Better Buy After Q3 Results: Energy Transfer Or Western Midstream? (NYSE:ET) (WES)

Both Energy Transfer (NYSE:ET) and Western Midstream Partners (NYSE:WES) are among the very cheapest high yield midstream businesses with investment grade credit ratings. ET is larger, better diversified, and has a higher distribution yield, whereas WES has a lower leverage ratio and a higher free cash flow yield.

In this article, we will compare them side by side after each business reported its Q3 results and offer our take on which one is a better buy right now.

Energy Transfer Vs. Western Midstream: Q3 Results

Both businesses reported solid Q3 results. WES’s report indicated solid underlying fundamentals that prompted management to reaffirm guidance, though management does now expect adjusted EBITDA, CapEx, and free cash flow to come in at the low end of its guidance range.

The company continued to advance its portfolio enhancement initiatives, increasing its Delaware Basin throughput across oil, gas, and water, acquiring Ranch Wester JV to be a source of capital-efficient growth moving forward, executed additional long-term contract amendments with Occidental (OXY) to further strengthen its cash flow stability, and sold its non-core stake in Cactus II for $265 million that it plans to recycle into accretive unit buybacks.

Given the Cactus II sale, the board increased the unit repurchase program to $1.25 billion, which remains a major capital allocation focus alongside debt reduction for WES moving forward. Overall, it was another steady as she goes quarter for WES as it remains focused on making incremental improvements to its underlying assets while retaining laser-focus on deleveraging and buying back units alongside a generous cash distribution. Our investment thesis remains firmly intact.

Meanwhile, ET also reported results that indicated a healthy underlying business as management not only reaffirmed but even raised its EBITDA guidance for the year. On top of that, it made solid continued progress towards deleveraging the balance sheet and still has over $2.3 billion in total available liquidity under its revolving credit facility. Moving forward, ET will remain laser-focused on reducing leverage even further in pursuit of an eventual credit rating upgrade, while also restoring the distribution to its pre-cut $1.22 annualized level as soon as possible and management gave a strong indication on the earnings call that CapEx is unlikely to surprise to the upside in 2023.

While the market may have not liked the fact that management did not give any indication of plans to grow the distribution beyond the $1.22 annualized level nor any specific plans to buy back units, we think it is good that ET is focused on fortifying its balance sheet right now while times are still good. When the cycle flips and the energy market declines again, ET will then be able to operate from a position of strength to buy back discounted units hand-over-fist if it so chooses.

Energy Transfer Vs. Western Midstream: Business Model

Energy Transfer is a leading midstream operator with access to all major U.S. supply basins via its interstate and storage business and therefore benefits from substantial economies of scale. By way of comparison, its enterprise value is $100.4 billion, roughly 5.8 times the size of WES’s enterprise value of $17.4 billion. On top of its size, it also owns a highly diversified asset portfolio, with natural gas, NGLs, crude, refined products, storage, fractionator, terminal, processing, and treating assets in its portfolio. Its diversification is further illustrated by the fact that it generates between 14% and 28% of its adjusted EBITDA from each of its five business segments, reflecting how it does not depend on any single commodity or business segment for revenue.

85-90% of its expected 2022 adjusted EBITDA is fee-based any between 10 and 12.5% of its expected 2022 adjusted EBITDA is commodity price sensitive, giving it considerable cash flow stability. Management has been working hard over the past few years to de-risk the business by reducing debt rapidly and bringing online its extensive growth project pipeline in order to bring down capital expenditures to a point where it is generating considerable free cash flow net of distributions.

WES, meanwhile, is more concentrated in its geographic reach and commodity focus, with its operations primarily servicing natural gas and natural gas liquids. It performs gathering, processing, and transportation services in the geographic regions of Texas, New Mexico, the Rocky Mountains, and North-central Pennsylvania.

