Chesapeake Energy (OTCPK:CHKAQ) has become one of most famous energy industry bankruptcies, with its share price dropping from a split adjusted $12,500 in 2008 to less than $ 4 / share currently. Now, the company, with $7 billion in debt, has asked the U.S. bankruptcy court to cancel a $300 million contract with Energy Transfer (NYSE: ET).
Chesapeake Contract Cancellation
Let’s look into the specifics of what Chesapeake Energy is seeking to cancel. The company is planning to cancel a $300 million contract natural gas contract along with a number of contracts with other producers. The company has $54 billion in annual revenue, and we don’t know over what time period the contract is spread over, but it implies 0.6% of revenue.
However, there’s several unique facilities of this case.
The Federal Energy Regulatory Commission (FERC) in a filing this week argued that it should have equal say with the bankruptcy court over regulated pipeline contracts. FERC recently sought to have its voice included in contract disputes including with bankrupt utility PG&E Corp.
Specifically, the company is arguing that many of these contracts that the companies want to cancel are “unique”. The specifics of that haven’t been argued, but the debate is that FERC should at least receive some say in the bankruptcy process. The pessimistic assumption is that FERC can likely be “lobbied” to make the favorable decision here.
However, there remains some risk, pending court decisions, that these contracts can be cancelled. That represents some risk to Energy Transfer.
Energy Transfer Bankruptcy Risk
However, Energy Transfer has stable fee-based cash flow meaning it has minimum bankruptcy risk.
Energy Transfer has incredibly strong fee-based cash flow with 95% fee-based cash flow. The company has $10.35 billion in 2020 adjusted EBITDA and a number of drivers that will still support growth. However, off of the bat, should prices collapse, it means that the company has minimal risk off of the bat to its adjusted EBITDA.
However, fundamentally, the thing that investors need to pay close attention to is that the company’s customers have minimal risk. The majority of the company’s customers have an investment grade credit rating. Realistically, through customer bankruptcies and fee-based cash flow, we expect the company still has 90+% security in its cash flow.
More so, there’s 3 reasons why we think customers going bankrupt is low risk for Energy Transfer.
The first is that generally, even if the company succeeds in bankruptcy court, they can only get the part of the contract for unused capacity revoked for pipelines. With COVID-19 lock downs decreasing, and prices on the way to recovering, capital spending will soon recover. That means less “unused volumes” and less contract issues.
The second is the majority of the world’s and the United States largest oil producers are still well positioned. Most learned their lessons from the 2014 price collapse, and can handle a world where $40+ WTI (where we are currently) is the new normal. That decreases the chance of a substantial part of the company’s customers going bankrupt.
The third is that long-term forecasts continue to have volume going up, defining value to these assets. Reorganized post bankruptcy customers will be interested in restarting production with much lower debt as long as it’s viable. Energy continues to be essential to our lifestyle and therefore the business environment of Energy Transfer.
Energy Transfer Cash Flow Potential
At the same time, Energy Transfer’s overall cash flow has remained strong defining the potential for strong shareholder rewards.
Energy Transfer Cash Flow – Energy Transfer Investor Presentation
Energy Transfer has a 52% conversion ratio of from adjusted EBITDA to DCF. The company still forecasts average quarterly revenue of $2.6 billion quarterly for 2020. The company had a distribution coverage ratio of 1.54x and $448 million in post distributions DCF. Given a near 20% dividend that’s an incredibly significant yield.
The company’s 2020 growth capital estimate is roughly $850 million a quarter, however, the company has already spent most of that. Going into 2021, the company plans to cut that to $325 million / quarter. That leaves an extra roughly $200 million a quarter the company can put towards a variety of sources. At a near 20% dividend, we recommend buying back shares.
But either way there’s significant potential for the company’s share price.
Energy Transfer Investment Opportunity
Energy Transfer is a unique investment opportunity at this time. Even if one assumes no further growth the company will have $5.4 billion in annual DCF and $1.3 billion in 2021 capital spending. From 2022-2023 that number will become $600 million a year. Outside of that, the $17 billion company can do whatever it wants with the remaining $4.1-4.8 billion.
That promotes the potential for significant shareholder rewards. Even with a modest drop in income, the company would still be capable of more than double-digit shareholder rewards after a 50% drop in DCF. The company is priced as if its going to cut its dividend by 50%, but assuming it doesn’t, buying back shares would also be a great use of capital.
Either way, regardless of the argued risk by the bankruptcy court, the company’s overall potential is high.
Energy Transfer Risk
Energy Transfer’s risk is fairly obvious, but in our view very minimal. The march collapse in oil prices caused a dramatic decline in capital spending, that could hurt volume. Eventually, should volume decline, contract renewals will too, which would hurt Energy Transfer’s cash flow. While we feel this risk is fairly minimal, in the long run it could hurt Energy Transfer’s cash flow.
Energy Transfer recently made the news for Chesapeake Energy petitioning the bankruptcy court to leave a $300 million contract with Energy Transfer. However, as we analyze throughout this article, this is a minimum risk for the company. Even if the contract goes through, that’s already priced in for the company that its DCF drops minimally.
The company still has 95% fee-based FCF, and quality customers that will continue to support the majority of its cash flow. The company’s capital spending will decline significantly in the coming years leaving it with significant DCF to reward shareholders. Overall, we recommend investing in Energy Transfer at this time.
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Disclosure: I am/we are long ET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.