Energy Transfer(NYSE: ET) has one very major positive to boast: Its distribution yield is a huge 8.1%. But don't get so enamored of the high yield that you overlook the rest of the story. In fact, while the fat yield is attractive, the master limited partnership (MLP) backing it has some very material negatives. Here's why you shouldn't buy Energy Transfer stock.
Energy Transfer: The good stuff
Although already noted, the big positive here is Energy Transfer's 8.1% distribution yield. Compare that to the scant 1.3% dividend yield you can collect from the S&P 500 index or the 3.1% on offer from Energy Select Sector SPDR ETF(NYSEMKT: XLE), which represents the energy sector of the S&P 500 index. Based on these comparisons, you can see why dividend investors would be interested in Energy Transfer.
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Now add in Energy Transfer's business. It operates a large portfolio of midstream energy infrastructure, like pipelines. These assets connect the upstream (drilling) to the downstream (chemicals and refining), helping to move oil and natural gas, and the products into which they get turned, around the world. Largely driven by fees, the midstream tends to produce fairly consistent cash flows that help support high yields.
If that were the end of the story, investors would be lining up to buy Energy Transfer -- but it isn't.
There's more risk here than meets the eye
Although the midstream is known for producing reliable cash flows, Energy Transfer ended up cutting its distribution in half in 2020. Peers like Enterprise Products Partners(NYSE: EPD) and Enbridge(NYSE: ENB) didn't do that and, instead, kept increasing their quarterly disbursements.
To be fair, 2020 was a difficult year for the energy sector as a whole. Oil prices fell dramatically as countries around the world effectively shut down in an attempt to slow the spread of the coronavirus. There is some logic behind Energy Transfer's decision to cut its distribution, as it allowed management to retain extra cash during an uncertain period. However, if you are looking for an income stream you can count on, well, that 2020 distribution cut should leave you with big questions.
This brings up yet another issue. In 2016, Energy Transfer agreed to buy Williams Companies(NYSE: WMB). Energy Transfer got cold feet because the energy market was weakening at the time. It attempted to and eventually succeeded in scuttling the deal because executing it as planned would have resulted in a huge debt load, a distribution cut, or both.
A part of that effort involved the sale of convertible securities, a large portion of which went to the then-CEO. It was a complex time period, and there were a lot of moving parts, but the convertible securities would have basically protected the CEO from a distribution cut if the deal went through as planned.
It would be completely reasonable for conservative income investors to see that and wonder if the board and management place themselves ahead of shareholders. And that concern will probably be enough to keep most investors on the sidelines here. After all, there are other midstream companies, like Enterprise and Enbridge, with much better track records and still quite attractive yields.
The risk-reward balance is skewed in the wrong direction
It is understandable that dividend investors would be lured in by Energy Transfer's huge yield. But yield alone is not a good reason to buy an investment. When you look a little deeper at Energy Transfer's track record, you see that when the chips were down in the energy sector, it cut its distribution.
Given the inherent volatility of the energy sector, it's hard to suggest that you can count on the income Energy Transfer provides. And if you go even further back, it isn't clear that unit holders can trust that the board and management have their best interests at heart. All in, there are probably better options in the midstream sector, even if you have to accept slightly lower yields.
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Reuben Gregg Brewer has positions in Enbridge. The Motley Fool has positions in and recommends Enbridge. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.