That said, like ET, WES benefits from the fact that the vast majority of its EBITDA comes from fee-based contracts, giving it little commodity price exposure. In fact, over 80% of its natural gas throughput, 96% of its crude oil throughput, and 100% of its water cash flows are connected to these contracts. It has a lengthy contract maturity profile, further insulating it from commodity price and industry swings and its main counterparties are high quality energy companies in Warren Buffett-backed Occidental Petroleum (OXY) and investment grade ConocoPhillips (COP).

Overall, both of these businesses have high quality business models, but we are going to give the edge to ET given its superior size and scale which should give it more long-term growth investment opportunities as well as lower exposure risk.

Energy Transfer Vs. Western Midstream: Balance Sheet

ET wins this comparison as well given that WES is only recognized as investment grade by one of the two main credit rating agencies, whereas ET is recognized as investment grade by both Moody’s and S&P.

On top of that, ET recently indicated that it may receive a further credit rating upgrade in the not-too distant future by stating on its Q3 earnings call:

Pretty much all 3 agencies put out there that you get to that closer towards maybe the lower end of that range [of 4 to 4.5 times leverage], you’re now looking at upgrades and that is important to us. We really do want to continue to get into that 4, 4.5 and get into that next higher notch on the rating agencies. All the dialogue we had with them has been very constructive, by the way. We think that they hear us. We think we’ve got a lot of credibility with them. And we’re going to continue to have this dialogue with them.

That said, WES is also deleveraging pretty aggressively and expects to get its leverage ratio down to a very conservative 3.0x by year-end 2024. It expects that once it achieves that leverage ratio it will likely receive full recognition as an investment grade business by both major credit rating agencies. In the meantime, it has plenty of liquidity and continues to generate substantial free cash flow that it is using to pay down debt alongside generous unitholder capital returns in the form of distributions and buybacks.

Energy Transfer Vs. Western Midstream: Distribution Outlook

ET appears highly likely to pay out a $1.22 distribution per unit in 2023, whereas WES has already stated its intent to pay out a $2 per unit distribution in 2023 alongside a potentially enhanced distribution alongside buybacks and debt reduction. The exact level of this potential enhanced distribution will largely depend on capital expenditure opportunities, the attractiveness of paying down debt, and the market price of its units at the time. Overall, we favor ET’s distribution at the moment as its expected 2023 distribution yield is 9.9% in contrast to WES’s expected 2023 normal distribution yield of 7.4%. The ultimate distribution yield will likely wind up being meaningfully higher than that given the potential enhanced distribution, but for income investors, the more certain higher yield from ET gets the benefit of the doubt. That said, for total return minded investors, it is important to keep in mind that WES is investing aggressively in buying back its own units, so its total unitholder capital return yield is likely going to be higher than ET’s in the near term at least given that ET will likely have higher capital expenditure and debt paydown demands.

Energy Transfer Vs. Western Midstream: Valuation

Both businesses also look very attractively priced when compared to sector peers as well as their own histories. Here is a side-by-side comparison of them:

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Overall, ET appears to have the edge in terms of distribution yield, EV/EBITDA, and P/2023 DCF. However, it is worth keeping in mind that WES looks slightly cheaper compared to its historical average EV/EBITDA than ET is relative to its own historical average EV/EBITDA.

Investor Takeaway

We love both and own both of these midstream businesses at High Yield Investor. Overall, we favor ET given its slight edge in terms of its credit rating, asset portfolio diversification, superior organic growth potential, and higher regular forward distribution yield and slightly cheaper EV/EBITDA and P/DCF valuation multiples. That said, for those that like an aggressive approach to unit repurchases, WES stands out from the crowd in the midstream sector on that front, especially given how cheap its units are currently. For more information, you can read our recent exclusive interview with WES here and our full investment thesis here. You can also read our full ET investment thesis here and our recent exclusive interview with ET here. Note that both businesses issue K1 tax forms, so keep that in mind before purchasing the units of either one.