are reasons to be concerned about it.
Look at S&P’s analysis of the company, for example. S&P has given the company a credit rating of BBB-. That’s the lowest investment grade rating. One more downgrade would take Energy Transfer to junk status. That, in turn, could be a major problem for the firm. Earlier this month, S&P lowered its outlook to negative on Energy Transfer.
Having a lower credit rating makes it harder to roll over debt and raise money in other ways. It can also cause contractual problems for energy companies. They tend to sign long-term contracts for the transportation or delivery of fuels and the hedging of fuel prices.
Many banks and other firms will not do business with a company that has a junk rating. Or they’ll charge much higher fees and interest. By paying a huge dividend today while its balance sheet continues to erode, Energy Transfer is risking its long-term future.
The Dividend Is Sustainable… for Now
To be fair, since Energy Transfer has gotten walloped lately, it could bounce back faster than other pipeline stocks if oil prices continue to rebound. Purely as a trade, ET stock could work. The company has tons of debt — which lowers its attractiveness as an investment — but its high debt will enable it to rise further if market conditions become more favorable.
And, in the short-run at least, it can sustain its current dividend. Over time, its ability to pay its dividend will decline. That’s because its businesses that are not tied to natural gas don’t enjoy returns that are determined by regulators and are far more linked to commodity prices and variations in demand.
As the shale bust drags on, Energy Transfer’s cash flow and EBITDA could get whacked. But that problem won’t affect the company this year, and short-term investors who are looking for high dividend yields may just focus on whether the company can sustain its dividend in 2020.
Additionally, while the company has enough money to easily cover its dividend, its free cash flow has generally been negative in recent years.
Thus, Energy Transfer has to borrow additional funds to maintain and expand its investments and to pay its dividend. In theory, that’s fine because its investments will help the firm generate more cash flow in the future. But when economic growth and energy prices are falling, its investments may not be that fruitful.
At some point, it will become more challenging for the company to keep adding more debt onto its already massive pile of loans, particularly with its credit rating heading south.
The Verdict on ET Stock
Companies that consistently borrow more and more money while paying high dividends are often not successful in the longer term. While investors can make money by trading Energy Transfer in the short-term, I think longer-term investors should avoid it.
If Energy Transfer cut its dividend yield to 6% tomorrow and used the cash it saves to reduce its bloated debt, how interested would you be in owning the stock? At that point, would you rather own Energy Transfer or a much larger and more stable pipeline company? Or how about a huge, integrated oil company with a similar yield? Beware of owning ET stock just for its dividend yield because its share price will plunge if it ends up cutting its dividend.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he owned XOM stock.
