Attractive valuation, but with late cycle multiple compression risks. Midstream stocks offer low double digit total return (dividend + growth), which is attractive at this point in the cycle especially for a relatively low risk business. Relative EV/EBITDA multiples are slightly below the SPX and UTY, and P/E is now in line with the market. We saw a 10-20% compression of EBITDA and cash flow multiples in 2018. The risk is market multiple compression in 2019, which has an amplified effect on equity values for a levered sector.
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Q3 results were even better than we expected. None of our covered companies missed with a median EBITDA beat for the quarter of 5%. More importantly, the median DCF / share growth in Q3 was 18%!! This figure excludes companies involved in M&A and is more reflective of true growth in the business – see p. 2. While this pace of growth clearly won’t last forever, what other sector is paying a 7-8% yield and growing cash flow per share by almost 20%? The fundamental picture is very strong, balance sheets are improving, and equity needs have been dramatically reduced. EPD’s CEO Teague stated this is “the strongest business climate we have seen in recent memory.”
We are forecasting Q3 EBITDA growth of nearly 15% vs. last year, with median DCF per share rising by 15% YoY as well. Fundamentally, the sector continues to benefit from positive dynamics as production volumes accelerate across most key basins, new projects come into service, and wide locational price differentials highlight the need for new infrastructure investment. The Q3 fundamentals are similar to Q2 which saw strong results and the AMZ outperform the market by 8% over the course of earnings season. However, unlike Q2 we see consensus as largely there; we have a roughly even split of beats and misses vs. consensus. So it’s less clear to us if Q3 will again be a positive catalyst or more neutral near term. Ultimately, we believe that as the companies continue to show above-average growth, simplify, and get to sustainable leverage, investor support for the sector will increase.
On the Q2 call, D management said it plans to announce a decision on future plans for DM in the next few months. D reiterated that DM is still not at a level where it can be used as a dropdown vehicle and underscored that the condition of the MLP new issuance equity markets is not at the level needed for confidence in supporting years of dropdowns. Even with the better revised FERC tax policy for MLPs (especially ADIT), the recent rebound in the AMZ, and the IDR reset, which have all been constructive for DM, it remains highly likely in our view that DM will be rolled up by D. In fact, given the 9% yield and potential for a modest takeover premium, it could be an interesting way to get into D. Our PT remains $16 and we remain Peer Perform.
Last night (7/18/2018) FERC issued a final rulemaking on how to handle tax reform in regulated gas pipeline rates as well as a clarification of the policy statement that eliminated the tax allowance for MLPs. These stemmed from initial orders in mid-March. While FERC did not change the fundamental position that MLPs (in a vacuum) still can’t collect an income tax allowance it appears that under the final rule natural gas MLPs that are consolidated by a parent corporation can claim that they are taxpayers. Bottom line, this appears to be a significant change from the initial ruling in March for a number of pipeline MLPs that are consolidated by C-corps.
With U.S. production increasing fast, several big simplification announcements, and oil prices much improved, the fundamental tone was positive at MLPA. Turnout was reportedly higher than last year even with each of the large C-corps still sitting out of the event. That said, FERC and structure were clear overhangs. On FERC, we heard more questions than answers. Structure / simplification was discussed at nearly all our meetings and often overwhelmed the conversation. We think continued (and speedy) resolution around FERC / structural issues should help bring investor focus back to a strong fundamental set up, but there will be uncertainty in the meantime.
Last week we had the opportunity to meet with INGAA and the staff of FERC to review the latest on the changes on the pipeline regulatory policy front and the next steps to watch for. Overall we got a better understanding of the legal constraints FERC was under that led to the decision to change MLP tax policy to eliminate the tax allowance for cost based pipelines. We came away with the view that there is not much room to change the policy. In that context it is not a surprise that in front of the 501-G filings this fall that already many pipeline MLPs are moving toward corporate structures - SEP, EEP, WPZ, BWP, and TCP. Despite the MLP tax policy change being unwelcome, we still believe the acceleration of structural changes is a good thing for the sector.
The annual MLPA conference, newly renamed as the MLP and Energy Infrastructure Conference (MEIC), will be held May 22-24 in Florida. Many MLP management teams will be in attendance. This report is a helpful guide for investors attending and includes questions to ask for covered companies, as well as summary model information. Key industry topics are discussed below with company-specific topics in the body of the report.
Despite recent uncertainty from the FERC tax order, Dominion is not willing to give up on DM just yet. While D has taken Cove Point out of the drop plan, distribution growth will continue at 5% QoQ (as long as coverage remains >1x) with an IDR restructuring on the table if DM is in a position to issue equity again. D has clear incentives to make the vehicle work: 1) LT cost-of-capital advantage, 2) financing optionality, and 3) better earnings and dividend potential long term. While we don’t see any quick fixes here, at $15, the upside option if DM gets working again appears cheap.
After a tumultuous March, MLP markets turned over the past two weeks alongside a run in crude and widening spreads. The last time we saw $70 Brent (outside a few days in early Jan) was December 2014. That said the AMZ remains an underperformer vs. the XLE, oil, and the broader market YTD and valuations remain attractive - the AMZ is still due for a catch-up trade. We see another generally constructive earnings season - Q1 DCF / unit growth up 7.4% YoY on operational leverage, projects in-service, and a more normal winter. The FERC tax order remains an overhang, but recent comments by Commissioner Chatterjee and charged industry feedback signal that more clarity might be forthcoming.
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