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This High-Yield Stock Comes With a High Risk

The lure of Energy Transfer's (NYSE: ET) high yield is difficult to ignore, especially when the stock has fallen to such attractive levels. Speculating on where Energy Transfer stock is headed is difficult. However, there are factors that contributed to its fall, and those concerns are far from resolved. In fact, worries have risen even more.

High leverage

Energy Transfer's debt levels have always been a concern of investors. The company's long-term debt rose from $43.4 billion at the end of 2018 to $51 billion at the end of 2019. For comparison, Enterprise Products Partners' (NYSE: EPD) debt roughly doubled in the last ten years, while that of Energy Transfer's rose more than four times over the same period. Similarly, Energy Transfer's debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization ratio) has historically been much higher than that of Enterprise Products Partners and many of its peer group.

ET Total Long Term Debt (Annual) data by YCharts

Energy Transfer's higher leverage highlights the company's aggressive growth strategy, which puts shareholders' interests at risk. It would probably have been better for Energy Transfer to use a part of its earnings to reduce debt, rather than to invest in projects with marginal returns just for the sake of growth.

With the challenging commodity price environment and bleak demand outlook for energy commodities, earnings of energy companies are surely going to be affected. Certainly, Energy Transfer's credit facilities require a minimum EBITDA for the debt that the company owes. If earnings go down, the ratio may fall below that required by the credit facilities, triggering restrictions, including on distribution payments. The MLP may be forced to slash its distributions, which may further hurt the stock. Moreover, a high leverage may negatively affect Energy Transfer's credit ratings, making it more expensive to raise funds.

On the positive side, the company has been growing its earnings steadily. The distributable cash flow for 2019 was roughly two times the distributions paid for the year.

Concerns relating to the MLP structure

Despite higher leverage, Energy Transfer managed to grow distributions at a higher rate than Enterprise Products over ten years. However, while Energy Transfer's distribution grew, the company had effective cuts at Sunoco Logistics Partners and Energy Transfer Partners -- formerly limited partnerships in the complex Energy Transfer group. This highlights the company's governance issues, which have long been another key concern of investors.

Image source: Getty Images.

It wouldn't be a surprise if the company makes another cut should it transition from a master limited partnership to a C corporation. A C-corp conversion may also have significant tax implications for unitholders, especially for the long-term holders with a low cost-basis. With the kind of interest that investors now have for MLPs, Energy Transfer stock may have a difficult time gaining back its losses while maintaining the MLP structure.

Overall, Energy Transfer stock's fall has made its yield attractive. However, if earnings fall, a high leverage may force the company to reduce distribution payments, further hurting the stock. Energy Transfer sure has an upside if commodity prices stabilize and demand doesn't get hit too much. All in all, it's a high risk, high reward stock at the moment. For conservative income investors looking for a stable dividend income, it's surely a risky bet.

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Rekha Khandelwal has no position in any of the stocks mentioned. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.


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